Has the NET Stopped GROWING? - Nortel CEO John Roth predicts decline in Internet traffic - Company Financial Information

NORTEL CEO JOHN ROTH MAY HAVE RAISED A FALSE ALARM ABOUT NET TRAFFIC, BUT THE WARNING SIGNS ARE REAL FOR THE STRUGGLING TELECOM INDUSTRY.

As CEO of Nortel, John Roth had the unfortunate duty to tell the world two weeks ago that his company was about to report one of the most disastrous quarters in business history, a loss of more than $19 billion. But as he tried to explain what's gone wrong with his company, whose equipment carries three-quarters of Internet traffic in the United States, Roth threw in an almost offhand comment: Nortel, he said, had seen Internet traffic decline for the first time in history.

Roth was probably just doing what any responsible CEO might in his situation -- blame the industry for his company's woes. But in doing so, he called into question one of the fundamental tenets of the Internet.

For almost anyone in the industry, the suggestion that online traffic could be declining is a shocker -- the Internet has been claiming some of the most fantastic growth rates in the history of business. Days later, Joe Nacchio, CEO of Qwest (one of Nortel's best customers) held an angry conference call in part to refute Roth's statement about traffic, which he called "legally misleading." He added, "I don't know who they were talking to, because ours is up 46 percent."

Nortel has since admitted that Roth overstated the case. What he meant, say the spinners, was that just a small segment of the market was shrinking, and Nortel did not see the negative trend continuing. But it's too late now -- Roth's comment revealed a telecommunications industry racked with anxiety, and for good reason. The once indefatigable Internet sector has turned into a slaughterhouse. The financial markets have almost completely turned their backs on the builders of the Internet, the telecom companies, which are staggering under backbreaking loads of debt and facing a dearth of services that could boost flagging revenues. With countless companies dropping off the face of the earth, it makes perfect sense to wonder if the phenomenal growth of the Internet is over.

Actually determining how much traffic traverses the Net and placing it in context isn't easy. After all, early growth estimates and incredible hype were carelessly entwined, repeated, amplified and spread by media outlets and popular pundits like George Gilder. Soon, certain presumptions became accepted fact, most notably that the Internet was doubling in the amount of traffic it carried every few months. (Most reasonable observers now think Internet traffic was doubling every 10 to 14 months at its peak.) It's impossible to know just how many leaky business plans were launched on this premise.

And the hype continued. From 1999 to 2000, most Internet networking companies claimed they saw traffic increasing at rates anywhere from 200 percent to 800 percent annually. Though few people were willing or able to bust the myths about Internet traffic two years ago, it's difficult to find anyone who will stick up for the estimates today. "I guess this is an opportunity to set the record straight," says Jim Crowe, CEO of Level 3, one of the leading carriers of Internet traffic, which laid off 25 percent of its staff a week ago in an effort to survive the carnage. "I have been associated with the Gilder crowd and the notion that traffic would double every four months. What I actually said, back when I was associated with [Internet networking company] UUNet, was that that company's traffic was doubling every four months. But that was a far cry from saying that global traffic was doing that."

Changing traffic patterns are further confusing the issue. In the early days of the Internet, every time a person went online, even just to e-mail somebody across the room, that transmission likely went out onto the public Internet, perhaps across the country or even across an ocean, before being routed to its destination.

But the Internet has matured, so more traffic is staying close to where it originates. In fact, UUNet reported that between 1997 and 1999, 30 percent of all U.S. traffic never crossed the national infrastructure but stayed within a local metropolitan network. And many smaller countries have built out their own Internet networks, which means less international traffic is routing through the United States. You can't look at just traffic on the national backbone to gauge Net use.

So the good news is that Internet traffic continues to rise at a relatively healthy clip -- a rate that, in fact, would make any other industry sick with envy. Most analysts still see 50 percent to 100 percent annual growth in most regions.

The bad news is that even this kind of positive growth can't sustain the number of companies competing in the Internet business, and hundreds of them will go bankrupt before the industry regains its health. "I see a bloodbath," says Hugh Martin, CEO of ONI, a maker of networking equipment. "This is a 10- to 15-year problem."

Some $70 billion has been spent in the past few years on the long-haul Internet infrastructure. And an astonishing $240 billion in high-yield debt has been dumped into telecom carriers over the same period. That easily eclipses the amount of junk debt sold in the 1980s, when Michael Milken and Wall Street arbitrage firms used high-risk bonds to finance takeovers and leverage buyouts.

Some 295 communications companies were funded in the past 18 months just to build the switches, routers and other gear used to run fiber-optic networks, according to venture capitalists Blueprint Ventures. But Merrill Lynch calculates that spending by telecoms on optical communications will be only $8.8 billion this year, and not much more than that next year. "I can attest to the fact that every one of them is promising $100 million in revenue by 2002," says Brian Kinard, a partner with Blueprint Ventures. "Do the math, it just can't happen."

The major presumption driving the growth of these businesses is that the need for more capacity on the Internet would grow exponentially, through the widespread adoption of bandwidth-sucking applications such as virtual private networks and video conferencing.

But the question now is, how badly has the industry overshot reality? More specifically, how much more capacity is in networks than consumers will ever need?

A number of telecommunications analysts, perhaps looking to prove just how meticulously they cover the industry, have taken to counting the number of fibers in every optical network that every telecommunications company has laid. Getting even more anal retentive, many have taken to counting how many of these fibers are "lit" -- hooked up to equipment and carrying Internet traffic. What they have found is that only a tiny fraction of fibers are lit -- as little as 3 percent by some estimates. That seems to indicate a shocking overcapacity. In fact, according to telecommunications research firm Probe Research, perhaps only 14 percent of the fiber laid across the Atlantic may ever be needed. In some markets, the problem is even worse.

But carriers complain that counting fibers oversimplifies the problem. For every dollar spent digging a trench and laying fiber, it will cost several more dollars to pay for the equipment and labor necessary to actually light and run a network. And since the financial markets have largely stopped lending money to telecommunications companies, it's difficult to light all that dark fiber.

"The game is not to see how much fiber you can put in the ground, the game is how well you actually run a network," says Qwest COO Afshen Mohebbi. "I don't care if someone has 99 conduits for fiber in the ground. Maybe you could lease them to the sewer department, but until you have customers paying you to carry traffic through the network, it doesn't mean a thing."

Level 3 estimates it would take $500 billion to light all the fiber that companies have laid. What that means is that while there is little opportunity for anyone to break into the business as an Internet provider for years to come, there will eventually be a shortage unless those networks can be lit.

Also, while carriers have too much fiber on long-haul routes that cross countries and traverse oceans, there is not enough in local networks, the systems that service metropolitan areas. Until that imbalance is solved, consumers will not see much benefit from the existing fiber.

The problem for the carriers (and subsequently, the manufacturers) is that despite years of hype and promise, no one has introduced an Internet service or application that has dramatically increased the need for bandwidth. The closest thing the industry has had is the music-swapping service Napster, which is now dying. According to telecommunications consulting firm Adventis, at the height of Napster's popularity the service was using about 5 percent of the network capacity available in the United States. That percentage has never been approached by any other service.

Over the past few years, hundreds of entrepreneurs have tried to convince investors they had what could be a wildly popular Internet service for consumers. They've been less than convincing. "There is no killer application; I don't think we're close," says Karyn Mashima, VP of strategy with Avaya, a software company for the telecommunications industry. "The only interesting thing I've seen anyone doing lately is on mobile phones. ... But what's that about: People downloading cartoons, and boyfriends sending good-night messages to their girlfriends."

Without a big draw, it was inevitable that growth on the Web would slow, and probably continue to do so for a while. Cable broadband company Excite@Home has found that the average time customers spend online decreased by 32 percent last year. And DSL companies have found that the number of people coming online has leveled off abruptly With the disappearance of alternative Internet providers like the bankrupt NorthPoint Communications, the only option for many people looking to get fast online connections are local phone monopolies like SBC, which have significantly raised prices for service.

"I don't want to necessarily draw a direct line between the fact that NorthPoint's gone out of business and Covad's struggling with SBC raising their prices," says Mike Lunsford, executive VP of broadband at EarthLink. "But it seems like a pretty close relationship, doesn't it?"

Business services also have yet to provide a cure for the industry. There has been so much competition to offer services that showed a lot of promise, such as Web hosting and virtual private networking, that most of these offerings have been sale-priced before they even take off, making it nearly impossible to generate a profit. That's in part because equipment makers like Nortel have been able to increase the amount of data these networks can carry and dramatically lower costs, which has led to pricing pressures. "I just sit there, and Nortel shows up every year with equipment that quadruples my capacity for the same price," says Paul Gudonis, CEO of Genuity.

By now Internet companies have embraced this decline -- according to Level 3's business plan, the company expects its prices to drop 25 percent every year -- something few industries could deal with. But to compensate for these declines, Internet service providers need to put more traffic from paying customers over their networks. Most of the services will simply replace the things older telecommunications companies do, but at a lower cost. Already, Internet phone traffic is starting to take off, and applications like virtual private networks are replacing leased private lines.

Yes, the Internet is still growing. But many of the companies that helped build it are not.

No one thinks the industry will right itself anytime soon, because years of recovery are needed. The market has to be weeded down to a rational number of companies so prices can stabilize. The financial markets, whose wholesale abandonment of the sector brought on this crash landing, will have to get over their aversion to all things telecom. Unless some money flows back into the sector, the new networks and services needed to keep the Net growing and return the industry to health won't be produced.

It won't be a pretty sight, but once the devastation is over, someone might actually make money off the Net.

"We may have overcapacity now, but the pendulum will swing back the other way," says Level 3's Crowe. "The seeds of a shortage are sewn by excess. Now we have to set ourselves up for recovery."

Assessing the Damage
Networking and communications
companies have watched their
values plummet, some to the brink.
          Market Cap
Company   Peak            Peak Date  Current
AT&T      $299.1 billion  2/1/99     $78.3 billion
Cisco     $959.8 billion  3/9/00     $129.4 billion
Covad     $14.1 billion   3/1/00     $128.2 million
Level 3   $47.6 billion   3/10/00    $1.8 billion
Lucent    $257.3 billion  12/8/99    $19.4 billion
Nortel    $261.1 billion  7/25/00    $26.9 billion
PSINet    $8.8 billion    3/8/00     N/A (bankrupt)
Qwest     $48.2 billion   3/3/00     $50.7 billion
SBC       $201 billion    7/16/99    $42.8 billion
WorldCom  $275.1 billion  6/21/99    $132.5 billion
Company   Fallout
AT&T      Is in the midst of a restructuring
          plan that will split the company
          into four pieces - wireless, cable,
          business and consumer businesses.
Cisco     Wrote off more than $2 billion last
          quarter; doesn't expect a recovery
          "for the foreseeable future."
Covad     Has been under threat of delisting
          by Nasdaq and recently reported
          a loss of $198.5 million, or
          $1.15 a share, compared with a net
          loss of $136.3 million, or 93
          cents a share, a year earlier.
Level 3   Announced it was laying off 1,400
          employees, about 25 percent of
          its staff, as part of restructuring.
Lucent    After backing out of a merger with
          Alcatel at the end of May, the
          company's stock has fallen from
          $8 to about $5 a share.
Nortel    Warned investors that it expects to
          lose more than $19 billion this quarter.
PSINet    William Schrader turned PSINet
          into one of the first and largest
          Internet backbone companies, only
          to see crippling debt send it to
          bankruptcy court this year.
Qwest     One of the few consistent
          performers among telecom companies;
          it has reiterated its earnings
          for the current quarter.
SBC       Is in legal trouble with the Federal
          Communications Commission for allegedly
          providing bad data to regulators,
          which may make it more difficult
          for it to gain entry to new markets.
WorldCom  Announced plans last November to
          separate the company's dying
          long-distance business from the
          rest of the company.
Source: Bloomberg, Stockpoint

Inside the Traffic Pattern

David Lake

Add together e-mail, e-commerce and Britney Spears downloads, and you have today's Internet traffic -- a massive cacophony of information. But as these measures below show, Internet traffic may be huge, but it's not growing as fast as it once was. Cable & Wireless' network, for instance, carries a stunning 2.2 petabits per month -- a far cry from the 0.1 it carried in Jan. 1996; but its annual growth rate is less than 100 percent now. AT&T reported 400 percent growth three years ago but now sees just 200 percent. Qwest had 42 percent growth during the first half of this year compared with 90 percent during the same period in 2000. A look at major traffic sources all show a similar dynamic. The red line shows actual numbers; the black shows the growth rate.

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