Shiver your timbers. Here's what's really going on in the telecom industry, as told by Ray Alderman, executive director of VITA.
Ahoy, Mate! Welcome aboard. Pull up a seat and let me tell you a seafaring tale about the Good Ship Telecom. Like all seafaring tales, this one starts-out on land. It comes from the thinking of a landlubber, Alvin Toffler. He wrote a book in 1980 titled “The Third Wave,” so even though he was landlocked, he knew about waves. In that book, he established a method of uncovering macro-trends, occurring over long periods of time, by observing micro-events occurring over short periods. He then evaluated and interpreted those micro-events, drawing some very interesting and insightful conclusions about the macro-trends. His book covers the Agricultural Age (the first wave), the Industrial Age (the second wave), and the Computer/Information Age (the third wave). I like his model and I have borrowed it here for my use, to show what's really going on in the telecom board and box business.
While the events in the telecom industry since 2001 seem as chaotic as rough seas, there are distinct and discernible patterns of poor seamanship that beg for explanation. My objective here is to weave my empirical and nautical micro-observations into a sail, using swatches of normal sail cloth that look seaworthy. But, at the macro-level, this patchwork sail will tear into shreds, even in mildest gales.
The collapse of the telecom industry in April of 2001, was a massive tectonic shift in that industry that created huge tidal waves in the calm and warm Telecom Sea. This seismic event sent out three sequential tidal waves, over the past six years, that crashed upon the shores of Telecom Cove and devastated the native companies basking in the warm glow of the Telecom Sun. The First Wave was the consolidation of the telecom equipment manufacturers; the Second Wave saw the consolidation of the telecom service providers; and the Third Wave that we are now experiencing is the consolidation of the telecom component supply chain.
The reaction to the first tidal wave was when the Telecom Equipment Makers (TEMs) started selling-off most of their manufacturing facilities and their people to the Contract Electronic Manufacturers (CEMs) at dirt-cheap prices. This is the “jetsam” component (cargo deliberately thrown overboard by the crew to lighten the ship and survive the storm) of the debris floating around in the Telecom Sea today. But, that action didn't lighten their ships enough, and the tidal wave started breaking-up the Good Ship Telecom, and this is where the “flotsam” (cargo cast into the sea by the waves and wind as the ship breaks-up) appears. The list of “jetsam” sales of TEM facilities to CEMs is so prolific, if we ground-up all the keels and masts of all the wooden ships that ever sailed the seven seas, and processed that pulp into paper, the resulting stack of pages wouldn't even hold an executive overview on the topic.
The “flotsam” floating around out there is much easier to count, by simply looking at the mergers and acquisitions among the TEMs. Today, we have Alcatel-Lucent, Nokia-Siemens, and Ericsson-Marconi, all collections of flotsam held together by creative accounting and incomprehensible financing deals. Nortel seems to be an independent piece of flotsam that's mostly submerged, and a navigational hazard at this stage of its existence.
It's clear, from a simple empirical analysis of all these mergers and acquisitions, that the First Wave, from 2001 to about 2004, did a lot of damage. Those who survived started to breathe easier, not knowing that the Second Wave was on the horizon, and would catch them sleeping on the beach yet again.In the Second Wave, the Telecom Service Providers (TSPs) yell “Fire on board!”, and are subsequently trampled by the refugees of the First Wave. Surrounded by a hodgepodge of switches, routers, hubs, protocols, and big black boxes made by many now-defunct TEMs, the TSPs realize that there were no safe harbors in this storm. With no place to anchor, and with no way of making this collection of obsolete and non-upgradeable boxes work together, they started to band together. As with the TEM mergers noted above, there's not enough paper available to list all the mergers, acquisitions and asset sales at bankruptcy of all the TSPs. Maybe it's best to just list the ones who remain afloat: ATT-Bell South, Sprint-Nextel, Verizon-AND WHO???, and Qwest-AND WHO???.
I'm sure there are a few smaller TSPs still out there in small skiffs, but they're over the horizon and hard to see with even the best telescopes. Let's say, for the sake of argument, that we're almost back to where we were, as far as the number of telecom service providers goes, before the Telecom Break-Up Act passed in 1996. It's difficult to define, with any degree of accuracy, what's jetsam and what's flotsam in the TSP business. The telecom services in America, and low quality of service, are bilge water compared to the telecom services in Europe, Japan, and other developed countries.
It's again clear, from observing all the M&A activity involving the TSPs, that a lot of damage was done by this Second Wave, from 2003 to 2006. Many of the TSPs are still surviving on the revenues from those old POTS switches, but about 5% of the landlines in this country are being disconnected every year, and the old voice switch revenue stream is declining like an anchor headed for the bottom of a shoal. The revenues from cellular services are under severe pricing pressures, the services they're developing for cellular are lame and targeted at a small audience of youngsters. The quality of service for the cellular networks we now have is worse than a steady diet of hard tack and salt water.
In September 2007, the Third Wave came ashore and started drowning all the vendors who believed the hype and unrealistic forecasts for telecom-oriented boards and boxes based on several consortia specifications. Both Intel and Motorola, the leaders in the telecom board business, jettisoned their board groups on September 7th and September 28th, respectively. They both followed those specs, which were centered around Intel-based PC technology for telecom applications. Board companies and box makers over-spent on product development, purely based on those sirens songs of billions of dollars in forecast revenue. Now, all they have to show for it is a hangover.
One of these specs sets the requirements for a board that's twice as large as a regular PC motherboard, but sells in the market for half the price of a motherboard. Another spec defines a board that's half the size of a PC motherboard, but sells for twice the price. Now, the crews of those ships in this telecom sea are astonished that they can't sell either, or make a profit.
Intel ran for the gunnels first. They sold their Intel Modular Communications Platform Business to RadiSys for 0.5 times sales (give or take a few dollars for inventory purchased separately) on September 7th. According to the press releases, Intel was doing about $50 million in annual sales, a far cry from the $20 Billion forecast for this board technology by the market researchers. And, 0.5 times sales says something about the gross profit margin (GPM) you get by selling commodity boards and boxes to telecoms. Using rule-of-thumb financial models, this multiple suggest a 10% GPM. It's clear that the Intel board group was riding high in the water, with no cargo in the hold. Compare their selling price multiple to Intel's purchase of telco board vendor Ziatech in 2000 (3.43 times sales) and their purchase of another board vendor, Dialogic, in 1999 (2.66 times sales). Ziatech was sold to Performance Technologies in 2002 for less than one times sales, and Dialogic was sold to Eicon in 2006, along with Intel's Media Server Group (no data available).About three weeks later, Motorola staggered to the gunnels, and sold their Embedded Computing and Communications Group (ECC) to Emerson for 0.67 times sales. That suggests about 12% GPM for them. The sales for this division were quoted at about $520 million for 2006, but this is 2007, so the 2006 numbers may not be a reasonable estimate. Additionally, the Motorola/ECC group has a significant part of their sales in other board technologies like VME, PMC, and other form factors. So, it's tough to gauge what percentage of their sales were telecom-oriented board business. As well, this ECC group had been making and selling some of these board technologies for the mothership in Schaumburg. So, it's a rough and splintery task trying to figure-out what they were selling to real customers. Motorola/ECC was drawing more water than Intel, but not enough to say she was loaded and headed out to sea. And, compare their selling multiple to Motorola's purchase of telecom board vendor, Force Computers, back in 2004 for about 0.8 times sales.
Let's jump back to the Mr. Toffler's macro-level for a moment and look at another recent transaction, and weave-in another patch that starts making this sail look increasingly unseaworthy: Flextronics (a CEM) bought Solectron (another CEM) for 0.3 times sales on June 4, 2007. Most, if not all, of the CEMs make their living by building telecom boards and boxes for one of the remaining TEMs in the flotsam floating around in the Telecom Sea. A brief but studied look at the financials of the public CEMs shows that they make about 7% to 8% GPM on a good day. As you can see, telecom board and box vendors are all selling for significantly less than one times sales.
Is there another tidal wave on the horizon? Yes, it's building now, and may hit the shores of Telecom Cove about 2010. The Fourth Wave is where the Good Ship Telecom gets all tangled-up in the rigging, and the FCC comes in to cut out the knots.
When you buy a PC, that device is not bundled with any communications services. You can buy a cable modem, a dial-up modem, a DSL card, or a WiFi card and choose your service provider. You can download any browsers or software you need to access the services of your chosen telecom service supplier. Cell phones are rapidly becoming small computers. But, when you buy a cell phone, that device is tied to and bundled with the telecom services. The purchase of the phone dictates the provider you must use because of the proprietary software, protocols, and other nuances in the phone. At some point, the FCC must unbundle cellular devices from cellular services. When that happens, you can buy your phone or cellular device at a local retailer, and then decide what service provider gives you the best services and quality at the best price. Today, consumers don't have that option. When it does happen, the Fourth Wave will hit the beaches of Telecom Cove.
We've seen from the micro-perspective, those little patches of sailcloth, that the telecom industry is in some rough seas with no clearing on the horizon. The old nautical axiom, “Red sky at morning, sailor take warning,” is appropriate here, and will remain appropriate for many years. Only when cellular services are unbundled from cellular devices will “Red sky at night, sailor's delight,” be applicable. With the top two telecom board makers selling out, that's an indication of the present state of the telecom board industry, and a harbinger of things to come. The few remaining telco board and box makers will continue the consolidation, or run for other markets. It seems as if the sail for the Good Ship Telecom, at the macro-level, is unseaworthy, and there are more storms and tidal waves on the horizon. It could be many years before the Telecom Sea is calm enough for this sail to be hoisted up the mast.
Ray Alderman is the executive director of VITA. He can be reached at firstname.lastname@example.org.