DSL Prime: Recession Looms

Cable is cutting capital expenditures as big deals are called into question by market uncertainties. One bright note comes from Google.

by Dave Burstein of DSL Prime and Future of TV [March 11, 2008]

Bell Canada Takeover Hanging in the Wind
Teachers Fund pushing ahead with high bid
The kicker behind the Bell Canada story is that the company has been goosing profits by raising prices, including DSL. They have not made the capital investment to compete against Videotron's DOCSIS 3.0. Another wireless company is coming, likely to drive down prices. It will be very hard to sustain the profits the deal requires without politically unpopular further price increases.

The stock market price of Bell Canada is now over 15 percent below the $48 billion buyout price, which means some very serious money does not expect the deal to go through. The CRTC has blocked the sale until they are assured Canadians would remain in control. Jeff Fan of UBS expects the obstacles to be overcome, which remains most likely. However, the PE firms Providence Equity (Mike Powell's gig these days) and Madison Dearborn would never make such a high bid today. The fourth partner is Merrill Lynch, which is currently reporting tens of billions of dollars in losses and would presumably love to get out of the deal.

Currently holding up the transaction are laws to protect Canada's cultural heritage. Many Canadian broadcasters and magazines have not been able to compete with the U.S. giants, resulting in limited Canadian production and news coverage. Canadian law requires 53.3 percent of the stock remain in Canadian hands so that not everything is taken over. Bell owns media and a broadcast satellite. The Canadian Press reports testimony "the structure of the holding company gives non-Canadian shareholders more control than their minority status because they have a veto right over fundamental changes." CRTC chairman Konrad von Finckenstein wanted to make sure Canada had more than "paper control"

The latest sticking point is that Ontario Teachers is proposing an odd way around the requirement they control no more than 30 percent of a company. They are giving a proxy for their shares to a retired executive, while implying he will follow their orders on how to vote. Finckenstein is requiring an approval from the pension regulator, which could tie up any deal for months.

Everyone on Wall Street is wondering whether Merrill can still raise the $23B in debt for this deal. Will Providence and Madison Dearborn pay this price, when today's credit market suggests their bid is $5 to 10 billion too high? Or will they try to find a way to kill the deal?

Bell Canada's DSL has been suffering. I joked a while back that if someone in Chicago wants decent broadband, they should move to Toronto. For years, the Canadian price was 30 to 40 percent less than the States, and the take rate much higher. More recently, Bell Canada actually raised their DSL prices with implicit support from Rogers and Shaw. The broadband net adds fell dramatically. Sabia and Cope want to sell now, getting a good price before trouble hits.

Bell Canada also faces more wireless competition. The CRTC regulator has been very generous with the telcos, but recently made a very smart move that the U.S. could learn from. Jeffrey Fan of UBS reports, "Industry Canada released the AWS auction rules that included 40 MHz of spectrum set aside for new entrants, mandated roaming (could range between 5 and 10 years) and tower sharing (both at commercial rates). Overall, we thought the rules are generous for potential new entrants." He's since looked at some of the details, which give the incumbents some advantages. The net result is likely to be a new national competitor and lower rates.

Cable Capex "Freefall"
Why do you think they need rules dropped in D.C.
"'Freefall,' Craig Moffett calls cable capital spending. The Bernstein analyst calculates Cablevision capex at 11.7 percent of revenues in the fourth quarter, versus 13.2 percent a year ago and 16.4 percent in the previous quarter," reports Jeff Baumgartner at CDN.

Time Warner Cable's CFO Robert Marcus wants to cut 7 to 8 percent per year. He says "CapEx as a percentage of revenues was 21.5 percent for 2007 a decline of roughly 160 basis points from the prior year. This is an important trend which we expect will continue. Baked into our free cash flow guidance is our expectation that capital expenditures will remain steady at approximately $3.5 billion both in the near term and over our long term. This would result in a reduction of CapEx as a percentage of revenues to approximately 20 percent in 2008 and this will continue to improve over the next few years."

The cable capex crunch may or may not delay DOCSIS 3.0 because the cost is relatively low. Tony Werner figures it will cost him the same to offer 100 meg as it now costs for 6. Steve Craddock called it so cheap "we could find the money in Bill Gates' couch." Whether they move quickly to 3.0 and whether they price to win customers is the great unknown. The engineers are very optimistic, but the field deployments so far are limited.

Is the economy dying like DSL CLECs in 2001?
Enormous Risk, True Recession Fears. Be very scared
The margin calls on a piece of the Carlyle Group are an ominous sign. Carlyle has been one of the most successful buyout firms, running tens of billions and reporting profits so high they can handle a recession. If Carlyle is in trouble, are Providence and Madison Dearborn next? That kills the Bell Canada deal, among others. My smartest Wall Street friends don't expect good news.

In 1999, "everyone" thought the good times would never end and took wild risks. What I'm seeing from the street looks so similar sensible people should be very, very scared. Rhythms NetConnections was a $3 billion company in 2000, and bankrupt soon after. Covad went from $10 billion to bankruptcy. Northpoint and a dozen others went from top of the world to out of business incredibly fast.

U.S. financial markets have seen a similar meltdown. Wall Street firms are firing people, expecting things to get much worse. Meanwhile, many of the "reassuring" comments show great ignorance. "Price declines of this magnitude [? over 10 points ?] were not supposed to happen in the leveraged loan market," comes from Bank of America "analysts." Gibberish. Leveraged loans by their nature tend to be risky, which is why PE firms demand such high returns. Most bought companies at well above what the stock market considered fair value. Many PE firms then milked the companies the first few years to get all their capital out.

The potential profits in PE are so that high some spend like drunken cowboys. The result is a loan with substantial risk, of which some are guaranteed to go bad. I learned that the best forecasters are wildly unreliable. I'm no better, and am suggesting prudence, not predicting a unstoppable massacres. I don't know.

Seven Terabits, 10,000 Kilometers,
$300 Million For New Pacific Fiber
Cost to Google: $1 to $4 per megabit per month
What Geeks Know sounds like an interesting subject. This is one example of the how the backbone will meet demand.
Bharti Airtel, Global Transit, Google, KDDI Corporation, Pacnet, and SingTel are building a new cable from Tokyo to Los Angeles, as Commsday first reported. The cable should be operational in about 24 months. There's no shortage of capacity on the route, but these companies decided it would be cheaper to lay their own cable. Cable laying ships built during the boom are now available at moderate cost, which also makes the East African cable economically attractive.

If the full 7.68 Tbps of bandwidth were efficiently used (impractical), that would equal 7 million or so megabit connections. $300 million over the standard 20 year lifetime of an IRU is $15 million per year, or $2 per megabit annual capital cost. Add operating and repair costs, as well as a factor for interest, and the cost is perhaps $6 per megabit per year. Only part of the capacity will be used initially, and networks run well under peak capacity most of the time, so I'm setting the minimum per megabit cost at $10 per year. For a more conservative ten year life, perhaps double that.

Different utilization assumptions, and the cost goes higher. A final cost of even $4 per megabit per month is less than half the high volume price of purchasing transit, and enables carrying a movie for a price in pennies. 32 Kbps or even 128 Kbps voice calls are a very small fraction of a penny. Upgrading dark fiber is considerably cheaper, so bandwidth costs should continue coming down.

Google is making volume deals like this around the world to gain a strategic cost advantage against Microsoft, Yahoo, and even major telcos. Two years ago, Google engineers were told to plan video and other high-bandwidth projects "as though the bandwidth was free, because the entire cost could be covered by the requirements for Google Search." While that is probably exaggerated, Google has driven down their bandwidth costs dramatically. That hasn't been enough to dominate the market, however. One of my bigger mistakes was projecting Google Video's low cost basis would quickly bring them to the top. In fact, they never gained traction and finally bought YouTube.

Copyright 2008 Dave Burstein.
The DSL Prime Newsletter is reprinted with permission.

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