Capital spending out of whack

Revenue growth not keeping pace Are carriers getting sufficient returns on the money they've invested in building out their networks? Not at present, according to analyst reports.

And that could foreshadow a slowdown in telecom equipment spending, especially if investors start to watch return on capital investments more closely. The boom could be over - at least temporarily - as carriers cope with pricing pressures and market share losses in their traditional lines of business, as well as network overcapacity in growth areas as competitors flood the market, according to a recent report by Blake Bath, wireline services analyst at Lehman Brothers.

Put simply, the telecom services industry may be overcapitalized, and the situation could get worse before it improves, Bath said. Since 1996, capital spending by service providers has grown an average of 26% annually, while total revenues and EBITDA have grown 10.5% and 11.6%, respectively, on an annual basis. Lehman Brothers' forecast for 2001 spending implies a 13% industry revenue growth and "a staggering" 63% capital spending growth, Bath wrote in his report.

Declining returns on capital and weaker asset turnover ratios also are not a good sign. In 1996, industry capital spending of $43 billion supported annual revenues of $219 billion, or a 5-to-1 ratio of revenue to capital spending. In 2000, this ratio deteriorated to 3-to-1 and could fall to 2-to-1 in 2001 (see figure).

The industry has been waiting for five years to see revenue growth accelerate and capital spending decelerate. But "the nirvana of accelerating revenue growth and decreased capital spending" may have to wait as carriers invest to support a new data and wireless revenue base and the resulting traffic on their networks, Bath said.

Indeed, wireless infrastructure is the area where equipment spending will see the strongest increases, as carriers construct third generation networks to handle wireless data, said Tim Luke, wireless and Internet infrastructure analyst for Lehman Brothers. The plethora of new wireless licenses issued in Asia, Europe and in the U.S. means global wireless capital expenditures could reach more than $74 billion in 2001 and $94 billion in 2002,Luke said.

However, how long it takes carriers to realize revenue on those investments is anyone's guess. The wireless auctions will make a huge dent in capital budgets for 2001, but if carriers can slow spending after the 3G build, the return metrics could brighten.

Meanwhile, in some sectors capital market weakness already is slowing large-scale infrastructure investments. For some competitive local exchange carriers, liquidity concerns have forced slowdowns in network builds.

Last week, for example, ICG Communications trimmed capital expenditure plans and moved into "controlled expansion" mode (see story on page 10). The service provider still plans to build into 22 markets, but one year later than originally planned, cutting its 2001 capital spending budget to about $300 million from a previous estimate of $800 million.

Emerging carriers without sound, sustainable business plans will be at the mercy of potential investors, especially in the equity markets. "The financing backdrop is in the process of changing dramatically as the megacaps squeeze the emerging players' access to capital through huge IPOs of wireless and data businesses," Bath said, estimating $60 billion of new megacap stock issued by the end of 2001 for growth business carve-outs.

Vendor debt funding still is available to the many facilities-based service providers, but potential recipients of such capital have diminishing bargaining strength, said Trent Spiridellis, analyst at Banc of America Securities. "While equipment vendors have come under increasing scrutiny for their lending practices to [integrated communications providers], many have indicated a willingness to continue to finance facilities-based carriers that have attractive credit profiles and advanced network strategies," he said.

The business impact of overcapitalization also has been felt among the larger carriers, as companies such as AT&T, Sprint and WorldCom have revised 2000 revenue growth downward. Most of the decreases have come from the long-distance voice and data and Internet access businesses, which have been the most commoditized and subject to the heaviest pricing pressures, Bath said.

Of course, some incumbent carriers have been better than others at producing incremental revenue from their existing network buildouts. For example, according to BellSouth Chairman and CEO Duane Ackerman, by combining local service with a package of convenience features, BellSouth generated $300 million in incremental revenues during the past year with virtually no capital expenditures.

In general, however, incremental revenue gains on investments catering to data and wireless services have delivered much more than the traditional voice business, Bath said.

Although carrier spending concerns have hit the stock prices of equipment providers, the providers of equipment to next generation networks are likely to be the most resistant to a downturn.

"There has never been a worse time to be a service provider," said Max Schuetz, analyst at Thomas Weisel Partners, in a report on optical equipment maker Corvis."In our view, only next generation optical net working equipment such as Corvis' can drive down carrier spending and lead to a return to profitability.

Such equipment combines the capital cost savings of all-optical transport with the reduced provisioning and management costs of a software-rich intelligent switched network topology," he added.