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t2 posted Ravi Suria's interview regarding the telecommunications industry debt and capital structure issues. Since I have been chasing this issue for a while, I promised t2 to write down my thoughts on the situation.

t2's original posts:

t2, as promised:

The telecom industry is surely a mess today. Let's cut right to the chase and blame the culprits: DWDM technology and regulation.

1. DWDM technology is THE disruptive technology hitting the business and residential telecom services industry. DWDM attacks the incumbant technology (TDM/Sonet) from below. Put simply, TDM is optimized for voice, DWDM is optimized for data. DWDM exponentially increases bandwidth supply at lower and lower cost but it under performs in key areas - scalability, reliablity, recoverability and service.

DWDM is good for pure raw cheap bandwidth. The missing pieces are just now being developed.

The flip side of disruptive technology is that the indumbants have no opportunity to commercialize the new technology. A new value chain must develop based on the economics of the disruptive technology. The CLEC's and bandwidth wholesalers were the first attempt at developing the new value chain. They ran into some serious problems and began to compromise. More on this later ...

2.) Regulation. Retail distribution of bandwidth to the home is regulated. The result is the last mile owners (RBOC and Cable) have monopolies. Leaving aside any argument for or against this situation, one impact of regulated monopolies is that it removes the incentive to innovate. Innovative attackers can't get access to customers and the incumbants can't make enough profit to justify the neccesary risk. Retail distribution of bandwidth is one area desperately in need of a good shot of experimentation and innovation. Watch all the 'impossibles' about fibre-to-the-home drop away if this area was open for competition.

So, there you have it, a disruptive technology needs a new value chain. In one very large market regulation makes it impossible for this value chain to form. A very bad combination and it leads to a mess.

All the business models assumed a higher need for bandwidth at the home. So, the cash flow gets hit and smart companies follow the path of least resistance ... business sevices.

Here you have another problem. The dreaded chasm. What business services? What business model? What physical delivery mode?

OK, we've all been to the chasm before. We know what it is and how to manage in it. However, the telco industry has never been to the chasm before and didn't see it coming. The borrowed all that money to build a backbone of incredible bandwidth and distribution to the customer is blocked.

This is the source of the 'bandwidth glut' v.s. 'exponentially growing demand'. Bandwidth distribution is extremely inefficient and cannot adequately sevice the demand.

Thus we have our second hit to the cash flow. We can't get business servce revenues to ramp yet.

Now the industry starts to compromise. Pure play business models become hybrid: Quest buys US West. Pure DWDM technology becomes hybrid: Next Generation Sonet. The whole industry and the fine folks who finance the industry start to try and put the genie (DWDM) back into the bottle.

The third and final kicker is that technology innovation never stops. New fibre optic components are invented constantly - Avanex, New Focus, VxCels, 10 Gigabit Ethenet ... All of this makes more bandwidth available for less cost.

Sounds good, right. Wrong. The bandwidth suppliers are in debt upto their eyelids paying off the older and now less efficient technology. The new technology has the effect of undermining the asset value of last years fast backbone (or MAN).

Cash flows increasing slower than anticipated. Competition increasing faster than anticipated. Compromise technologies and business models. Descreasing asset value securing the industry debt.

That is the mess.

The way forward.

1) Deregulate the local phone and cable access markets. This will happen. How and when are the only questions.

2) Business sevices cross the chasm and get into the bowling alley. A new layer of player will emerge to supply these services. Exodus and the web hosting services are one. Loudcloud and ebusiness operations support is another. Yipes and the Ether-LECS are another. Voip, VPN and data centre outsourcing are all candidate services. Crosspoint Ventures - one of the big optical VC's - specializes in what they call vertical service providers. The forces of innovation are at play already.

3) The telecommunication industry will restructure. It cannot pay it's debts or finance the required technology deployment. The industry will continue to operate but the most of the equity will disappear. It will emerge on the other side in much better shape. Inefficient networks will be sold for scrap or be upgraded.

4) The all DWDM packet optimized backbone and MAN will emerge and it may be developed and owned by companies which don't currently exist. The business model for these operators will take some experimentation to discover.

What should investors be avoiding or seeking?

1) Avoid telco stocks.

2) Avoid transport level technologies (Ciena, Sycamore, Avanex, ...) until the business model for the all DWDM packet optimized network becomes clear and the technology to support the business model is chosen.

3) Watch Exodus, Loudcloud, Yipes and all other new generation business service providers. It is too early to invest but it is worth watching.

4) In the three level model (transport, network, service) the network level is the most important today and will continue to grow rapidly.

This is the Juniper v.s. Cisco battle. A new technology which is coming later this year is critical - GMPLS. GMPLS allows bandwidth providers to configure networks to offer specialized services without incurring the full expense of opening each IP packet. Juniper and Cisco will begin promoting GMPLS in a big way. The winner of this game will be the supplier that provides the best tools to network engineers and architects. They use these tools to build, rollout and provision new services. A new value chain of sevice provides will form around this layer of software.

IMO, Juniper is leading this race with JUNOS and Cisco is hobbled by having to maintain compatibility with it's legacy software - IOS. The core router market is about to transform into the 'core router / service switching' market and grow even faster.

5) Component companies will begin to integrate GMPLS into their components. This is a key point. If a company like JDSU or AVNX or Corning or PMCS etc. misexecutes the GMPLS switch - they will lose market share very rapidly.

Until the GMPLS landscape is clear - the optical component companies look very risky.

6) Nortel will do quite well for a quite a while. There will be an increasing demand for systems integration products and services. This is Nortel's game and they play it very well. Nortel may well become King but it will not become King Kong (Gorilla).

7) All of this start to bleed into the 3G world but that's a long story.

Finally, DWDM is a disruptive technology and it will not be stopped. The new services are being developed today and already the capital structure looks more reasonable. Equity financing forces the industry to get to operating cash flow positive in a hurry. Debt financing actually served as a disincentive to innovation.

Let the games begin.

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