Telecommunications Is Nothing To Call Home About

Worldwide deregulation of the telecommunications industry is fueling the formation of weak companies about which the investor should be aware. Much of the activity is taking place in the international long-distance segment of the market where FCC and World Trade Organization rulings have been designed specifically to spur increased competition and new products.

No High Tech Here
Although the word telecommunications carries an aura of being high tech, its long-distance service segment is far to the contrary. This part of the industry does not create or necessarily use new technology. Typically, it has no R&D and no patents. Indeed, it’s possible for a new company entering the industry to sell long-distance time without any capital equipment or technical staff and with little more than a way to market and bill the customer.

Lots Of Revenue, No Margin
While many companies are able to show impressive leaps in revenue the investor should not use this as a measure of company strength. Long distance, especially in the international arena, is a growth market. As deregulation and increased transmission capacity drive prices down to an affordable level for more people, usage goes up inversely. It is not to say, however, that the revenue shown in the financial statements of a company always comes from the end user. In fact, it could come from a competitor who is leasing the company’s equipment on a volume basis at very little cost.

Leasing Alone Is Not Enough
Consider this scenario. A phone call originating in Los Angeles goes through the local lines of PacBell, then shifts onto the trunk lines of MCI to New York. From there it passes through the routing switch of TeleGroup and onto fiber optic lines across the Atlantic, which are co-owned by a score of companies. It arrives in France through a British Telecom terminating switch, and thence goes across the local lines of France Telecom to a private home. At each step along the way, usage is accounted for through complex formulas that eventually get billed in terms of credits or money.

Leasing is an essential way of uniting into an operational whole all the equipment that constitutes the world’s telecommunications infrastructure. It also complicates the picture of how increased usage by the end user translates into revenue growth. What is clear, however, is that leasing can pump the revenues while at the same time negatively impacting the company’s profit margins. Thus, most new companies seek public funds to purchase routing switches or buy shares of fiber optic cable in order to own more of the call from end to end. As reasonable as it seems on the surface, it may not be enough. Companies with some equipment and no market are hardly better off than those with some market and no equipment.

The Turbulence Of Deregulation
Many of the new companies formed around the sale of time for international long-distance calling, which are going public, have a limited track record, virtually no cachet, and little marketing experience. It is far easier to buy capital equipment and lease to competitors than it is to wrestle in dedicated customers. Leasing, with a gross profit margin of 9 to 12%, is not sufficient for viability. Yet creating a market during the turbulence of deregulation is a challenge for even the most savvy of companies. Numerous critical rulings remain undecided and each country is moving at its own pace. It opens the likelihood that many companies will commit to a strategy of growth, which is ineffective. Weaker companies will be found resorting again and again to the sale of stock in order to continue their operation. They will not have the expertise or the financial resources to implement a plan that gives them a sustained share of the market. A great deal of investor funding will be spent propping up companies whose long-term prospects are not good.

Many of the new companies appealing to the public for money don’t have a clear solution to the gross profit margin problem. Like low cost products without a brand name, the sale of long distance time is a commodity business. Margins are extremely thin with brand loyalty almost nonexistent. One Plus dialing is an example of a service, high in value to the customer, but which subverts a company’s attempt to differentiate itself in the marketplace. The user can change from one long distance company to another with hardly more effort than dialing a different code that precedes the telephone number. People will shift services based on minute advantages. In this highly competitive climate, where companies have little latitude to offer uniqueness or added value, we can expect gross profit margins to be driven even lower.

One Plus dialing, which has taken hold forcefully in North America, will eventually find its way into all the key international markets where deregulation is under way. It will be one of many unsettling perturbations with which small companies, and large, must contend as they attempt to exploit this segment.

Division Between Strong & Weak
In the U.S. the first serious move toward deregulation came with the breakup of AT&T into the several regional Bell companies. Each trades on the NYSE, is rich in infrastructure, has a matured operation with a track record of net income, and does at least $1 billion in business. They and others describe an industry, which has bifurcated between the strong of the NYSE and the weak of the NASDAQ. There are exceptions, of course, one being MCI, a NASDAQ company, which showed $1.2 billion in net income on $18.5 billion in sales for 1996. But in general consider the differences depicted in Figs. 1 and 2. Companies on the NYSE exemplify what one expects of a telecommunications company. They show a strong linear correlation between the revenue they generate and the income they make.

The picture is very different on the NASDAQ. One would expect to see a more diffuse array of performance for companies in their early stages, and it clearly appears. Except for a couple of high fliers (MCI and Worldcom) most of the companies on the NASDAQ reside at the low end of the revenue spectrum, under $500 million. Among those, most generate well below $200 million. A majority of the companies under $200 million in revenue are taking losses. In fact, total losses exceeded profits by $377 million among the 21 NASDAQ companies sampled. Half of those companies generated revenues under $117 million, and half showed a net loss greater than $3.6 million.

The effect of income on stock price is direct and apparent, as it should be. The matured companies on the NYSE, which can show net income as high as $6 billion annually, tend to have robust stocks starting in the mid $20s. Many settle into the $40–50 range (Fig. 3).

On the NASDAQ companies taking a loss tend to have stocks under $15. However, when they show an income, no matter how slight, the market responds. Stocks can get lifted by $10 when people think there’s an inkling of hope (Fig. 4).

Is there anything that can be concluded in this division between weak and strong? Several points can be made. Strong companies control local markets and own most of the infrastructure. Local markets generally remain captive to a single company, produce more income, and overall are a stronger segment than long distance. Companies formed around the capture of long-distance market share find a more highly fragmented segment with lower margins. They must walk a fine line between expanding their capital equipment and building a dedicated market in an uncertain, environment. It’s unclear whether deregulation will help or hinder them in the long run. Deregulation may let strong companies, which are currently focused on local markets, extend their reach into long distance. When that happens there will be a consolidation down at the low end.

Investors should proceed cautiously with any company whose main line of business is the international long-distance segment.