What now?—The search for new growth opportunities

Feb 20, 2002 12:00 PM

The telecommunications bubble may not have completely burst after all. With the recent downward slide in the telecommunications sector, many carriers and communications private equity firms are searching aggressively, unsure where the next growth opportunity exists. While a number of attractive strategic alternatives do exist in this sector, the dynamics of the marketplace must be fully understood before selecting and implementing a strategy.

Market context

The telecommunications market is on the verge of tremendous change on the heels of its largest expansion phase in history. The burst of capital spending by CLECs and next-gen service providers after the 1996 Telecom Act led to a significant metro vs. long-haul capacity imbalance. ADVENTIS estimates that long-haul capital "overspending" since the act was $70 billion to $100 billion (Figure A).

Many existing service providers and emerging carriers (via the private equity firms backing them) fueled this capital expansion. The resulting bandwidth commoditization caused significant price erosions for service providers. Going forward, these economic forces will inevitably drive consolidation and rationalization of the telecommunications market.

Impact to the players

With the likely consolidation of ILECs, IXCs and CLECs, the effect will ripple across the industry. Consolidation will likely occur both horizontally with voice, data, and IP providers (e.g. WorldCom and Qwest) and vertically with local, metro, and long-haul providers (e.g. AT&T and Bellsouth). Additionally, the number and mix of players focused on the residential and business segment will reduce significantly. Many CLECs and next-gen carriers have already collapsed, and others will follow.

The remaining service providers will shift focus to servicing their most profitable customers and segments, restructure by shedding unprofitable assets and make select investments in new technologies given their new capital structure.

The private equity firms that invested in these CLECs and next-gen carriers have a tremendous amount of capital tied up in these investments. Many firms have experienced bankruptcies and write-offs in the $100 million to $1 billion range. As a result, future investments in telecommunications must focus on highly selective growth opportunities.

Growth opportunities

There are three strategic growth areas for telecommunications carriers and private equity investors:

• Higher margin service offerings

• Emerging equipment and software technologies

• Alternative partnering models. 

Higher margin service offerings: Data and IP services such as VoIP are commanding higher margins, most notably with enterprise customers. Next-gen carriers providing services such as VOIP, IP/PBX, high-performance IP VPN, and vertical solutions can expect growth rates through 2005 in the 20% to 40% range (Figure B). 

VOIP costs remain significantly below circuit voice costs, even with charges for local access imposed over VoIP calls. VoIP prices are dropping significantly, from 4.3 cents per minute in 2001 to an estimated 2.7 cents per minute in 2004, compared with circuit voice of 6.0 cents per minute to 4.4 cents per minute, respectively. Software that enables VoIP technology, especially within a PC environment (i.e. Net2Phone), should realize attractive take rates.

The consumer market, like the business market, is clamoring for converged applications with attractive benefits and pricing. Financial, sports, gaming and entertainment applications available on wireline and wireless platforms, are experiencing attractive adoption rates. Service providers that can license applications through known brands, and in turn bundle with core services, will realize greater overall take rates and profitability.

Emerging equipment and software technologies: Several emerging telecommunications technologies and services will experience greater acceptance by the service provider community. Specifically, the CapEx composition in the U.S. still favors core networking equipment (Figure C).

Gigabit Ethernet provides faster network speeds (100 Mb/s to 1 Gb/s) and is more cost-effective to deploy than a traditional T-1 line and at half the cost ($100 per month for Gigabit Ethernet vs. $1300 per month for T-1). Gigabit Ethernet will also enable fully integrated voice, data and video service offerings over a single network.

Given the current state of equity and debt markets, last-mile technologies such as free space optics, which require less capital and installation costs, will realize greater take rates. Wireless technologies such as 802.11B will play an important role in 2.5G and 3G, serving as the wireless LAN standard. It will be a competing technology in markets where wireline access costs are high (e.g., in-building networks). Operations support systems software, such as billing and customer care, is still badly needed by both large and small service providers as legacy systems continue to strain their ability to launch and bill for new higher-margin services.

Alternative partnering models: Investments in the communications sector have always played a significant role in the private equity community. Given the shortage of attractive new deals in today's environment, alternative investment partner models should receive renewed interest. Private equity firms can co-invest or create co-funds with larger, more established service providers and target mutually attractive investments. Many service providers are cash-constrained and serve as a viable customer for services of the newly formed or acquired company. Private equity firms benefit from increased investment opportunities and viability of deals.

With all the uncertainty that exists in both the communications sector and private equity markets, select opportunities still exist. The telecommunications sector remains one of the largest markets in our economy and will continue to evolve and grow over time. Carriers and investment firms will need to decide which strategic growth option best meets their risk profile and direction, but knowing how to navigate through these opportunities will be the most challenging aspect of the journey.

Blaik Kirby is Global Carrier Practice Leader and Michael Grossi is a Manager for Adventis.

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