Ratings for Major Telecoms Should Be Suspended
I know it sounds a bit over the top, but there is an argument for this. Long gone are the days of the trusty old monopoly of Ma Bell that was dismantled decades ago. With the advent of the internet, the major telecoms have become susceptible to new perils. Wireline voice, this would be your normal landline telephone voice service, sometimes called POTS (plain old telephone service), is in a persistent downturn.
Let’s look at the numbers. These are AT&T’s (T) revenues from wireline voice in the past few years:
- 2008 - $37.2 billion
- 2009 - $32.3 billion
- 2010 - $28.3 billion
Do you see the pattern here? If I were the CEO of AT&T I would be rather alarmed. Though with his profits up in the last year by $7 billion to $19 billion, I guess he’s not worried.
Well, maybe he’s not worried, but almost all of that $7 billion improvement in the bottom line was due to an adjustment to income taxes. Otherwise, profits would be the same $12 billion of the prior two years. Keep that figure in short-term memory, we’re going to re-visit it again later.
It’s Schumpeter Again
Schumpeter’s idea is that new things come along - like in this case the internet, and specifically telephone services designed to take advantage of the internet - and in their wake the old ways of doing business - in this case, analogue telephone service - gets discarded in the process.
It is our contention, just to be clear, that the tier one telecoms, AT&T, Verizon (VZ), Sprint (S), and the rest, are not truly investment worthy until the Schumpeter game-changes of the internet are fully played out:
In January 2009, Verizon announced that it would be routing all calls through the internet by 2015. There’s your starting point. That tells you that it has completely abandoned its old proprietary means of transmission to opt for the ever-present internet. The problem of the internet is that although it’s cheap, it’s also like a commodity; the value-added is in the apps on top of the internet, and here it looks like the majors are failing.
The principal agent of change is Skype, but Google (GOOG), via Google Voice, is coming on, and there may be more elements to play out. Clearwire (CLWR), Vonage (VG), and the equipment companies will all have a role to play. Facebook can connect people in a way that seems perfect for internet telephone. People can easily connect with many friends whose phone numbers they don’t even have, so it makes for a perfect directory.
The Skype model is the model of the free/cheap introduction to new service. Those who were there at the introduction of cable TV service saw very cheap basic cable with more channels and free service for many premium channels. Skype’s free video telephone service is not even available from the Tier One carriers, even for someone willing to pay for such service.
Skype has secured nearly 20% of the international long distance market in a few short years with the introduction of free wireline video telephone service. The major telecoms appear to have basically ignored this development.
Similarly, Google - with its free mobile operating system, Android - has secured the largest part of the cell phone market. The early consequences of this are that Google is no longer flexible with changes to its operating system, which allowed an opening for Microsoft (MSFT) at Nokia (NOK) when the company ran into problems negotiating with Google over Android.
Meanwhile, Skype is cutting down revenue like loggers in the rainforest. Skype has nabbed something like 102 billion minutes out of an international market totaling 515 billion minutes, or 19.8%. And, like loggers in the rainforest, Skype is working at the edges, but the deeper the penetration, the more severe the damage.
We take as our model the music industry, an industry savaged by “free” and also ruled by the huge pipes of the internet. Napster did most of its damage between June of 1999 and July 2001. In this short but nasty period, music changed hands in a way never possible with vinyl. Perfect digital copies passed between users for free, and quite easily. Not only did the artists suffer from not receiving their normal royalties, but the music industry itself suffered. Music industry revenues, which were $18 billion in 1999, have never totally recovered. By 2009, those revenues were down to $8 billion. This represents a 56% drop in revenue.
I don’t see how any analyst of the telecom majors can walk away from this lesson with any happy conclusions. Sure, telecoms are the pipes of the internet, the transmitters of data, and they get paid for that. But if you remove the voice telephone services on top of these internet charges, you are talking about the loss of a lot of revenue.
Telephone Revenues May Fall in Any Case
Telephone service revenues may be doomed to a path of lower and lower returns, but this does not have to be the wholesale route that occurred in the music industry. Indeed, after the two year Napster rendering, iTunes (AAPL) made the online music business more sensible. But here is my takeaway from allowing Napster to operate for as long as it did: only 64% of people feel that music is worth paying for. Lots of people check out CDs from their local libraries and rip them to their hard disks. And if you consider internet users, only 44% feel that music is worth paying for. Even iTunes buyers often only buy the song that is popular, leaving the rest of the album to rot.
The numbers for international phone service below may be open to question, but I think the trend is not in doubt.
[Information from SkypeJournal.com; Trad.= traditional; estimates are my own]
These figures suggest that all international phone business will go to Skype by 2015, assuming that Skype continues to increase its percentage by the average 48% of the past 5 years. By the way, the curve has not slowed yet to this 48% rate. Last year, the Skype percentage of international phone minutes increased by 69%.
Paul Allen – Fat Pipe Remains By and Large Dumb Pipe
In his recent autobiography, Paul Allen says,
[Cable] Operators have reaped handsome profits from selling high-speed data, but they’ve yet to capture much added value with new products and services over the top of the data stream. Even today, the fat pipe remains by and large ‘dumb’ pipe.
That would be looking at it from the point of opportunity, but there is another side to the story, that those like AT&T who are offering telephone service have yet to realize that as it migrates its most important apps - like wireline telephone, formerly called POTS - to the internet, it might lose to more nimble competitors.
Back to AT&T
If wireline voice were to follow the pattern of the music business, then you could expect a fall off of something like 55% of its wireline voice revenue. If 2008 was the top, then you could expect revenues to fall to $20.5 billion - a stunning revenue loss of $16.74 billion, but not so unbelievable, since AT&T has already lost $9 billion of that sum. If total profit for the company is really only $12 billion, then we are on our way to removing all profit, and we are drawing blood.
Wireline is particularly susceptible to this analogy since that is where most of the VOIP (voice over internet protocol) action is right now. Mobile is not as much under attack at present. Today nearly all carriers bundle voice and data. But eventually some competitor will break them out, and then consumers will be able to buy just data plans (“dumb mobile pipe”) and forget the voice because they can buy a telephone app to work with their data plan, and then the telephone carriers will face possible bankruptcy. By the way, Clearwire (CLWR), otherwise known as CLEAR, already offers this kind of dumb mobile pipe, so it’s not pie-in-the-sky, it’s here.
Dumb mobile pipe is what could turn the huge numbers of the T-Mobile deal into a molehill. If the majors, like AT&T, were to lose, let’s say, half of their mobile revenue, the company would not survive. Mobile phones have been great revenue generators, but if Verizon and the like permit Skype to lay eggs inside the mobile market, you are looking at further deterioration of revenues, especially if consumers can opt for data only plans, like those at Clearwire.
I think it’s likely the FCC will permit AT&T and Verizon and Sprint to charge more the dumb pipe to keep them afloat, but what is plain is that the major telecoms have failed to compete on on-top-of-the-internet apps. This is Paul Allen’s point.
I think you can only grant Verizon and AT&T an average financial rating. There does not appear to be any reckoning of technology trends in the ratings, admittedly a difficult call. I see continued deterioration of their international business, continued deterioration of their old billing structures in the face of Vonage type one-price competition. Internet provisioning, “dumb pipe” will continue to be solid, but this is only a part of their business.
Will the Majors Play Hard Ball, or Disappear? Signs to Look For.
- Taxes. A sign that the telecoms are in earnest will be when they lobby to force the free-loaders, the “internet telephone companies”, to start collecting the taxes which make the majors so uncompetitive. If “free” is paid for in advertising revenue, then the FCC needs to be forced to tax that. A level playing field would certainly leave the majors less exposed. I take it that political correctness accounts for the telecom timidity. Add to this the healthy self-interest of vulture consumers for a tax free black market on the internet. The days seem to be long gone when the auto companies bought the trolley systems and buried them. But the ordinary defensive reactions of the telecoms are muted. If it is not a level playing field, then why shouldn’t Skype go out and cream the competition and lay waste to the big telecoms?
- Patents. It is likely there are patents that Skype and others have infringed on in their rush to be the firstest with the mostest. Patent lawsuits would be another sign that the majors are going to try and save their businesses.
- New Services. We would expect to see the majors begin to provide the kinds of services, like video, that Skype is already delivering, namely, wired video phone calls, mobile video calls, plus all the extras that a firm like Vonage can provide by using the internet. (Vonage, for example, is promoting the conversion of audio messages to email texts.) Such services are not widely available even if you are willing to pay for them. AT&T had a wired video product, CallVantage, but then withdrew it. It seems mind-boggling that AT&T would just leave the field open to Skype, that it would just withdraw from competition. But this is a pretty clear sign, albeit probably not intentional, that it intented ultimately to be only in the dumb pipe business.
Perhaps one of the reasons that the likes of AT&T are not providing video telephony is that it is a bandwidth hog, and AT&T’s network is already bursting at the seams. Certainly, it would be fair to charge for enhanced services like video to restrict its use of resources (and pay for them), but perhaps you can only charge for it after it is widespread enough to make it worth paying for.
“Without Exception, All of My Biggest Mistakes Occurred Because I Moved Too Slowly” – John Chambers
That’s what John Chambers of Cisco (CSCO) said of his response to the dot-com bubble bursting. He felt he moved too slowly in his responses to changing conditions, especially for high tech game-changing businesses.
Certainly, the music companies lost revenue for failing to act. No one could accuse the major telephone companies of moving too quickly. But size itself becomes a problem. Accenture (ACN) not too long ago featured an elephant on a surf board with the idea that large companies can still be nimble. Get serious. I’ve never seen a worse ad. Sure, size gives you the heft to do big things, but on the other hand, it takes a lot to move a super tanker, if you get my drift.
Implications for Investors
If the music industry and internet models may be relied on, probably telecom revenues will fall no matter what, which makes the major telephone companies a lousy bet in any sequence of events. Consider this: Skype has less than 1,000 employees, and it has 20% of the international market. So job loss seems a given. With job loss comes lower costs and possibly lower pricing and concomitant lower revenues. But destruction of revenue could be limited if the telecoms act to defend their turf. iTunes did not come along until a couple of years after Napster. But the lawlessness of those few years wrecked the industry. I submit this is already underway in the telephone business.
Microsoft (MSFT) bought Skype for $8.5 billion. A few years ago Microsoft bought a small telecom software company, and put out a telephone add-on (softphone) to Windows, but with no major telephone company wanting to connect with Microsoft, this tool went nowhere. Now it has bought its own internet telephone company. This is far outside of its main business of operating systems.
What is troubling is that this internet telephone company does not generate that much revenue, and looks like it could be more junk in Microsoft’s online business. If Microsoft starts to charge, then it will begin to lose a large portion of its huge user base, one of the reasons Microsoft bought Skype. My initial take is that we are reprising the eBay purchase of Skype, but in large. That is, Skype never worked for eBay (EBAY) the way it was supposed to, which is to say it never connected buyers and sellers of its auction market. They still used email.
I see no immediate improvement in Microsoft earnings. Therefore, you must consider Microsoft on its own, and I consider it an embattled company with its main business - operating systems - at risk of becoming irrelevant by not becoming a major force in cell phones, though certainly the deal inked with Nokia may help put it on the map. And it is fighting for its life on the new turf which consists of tablets like the new iPad. Apple (AAPL) and Google make formidable competitors. I have already written about Microsoft, and the purchase of Skype looks like a distraction, and does not change my mind. I would look elsewhere.
One can invest in the internet equipment providers, but Cisco (CSCO) is one of those large “elephant” companies, what I want to call a GDP company. This was made clear when Cisco said business would not grow as much because state governments were ordering less. Juniper (JNPR), not really suffering quite the same size problem as Cisco, has also spoken of this same malaise.
Alcatel (ALU) may be the best bet in this group at the moment. After losing money for years, and after continual downsizings, Alcatel has found astute leadership in Dutchman Ben Verwaayen. ALU is well-positioned for where the business will come from: cell phones and the internet. Its share of the router market has increased from 12% to 16%, and ALU has passed Juniper to become No. 2 in routers. It is also well-positioned in the up-and-coming 4G cell phone market. It has big contracts with Verizon and Sprint and is therefore good bet for the institutional investor.
Obviously, I think Clearwire is very interesting, but start-ups are speculative. For this reason, it is too early for me to make a call.
Vonage (VG) is interesting. It collects the taxes; consequently, a change in the taxing of “free” online carriers would not affect it so much, and might actually draw business to it, especially if it offers internet services that Microsoft/Skype is offering. In the meantime, it is very competitive against the major telecoms because it is already offering a billing structure that includes all long distance, domestic and international, for a fixed charge. In addition, it includes in its basic charge services that are hard or impossible or very expensive to get, like forwarding calls to a foreign country.
Vonage has not done anything with video or mobile, but these are probably under consideration. Its finances seem a bit squirrelly, so one could wait. On the upside, it is possible that a major could buy it just to get its customer list and integrated technology. Or a hedge fund might buy it. After all, a hedge fund bought Skype from eBay.
A number of small telecom software companies have already been gobbled up. Google bought Gizmo5 and GIPS on the cheap. Microsoft bought Teleo for an undisclosed sum, but probably did not pay a lot for it.
Counterpath (CPAH.OB), which counts as many customers as almost every important telecom (AT&T, Verizon, Sprint, etc.), is probably the best of the lot. When the major telecoms decide to upgrade their services to the level already offered by internet telephone carriers, they will turn to a company like Counterpath, or one of the equipment providers already connected with Counterpath (Cisco, Ericsson (ERIC), Juniper, et al). In the meantime, while waiting for the major telecoms to make up their minds, Counterpath has become seasoned in the enterprise world. It is an expert in voice over internet (VOIP) and has wireline video and mobile and mobile video in its portfolio, patents, and all the extras. It has apps for the iPhone, iPad, and Android. It has informed leadership emanating from Terry Matthews, who made his billions picking winners in telephone and networking and selling them off. Sales will shortly be over $10 million, and it looks to be profitable any quarter now. Major telecoms have done little with video, and lack the kinds of services a true internet telecom should be able to offer. In an M&A market like the one we are currently experiencing, it is very cheaply valued, though it is a tiny company, highly speculative, and not for the risk averse.
Disclosure: I am long CPAH.OB.