Crunch time
Credit Crunch. Good for the Long Haul?
The V shaped nature of the collapse and recovery in financial markets over the past eighteen months has been attributed in part to the speed at which inventory levels adjusted to the corporate liquidity crisis triggered by the credit crunch. Supply chains in our interconnected global economy are leaner and more efficient than they have ever been and the shock absorbing properties historically provided by higher stock levels and slower response times have been dramatically reduced. As a result the global economy can and does react far more violently to any bump in the road. These violent swings are a negative side effect of a vastly improved level of capital efficiency.
How ironic then that a subset of the communications industry, long haul networks, itself a key component of the digital age that supports these broader economic improvements, has in the recent past demonstrated the very worst sort of capital efficiency, that is total capital destruction.
Slowly but surely though, things are changing. The industry has improved its performance in recent years and there is every reason to expect a capital constrained world to reinforce that process of recovery.
To understand why things are improving it's important to put the collapse of 2001 in context. According to the Economist Magazine shareholder value destroyed by the banking sector in the current downturn has been $4.6tn to date. The telecom bust destroyed $2.8tn, so the two are comparable in value terms despite the latter's effect on the wider economy being much less. After such a monumental financial mess, no surprise then that the recovery process is a slow one.
At the root of the telecom collapse were three factors. Firstly, the transformation of an industry that had been in public ownership since the first decade of the last century to the private sector. Secondly, this change in capital structure and ownership coincided with a number of destabilising technological advances, most notably the combination of lasers with fibre optics which led to a surge in long haul network capacity long before such speeds were available in local networks. Thirdly, into the mix of privatisation and technological advance was added freely available capital during the heady last years of the financial bull market that motored from 1992 towards its ultimate collapse in 2001.
In the immediate aftermath of the collapse there followed a wave of bankruptcies sales and mergers out of which emerged, largely unscathed, the physical network assets. Unencumbered by cost bases that reflected replacement cost, these emerging companies substantially undermined others which still laboured under higher cost bases. This process has, not unreasonably, taken years to run its course.
Investors who had not had every ounce of appetite for investing in long haul knocked out of them by the end of 2002 are likely to have suffered sustained underperformance since then and today it is difficult to find any investor with a good word to say about the returns in this sub-sector of the industry.
Now however there are grounds for quiet optimism. Firstly, capacity is being absorbed at a rapid rate. According to Telegeography estimates, current capacity on the North Atlantic will be full by 2014.[1] One of the principal drivers to this healthy growth in usage (30% plus on the N Atlantic) is more widely available broadband in the last mile. At last customers are more able to make use of the huge amounts of capacity previously tantalisingly available only as far as the carrier data centres. A better balance between long haul and last mile has led to the emergence of new applications that can take advantage of this new order. It was built and they did indeed come, just ten years later than some optimistic forecasts in 1999.
Most compelling of all however is the fact that on some routes the replacement cost is substantially higher than current market price. Even with technology advances that reduce production costs and increase the number of wavelengths that can be carried on each fibre these strategically vital links will have to be replaced in time.
If you were looking for an out of favour industrial sector about which there is hardly a single investment professional making optimistic noises, which has been in the doldrums for nearly ten years, in which the replacement costs are materially higher than the market price, and in which prospects look brighter in a capital constrained World, look no further than long haul.
Richard Elliott
Managing Director Apollo Submarine Cable System Ltd.