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Good afternoon Mr. Chairman and distinguished members of the Subcommittee.
Thank you for inviting me to appear before you to discuss the state of the
communications market. I am truly honored to be here.
As a financial analyst my primary role is to make stock recommendations for
Merrill Lynch's investor clients. As such my perspective on the telecom industry
reflects a mix of considerations: the broader industry structure and growth
outlook, the way factors such as technology change and regulation impact the way
individual companies participate in the growth of the broader industry, the
capabilities and strategies of individual companies and ultimately the way all
that plays into the outlook for their stock prices.
Observed through the lens of the stock market the US telecom services industry
would appear to be in pretty bad shape. Many companies, large and small, have
seen collapses in market value since the March 2000 peak. In addition there have
been many high profile bankruptcies, some with alleged fraud. Measured in terms
of the S&P integrated telecom index stock prices have declined in each of
the last four years. That makes for a 63.6% decline from January 2000 to January
2004. Over the same period the broader S&P 500 index fell by only 24.3%.
As with the larger market "bubble' much time and effort has been invested
in trying to identify the causes of "the problem" of which this
collapse is deemed to be a manifestation. Also of course many look to identify a
"solution". Was the 1996 Telecom Act flawed? Have there been major
management failings? What about the role of the FCC? By way of example the
Columbia University Business School Center for Tele-Information recently
conducted a major research study on "Remedies for Telecom Recovery."
However, all this deliberation presupposes there is a "problem" in the
first place.
Before going any further I think it makes sense to review how the market
actually looks today:
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As reported by the FCC in its last local competition survey the US has
182.8MM access lines, of which 14.7% are served at a retail level by competitive
carriers, up from 4.3% at end 1999. AT&T and MCI in particular are growing
their bases of retail access lines served, but so too are smaller competitive
carriers operating "under the radar screen" of media scrutiny such as
Broadview Networks and Paetec. Meanwhile quality of service reports filed with
the FCC report rising quality of voice service for most all major carriers - as
measured in terms of faults per line, time to repair and so on. For example,
based on data reported to the FCC and available through its ARMIS database,
total trouble reports per month per 100 residential access lines has trended
lower over the past several years from 2.79 trouble reports per 100 lines in
1993 to 2.57 in 1996 to 2.16 in 2002.
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The US now has 157MM cellular telephone users. Wireless calls account for, we
estimate 23% of voice traffic on the US networks with wireless voice minutes
rising at 36% per year currently. Indeed, we estimate that the number of cell
phone users will exceed the number of US wireline access lines some time during
2005. Meanwhile the total number of US access lines fell in 2001 for the first
time since the Great Depression and continues to fall, despite a strong economy
suggesting that long established wireline service is being substituted for by
other technologies. For wireless our average price per minute at $0.10 is the
lowest of all the developed countries tracked by Merrill Lynch - and still
falling at close to 20% per year. This continues to drive new patterns of
behavior - indeed an estimated 7% of telephone users only have a cell phone.
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Broadband penetration at end 2003 was 22% of US homes. We estimate total
year-end 2003 broadband subscribers of close to 23MM, higher than any other
country in the world, with net additions of subscribers of 7MM - the highest
absolute level of any country in the world. It has to be said however that
penetration is lagging other markets at 22% of homes and 8% on a per head of
population basis. Of larger countries Korea and Canada stand out with
penetration levels twice or more that of the US. But US penetration still ranks
higher than all of the UK, Germany, France and Italy - and some 10x that of
China. We project US broadband subscriber growth of roughly another 7MM in 2004
taking penetration to 27% of homes at the end of this year. Broadband subscriber
growth in 2001 was just 4.8MM. This acceleration of broadband growth is perhaps
not surprising - prices have fallen and speeds increased combining to drive
improved "value" for customers.
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As broadband deployment picks up the new data "platform" created by
high-speed internet local access and the public internet is being put to use.
Insurgent players such as Vonage have gathered much attention as they deploy
VoIP, in Vonage's case to just in excess of 100,000 numbers (the term
"line" becomes meaningless for an IP based offering). More importantly
perhaps major cable companies have indicated they will deploy VoIP phone service
to all their markets - in Cablevision's case that was achieved end 2003.
Meanwhile for the real aficionados there is Skype. Indeed it may well be that
VoIP proves to be not just a consequences of, but actually a driver of,
broadband take up.
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Major incumbent providers are rising to the challenge. Verizon recently
committed to invest $2B over the next two years to accelerate the transformation
of its wireline network. As part of that effort they announced that they had
selected Nortel as their VoIP equipment provider and, at an investor conference
they hosted last week, laid out plans to deploy VoIP over DSL starting next
quarter. They cited the benefits to customers of new innovative services and,
for themselves, lower costs of network operations. Meanwhile Verizon has also
announced it will spend $1B to deploy a high speed wireless service to most
major markets by end 2005 - offering internet access at speeds 8x that of dial
up.
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In the enterprise market in November last year SBC announced a VoIP
deployment for business as part of this major carriers strategy to compete in
the enterprise market in and out of its local service region.
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The industry is offering consumers the opportunity to "bundle"
services at attractive price points in a way unheard of even just a year ago.
For example all of the major ILECs will launch packages of telephony, data and
video services (by working with satellite providers Echostar and DirectTV) this
year. Better rates are available from cable providers if you take their
"triple play." Wireless can be bundled with wireline in some areas
with the added benefit of a single bill.
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And finally, as reported in a survey of advertising trends we at Merrill
Lynch released in December 2003, the outlook for ad spending by telecom
companies remains firm as they seek to promote new services, new packages and
new price points.
Whilst selective these datapoints suggest that when observed through the lens of
the consumer things look rather different than that provided by the stock
market. Indeed arguably totally different. As I have noted in several of my
research reports, investors and for that matter company managements looking for
some major regulatory shift or other "solution" to the
"problem" of telecom miss the fact that, for most all of 293MM
Americans there is really no major problem. Clearly on a case-by-case basis many
individuals suffer from service availability of quality problems. But I would
argue that for the majority the state of the telecom market looks pretty good -
prices are falling, the range of products and services (and the number of
players offering those products and services) is expanding and quality is rising
also.
Note that telephone spending, as a percentage of household expenditures, has
remained at about 2% for decades. However, think about what you get today vs. 20
years ago. Today your telephone service includes unlimited local calling,
unlimited long distance, a number of calling features and a wireless service
offering a large bucket of minutes and the utility of nationwide coverage.
On the subject of broadband I know the issue of the level of penetration in the
US has concerned policy makers. My observations here is that whilst the 22%
penetration of households may lag the 80%+ we see in the "market
leader" today, namely Korea, that deficit does not (any longer) reflect
lack of investment by the communications industry. The reason I say that is it
seems to me that we have a take up deficit, not an availability deficit. The
three largest wireline providers have reported that something at or approaching
80% of their access lines were DSL capable at end 2003. And some of the highest
levels of DSL penetration have been reported by small rural carriers such as
Madison River. Meanwhile the $80B the cable industry has spent upgrading its
networks in the past decade gives them close to 100% availability of cable high
speed data across the 68% of homes served by the cable companies (TV homes
passed by the cable industry is 95%). That suggests, allowing for some mismatch
in footprints, perhaps 85% or more of US homes have a terrestrial
"pipe" into their home over which they could currently get broadband -
if they wanted it and could afford it. Indeed combining the two primary
terrestrial broadband platforms with wireless broadband that will be delivered
over conventional cellular networks and other means of broadband access (WiFi;
so called WISPs - wireless internet service providers; satellite; powerline) and
within two years I suspect broadband in some form will be available to 95% of
homes - that is as many as use conventional phone service today. By then uptake
will be close to solely a function of affordability and desirability.
It's fair to say that there are aspects of the US scene that do look, say we say
"odd" - especially to non-US observers. The US bankruptcy laws
certainly have an impact on the state of competition in the US market that
differentiates it from other countries. I have dubbed "The Frankenstein
Effect" the phenomenon by which several large bankrupt long distance
carriers (such as MCI, Global Crossing, Williams Communications, 360 Networks)
have or are about to emerge from financial restructurings which leave their
assets intact but their debt burdens greatly reduced. The plus point for the US
economy is that multi $B investments in new technology networks have not been
idled but remain in active use. The negative point as, seen by competitors such
as AT&T, is that over capacity has not been reduced with consequent
sustained downward pressure on prices. But, as with other areas of US telecom
where prices are deflating, while AT&T and others are impacted the broader
economy enjoys the offsetting but more diffuse benefits of lower
telecommunications costs.
The US regulatory regime is complex. I for one do not envy Chairman Powell and
his colleagues at the FCC their task of fitting today's telecom world into a
framework defined by the 1996 Act. The Act was signed into law in February 1996
but as I understand it had been several years in the making - so the market
structure, technology environment in which it was framed is actually close to a
decade old. A decade is a long time in telecom. One example. I have noted that
here are 157MM cellular subscribers in the US today … at end 1995 there were
just 34MM. As a force for so called intermodal competition wireless was simply
not on the map when the act was being drafted. That said the Act is, after some
delay and with intervention through the courts all the way to the Supreme Court,
clearly having an impact as the "cross entry" battle between incumbent
and local carriers heats up.
A crucial measure of the state of an industry particularly for investors is, of
course, cash. As investors have been reminded through the last several years,
companies ultimately generate value for equity owners and ensure their viability
through the delivery of products and services at prices that allow them to cover
their day to day expenses, invest in assets to support current business and
growth opportunities as well as meet the needs of the tax collector and
providers of debt capital. Particularly in telecom "Free Cash Flow",
the cash left over after meeting all these needs and thus available either to
distribute to equity owners, to pay down debt or perhaps acquire new businesses
is now a very closely followed metric.
Despite the genuine anguish that the industry has suffered, including of course
that of the many workers who have lost their jobs, this measure tells an
interesting story. I combined the results of the all the US telecom service
providers, wireline and wireless, covered by the Merrill Lynch research team.
The result? Aggregate free cash flow (before dividends) in 2001 from these
companies was negative $4.2B. We estimate that in 2003 it was positive to the
tune of $42B. The point being that the industry has refocused attention on the
most compelling investments, has adapted to the decline being experienced in
some areas, has responded to investor pressure to better manage capital programs
and balance sheets and has reduced costs in an effort to maximize profitability
even in an environment of increased competition and falling prices. Consequently
free cash flow has risen dramatically. Indeed all of SBC, BellSouth and AT&T
acknowledged their stronger balance sheets and healthy cash flows and raised
their dividends to equity owners by between 16% and 27% in 2003. SBC alone pays
annual dividends now running at $4.2B. I think many people looking at the
telecom industry might be surprised by these statistics.
That's not to say that the industry structure is perfect as it is by any means.
Indeed in any industry undergoing the level of change and stress that we see
today in telecom new combinations of companies form, and more likely than not,
there will be consolidation over time in the US industry. From the service
providers view point consolidation can bring more stability to the market
structure, which in turn can foster investment, so not necessarily being harmful
to consumers. I think this is one issue that both the anti-trust authorities and
telecom regulators will have to deal with in the next few years.
Another challenge, particularly with respect to regulation, is the "how do
I get there from here" problem. The nirvana of ubiquitous terrestrial and
wireless connectivity at broadband speeds offered through multiple platforms by
multiple providers is one in which regulation will likely play a very limited
role. However the legacy of monopoly, the geographic based and jurisdictional
decisions that made sense in a monopoly or near monopoly, environment will live
on for some time. And quite rightly so given the safeguards they provide to
consumers. But the current framework throws up non-trivial problems looking into
the future - How should the objective of universal service be pursued and
funded? Do we consider just basic telephony or broadband in our Universal
Service objectives - and what about wireless? What happens to the access charge
regime (especially in rural areas with their higher termination rates)? What
should the balance between state and federal responsibilities be especially in a
more data centric world? How should VoIP be regulated - is it a phone service or
not? Whatever it is, how should the balance between economic and social policy
objectives be struck for VoIP? And would "too much" regulatory
intervention stymie innovation related to VoIP? How do we bring together the
regulation of cable and telecom as the services each offers converge? There are
no easy answers to those questions. Whatever decisions are made, changes in
areas such as the USF and access charge regimes will inevitably create winners
and losers in the corporate world as of course will VoIP.
My conclusion is that, considered in the round, the state of competition in the
US telecom market is mostly "good". There is robust competition in
many consumer and business markets between traditional providers, there is
growing intermodal facilities based competition (from wireless and increasingly
cable companies). Prices are falling, offerings expanding and quality generally
is rising. Crucially the major incumbent players are dealing with painful
transitions as revenues shrink in some areas (wireline voice, especially long
distance), grow in others (noticeably wireless and broadband) and shift between
players yet at the same time are generating adequate cash to finance investments
in their current infrastructure as well as new technologies. Meanwhile new
technology is enabling new competitors to enter the market place.
Finally what changes are to come? My closing thought is that the transition of
the telecom industry from a voice centric to a data centric model, under way for
many years now, is still at an early stage. Roughly speaking voice accounts for
80% of industry revenues but 20% of traffic as measured in bits - a form of
Pareto rule. As technology, and in particular broadband local access break down
the ring fences around the voice world traffic bits will migrate to the cheaper
transport path, namely data - and mostly data transported as IP packets. As this
happens the ties between infrastructure and services are broken and, in the
jargon, "voice becomes an application" running over the data network.
I suspect that the competitive forces we see today will pick up speed - as
evidenced late last year when a swathe of major carriers announced VoIP services
within weeks of each other. In this sense I suspect that a more profound
reshaping of the industry has only just begun. I have no doubt that the
consumers and businesses that use telecom services will come out clear winners.
For telecom investors the winners in the service provider world are much harder
to predict.
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