Archive for February, 2013

Fueled by the Dot Com boom, billions of dollars were invested in constructing and lighting fiber networks in the late 1990s.   Valuations soared, and those who timed their exits right became multi-millionaires.   Those who didn’t exit by the early 2000s saw their fortunes evaporate.

Like all massive corrections, the telecom meltdown was fueled by truisms.   The Internet would change everything, and it did.  Bandwidth would grow rapidly for as far as the eye could see, and it has.  Fiber would be the workhorse of the Internet, and it is.  These trends are as powerful today as they were speculated to be in the 1990s.  Moreover, they will be prominent a decade from now, and the decade thereafter.   The telecom boom was built on a rock solid foundation.

Only partially true was the notion that the meltdown was caused by the overbuilding of fiber and capacity.   The majority of fiber in use today was constructed after 2002.  Without doubt, > 95% of the capacity in use today was created long after the end of the telecom boom.  Looking forward, more fiber will be built in the next ten years than exists today, and 95% of the capacity in use ten years hence has not yet been created.

So what went wrong?   What caused the meltdown?

First, during the telecom boom, too many fiber companies were created.  In their rush to build network, they focused on the most obvious geographies to build fiber.  They built networks in NYC, in Chicago, in the Washington D.C. market, in Dallas, and in the big California cities.  They connected to the same dozens of buildings in these markets, and they connected up the major markets along similar routes.   In many cases, they traded fiber strands with one another – or leased fiber on a competitor’s network.

Second, these companies rushed to light their networks, creating a glut of finished capacity relative to the embryonic size of the circa 2000 Internet.  Too many competitors combined with too much finished capacity created a blood bath.

Third, over-exuberant investors and inexperienced management teams added fuel to the fire.   Instead of acknowledging the situation, they hid behind story telling, fiber swaps, accounting gimmicks, and acquisition dust clouds.  They looked to buy themselves time, hoping to find an opportunity to exit prior to the boom turning to a bust.   They denied fault and instead blamed their competitors.

For fiber-based providers of bandwidth, the meltdown ended in mid 2005.   Since the mid 2000s, nearly all Bandwidth Infrastructure companies have done very well for their investors.   Revenues grew at double-digit rates.  EBITDA grew even faster, with many producers of bandwidth generating EBITDA margins in the 50-60%+ range.   Most generated free cash flow.

Slowly, the “too many suppliers” problem corrected itself. Today, roughly one of twenty companies remains in business, and only a handful of companies exist with substantial size and scope.  Consolidation will continue–as it does, balance will emerge between those who supply and those who consume bandwidth.

Despite these fact-based observations, a fundamental question lingers.   Is the owning of fiber network, and the production of bandwidth, a path to creating equity value?

The naysayers need only to point to Level 3 Communications.   Level 3 owns the most fiber, across the broadest of geographies, and with the fullest range of service offerings.   It led the consolidation of the industry by purchasing dozens of fiber providers.  Yet, its financial results remain disappointing.   Organic revenue growth is underwhelming and EBITDA margins are in the mid 20%s.  Its stock price remains low.

The dearth of other public companies puts additional weight on Level 3’s results. TW Telecom and Cogent perform well, as did Abovenet when it was a public company.  However, XO Communications (now private) and Global Crossing (acquired by Level 3) performed poorly.   All cite the challenges on pricing pressures, difficulty in growth, and capital intensity.  The development of value added services and the expansion to new geographies are positioned as necessary to preserve revenue and margin, instead of as an opportunity for incremental value creation.  With the exception of Cogent, all are (or were) opaque on their operational financial metrics.

Adding to the murkiness is the impact of traditional telecom companies (Verizon, ATT, Centurylink) and CATV companies (Comcast, Cox, TW Cable).  Will these companies hurt Bandwidth Producers in their quest to develop profitable business models?

Intuitively, powerful trends suggest bandwidth production should be a great way to make money.  Bandwidth demand is growing by 40-50% a year, and this will continue for as far as the eye can see.   Fiber is the critical resource needed to produce bandwidth, and industry consolidation is leading to a favorable balance between those who need and those who produce bandwidth.  New entrant barriers are gigantic, ensuring improving environment will not be disrupted.  Yet, if owning fiber networks and producing bandwidth leads to equity value creation, why aren’t we seeing empirical proof of it? 

The positive results of TW Telecom, Cogent, and Abovenet (when public) are positive signals that bandwidth production might be on a path toward being a lucrative business.   Their business models vary, and their messaging about the state-of-the-industry, raises questions.  Nonetheless, their financial performance in recent years has been strong.  All have seen 8 – 12% revenue growth, achieved EBITDA margins of 35 – 45%, and generated free cash flow.

Perhaps more promising is the valuations credited to private companies that focus primarily on bandwidth production.   Fibertech was purchased by Court Square in late 2010 for 12X LQA.   Abovenet was purchased by Zayo Group, with backing of new investor GTCR, at 9.5X LQA.   Lightower buyout by Berkshire at 12X LQA was announced in early 2013.  Highly respected Private Equity firms facilitated these three transactions.    The healthy multiples suggest a consensus view that owning fiber networks and producing bandwidth will lead to equity value creation.

The ultimate answer to the question seems obvious.  With robust bandwidth demand curve, increasingly healthy industry structure, and high barrier to entry, Bandwidth Production will prove to be lucrative.   However, the path toward this answer is likely to be bouncy.  Not all of the potholes have yet been avoided.

Strategies still need to be sorted out.   Multiple strategies will prove to be effective, but not all strategies.  Some strategies will lead to poor outcomes for investors.

Execution Matters.  Though bandwidth producers have strong tailwinds behind them, they also face execution challenges.  With bandwidth growing at 40-50% annually, the business environment is in a constant state of flux.  Technologies change.  Pricing is fluid.  Integrations are hard.  Industry consolidation creates murkiness.   Processes and systems are complex.

Poor Track Record in Creating Value.  Telecom management teams have a poor track record in creating value for their investors.   Perhaps circumstances dictated this outcome.  Perhaps weaker management teams have been weeded out.   Nonetheless, the fact remains that most telecom management teams do not have a sustained history of running large fiber businesses in a way that creates value for their equity investors.   Until proven otherwise, investors will remain susceptible to unproven management teams.

Effects of Remaining Consolidation.   Most of the consolidation has already occurred.  However, the remaining steps will be the most profound.  The long term industry structure will undoubtedly benefit, but some investors might not fare well along the way.

New Fiber Construction Projects / Entrants will Face Steep Hurdles.   The past five years have proven to be lucrative to many owners of fiber networks.   Some investors will over-react to these successful outcomes and, in hopes of achieving similar results, will make poor investment decisions.   They may overlook the cost of developing new fiber networks, and the difficult inherent in competing against focused competitors with established business models and deep customer relationships.

In the 1950s, Oil Production must have been a lucrative business.   Imagine a conversation that might have taken place between two savvy investors in the space.

“We certainly are fortunate to be in the Oil industry during its heyday,” says one magnate as they sip cognac at their country club.

“Ah Yes.  We are lucky to have been in the right place at the right time,” agrees his colleague, as he puffs his Cuban cigar.

The first ponders out loud: “The question is ‘how long do you think this Oil Boom can last?’.   Should we sell now before this Oil trend subsides?”

Fiber, like oil, is a scarce resource that will be relevant for multiple generations.  Bandwidth production, like oil refinement, will be a lucrative industry for many decades to come.   The telecom boom and meltdown was the first chapter of a long novel, one that will be played out over 100 years.   Though the remaining chapters will be less dynamic, many fortunes will be made and lost in the coming years.