Home - Key Questions - Fixed Networks: Section 1 - Question 2

Section 1: Questions regarding the incumbent telecoms companies and the new facilities-based operators

Question 2: How will the fortunes of both incumbents and new facilities-based operators be affected by a capacity glut?

Why have the share prices of operators such as MCI WorldCom, Qwest, Global Crossing, Level 3, COLT, Energis, Vodafone and Mannesmann risen so much over the last few years?

The main reason given by the telecoms companies, financial analysts and journalists has been the explosive demand for data communications largely driven by the internet. This demand, it is argued, has placed a premium on the assets of those telecoms companies that are able to carry and connect the data that is the lifeblood of the internet. Although many of the new operators are still making losses as a result of the costs of constructing their networks, the price of their shares has risen dramatically. Driving this increase has been the expectation that their future earnings and profitability will be high enough to justify current share values due to the anticipated demand generated by the internet.

For example, at a recent conference an MCI WorldCom executive noted that it was only in 1994 that the advent of web browsers unleashed the World Wide Web. In 2000 there were an estimated 163 million users of the web. Demand for internet bandwidth doubles every three to four months. The speaker concluded that “the lack of available bandwidth is one of the key factors driving WorldCom’s business strategy today”.

But is the argument purporting to explain the share price rise correct?

At the very least it can be said that any argument about company worth which is based on an examination only of the demand side, while ignoring the supply side, must be incorrect. While there may indeed be an explosion in demand for broadband capacity it is also necessary to analyse what will happen to the supply side. In order to assess the operators' future earnings and profits one essential question is whether demand for broadband capacity will grow faster than supply or vice versa.

The supply of broadband capacity will increase in the future for two related reasons. Firstly, investment in additions to broadband capacity is increasing rapidly, fuelled by support from capital markets. Secondly, rapid and radical technological change, particularly in the area of optical communications, is fast increasing the capacity of both existing and new networks. For example, at the beginning of 2000 Lucent's Bell Labs was able to send 1.6 trillion bits (terabits) of information through a single optical fibre using a technology called dense wavelength division multiplexing (DWDM). This technology uses different wavelengths, represented by different colours, to send many signals simultaneously through the same optical fibre. This is enough for 25 million conversations or 200,000 video signals and one cable may contain a dozen such fibres.

To make matters worse for the future earnings and profits of the new operators, the equivalent of the famous Moore’s Law in semiconductors – which states that the transistor density on a silicon chip will double each year – is also operating in the area of telecoms networks. For example, due to the technological change referred to, the carrying capacity of optical fibre is doubling each 12 months and that of wireless channels every 9 months.

What are the earnings and profitability implications of the explosion in demand for data communications, on the one hand, and the rapid increase in the supply of capacity on the other?

In order to understand what will happen to total revenues two different effects must be distinguished. The first relates to the increase in demand and supply and to which of these is growing more rapidly. If supply is increasing faster than demand (technically, the supply curve is shifting more than the demand curve) then the price of capacity will be falling. The second effect relates to the responsiveness of demand to changes in price (technically, the elasticity of demand). If demand is very responsive to a change in price (i.e. there is a high price elasticity) then, all else being equal, a fall in the price of capacity will lead to an increase in demand. This implies that the total revenue of all the operators will increase even if the price of capacity falls. For example, if, as a result of falling broadband prices, it becomes cheaper to run video-enabled web sites there may be a significant increase in demand for these. In turn this will generate a futher increase in the demand for broadband capacity.

But what are the implications for the earnings and profitability of individual operators?

Assuming that, as a result of the high price elasticity of demand, the total revenue of all operators rises as the price of capacity falls, we still need to know how this revenue will be shared amongst the telecoms operators. Essentially, this will be determined by the competitiveness and success of each player. In order to calculate the earnings and profitability of the individual operators we need to deduct their costs from their revenues. Obviously, the fact that total revenue for all operators is increasing is no guarantee that the earnings and profitability of any particular operator will rise.

But what is actually happening to demand and supply and how elastic is the demand for capacity?

Unfortunately, there is no consensus regarding the answer to these questions. On the one extreme, there is the 'capacity shortage school' arguing that over the next few years increases in demand will outstrip increases in supply and that the high price elasticity of demand for capacity will create significant opportunities for efficient operators. This will be accompanied by rising earnings and profits thus justifying sharp increases in their share prices.

At the other extreme is the 'capacity glut school', arguing that supply will outstrip demand and that the price elasticity of demand will be insufficient to generate greater total revenue for all operators. This school, accordingly, is more pessimistic about future earnings and profitability.

In the middle is the 'pendulum school' arguing that demand and supply will interact so that overshooting occurs, i.e. excessive demand will lead to excessive supply that in turn, via capacity price falls, will again result in excessive demand, and so on.

The problem is that the effects hypothesised by each of these schools lie in the future and there is significant uncertainty regarding what the precise effects will be. Under these conditions of uncertainty there is interpretive ambiguity regarding what will happen next; precisely the situation in which people will construct different visions of the future.

For more details on visions and uncertainty see Defining Visions.
If you wish to express your views on questions such as these go to the Workshop (Area 1). To compare your visions with those of others go to Vision Check.