Doom and Boom

Nov 30, 2001 12:00 PM, Kevin Mitchell

It is certainly not bold of me to say that these are gloomy times. I do not derive any pleasure by delving into the doom, but this market needs some examination to see the boom at the end of the tunnel. The largest unanswered (and unanswerable?) question is that of the timing of the cycles.

As was famously said during the last downturn 10 years ago, it's the economy, stupid: the free-wheeling days are over -- at least until the next boom cycle -- and all eyes are focused on revenue and profitability. Service providers are under pressure to reduce capital expenditures by using their equipment more efficiently and by buying new products only where the operational cost savings are clear, such as with next-gen voice equipment and intelligent optical hardware.

Although the large Tier 1 service providers have more resources than the smaller service providers -- giving them, in some cases, more ballast to throw overboard -- they too feel the effects of the economic slowdown. As shown in our new study on U.S./Canadian service providers, while still spending billions on equipment, their major concerns are now revenues and profitability. Based on their financial statements and our estimates, the public U.S./Canadian Tier 1 service providers' domestic capital expenditures were $108 billion in 2000, and we expect expenditures to drop 25% to $82 billion in 2001 and another 27% to $60 billion in 2002. This is not a pretty picture in which to be selling equipment.

There is a new buzzword that service providers and financial analysts are using to explain future spending: success-based spending -- linking capital expenditures to how the company performs (we call it smart CAPEX). This requires next-gen equipment that drastically cuts hard and soft operational expenditures and allows for new or incremental revenues.

Waves of specialization and consolidation are a constant in all tiers of the service provider market, and the specialized newcomers are often a source of innovation and the cradle of new market segments. The newcomers -- most of them in Tier 2 and 3 -- put pressure on the top tier to adopt technologies and roll out new services faster than they would otherwise. The market is experiencing a sustained and thorough consolidation of CLECs, BLECs and DLECs in the Tier 2 market. However, the Tier 1 service providers won't escape unscathed either.

There are 30 U.S./Canadian Tier 1 service providers now, but this number will decrease over the next 5 years due to mergers, acquisitions and a few of the weak dropping off, and in 2005 we expect there to be about 24. A few new players may join the fray (but that is becoming increasingly unlikely), and 2 or 3 Tier 2 service providers may graduate to the Tier 1 class.

Five Tier 1 service providers are especially troubled, and most probably won't emerge intact:

• 360networks is hunkered down but planning to survive under protection of bankruptcy

• Electric Lightwave is majority-owned by Tier 2 service provider parent Citizens Communications, which is committed to continue financing ELI's cash requirements until June 30, 2002, at which time we suspect it will get absorbed by its parent or its assets will be sold

• Excite@Home is selling their assets and business to AT&T, already the majority stockholder. Its operations continue now while it restructures debt under Chapter 11 protection; this entity will disappear by the first half of 2002

• MFN announced its $611 million financing package (including $231 million in vendor financing) that will allow them to complete its business plan

• PSINet is overbuilt, having acquired many of its parts at over-inflated boom-era prices, and is now selling some of those parts at a loss. Canadian Tier 1 CLEC Telus completed its purchase of the Canadian operations and facilities of PSINet; what remains of its U.S. network may be a paired-down service provider or assets that other service providers purchase for cents on the dollar.

Over the past several years a few upstarts have joined the Tier 1 service provider ranks. Our definition of Tier 1 includes a nationwide fiber backbone, which was a status relatively easy to achieve by buying a few IRUs and gathering a few rounds of multiple tens of millions in venture capital funding. That approach has come to an end: Aerie Networks, for example, was attempting to follow such a route but changed direction as it became apparent that nationwide fiber backbones by themselves were no longer a strategic asset.

Despite the overall market pall, innovation continues. Metro networks are the focus area of many vendors and service providers. Looking at the Tier 2 service provider market, we see evidence of various small specialization waves taking place as operationally young carriers such as PointOne, Exario, EPIK and Grande Communications enter the scene. We expect that the number of Tier 2 service providers (currently about 75) will fluctuate over the next 5 years but will end up at about the same number in 2005 due to new entrants (coming in at a slower pace than years past) and Tier 3 service providers growing up to Tier 2 status.

It is not all sunny for Tier 2 service providers, however. This is probably the tier hit hardest by the change in cycles. Covad, ICG Communications, e.spire, and now most recently Ardent Communications (formerly CAIS) have all filed for Chapter 11 protection and may not make it as viable entities, but they are positioned better than other service providers that have collapsed in the past. Winstar is mired in bankruptcy protection, and it will most likely sell its entire company or assets. In the past 15 months, 19 Tier 2 service providers have closed their doors and the list reads like a who's who of service providers who won awards and praise but no market share:

• @Link

• Actel Integrated Communications

• Advanced Radio Telecom

• AGIS (assets bought by Telia Internet, which in turn was bought by Aleron)

• AXXENT

• C1 Communications

• Convergent Communications

• Cannect

• Flashcom

• HarvardNet

• Jato Communications

• Net2000 (assets being sold to Cavalier Telephone)

• NorthPoint (assets purchased by AT&T)

• Netrail (acquired by Cogent)

• Prism Communication Services

• Rhythms Canada

• Teligent (auctioning its assets after it could not find financing)

• ZipLink

• Zyan Communications

Despite all the capital expenditure cuts, bankrupt service providers and equipment manufacturer layoffs, the market will grow again in the long term (and some will even grow in these dark times); unfortunately, the weaker service providers, vendors and component suppliers will need to fail in the short term. This will set the market for growth again. A forest fire is devastating, and the charred remains look bleak and hopeless, but life springs anew with more vigor.

As the service provider market consolidates and the real competition picture becomes clear, Tier 1 service providers also see competitors and time to market as key business challenges they must address in the coming year. This change in focus will be supported by additional spending and network buildouts.

In our recently released market share reports examining the Q3 2001 service provider equipment markets, most of the equipment categories, such as DSLAMs, core routers and ATM edge switches, have contracted compared with Q3 2000. However, we see a few markets with growth in 2002, but most retrenching for stronger growth in 2003 and beyond. Sales of some of the nascent equipment markets that are indicative of the smart CAPEX approach have increased since last year. In fact, intelligent optical hardware is up considerable compared with 2000 because of service providers transitioning to this more cost-effective gear.

Data traffic is still growing. As a leading example, in a presentation earlier this year, an AT&T spokesman mentioned that he anticipates AT&T's ATM traffic will grow 100% this year, frame relay 50% to 100%, and Internet 200% to 300%.

Despite the downturn, Tier 1 service providers are announcing increasing revenues from IP and Internet services. The following Tier 1 service providers have year-over-year (Q3 2001 compared with Q3 2000) growth in data and Internet revenues, based on their Q3 2001 financial reports: AT&T Business Systems, Bell Canada, Broadwing, BellSouth, Global Crossing, Qwest, SBC, Sprint, Telus, Verizon, Williams and WorldCom.

End-user demand for services and bandwidth has not abated. Our forthcoming study on small, medium and large organizations' adoption of "advanced" services in the U.S./Canada shows strong and growing adoption of VPNs, security, storage and more from now through 2005. This demand will be met only by additional spending by carriers.

So, while this is indeed an ugly time, a gloomy landscape that could only follow the highly caffeinated growth economy of the mid- and late-1990s, we shall see the boom cycle again.

Kevin Mitchell is Directing Analyst, Service Provider Networks for Infonetics Research, Woburn, MA. He can be reached at Kevin@infonetics.com.

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