Too Much, Too Soon for Telecom

From 1996 to 2001, the telecommunications industry spent nearly half a trillion dollars building a monumental high-tech network to ferry phone calls, e-mail and faxes around the world at the speed of light.

But that investment--roughly twice what the federal government spent on the interstate highway system over the last 50 years--turned out to be a far bigger bust than anyone expected.

And the nearly $300 billion in debt that piled up during this dramatic build-out is wrapped like an anchor around the neck of the sinking telecom industry as it suffers one of the most dramatic collapses in U.S. corporate history.

The meltdown was punctuated last week with a fraud lawsuit filed by the Securities and Exchange Commission accusing long-distance provider WorldCom Inc. of improper accounting that masked its true health. In January, telecom network builder Global Crossing Ltd. filed the fourth-largest bankruptcy case in U.S. history. Firms such as AT&T; Corp. and Qwest Communications International Inc. remain on shaky ground.

The total cost of this wipeout--to investors, consumers and taxpayers--may not be clear for years. But “we’re looking minimally at several hundred billion dollars of real investment that has gone south,” said Lee Selwyn, president of Economics & Technology Inc., a telecom consulting firm.

A Times analysis of six years worth of financial statements of 116 telecom companies reveals an industry that spent furiously to exploit new technology and capitalize on the rising appetite for voice and data traffic. But it built too much too quickly, and demand is years from catching up with supply. The result is an industrywide implosion that has wiped out more than 400,000 jobs and obliterated trillions in shareholder wealth.

The numbers tell the tale:

* The industry devoted more than $444 billion to capital expenditures from 1996 to 2001. On average, companies spent more than $3.8 billion each on long-term assets such as factories to build equipment and communications networks. By comparison, $3.8 billion could fund National Park Service operations for almost 2 1/2 years.

* Investors threw $49 billion at start-ups through venture capital firms and public stock offerings.

* Telecom companies’ return on their capital investment has been dismal. In 2001 the average was a negative 82.8%. That’s like spending a dollar to end up with 17 cents.

* Trillions of dollars of telecom companies’ market value has vanished since 2000.

* Industry debt ballooned throughout the late 1990s, growing at double-digit rates before peaking at $306 billion in 2000. Much of it may never be repaid.

Much of this spending and speculation was fueled by the Telecommunications Act of 1996, a landmark reform that opened up markets, such as local and long-distance phone service, to greater competition. At the same time, new technology was making it possible for start-ups to challenge entrenched companies.

Beginning of an Era

Taken together, these developments created a gold-rush mentality among entrepreneurs and investors who believed they were witnessing the birth of a new era. The opportunities seemed limitless, and the massive hype obscured the true risks.

“Any time there’s great changes in the society--like with railroads in the early 1890s or the auto industry--you saw a lot of investment being thrown at new industries, and then there was a shakeout,” said James Alleman, a visiting associate professor at Columbia Business School in New York. “That’s a nice analogy with what’s going on today with telecom. Everybody was trying to get in and find the gold. Some will and most won’t.”

That’s not to say the investments were a total loss. Some observers, such as Johannes Bauer, associate director of the James H. and Mary B. Quello Center for Telecommunication Management and Law at Michigan State University, believe that profit motives will persuade companies to find a productive use for all the excess network capacity, or bandwidth, built during the boom.

“The networks are not lost,” Bauer said. “These are assets that are still available. Someone will come in and buy them cheaper, and it will very likely benefit the public in the future.

“If they can be reutilized in the next year or two, then the physical losses will be fairly limited. But those who bought at high stock prices and then lost money in the process--that money is probably unrecoverable.”

At the heart of the telecom revolution were the entrepreneurs with long-shot dreams and the venture capitalists who financed them. The number of venture-backed start-ups focused on building equipment and networks grew from 30 in 1996 to 42 in 1997 and then spiked to 62 a year later, according to the PricewaterhouseCoopers/Venture Economics/National Venture Capital Assn. Money Tree Survey.

Deal-making remained active until last year, after the telecom meltdown was in full swing. In 2001, 34 telecom companies received venture-capital funding, according to the survey. Altogether, venture capital firms invested $4.9 billion in these telecom firms, including $2.2 billion in 2000 alone.

Tapping Public Markets

But that was just seed money. The start-ups that flourished tapped the public markets for additional capital by selling shares to outside investors through initial public offerings, or IPOs, and secondary offerings.

In 1996, when the telecom renaissance was taking hold, telecom firms raised $4.2 billion through public stock sales. By 2000, the amount had grown to $18.1 billion, before falling off to $4.8 billion last year. Altogether, companies in the sector culled more than $44 billion from public offerings, according to SEC filings.

Some young firms were particularly adept at tapping the public markets. Level 3 Communications Inc., now on the brink of a bankruptcy filing, raised more than $3.5 billion this way, including nearly $2.2 billion in a single offering in February 2000. Other upstarts raised more than $1 billion each from the public markets, including Allegiance Telecom Inc., Focal Communications Corp., Time Warner Telecom Inc., Ciena Corp., Corvis Corp., Juniper Networks Inc. and Sycamore Networks Inc.

For a time, market capitalizations swelled for these companies. Savvy investors who sold their shares when they were valuable were richly rewarded. Global Crossing founder and Chairman Gary Winnick, for instance, made a profit of $577.9 million selling company shares before the firm filed for bankruptcy protection in January.

But most investors didn’t recognize the peak when it came, and they held on to their stock as share prices tumbled further. By September, the 10 leading telecom equipment suppliers’ shares had fallen 90% from their peak values, said Susan Kalla, senior technology analyst for Friedman Billings Ramsey, an investment house.

Among the hardest hit were employees of telecom companies, whose faith in their work convinced them to hold on long past the point where they should have cashed out. Some workers also saw their 401(k) accounts wiped out because they built their retirement funds on company stock.

Some of the money raised in public markets was used to pay for routine business expenses such as salaries, marketing and rent. But perhaps the most important outlays for telecom companies were capital expenditures.

The capital spending accelerated as the 1990s drew to a close. In 1999, the companies invested $81.2 billion in capital equipment. The next year, that figure grew 40%, reaching $113.9 billion. The spending started to ease in 2001, but still totaled $97.3 billion for the year, even after the wave of bankruptcy filings had begun.

Few Positive Returns

The heftiest capital spending came from traditional carriers such as AT&T;, SBC Communications Inc. and Verizon Communications Inc. But among the top 15 spenders were upstarts Qwest ($24 billion over five years), Level 3 ($12.5 billion), Global Crossing ($7.2 billion) and Williams Communications Group Inc. ($6.9 billion).

Only half a dozen companies generated a positive return on their massive investments over the six-year period, according to figures compiled by The Times. The only start-ups among them were telecom equipment maker Advanced Fibre Communications Inc., which recorded a 3% return on investment, and Comverse Technology Inc., a maker of telephone messaging systems that scored a 2.4% return.

More typical was StockerYale Inc., a Salem, N.H.-based firm that makes specialty optical fiber and optical networking components. From 1996 to 2001, StockerYale’s return on investment was negative 37.5%, just slightly below the median for the firms analyzed by The Times.

That’s still far better than the performance logged by New Visual Corp., which is developing technology to increase the data-carrying capacity of copper phone lines. Its six-year return on investment was negative 1,047%. Even worse was Mphase Technologies Inc., which is developing similar technology. Its six-year return was negative 1,171%.

Revenue from product sales helped fund some of this spending. But most of it was financed by debt.

Money Not Wasted

Debt levels for telecom firms soared in the late 1990s, according to a Times analysis of SEC filings. Total debt ballooned from $9 billion in 1996 to $127.3 billion in 1997, then continued to expand until 2000, when it reached $306.4 billion.

As the number of bankruptcy filings continues to grow, so does the amount of debt that probably will never be repaid. But few analysts believe that all of the money was wasted.

Rick Morris, director of Northwestern University’s Program in Telecommunications Science, Management and Policy, predicts demand for the extra bandwidth will spike once someone figures out how to bring faster Internet connections to homes.

“It will be sopped up like a sponge because the consumer has an insatiable appetite for entertainment and information,” Morris said. “Overcapacity is a temporary problem. The consumer will save telecom.”

Even some of the money that wasn’t used to build infrastructure had a lasting effect on the economy, said Kalla, the Friedman Billings Ramsey analyst who is an expert on telecom equipment companies.

“What you did was, you employed people,” she said. “And they, in turn, spent on houses....There was more than just laying cable. You trained all these people, so they have skills. You can make the argument that they fueled the 5% GDP growth, so it’s not all waste.”

Still, it seems the private sector’s massive investment in telecom was far less productive than the $329 billion that federal, state and local governments spent to construct the 45,025 miles of interstate highways that crisscross the country.

According to a report prepared for the American Highway Users Alliance, every dollar invested in the highway system has generated more than $6 in economic benefit.

Selwyn, of Economics &Technology; Inc., said some waste is unavoidable when an industry is beset by rapid change.

“Every single industry at some point in its history has gone through a period of rapid expansion, with multiple entries and multiple failures,” he said. “That’s to be expected. No one believes that we’re going to see as many survivors as there were entrants.”

Who will pay the price?

“We all do, in a sense,” Selwyn said. “When you have a major sector of the economy sucking up resources, it means resources are being diverted from other places. That forces prices up, it forces professional salaries up, and when that falls apart, we all pay.”

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METHODOLOGY

The Times examined public companies that described themselves as providers of telephone or communications services or equipment. Companies that focused on the mobile-phone industry or had their primary operations outside North America were excluded. The findings in this story are based on audited numbers reported to the Securities and Exchange Commission.