Financing the Coming Bandwidth Glut

Williams Communications' planned IPO is the latest effort to finance massive high-speed networks. But is there demand for all the new lines?
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SAN FRANCISCO -- Williams Communications' planned $750 million initial public offering will further feed the appetite of investors hungry for a diet high in fiber-optic stocks. But Williams is moving at a time when some analysts are warning of a coming bandwidth glut.

Breaking out the telecommunications unit from the Tulsa, Okla.-based energy concern

Williams Cos.

(WMB) - Get Report

should provide the up-and-coming company with the more generous valuations afforded the new generation of telecoms to which it belongs. It will also help Williams Communications raise the substantial capital needed to complete its own fiber-optic network.

SBC Communications

(SBC)

has committed to invest up to $500 million in the company, in addition to the capital the IPO raises. Even so, that accounts for only a portion of the $4.7 billion the company will need to finish the construction of its 32,000-mile fiber-optic network, which it says will connect 125 cities in the U.S. by the end of 2000. The balance will come from its parent, bank borrowing and a note offering.

The stunning market success of the so-called "bandwidth barons" such as

Qwest Communications

(QWST)

and

Level 3 Communications

(LVLT)

has allowed them to finance multibillion-dollar construction projects of fiber-optic networks by turning to the capital markets. Qwest is up 310% since its 1997 IPO, while Level 3 is up nearly 250% since being spun off from its parent

Peter Kiewit & Sons

more than a year ago.

Earlier this month, Qwest announced plans to sell a 10% stake to

BellSouth

(BLS)

for $3.5 billion. That followed a March secondary offering from Level 3 that raised $1.5 billion for the company.

But as communications technology improves and these new networks light up, some analysts have started to talk about a growing bandwidth glut in the making. New technology called Dense Wavelength Division Multiplexing, or DWDM, is rapidly increasing the traffic that a single optical fiber can carry by allowing multiple transmissions to travel simultaneously along each strand. In addition, the new networks being constructed boast significantly greater capacity than existing networks of telecommunications giants, such as

AT&T

(T) - Get Report

,

MCI WorldCom

(WCOM)

and

Sprint

(FON)

.

While this is expected to be good for consumers, who will enjoy falling prices and greater competition from service providers, it may be less beneficial to investors betting that development of new applications will create the traffic needed to fill the pipes being built. Some analysts see the risk that a bandwidth glut will drive prices down as companies fight to fill their networks with traffic. This would put a squeeze on profits and make it difficult for some to recoup their investments.

"The key metric is that today, demand is tripling or quadrupling on an annual basis, while capacity is going up 100-fold. It's simple supply and demand," says Charles Rutstein, an analyst with

Forrester Research

. "We expect to see the glut as early as 2003. Prices will start falling. The $64,000 question is whether we will find additional applications that demand bandwidth. There are very few on the horizon right now."

That doesn't seem to trouble too many investors right now, who are confident with their if-you-build-it-they-will-come philosophies.

"The more demand there is, the more improvements there are in the technology. The more improvements in the technology, the lower the cost. And the lower the cost, the more demand there is. It becomes a cycle that feeds on itself," says Henry Woo, a telecommunications analyst with

NationsBanc Montgomery Securities

, which currently has buy ratings on Qwest,

Frontier

(FRO) - Get Report

and Williams Cos. "Internet demand is doubling every 100 days. There will be new needs for bandwidth that we never would have imagined. That is the phenomenon that these companies are recognizing and positioning themselves to capitalize on."

Eric Zimits, a communications analyst with

Hambrecht & Quist

, says if you take into account all the bandwidth that is being constructed or planned, you can calculate that every man, woman and child would have to spend hours a day sucking down Internet content to make use of it. "It can sound pretty ridiculous," he says.

Zimits says he believes demand will catch up to supply in the end, but profits at the network builders could be "erratic" until then. That's one of several reasons why these stocks are risky. "Bandwidth doesn't guarantee success," he says. "It will depend on their ability to operate a sound business, develop differentiated, high-value applications, flexible technologies, low-cost service and all the system and support to make their customers happy."

Given such risks, it's critical to pay less attention to technology and more to management and business strategy when investing in the sector, says Daniel McKelvy, managing partner of the private equity firm

Forte Capital Partners

in San Mateo, Calif.

That's where these companies will differentiate themselves. "Generally speaking, the technology they are all putting in the ground today is fairly comparable," says McKelvy, who holds a position in Qwest. "It's a question of gaining as many customers as you can. There's always a threat that they won't fill the pipe. That's where the sales and marketing come in."

Daniel S. Levine is a freelance writer covering business and Silicon Valley. He is editor of the Web magazine www.disgruntled.com.