FOOL ON THE HILL: An Investment Opinion
The oldest of the mass communications business models is the vertically integrated service provider. Through regulatory and business migration, this has been broken into several portions, the most visible being that of the carriers of voice and data. These companies in aggregate form the "Sunk Assets" portion of communications, in which companies deploy large network and switching facilities at tremendous capital cost. Given the rapid change in the mix of data and voice and the continued expense of meeting consumer needs, such networks are quite often valued on the basis of the replacement value of their assets.
Of the networking business models, "Sunk Asset" is the oldest. The original telecommunications carriers were almost entirely vertically integrated, they were monopolies, and their success was predicated on interoperability and coverage. In this age of extreme competition and rapid change in the industry, its easy to forget that prior to the 1984 breakup of AT&T (NYSE: T), American telecommunications were almost entirely self contained.
AT&T was long distance, undersea cable plant, satellite, wireless, and local distribution. It even produced much of its own equipment through the Bell Labs, which became Lucent (NYSE: LU) in a later spinout. Prior to 1980, most countries had single monopoly carriers and in many countries this is still the case (though the 1998 Singapore Protocol has set a time table for signatories to open up their markets to competition). The vertically integrated carrier is a dying model.
In its place we have the equipment companies and the new generation of carriers, which can best be described as service and equipment bundlers. Some carriers own none of their own transmission or distribution facilities, instead developing value-added switching interconnect and co-location points of presence. Others have gone to great length to build out their own networks, either through construction of their own long and short haul facilities or through indefeasible right of use of a portion of facilities from other companies.
"Sunk Assets:" The Service and Network Aggregators
These carriers and hubs are not equipment companies per se. The "Sunk Asset" model is predicated upon the deployment of large amounts of capital and the value-added aggregation of equipment and transmission/distribution facilities. Given the enormous barriers to entry from a market, financial, and regulatory perspective, the companies are often times valued in the market on a take-out basis. That is, they are valued less on discounted future cash flows, and more on the replacement or opportunity value of their integrated facilities.
A synopsis of the barriers to entry in the "Sunk Asset" model:
We should divide the Sunk Assets models into several subcategories. First and foremost are the backbone carriers. Backbone is a word that is more associated with Internet service than telecommunications, though the difference is minimal between the two. The largest international telecom networks operated by AT&T and Japan's NTT (NYSE: NTT) are just as much in the backbone vein as those of more Internet-centric practitioners such as PSINet (Nasdaq: PSIX) and WorldCom's (Nasdaq: WCOM) UUNet division.
Entering the backbone game are energy companies like Enron (NYSE: ENE) and Montana Power (NYSE: MTP), which are leveraging their millions of miles of right-of-way to inexpensively offer their own data and telecommunications services. Finally, Qwest (NYSE: Q) and Global Crossing (Nasdaq: GBLX) are among the newer breed of non-dominant domestic and international backbone providers. But both have consummated transactions over the last several months that have added elements of a second model -- Distribution.
Distribution: Delivering the Goods to Endusers
The Distribution companies provide the most asset-intensive portion of the public network, the connection to the end customers. All of the Baby Bells and the competitive exchange carriers fall under this description. These may also be the least likely to be valued on a revenue basis, since the replacement cost of distribution networks is a prohibitive barrier to additional competition. This description would include the Wireless network providers, including Nextel (Nasdaq: NXTL) and Vodaphone (NYSE: VOD).
Distribution's buzzword is "bundling." Companies in this realm have the advantage of being the first and last miles of the majority of all communications transactions. The approval of several Bell Operating Companies to provide long distance and Internet services in some locations allows them to match the Competitive carriers in providing the full host of communications services, where earlier regulatory strictures prohibited them from doing so. In New York, Bell Atlantic, now called Verizon (NYSE: VZ) has signed up more than 1,000,000 customers in the year that it has been able to provide long distance services.
On a competitive basis, the distribution systems in place will be taxed as higher bandwidth requirements flood a network that was originally configured for voice. As such some of the concerns for the Transmission companies are co-extensive here, particularly trunking and backbone capacity. Companies that are able to provide "multi-local" services and the long haul portion between them will retain significant advantage in this realm.
Non-Network Based "Sunk Asset" Companies
And finally, there are the Transmissionless asset models, best portrayed by Exodus Communications (Nasdaq: EXDS). Exodus' value added proposition is in the configuration of its facilities to perform server hosting and data management for Internet companies. The Transmissionless companies are aggregators of equipment and facilities, and they enjoy lower barriers to entry, but significant consolidation advantages through internal traffic management and efficiencies of scale.
The Transmissionless companies are betting upon differentiation through superior use of technology at their points of presence. Exodus, for example, has considered purchasing long-haul capacity on occasion, but has not yet done so. The prevailing rationale may be that backbone capacity is destined for commoditization, that Transmissionless companies believe that there will be sufficient bandwidth that they may continue to outsource the interconnect to their facilities.
From a profit model perspective, this is a pretty good bet -- unless bandwidth demands grow so rapidly that the public network cannot keep up. But these companies are largely counting on their superior technology and intellectual property to differentiate themselves to customers, and they count on high utilization factors of existing facilities to generate cash flow through scaling.
Of the convergence business models, "Sunk Asset" may be the easiest for the lay investor to understand. The "Sunk Asset" model is 100 years in development. Though some of the older companies are hindered by being saddled with huge analog legacy networks, the lead that companies have by having pre-installed networks provide investors with significant margins of safety, even for companies that are currently unprofitable.
Tomorrow, Brian Graney is going to take the lead again and discuss the companies that are best defined as "Agnostics." These are the players that have structured themselves so that they can provide equipment and services regardless of the twists and turns of dominant technologies or standards.
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