Jumpstarting a Brighter Broadband Future
Remarks by David Dorman, Chairman and CEO, AT&T
September 15, 2003
Unedited transcript prepared from a tape recording
Proceedings:
I am delighted to be here with you today and what I am going to try to do is give you some of my views on the current state of the industry, what it will take to return investment and prosperity to the telecom sector, which is not going to be a small feat. To keep our lawyers happy, not the least of which is our general counsel, Mr. Ciccone, I have to note that my remarks may include forward-looking statements which are subject to the Safe Harbor provisions of the Private securities litigation reform act of 1995.
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Now with that, telecom is at a critical juncture. It has been at a critical juncture it seems like every year since the Telecom Acts, but frankly, the forces that are in play today have never been more acute. The volumes of use, believe it or not, are still growing, although modestly, this is not in every single category, but certainly minutes, the long-predicted demise of long-distance, you certainly wouldn’t know from the volumes of the AT&T network, where we’ve had 10 of the top 11 all-time volume days of minutes in the last nine months. The largest day, of course, September 11th two years ago, which I hope we never have a repeat of, messages, IP traffic, all continue to build, we’re carrying over a katobyte, fifteen zeros, of IP traffic a day, this is a mindboggling amount of traffic and it has built rapidly.
There is, however, lots of substitution, this intermediation from wired to wireless, from fax and voice to email, web enablement has moved traffic from 800 services over to the web, and IP is beginning to get traction in corporations, not just as an access vehicle to the internet but as a replacement for legacy data services including the long-declining private line product set as well as ATM frame relay.
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Revenue, however, is still declining due to very intense price competition. That, again, no surprise given the excess capacity in the industry and the re-pricing at the base of the large players. There has been massive cost cutting, certainly AT&T has had its share of that, which mitigates some of the profit decline but certainly profits are still declining for the industry and are not keeping up with the decline in revenues through cost-cutting. I think the economic recovery, you know the sort of ever-receding imminent bonanza for telecom is, well, you know, maybe the economy will make it better.
The economy will help, especially if the economy recovers with jobs, since human beings do the communicating, GDP growth obviously lagging and jobs and telecom lagging the job creation. It will be a while, but frankly, structure continues to have a bigger impact, in my view, on the supply side against the nominal demand growth. So demand, if you went back and regressed demand to the pre-bubble levels and extended it forward on the historical nominal basis you know the demand isn’t radically off from what one would expect it to be again you know if you didn’t have this mountain between us and the time before the bubble, but we do have enormously more capacity to ford out there chasing what demand is in the market.
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I think that wireless local, long distance, broadband are converging at different paces, you know not all together all at once but sometimes in fits and starts, and choice is still fairly limited. I’ll talk more about structure later, but even how we define the industry I think is fascinating. Is it by components, is it taken as a whole, is it local or is it LD, is it one voice business or is it one data business, I think broadband ….I’m not sure that competitors or investors or customers see it at all the same as regulators, antitrust officials, and legislators. Frankly, it depends upon where you sit, and how you think about the business.
I do find that when we intermingle with those different consitutencies that we tend to agree about the future, with an indefinite view of when the future becomes today. In fact, there are radically different conclusions that have been therefore proposed, as a result of those different views.
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I’d like to take a little closer look at competition and its evolution in the consumer services segment. the bells today have the ability to offer local and long distance bundles in 43 states, which serve more than ¾ of households. They offer a local and DSL bundle, across also ¾ of households, but not exactly the same ones. Cable telephony, which we have only been hearing about for about 20 years, I can’t even remember when it was Ray Smith and John Malone were going to merge things, like, 100 years ago, probably only 10…
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But cable telephony is now available in a startling 13% of households, and is currently taken by 2% of households, which is about 16% of homes past. You know, it’s a start, since we were hell bent for leather doing it as AT&T broadband, but there’s not as much pursuit of that, but you know it’s evolving, which I think is the right way to think about it.
Wireless is an economically attractive substitute for some residential customers, and I think there’s speculation that there may be as many as 5% of consumers who avail themselves of a wireless-only communications service, but it’s not a full-service substitute, with all due respect to my former colleague and now large customer John Ziegles, I can’t use AT&T wireless at home without going out and standing in the driveway which at times can be inconvenient.
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That’s not a surprise either because wireless networks have been largely deployed not as residential usage, but as commute usage and major thoroughfares and business districts, not in residential communities except you know I won’t say by accident but by opportunity, because of proximity. It wasn’t designed that way.
I think by far, the most meaningful choice offered to Americans today is based on uni, the unknown little network’s platform for basic services. There are now 14 million lines of consumer and small business uni-based services out there, we estimate consumers probably in the range of 10 to 11 million lines of that, and the benefits for consumers is no longer a matter of speculation, I think the record is now quite strong, that as facilities-based alternatives evolve, and there is no sort of magic big bang here where 40% of the country will immediately have an alternative to the telephone network, uni is crucial in the building and evolving of customer bases which will support investment in new facilities; and only through the sustaining of that kind of capability will capital get formed to ultimately create good substitutes based on facilities.
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Michigan, New York, California and many other states can demonstrate that the incumbent leps have responded to offers made by their competitors to their customers by offering very very dramatic price discounts, better packages, more value, consumers are saving money and they’re availing themselves of choice, and so once again we are proving that most quoted thing, "competition works," it’s causing people to respond. Regulators have to understand the importance of choice in building a customer base, and then building facilities. Capital formation simply won’t occur on a field of dreams basis in telecom, ever again, at least in a relevant time frame.
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When I meet with investors and people who manage capital, once they get over the shock that I’m going to talk about telecom, it’s pretty clear they’re very skeptical. We had $65 billion of defaults and debt securities in 2002, I don’t know, Jeff, what, half a trillion, a trillion a billion, however you want to count it in equity values lost in the sector: there’s a lot of reason to be skeptical. Innovation and investment can be killed, or at least certainly delayed dramatically if this transition from uni P to something else is managed incorrectly. We came perilously close in the triennial review, of that kind of setback.
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In terms of where we go from here, I think the new technologies, in addition to cable, which will evolve, and wireless as I’ve suggested, we are going to see voice-over IP come into its own, I refer to it as voice as a hosted application, what I mean by that, just like email is hosted in a server, and you don’t have to own the customer as an ISP to offer email, like yahoo, voice will evolve in a similar fashion. It will become access agnostic; and as time goes on, the quality of voice-over IP will get better and better.
The more that you are able to manage the inlink, the better the quality will be, but frankly, we have to get it out of people’s mind that we can take a hobbyist service and apply it to the masses, because John Q. Public will not accept something against the ……of reliability of the voice network they’ve come to expect and accept that as a full substitute. Will there be segments who in fact have that and take that …….? Yes. But as a broad-based competitor to the Bells network, it’s got a ways to go, but I am very encouraged by what we have seen, and we will be a big participant in the process of evolving it.
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Fixed wireless alternatives for Broadband delivery to households and WiFi, both at the edge, you know the 300 wi fi that we know today going to WiFi max and other derivatives, are going to offer some really compelling economics to a lot of customers. Again, it’s not going to be one silver bullet, one size fits all, I think it is going to be some of each of these, and frankly, one of these that we’d had hopes for a while back is now re-emerging, it’s the use of the electric grid. Being able to put a digital carrier wave through the electric utilities system, being able to get around the issues of noisy transformers and ….and are really based on advances in digital signal processors.
Now again, it’s not going to work everywhere the same way; there are issues about getting off the grid, going through the last set of transformers, but WiFI from the pole, there are going to be cases where we think that will also play an interesting role, not 40 million households, but some subset that we think will be able to be served through such technologies.
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Resale is not a new concept; I’d like to go back to my experience of 14 years with Sprint. Watts resale was created as a choice, and filled the gaps for both Sprint and MCI as they built out their network, as they tried to form capital by fits and starts. You know, we forget the fact that Sprint has been around for over 30 years, and my history with it ended about nine years ago, so of the 23 or 24 years of time that I can talk about, the fact is, without watts resales, we could not have financed building out a fiber network and competing with AT&T, nor would AT&T have been forced to respond by writing off back in circa 1989 or 1990 several billion dollars of, quote, "antiquated plant," and deploying and accelerating their plans to build an all-digital and all fiber network as well.
So AT&T responded, and built out fiber very rapidly following Sprint’s proof of concept, if you will. The same thing applies, I think, will the Bells. The fact is that resale is a path to facilities-based competition, and the Bells choice today for long distance services is protected by competition that was built on the original watts resale premise. In other words, Bell today rents long distance, they haven’t built new facilities carriers.
There are six or seven carriers who will happily sell minutes to Bell for completion. They do complete traffic on their own network, they make rational least-cost routing decisions to use their own facilities or others, and over time, I don’t doubt that over time they will develop their own strategy. Right now, there’s a very efficacious, make versus buy, choice for them, but it goes back to resale at its roots. Had we not had watts resale, capital wouldn’t have been formed for competitive long-distance business, and the same thing is true with local.
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I’d also point out that AT&T was regulated until it had 55% market share, where it was then being non-dominant, and the Bells would have you believe the day after losing 8 or 10 percent, "okay, competition’s here, we should be deregulated." We share their goals for ultimately deregulating the sector, but only after competition has established itself irrevocably. We came very close to being "revocable" just a few months ago.
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Healthy competitors will make decisions about allocating capital based on competitive response and competitive necessity. AT&T this year, quite to the contrary of others, is going to spend about $3 billion in capital to enhance its network. It’s not about building capacity so much anymore as it is lowering our operating cost, removing error in re-work, improving processes, and yes, lowering our unit costs on the network side.
So it’s about reducing costs of goods sold—the cost to serve the customer—as well as the administrative cost of support that network. We’re making that investment because we believe that, first of all, we have a capital structure that will support it, we’ve taken $65 billion in debt and reduced it to what we have now said will be less than $10 billion of net debt by the end of this year, we’ve generated about $2.4 billion of free cash flow in the first two quarters of the year, and we have been very focused on using that capital judiciously to reduce costs because we believe as time goes on and the industry shakes out, we will have a lower unit cost and a higher operating leverage from having done that.
Now we could have taken the approach, you know, spending half that. Basically a maintenance level of capital or less, paying off yet more debt, but quite frankly, it’s not about the capital structure for us anymore. That’s not true of others. Healthy competitors won’t invest because regulators will it, or if regulators respond to the entreaties of "deregulate us, so we can spend more," from transitioning monopolies.
The fact is, we’ve already gotten a strong lesson from the special access deregulation that took place two years ago, and what the consequences are of premature deregulation. At the time it was deregulated, special access had a mandated 11.25% rate of return. By the Bells on public filing today, they’re earning in most cases over 50%, some less, and some actually more than a 50% rate of return, and prices haven’t come down. Now in my experience of competitive markets that I’m in, I am not familiar with my margins going up 4x and my prices not going down. Obviously, we need some consulting help.
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So I think that that is an example, and frankly AT&T has invested billions at this point, if you include the cost of purchasing teleport and the capital we’ve put into that since we bought it, $20 billion invested in local facilities, just for that acquisition and the capital allocated to the teleport business, and we can today serve about 20% of our own needs for special access. So we’re still buying 80% of it from the Bells, and frankly, other [unintelligible]s, we are buying from other [unintelligible]s as well. I think that the regulatory outcome on broadband in the triennial was a positive thing for the Bells, and certainly, they got what they asked for, but perhaps not what they wanted.
If we look at what’s being said today, and again, I’m not going to criticize them for their economic judgment, because the facts are the facts, and that it’s costing, as Mr. Whitaker said last week or so at the Morgan Stanley conference, 1500 bucks per household plus five to eight hundred dollars per household for trenching to get to the house, $2300 a household for broadband, if that number is near right, is a pretty high investment cost to get access to the video revenue stream, since they already have voice, long-distance, local, and DSL available, how much new revenue will come from that investment, from the video business or what’s our estimate on how much video share they can gain over x time from a garden start without a content business to support it or a content partnership?
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Well, the answer is, go do a deal with dish networks. Looking at the impediment here, it isn’t regulatory confiscation, it’s really cost versus opportunity. That’s what will drive it. And competition will certainly force them to change that, just like Sprint and MCI forced AT&T to change its mind about how fast it would go to digital. To sum this part up, I don’t believe industry can continue as it now exists. There are too many players, and frankly too many players at the edge, looming debt maturities, little or no free cash flow, insufficient scale, lack or tainted brand and distribution capabilities. We’re just not destined to have 12 or 13 big players across wire line and wireless for sure, but I think the answer is both organic, cross-sector competition as well as inorganic consolidation. So you can expect some more bankruptcies, some recurring bankruptcies, like we saw in the airline business.
I think one thing that could help those ultimate survivors, however, is we could stop the civil war that’s been going on since 1996, some would argue since 1984, but frankly, I think since 1996 in the most harmful way. It really doesn’t help anyone ultimately and it does enormous harm to our industry over the next few years. A mature industry will react to this, and prove that we can work out difficulties without basically creating solemnic judgment requirements for regulators. We’ve proven that we could do it with something that was pretty tough, the calls plan, where we exchange a give and get and put pricing reforms on the interstate access that allows the Bells to get a get and we got a get and a give and we came together and worked that out.
I think there are a number of examples that stop short of playing zero-sum games with the government, and trying to discourage that…that doesn’t help build capital get formed and we can end up with working these things out commercially. Having a regulatory framework that can support both competition and deregulation is possible, and I’m not just saying that because I believe in the tooth fairy. I think investors clearly have been negatively influenced by the instability in policy tweaking is one thing, but reframing over and over issues that have been legislated and then litigated in the Supreme Court—investors have grown tired of this and if we start all over again with ….-like legislation efforts or the Illinois bill, it just simply exacerbates it.
Telric pricing is a good example. It has been tested and validated in the Supreme Court, supported by the FCC since the enactment of the Act, and supported by the … in all fifty states. Going back and reopening that completely again would be a terrible mistake, and investors need a degree of reliability in policy and consistency that making major changes to telric would be against.
Telric was envisioned as a flexible platform. It has the capability to make adjustments, and I think that kind of tweaking is very different than taking it apart. Disagreement with congressional will or Court interpretation does not encourage investment, any more than premature deregulation of a transitioning monopoly would.
Final comments. I can’t pass the opportunity to talk about the importance of integrity in the eradication of fraud in this sector. You know the law is the law, I’m not up here talking about reforming bankruptcy laws, we’ve got them, they are what they are, but the exploitation in unintended ways should be dealt with swiftly. Both in the context of the IRS and Congress, they’ve spoken about these things, I think that there are a lot of financial speculators looking to make money quickly, and I think some of these things will be cut off and will be dealt with appropriately.
I also think that rapid indictments and prosecution are very important and send the right signal as a deterrent for people believing that you can get away with massive fraud and then live to fight another day. It is very critical for the sector for those who haven’t cheated should not be disadvantaged by unintended consequences. And where real guilt exists, punishment occurs, and it will deter in a decisive way those committing those types of crimes.
Right now it’s a bit surreal. We’re now a year past the point in time when fraud has been announced that would stun anyone, and of all places, Oklahoma, they took up the cause and said, "what’s going on here?" and they indicted new individuals and the company. While it may not be the right litigation strategy, you know, criminal prosecution strategy that some might have wanted, I actually take heart that someone noticed that something really bad happened, and we should get to the bottom of it and do it more quickly.
Finally, the inconsistency in the messages of our government to those who perpetrate fraud or attempt to benefit from its aftermath, has got to stop. It’s just inconceivable to me that the government could have awarded new contracts while investigations were ongoing, and only after congress intervened and held hearings, was perspective business temporarily suspended. The government should send the message that it doesn’t do business with companies that violate the law, even if it’s inconvenient. Inconvenience is not a reason to look the other way or to pass over it.
I remain a bull on the telecom sector in the long-term. As another CEO in another industry said to me, whose business principally deals with the forces of gravity and weather, that’s George Davis of United Technologies, who make things that fly, and elevators that lift people up, and air conditioning, said "I have a feeling that when the bubble was going on people thought we were in a boring business, but gravity and the weather are a good thing to be in." He said, "you’re in a good business, too, because people will communicate. And they will communicate more prolifically because of the tools that have been developed around the cell phone, the BlackBerry, the PDA, and don’t give up, you’re in a great industry, this will pass. With that, I’ll stop my remarks and throw it open to questions.
