SUNDAY JULY 11, 1999

Jumping Off the Bandwidth Wagon – Long Distance Carriers Regroup

by Seth Schiesel

In a dingy warren of cables and wires on Manhattan’s Upper East Side, phone calls are starting to look a lot like pork bellies.

There, in his cramped office above the Pulse Night Club, Alex Mashinsky, 33, has created an electronic trading floor for telephone service that resembles nothing so much as the international market for traditional commodities.

Communications carriers from around the world, including giants like AT&T and Nippon Telegraph and Telephone, link to the Web Site for Mr. Mashinsky’s company, Arbinet Communications, to trade unused long-distance telephone minutes from New York to every corner of the globe. On Friday, a minute to Israel sold for as little as 8.4 cents, while a minute to Hong Kong cost as little as 4.6 cents.

Although it is tempting to hold up Arbinet as a creator of a new communications landscape, in fact it is only a stark symptom of a much larger shift in the electronic world: While consumers and regulators focus on the communications bottleneck in the so-called last mile of wire to homes and businesses, long-distance communications capacity — or "bandwidth", one of the hot buzzwords of the Information Moment — is fast becoming a commodity.

Deregulation, rapid advances in optical technology and generous capital markets have combined to create an explosion in communications supply — a supply that exceeds even the surging demands in communications unleashed by the Internet. Accordingly, long-distance prices are falling sharply. On Friday, AT&T sold its biggest business customers a minute of telephone time to Israel for 35.4 cents, less than a third of the cost three years ago, and a minute to Hong Kong for 27.2 cents, down 57 percent. The big gap between the retail marketplace and spot markets like Arbinet’s cannot last for long.

More significantly, for the companies and investors alike, margins in some parts of the communications business are following suit, as long-distance bandwidth for both telephone and data services turns from scarce to plentiful.

The shift is driving many of the strategy reversals and multibillion-dollar deals that have become almost commonplace in the industry. It explains AT&T’s burst into the cable television business and the continuing, soap-opera-like bidding war between Qwest Communications International and Global Crossing for the Frontier Corp. and U S West.

At the same time, the fierce competition in the long-distance arena only highlights its relative absence in local markets. That, in turn, reinforces the almost overarching value of local communications networks — and is prompting some investors to rethink their portfolios for the digital future.

A New Profit Formula

The changes in the long-distance industry are undermining what is perhaps the fundamental rule of telecommunications economics — that margins stick to assets.

After AT&T began to face significant competition about two decades ago, it became clear that long-term profits in the business stemmed largely from controlling physical assets like fiber optic lines, copper wires and communications switches. For years, the cost of running a network was a big part, perhaps a third or more, of running a communications business. A major component of making money was keeping the continuing network costs low, and the main way to do so was to own the network.

That is one reason Sprint emerged from a venture of the Southern Pacific Railroad, which could use its railroad rights-of-way to lay fiber-optic lines. It also explains MCI’s original name, Microwave Communications Inc.; by using microwave links it had developed, MCI could provide long-distance services for less than AT&T. (MCI eventually built its own fiber optic network, to help the company compete more broadly.)

Most of the hundreds of other new long-distance companies that emerged after the 1984 breakup of AT&T, however, leased communications capacity from others, and few have had consistent profits and growth.

Drawing from that experience, new companies like Qwest, Level 3 Communications, Global Crossing, IXC Communications and the communications units of the Williams Companies and Enron, two energy giants, have been founded — and financed — on the logic that owning physical assets was essential. Each of the companies is building a new fiber optic long-distance network, some in the United States and some globally. Combined, the first three have raised or borrowed more than $10 billion over the last three years, mainly to build their new networks. At the same time, new optical technologies have been expanding the capacity of existing networks by factors of 16 and 32, with a potential of 160.

To grasp just how much bandwidth is being created, consider this: According to Telegeography, Inc., a research firm in Washington, in 1997 the world’s public telephone networks carried 81.8 billion minutes, or 155,632 years, worth of international phone calls. The newest optical systems can transmit the digital equivalent of all of those calls over a single fiber in about 11 days.

Hence the new carriers’ predicament: Their investments are alleviating the very scarcity that made their original business plans so attractive.

The problem is not that a glut of bandwidth has been created. It is clear that new, bandwidth-hungry services will fill all of the available communications pipes. However, the big profits in the industry are migrating away from raw bandwidth and toward the applications that use it.

An early sign of how prices would turn volatile as bandwidth supply played leapfrog with demand was in the market for T-3 Internet lines, which can carry 45 million bits of digital information a second.

When they first became widely available in 1995, the lines sometimes cost less than $20,000 a month; buyers included corporate customers and Internet service providers. But as the use of the Internet exploded, demand outpaced supply, and prices shot as high as $70,000 a month in early 1996.

Since then, however, prices have fallen consistently, by about 10 percent a year, as new and existing carriers have built up their networks. T-3 lines now cost about $50,000 a month, and many in the industry expect the trend to continue or even accelerate.

"People have been thinking about bandwidth from a Malthusian standpoint: ‘How do I ration this?’" said Daniel Smith, chief executive of Sycamore Networks, a communications equipment company, whose previous business, Cascade Communications, another equipment maker, was bought by Ascend Communications in 1997 for $3.7 billion. "And now we’re saying, ‘How do we think about this from a standpoint of plenty?"’

Many of the nation’s communications carriers have come up with an answer: They need to evolve up the digital food chain — from mere bandwidth suppliers to providers of advanced services — to maintain their profit margins in the future. They are scrambling to acquire direct links to homes and offices — not for the assets per se, but because in the next century, margins in the communications business will stick to services and customers.

"If anything, the cost of communications is falling faster than the cost of computing, so assume unlimited bandwidth,” said Howard Anderson, managing director of the Yankee Group, a technology consulting firm in Boston. In that case, he said, “you are either the application service innovator, or you’re dead meat."

Moving to Plan B

The shift has shred business plans across the industry and helped fuel the paroxysm of takeovers reshaping the communications landscape.

AT&T provides a classic example. Many strategic subcurrents have been at work behind AT&T’s $90 billion leap into the cable TV business, from a need to protect its long-distance base to the simple desire to shake the company out of a torpor. But at the root has been a quest for sustainable profits, and the brain trust at AT&T’s headquarters in Basking Ridge, N.J., decided that such profits were not to be found merely in the long-distance business.

Having a long-distance network is "a necessary, but not sufficient, condition to succeed in the future," said Frank Ianna, president of AT&T’s network unit. Instead, AT&T concluded that it again needed to connect directly to its customers. "That’s where there’s the least amount of competition," he explained, referring to local markets, " and that’s where you have the ability to differentiate from your competition."

AT&T is betting that owning cable lines directly into customers’ homes will allow it to deliver interactive television, high-speed Internet services and local phone service — all products that should support higher margins than its core long-distance service.

MCI Worldcom, the No. 2 long-distance provider, after AT&T, has almost the same philosophy, but with a focus on serving business customers. It, too, sees its future in services and applications, not simply bandwidth. And it also wants to own the direct link to the customer.

"Our story is very different from offering raw capacity," said John W. Sidgmore, vice chairman of MCI Worldcom.

In Worldcom’s evolution from communications nobody to industry titan over the last decade, the company’s deal to acquire MFS Communications in 1996 looks at least as important strategically as its acquisition of MCI last year. The MFS deal gave Worldcom not only direct, local fiber optic links to business customers, but also the Uunet Internet operation run by Sidgmore. Uunet, coupled with MCI’s corporate data communications operation, is now driving MCI Worldcom’s growth, by developing the advanced data applications, like intranets, demanded by big business customers and delivering them worldwide.

Since MCI and Worldcom announced their merger in the fall of 1997, telephone service revenue has dropped from 68 to 61 percent of the combined company’s overall sales, while Internet and corporate data services have grown from 22 percent to 30 percent. In the first quarter of 1999, telephone service revenue increased only 7 percent over the comparable 1998 period, while data services sales grew 30 percent and Internet revenue 60 percent.

At Qwest, the shift in focus toward the top of the food chain has happened in fast-forward, and some investors have found it unsettling.

When the company first offered shares to the public in 1997, it was seen on Wall Street as a bandwidth play. Investors expected Qwest to concentrate on using the latest technology to build a long-distance network with more, and cheaper, capacity than those of companies like AT&T or MCI, letting the upstart take market share away from slower, less-advanced competitors.

Over the last year, though, Qwest has repositioned itself as — surprise! — a provider of advanced communications services for end users. This year alone, Qwest has announced partnerships with companies including KPMG, BellSouth, Siebel Systems, SAP America, Hewlett-Packard, Oracle and Automatic Data Processing’s Brokerage Services unit to develop high-margin applications like software for sales forces, aimed at various market segments//cut for space.

And now, Qwest is making an unsolicited run at acquiring Frontier, a long-distance company that also owns Globalcenter, one of the biggest Web-hosting concerns, and US West, the regional Bell company based in Denver. U S West is the slowest-growing Bell, but it still has millions of customers, whom Qwest needs for the new services it is developing.

Qwest is trying to wrench Frontier and U S West from the grasp of another erstwhile bandwidth play, Global Crossing. While both Qwest and Global Crossing have made cases for why their deals make sense, their sudden transformations have left some investors scratching their heads.

"It’s created confusion," said Eric Strumingher, an analyst at Paine Webber. "Qwest and Global Crossing have represented themselves as growth companies, as nimble companies based on modern technology and that had the most flexibility. Now they’re attempting to combine with a company that was not representing itself like that, and is in fact not like that. That is the big source of the indigestion."

Divergent Philosophies

To James Q. Crowe, perhaps the most prominent executive still carrying the flag for the pure bandwidth strategy, this is all tantamount to heresy.

Crowe is chief executive of Level 3, which is building a national fiber optic communications network based on Internet systems and the latest optical technology. Crowe says he has no intention of selling advanced services to consumers. He says that through shrewd investments, he can sustain a technical dvantage over his competitors. That, in turn, would let Level 3 sustain a cost advantage, enabling the company to persist as a wholesaler of long-distance bandwidth.

"I think I can drop prices faster than anyone else can keep up with and have margins that are sustainable," Crowe said. "If you can get a six- or nine-month technical advantage over your competition, you can have a long, long, long life."

The stock market has hardly abandoned Crowe’s world view — shares of Level 3 are up 56 percent this year — but others in the industry say he is ignoring the commoditization of bandwidth at considerable peril.

"I respect Jim and I’ve worked with Jim, but I think he’s absolutely, completely dead wrong," Sidgmore said. "It really is black and white. The fact of the matter is that if you just stand back and think about it, Jim is not going to invent any new technology. It’s coming from Lucent or Cisco. And do you think they’re going to give anyone an exclusive? If you wanted to give someone an exclusive, it would be the company that could buy the most product; it would be MCI Worldcom or AT&T."

But Level 3 is different from those companies — if not from Qwest or Global Crossing, in their original guises — because it has no existing customer or revenue base to protect. That, Crowe says, will keep his company more focused.

"History tells us that when you get bigger and bigger and more and more vertically integrated, you break businesses apart," Crowe said. "That’s like starting a computer company in 1980 and saying the model is IBM." Integration is also the exact opposite of government policy and market activity in, for example, the power business, which is splitting into distinct segments that generate electricity, transport it over long distances and then deliver it to users.

Indeed, some communications experts think that consumers will suffer as carriers seek vertical integration — offering advanced services as well as raw communications pipelines — to fight off the margin-eroding tides of commodity pricing.

"As someone on the buying end of it, rather than the selling end of it, I’d like the companies that provide bandwidth to do a really good job of that rather than do what the local telcos have done, which is bring services into their networks," said Robert M. Metcalfe, one of the founders of the 3Com Corp., the big data networking company.

Metcalfe, now an industry consultant, contends that the Bell companies, which dominate local communications, have done a poor job of making advanced services available to consumers, even as they try to fend off competition.

For investors, it may not really matter who is right. Even some people who own or recommend the stocks of companies like Level 3 acknowledge that the pure bandwidth strategy may not endure for the long term — but add that many such companies will probably be acquired in the next few years anyway, perhaps as foreign carriers expand into the United States.

Still, some professional investors are shifting their focus to the remaining points of scarcity in the communications business — local assets and expertise in advanced services, especially on the Internet.

That is why Michael J. Mahoney, director of telecommunications investment at Dresdner RCM Global Investors, likes MCI Worldcom but is also becoming more bullish about local communications companies.

"We have a decent position on the local side," he said, "and if anything, we’re steadily growing in our affection for the local side." Mahoney particularly likes GTE, which is trying to merge with Bell Atlantic, and SBC, which appears close to completing its deal to buy Ameritech.

Mashinsky of Arbinet, the communications exchange in New York City, watches the new world of long-distance evolve every day on his computer screen. To him, the shift is clear. The future is not in electronic pork bellies; it is in the fiber optic equivalent of processed meats.

"Over the last three years, $402 billion was invested in telecom worldwide, and a lot of that went into infrastructure," he said. But many of the entrepreneurs "have not been able to fill up their networks, because there are too many people building networks. "So a lot of these guys are refocusing," Mashinsky added, "and saying that if we want to retain our margins, we have to get a hold of some customers and add some value."