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Good morning, Mr. Chairman and
other distinguished members of the House Committee on Energy and Commerce.
Thank you for inviting me here to discuss “The Internet Freedom and Broadband
Deployment Act of 2001.” I am appearing today as an industry analyst whose
focus is on telecommunications, in general and telecommunications technology,
in particular. My views should not be
attributed to Bear Stearns & Co., my employer, as they have not taken an
institutional position on the legislation being introduced today.
My views on today’s topic are
shaped by my experience as a equity analyst, since 1994 to the present time, my
work experience at the American Enterprise Institute and specifically research
conducted while writing a recent Bear Stearns publication, Saving
Telecommunications: The Next Generation Access and Services Evolution. I believe that copies of this publication
have been sent to the Chairman and other distinguished members of the
Committee.
I would like to offer a financial
analyst’s perspective on the topic of today’s hearing. I will make my comments
as general as possible and in doing so will seek to address just a small number
of the many important issues the telecommunications industry is facing today.
However, before we get into those issues, I would like to make a few comments
on how integral I view the health of the telecommunications sector is to the
health of the US economy, US competitiveness, and to technology in general.
Over the past decade, a diverse
set of advanced and widely available telecommunications services have become
ubiquitous enough to become an integral part of our national fabric. They have
infiltrated our daily lives in ways that were not so long ago unimaginable. The
benefits are largely self-evident (through all income and age classes) and have
been a major contributor to what economists commonly refer to now as a period
of historic productivity gains. We do not believe it a stretch to say that the
process, for a time, made our telecommunications infrastructure one of our most
important and differentiating national assets. In fact, it has been the focal
point of what is arguably our most important asset: our technology-based human
capital.
As the telecommunications sector
advanced it also broadened its sphere of influence. Today, I believe these
advances have reached the point where it can be accurately said that
telecommunications is the center around which the greater technology sector
revolves around, the straw that stirs the drink, if you will. This relationship
is not only found here in the US. It is a global phenomenon. As such, all
citizens now have a stake in the ongoing development of our communications
infrastructure: those who use it, develop it and invest in it, which means more
of us than it used to. In essence, telecommunications has a global
constituency.
To date, the sector’s development
has largely been a race to the top, and the end result has been a more
efficient system for gathering, processing and disseminating information.
Better yet, it has not all been work related: the communications revolution has
changed the way we entertain ourselves, yet another example of its reach.
Unfortunately, we are only part of
the way there and it is clear that all is not well. Conditions in the sector
have rapidly deteriorated and an industry once thought to hold so much promise
now appears to have relatively little. The same can be said for many of its
participants, which just a short time ago were thought to have bright futures,
but now are considered to have little to none. These statements ring true for
both carriers and vendors and its effect is destabilizing for everyone. As an
analyst, it is clear that we have now entered into a period where bankruptcies
and layoffs are as much or more frequently part of the news than new product
and service initiatives. This will likely be followed by a period of
restructuring which will then give way to a new investment cycle. The latter
stages will be a healthy development but can only be done when the rules of the
game are set. Because that is a
prerequisite, it is imperative that these rules be set soon.
I. The Industry’s Three Challenges
Why are we here? We believe it is
the result of the sector having reached a number of important cross-roads at
roughly the same time, all of which participants are having trouble navigating
through. In essence, today’s difficulties are the result of the industry
collectively confronting three important challenges. The first is the move from
narrowband to broadband networking, the largest, riskiest and most expensive
undertaking the industry could ever attempt to accomplish and a necessary
precursor towards next generation services. The second is a microcosm of the
first, a move from core (or long-haul) network modernization to access
modernization, something that is well underway, but which has stalled due to
over-investment in the core and lack of follow-through from the access network
on which the core so desperately depends. The third and most important issue
represents a shift from an industry business model historically driven by voice
revenues and profits to one that will be more data and voice and data driven.
While all are obviously secular
issues, current economic conditions are making a bad situation worse. As such,
almost all stocks associated with communications and technology have either
been in a freefall or are sputtering around with little direction. This is what
happens when visibility into future revenue and profit growth is near zero.
Moreover, telecommunications is a capital intensive business and because few
service providers appear to be attracting capital, moving forward is
problematic. Yet the capital issue is not the problem, but a symptom of it. In
essence, the market no longer wants to own the arms suppliers nor those who
make use of their technology.
In such conditions, the sectors’
participants as well as those with a stake in things (basically, all of us) are
largely in search of a catalyst. Rate cuts do not seem to have helped and
neither has the prospect of a tax cut. In our belief, investors have made the
correct conclusion, for the industry’s problems are as much about regulation
and new service identification and how these issues affect the all-important
rate of return equation as they are about anything else. In other words, the
problems are secular and need, for starters, secular attention. Without it, the
communications malaise that has quickly turned into technology malaise will not
be a short-term problem. Thankfully, it does not have to be this way.
To put it simply, the
communications industry is rapidly coming to grips with the fact that its
workhorse (voice) is getting old. Voice revenue growth, wireless subscriber
growth, and many other voice metrics are indicative of slower growth. This is
not a good thing: voice services constitute well over 80% of industry revenues
and thus an even higher percentage of its profits. Moreover, voice services are
no longer thought to be price elastic (i.e. lower prices do not stimulate more
usage), voice has more, not less profitable substitutes than ever before (i.e.
short messaging and e-mail) and in the end, it primary method of pricing
(distance) is thought to be going away.
Early forays into the proposed
answer (advanced data services) have not been encouraging. Simple data
transport (Internet access) and flat rate pricing have instead proven to be a
lethal combination to the industry’s bottom line. The most popular data
service, dial-up Internet access, is something we prefer to categorize as
communications’ third rail, not its savior, yet it was the last great growth
driver for technology markets in general. While a form of data access, it is
preclusive to broadband services development because it is not fast enough to
deliver the kind of services that could provide an answer to the maturity of
voice revenues and the recent demise of most Internet mass market applications.
In fact, it is these services that will be required to pay for it in the first
place.
Think of it this way. The networks
that connect customers to the public switched telephone network (PSTN) and the
Internet itself were designed to support a product catalog consisting of voice
services. The same can be said for wireless. To extend this catalog, we thus
have to rebuild the network. We have done so in part, but the parts in which
this have been done are largely where it was easiest and least expensive. The
big build is ahead of us. As our friend
Tom Nolle of CIMI Corporation recently noted, “while there is no consensus on
what the future revenue engine of the market will be, there is general
agreement that whatever it is, it will require broadband customer connections.
Thus, the highest priority in networking is to modernize the access network to
support broadband.”
II. The Wrong Order
It does not help that, in running
in the direction of network modernization, we have gone about the task in the
wrong order. We started the modernization process in the core of the network
and are now only beginning to think about how it might happen at the edge
(access). Simply put, we have modernized our highways but not our local roads,
making it difficult to get on, go fast and go to the places we might want to
go. Access is the platform on which broadband services have to ride and today it
is the bottleneck. Without change here, we will not get much change anywhere.
There are a number of reasons for
this reverse order, although by now it is something more than just coincidence
that capital was largely directed to the part of the network deregulated first
(long-haul transport). Deregulation spurred investment, as it usually does, yet
the investment was made based on one fatal assumption: that access
modernization and ultimately the new services revolution would follow. When we
had the Bell System, that would have been a natural conclusion to make for we
would have regulated modernization in. Under the current framework, this has
not occurred and now the core has a problem. Why? Because access markets are
governed by a regulatory scheme that has served to dis-incentivize those who
own and control it.
The reason for this is simple. Our
networks are a network of networks and
the services equation means that whatever service is offered is done so at the
lowest common denominator of the network. Today, that is access usually at
dial-up modem speeds. Even the Internet itself is a best efforts network and
thus cannot generally deliver any kind of quality of service, yet another
necessity for the introduction of a variety of advanced services and in
particular, video. Without access modernization, the core is helpless to get
out of its current predicament (less spending will help), and core optics and
transport cannot recover. The idea here being that traffic is more easily
created from broadband customers than from dial-up customers. With it, things are only a little less bleak
in the core, for access modernization will be a time consuming process under
the best circumstances. Breaking up the RBOCs or what is sometimes called
“structural separation,” in our belief, would be worse, not better, at least
from a timing perspective. This would take a long time and would delay spending
and thus modernization and would also facilitate a delay in the restructuring
of the industry. At least from a technical and global competitiveness basis, we
need to take action that is more time sensitive.
End to end broadband networking is
a place that only the local exchange carriers (LECs), particularly the Regional
Bell Operating Companies (RBOCs), the cable television multiple systems
operators (MSOs) and wireless service providers can take us to. It is a place
that will require an extraordinary amount of investment made on riskier
presumptions than any of these service providers are used to. The first go
round was about voice, which was more or less a known commodity. Networks could
be ratcheted up to deal with the volume. It was more incremental anyway you
look at the services equation. Modernizing access is much more complex and
costly: we would estimate that modernizing our wireline access infrastructure
will likely cost over $200 billion from start to finish. Moreover, it will be
done without a firm grasp of what services will be demanded and at what price
they will be purchased.
III. Problems and Solutions
The question for the industry is
how to make that happen. If the past is any lesson, the answer is to
incentivize those that can initiate change. In particular, we need regulation
that will reward risk taking, e.g. one that gives those who do the risk-taking the
incentive to garner its rewards. The three groups mentioned above are the only
ones that can realistically be said to have such an opportunity and it is
important that a reasonable profit picture can develop.
Yet, today, two of the three major
access segments are required to share access to their networks (in different
ways), which means they currently have little incentive to spend because some
of the potential benefits will go to others. In essence, they know that their
own capital investment cannot be optimized when the benefits of investment
potentially will flow to competitors while the risks are solely theirs. And as
we noted earlier, we just have happened to reach a point in the industry’s
cycle where the investment to be made is a little bit more risky than
usual. This is mainly because we are
talking about designing a new network for services of a different type than
today’s network was designed for.
This is true for, as we noted, the
telecommunications industry is at a services cross-roads. Voice revenues will
continue to decline under technological and competitive pressure, destabilizing
the major service providers that rely on it as a source of cash flow. To offset
this loss, we need non-voice public services. Yet, as we have noted, such services
will require broadband access. All things narrowband have largely been
attempted. There is no way around this reality. Think of it as a pre-build.
The Telecom Act of 1996, by
accident or design, had the result of focusing new investment on the access
modernization task. Unfortunately, its rules set up a structure that never lent
itself to the kind of investment that consumer broadband empowerment embodies.
Think of it this way. The end user market can be segmented in three ways:
multi-site businesses, single-site businesses, and residential. The single site
market is usually thought to house either small businesses or mid-size
businesses. The multi-site market can be divided into principal sites and
satellite sites of large businesses. The multi-site market is where the focus
of competitive carriers has been and the former two are not, for a reason. Big
businesses are easier to target: they are a smaller in number, are located in
areas that tend to have a high concentration, and they tend to have the highest
willingness to pay. Conversely, the single site, small business and residential
markets do not have these metrics, yet are virtually linked together based on
where they are located and how they are serviced. In large part, it became a
game of one or the other and we know what happened.
In hindsight two things are
apparent. First, that the changing nature of voice and simple data transport
services in a competitive market ended up yielding a much lower return on
capital than initially expected. Second, because of this, massive economies of
scale became paramount. As this was borne out and some would argue was present
since inception, participants were forced to focus on low-risk builds, which
equated to a replication of the services and networks already in place geared
towards those who would pay the most: large businesses. The mantra was: it’s
better to offer services that are known quantities than to offer something new
and untried. The result: we now have an overabundance of capacity in many areas
of the network, with the exception of access, particularly for small to medium
size businesses and residences.
More technically, what is needed
are new rules and we are supportive of those proposed. With them the winners
will be two-fold. End users would be the recipients of the benefits that come
from advanced services offered through a modernized network. Industry
shareholders would benefit through a revitalized technology market that depends
on a revitalized communications network platform and broadband networks. The idea here: jumpstarting broadband access
will jumpstart technology, from PCs to software to servers to storage. Finally,
the US economy would benefit for we would have a network that is the competitive
equal to one that will be built abroad that in many cases, can be done more
efficiently based on better consumer densities and more facilitative
topologies.
We can get our telecommunications
and our technology markets back if we take the right action on a timely basis.
The alternative is a long-running period of technology malaise. This is a
result that neither the global telecommunications consumer, those employed by
the technology sector and of course,
those who have a stake in technological advancement want to see.
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