Telecom’s continuing death spiral

OPINION: Telecommunications, the sixth largest industry in the United States has been in a death spiral for the past three years. More than a million jobs lost, nearly a trillion dollars in wealth gone. Since last summer, the telecom stocks have appreciated considerably, with investors betting on better times ahead for the telecom business in recent months, but this is just a pause before the industry continues its meltdown. Those who disagree, should look at the price war that has broken out in the VoIP space. Primus, Vonage, and everyone else is cutting prices, perhaps waiting for Verizon to make its move.

The first phase of the telecom meltdown began in the Fall of 2000 with the failure of wholesale bandwidth providers. Overcapacity and competition mostly because of indiscriminate funding and the stock market bubble led to price wars and the collapse of newer telecom operators. This was the first phase of the telecom meltdown that started in the Fall of 2000. The descendants of AT&T, the regional Bell operating companies and most wireless carriers escaped the carnage because they had a monopoly on the connections to and from our homes, that aging piece of copper wire called the “last mile connection.”

Over the past two years, a new alternative to this last mile connection has emerged. This is the cable television network. The cable networks had long been dismissed as a clunky patchwork of disparate networks, of not much value except for beaming channels selling baubles and trinkets. In past five years cable companies have spent billions of dollars upgrading their networks for two-way communications, and thus becoming a viable option to phone companies’ copper connections.

This new last mile connection comes with high-speed Internet, which makes it possible to make phone calls over the Internet, cheaply. This is a marked shift from the traditional way of making phone calls. For nearly a century, when a phone call was made, a virtual circuit was created between the caller and the recipient. Expensive switches and other gear that cost tens of millions of dollars helped create these virtual circuits. Technologists have figured out a way to send the same voice traffic over the open Internet.

Powerful computers running a specialized piece of software that can do precisely the same thing for a few thousand dollars have replaced the old multi-million dollar switches. (This has already devastated two major switch makers, Lucent Technologies and Nortel Networks, which have seen a sharp decline in revenues and have let go thousands of employees.)

With a few thousand dollars, any one can set up a phone company, and go into the business of offering phone service. This has created a situation not so different from the early days of commercial Internet, when mom-and-pop service providers sprouted up all over the United States. There are dozens of these voice service providers, who are offering unlimited phone calls for as little as $20 a month. With nearly 33 million high-speed connections in America, it certainly is a big enough market.

The telecom industry has thrived in the past because phone companies could charge a few pennies per minute for the local call. Theses flat rate unlimited phone call services are changing the rules of the game to a “fixed price” model. When such a shift happens in any industry, there is a major upheaval and often chaos.

For evidence just look at what happened to the brokerage industry, where high-priced brokers were replaced by flat-rate service providers such as E-Trade and Ameritrade. Established brokerage houses, such as Merrill Lynch and PaineWebber saw a sharp decline in their retail business. The telecom industry now faces the same quandary and is likely to go through an even more cataclysmic change.

The flat rate pricing model comes at an inopportune time. The regional phone companies are locked in mortal combat with the wireless and cable providers in this battle to sell voice services. More and more people are looking to forego their landline phone connections in favor of wireless phone connections. That is one of the main reasons why the local phone revenues fell 2.9% to $118 billion in 2003 following a 3.3% decrease in 2002.

The revenue declines will accelerate with an all-out subscriber war in 2004. Cable companies are basing their strategies on the assumption that they can increase their per-subscriber value by offering a diverse set of services to existing customers. In an effort to gain more customers, cable companies now have the technologies to sell unlimited phone service for as little as $9.95 a month and make a profit. This is going to force phone companies to match those prices. This could lead to a very intense and destructive battle for both sets of service providers.

All this costs money. In the past, any growth into new markets has been paid for by voice services. But that gravy train is now coming to an end as a price war looms. Everyone from phone companies like SBC Communications to wireless carriers such as Sprint, to long distance providers such as AT&T to cable operators like Cox Communications and a slew of wireless companies have been nibbling away at each other’s voice market share, mostly through indiscriminate price cutting.

What we are witnessing is commoditization of the only communications service that makes money: voice calls. As a result you have lots of large companies (and some small companies) with mostly unsustainable financial structure of the incumbents in a declining business, with massive and overwhelming fixed costs on their balance sheets. This is putting pressure on the ability of these companies to raise money from the debt markets, and is forcing them to cut costs mainly through continued lay-offs.

The next five years are going to be even more painful for the telecom industry, which will see its revenues shrink, and its suppliers vanish. This painful restructuring will eventually end with fewer and mostly likely with new players. Telecommunications adds up to a substantial portion of the US economy, and its continued troubles don’t bode too well for the future.