What now for submarine telecom? Overcapacity, valueless assets, and no pricing power��are there any reasons to be cheerful in an industry that finds itself under financial water?

The submarine telecom industry--which knits together the global infrastructure backbone--remains in a depressed state. Nonetheless, slowly but surely, the sector is changing its shape as it struggles to adjust to post-bubble times and prepares for the anticipated global recovery in telecom.

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But what is the way forward? That depends on what the industry sees as the key problem. For many observers, the operator sector of the industry has been mired in overcapacity for at least three years on the most built-up routes--which are the trans-Atlantic and trans-Pacific segments. Regional and niche plays, say experts, fare much better. There, demand is still evident and supply is limited.

Key questions still overhang the debate about the future direction of the submarine cable industry. The first is: should the industry force itself into a restructuring process via consolidation? This would limit overall capacity and ensure some measure of price stability and adequate cash flow, thus enabling longer-term survival. This begs the second question: should it wait for external players, perhaps specialist infrastructure investors or even speculative vulture funds, to effectively achieve the same result?

A changing industry?

If and when restructuring does occur, the eventual shape of the industry could be very different. "The submarine telecom industry is quite scary at the moment," says David Beck, associate director of the Macquarie Infrastructure & Specialised Funds based in Australia. He probably reflects the feelings of many investors around the world looking at the industry, and continues: "We would like to see consolidation, and the industry return to the positive cash flow and get rid of some of the excess capacity inventory."

Some experts predict the effective end of the long haul carriers' carrier model altogether, at least for those operators that exist independently of major incumbent players. Those who agree with this argument usually go on to say that the industry itself will once again become a subset of the incumbent telco community asset base. In doing so, this outcome would see the clock turned back perhaps a decade, to the world of submarine telecom as it was before private cable systems arose to compete; back to the club-based systems specified and put together by the major incumbents. At the moment, say observers, the industry remains precariously hung in a wait-and-see mode. But it is nonetheless a peculiar and ironic time for the industry.

With pricing so depressed thanks to overbuild, valuations of some key and high profile submarine telecom systems are marginal, perhaps at or near zero while, at the same time, opex costs are still significant. "At this level, wet maintenance for all the Atlantic systems is around US$50 m per year [and] this is potentially more than the entire value of the cables themselves," says Alan Robinson, SubOptic 2004 President and VP of Cable & Wireless Global Operations Engineering Services. "[So] I have to question why, in the case of the Atlantic, we are paying for a 365/24 operation when this opex is alone is probably enough to buy all the troubled trans-oceanic systems," he says. Robinson adds that the industry may find itself in a position where it foregoes round the clock operation on every cable system, allowing failures in the submarine segment but still ensuring enough capacity to cover in case of outfall.

Some operators object to the idea of having spare capacity they could switch into place. This is mainly because of availability commitments they have made to their own customers, but no one denies the opex overheads have become onerous. "O&M is our number one cost," says Robin Russell, CEO of Australia Japan Cable (AJC), "and compared to it, other expenses are miniscule." Whilst not asking for outright consolidation, Russell says a lot more could be done in terms of co-operation between operators to reduce these expenses.

Brian Roussell, president and CEO of a regional operator, WCI, says notwithstanding the possible anti-trust fears, he continues to favour some form of 'newco', an infrastructure entity created by the pooling of excess capacity resources on the key routes. Operators, says Roussell, would contribute their cash resources, pool opex and capex requirements and share equity under such a scheme. The newco would effectively consolidate the appropriate parts of the industry and owners and operators who would benefit from the efficiency and rationalisation that would result. Of course, they would also have to acknowledge upfront the financial pain of write-down, and get used to the idea of supporting competitors in order to help themselves. Industry insiders who mull this sort of idea warn that the psychology of the major players has yet to accommodate that notion. However, as Roussell points out, "a continuation of the current situation is in no one's interest".

It seems that the industry, having been through booms and busts in the past, is set to await the upturn. Ironically, if and when it comes, it could eradicate the capacity inventory overhang too quickly. Some industry executives--such as C&W's Robinson--suggest this might generate another crisis point, but this time of capacity shortages down the line. This would pose problems, not least for a supplier community that is already concentrated and has made deep manufacturing capacity cutbacks.

What recovery and when?

After three years in the doldrums, there is expectation of industry recovery, but reluctance to predict exactly how and when it might occur. Indeed, some observers are questioning what is meant by "recovery"? For some, the answer is in graveyard humour, as pricing remains extremely depressed and likely to sink further. Anecdotally, industry behaviour seems to suggesting continued price undercutting by players just to get cash in--even if that cash is not likely to cover opex. One executive comments "what pricing" when the subject is mentioned, another says that the US$1 paid for an entire sub-oceanic system recently looks "like a very good deal in hindsight". Not all markets are equally affected, however. WCI's Roussell says: "Unlike long haul markets, [as a niche player in Alaska] WCI has some ability to generate price points for its capacity that provide a reasonable return for its own business." WCI itself was a Chapter 11 victim prior to a recapitalisation.

Meanwhile, industry observers continue to ask what factors will drive recovery when it appears. Experts acknowledge that, in the absence of a market demand upturn, and barring outside intervention (for example, some form of regulatory restriction, or direct government fiat perhaps because of national security implications) internal consolidation of the major systems seems to be the only spur. However, looking over the post-bubble period, any consolidation seems to be progressing a snail's pace. Indeed, many in the industry are worried about openly advocating consolidation between players for fear of breaching anti-trust legislation in the US or Europe or both.

The national security worries that accompanied bidding for Global Crossing in 2003 show the sort of stumbling blocks that can arise. The US government objected to a consortium composed of Singapore Technologies and Hutchison Whampoa and, eventually, Hutchison withdrew. However, whatever the potential difficulties, privately, most executives concede that some form of consolidation is the only way forward and signs of movement may already be there. Reliance's acquisition of FLAG Telecom in January 2004, for example, could augur wider consolidation within the industry, though the Reliance strategy seems to be geared toward obtaining an international network to support its domestic Indian connectivity (see global news analysis, page 11).

Some observers have suggested that the US$211 m purchase price for Flag-was higher than strictly justified by the current market conditions, but Ed McCormack, Flag COO, points out that, "Flag is a small, unencumbered company relatively free of joint ventures, partnerships and other complications. It has a very good customer base, with good relationships with Tier 1 operators around the world." He continues: "Reliance wanted to globalize its Indian telecom business, which has been growing very substantially, [and] Flag was the perfect fit." McCormack also argues against the idea that the post-bubble industry trend has effectively meant that independent carriers' carrier operations will disappear from the marketplace, though changes are evident in the industry landscape. Tyco, for instance, is in the process of selling its entire global network, TGN, built over the past few years to become a 60,000km long global system. Tyco added operations to its traditional activity as a supplier but Bill Marra, CTO of Tyco Telecommunications with responsibilities in both supplier and operator functions, acknowledges that, "TGN business does not align with the [new] strategic objectives of the Tyco management team. The company, says Marra, will retain manufacturing and supplier capability.

Broadband demand

Optimists in the industry take the view that broadband growth on the retail and domestic side will--eventually--show up strongly in the long haul side. Certainly, broadband take-up around the world is beginning to impact national traffic patterns. "We are in the fortunate position in Australia of seeing broadband beginning to bite; there is about a 20-25 per cent growth per quarter on the latest figures in broadband in Australia," says AJC's Russell. But equally, there is concern that this demand may not actually dramatically improve the economics of the submarine telecom segment. This lack of leverage is in sharp contrast to the historical situation of the submarine telecom industry, which was traditionally seen as one of the key bottlenecks in the telecom network and, thus, immune to pricing pressure.

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The relative decline in importance of submarine networks should not hide the fact that there is increasing opportunity in some marketplaces. The Reliance Flag deal highlights the fact, for example, that the Middle East/Indian portion of the global submarine network is not over-supplied and that this is potentially a "sweet spot", argues Flag's McCormack. Other opportunities might exist too, says Robinson, such as in the Caribbean--and there could be business in satisfying intra-Asian regional demand. The Southern Hemisphere saw a less pronounced downturn, AJC's Russell points out because, historically, Australia has had restricted connectivity. And even globally, the picture is not necessarily all gloom.

Tyco's Marra says TGN has seen "consistent growth". From a standing start last year with no customers, it now has about one hundred. "We do see a growth that should in the very short term [provide revenue to] exceed opex, which is a good sign." Marra says that although most of the customers are taking short term leases, some have bought the traditional long-term lease in the industry, the IRU. But Marra cautions that the problem for the industry in general is long-term survivability if pricing points continue to be eroded. AJC's Russell says he believes across the world "the trans-Pacific situation is similar in problems to the trans-Atlantic situation" but adds that "it would be a big mistake to see this industry in a single global sweep." Russell argues that "the price points being reached today are in some cases below the cost of capacity, and this will cause a dilemma at some point".

But how will investors react to the changing times in the submarine cable environment? Macquarie's Beck argues that different investors have different attitudes to risk and different needs. "We are interested in 'boring' stable investments with predictable cashflow, and the submarine telecom industry recently has been anything but stable." But in spite of the pessimism in the submarine telecom community, Beck argues: "We [investors] have seen a crash in several industries." His advice? "Cheer up."

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written by Stephen McClelland

Stephen McClelland, editorial director. This article is based on a SubOptic panel discussion at PTC 2004. Telecommunications[R]

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