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Page 44
7
Building the NII: Will the Shareholders Come? (And if they
Don't, Will Anyone Really Care?)
Robert T. Blau
BellSouth Corporation
More often than not, public policy debates concerning the
national information infrastructure (NII) begin with a presumption
that the proverbial "information superhighway" will be built
regardless of what the government does. The only thing public
policymakers really have to worry about, the reasoning goes, is to
ensure that users, rival service vendors, and equipment vendors
have affordable access to the nation's interoperable network of
networks.
Many knowledgeable observers further assume that the
telecommunications and cable television industries will move
aggressively to upgrade their respective networks over the next 5
to 10 years. They presumably will do this to take advantage of new
market opportunities spawned by interactive multimedia services,
and to respond to competition. Still others, including several key
federal officials, contend that the government will play a positive
and constructive role in facilitating significant amounts of
capital investment needed to extend broadband networks to
households, businesses, schools, hospitals, and other public
institutions throughout the country.1
This paper examines these expectations from the perspective of
telephone company shareholders. Several key issues are addressed.
How do returns on Bell company investment in local network
facilities compare with returns on investment opportunities outside
local telephone markets? Have shareholders been rewarded or
penalized by Bell company decisions—given the prevailing
regulatory environment—to upgrade their respective wireline
telephone networks in recent years? On balance, do shareholder
returns matter much to anyone other than the shareholder and
telephone company managers, and if so, to whom, how, and why?
Background
Customer Expectations
In a recent Delphi survey, the consulting firm of Deloitte &
Touche questioned 120 executives in the information,
communications, and entertainment industries about how soon they
expect various new communications products and services to arrive
on the scene, and how rapidly markets for these products and
NOTE: Robert T. Blau, Ph.D., CFA, is executive
director of policy analysis for BellSouth Corporation. He would
like to thank Stephen Barreca, manager, infrastructure planning at
BellSouth Telecommunications, for his valuable comments and
assistance in developing aspects of this analysis that concern Bell
company deployment of advanced network technologies. Views
expressed in this paper are solely those of the author and are not
necessarily shared by BellSouth or its subsidiaries.
Page 45
services will develop.2 With
regard to the commercialization of interactive multimedia networks
and devices, the panel came to the following conclusions:
•
During the next 5 years, both local telephone
companies and cable television operators will make significant
progress in building new ''infostructure." A majority (54 percent)
expect that advanced network technology will be available to 10 to
25 percent of telephone company residential customers, while a
plurality of those surveyed thought 25 to 45 percent of all cable
television customers would be served by upgraded networks by the
end of the decade. Using Census Bureau population projections for
the year 2000, this translates into a possible range of 10 to 25
million homes for telephone companies and 25 to 45 million homes
for cable television operators.
•
A majority (57 percent) of the executives surveyed
believe that over a quarter of all schools, libraries, hospitals,
and clinics will be connected to a fiber optic network by the end
of the decade, and 23 percent believe that over 45 percent of these
public institutions and agencies will have such a link.
•
A majority (54 percent) of the participants
believe that by 1998–2000 more than one-quarter of all U.S.
households will have at least one computer with online capability,
and 39 percent believe the penetration rate will be in the range of
25 to 45 percent of all households.
Interestingly, information industry executives surveyed by
Deloitte & Touche also had a generally favorable view about the
role of government in promoting investment in the NII.
Approximately 62 percent thought the net effect of government
actions by 1998–2000 will be positive (41 percent) or neutral
(21 percent) "in terms of encouraging investment, fostering
research and development, and promoting the rapid spread of
advanced information, communications, and entertainment
offerings."3
Satisfying User Expectations
Are expectations for building the information superhighway
realistic? In several key respects, the answers to that question
will rest with those individuals who will be asked to put up the
significant sums of capital needed to upgrade the NII, and
particularly ubiquitous local telecommunications networks where the
lion's share of these costs will be incurred.
If shareholders believe that risk-adjusted returns on investment
in advanced network technologies will remain competitive with
returns on alternative investment opportunities, then those
technologies will be deployed and the new service features they
make possible will be brought to the market in a timely manner. If,
on the other hand, shareholders do not regard prospective returns
on network investment to be high enough to compensate for risk
incurred, then lesser amounts of discretionary capital spending
will be committed to new network technologies. In that event,
telephone company deployment of new technologies will slow,
possibly to the point of lagging user expectations and needs. This
could be especially problematic for developers and users of new
multimedia service applications requiring substantially more
bandwidth than is readily available over the public
switched-telephone network (PSTN).
The balance of this paper analyzes relationships between
shareholder returns, network investment, and the deployment of the
types of advanced network technologies that will make up the NII.
It begins with a discussion of recent trends in each and their
implications for future investment. The paper concludes with a
brief discussion of steps that telecommunications policymakers must
take to create a more technology-friendly market environment.
Page 46
Analysis
Relationships Between Network
Investment and Shareholder Returns
Figure 1 highlights relationships between regional Bell company
(RBC) investment in regulated wireline networks and total
shareholder returns between 1988 and 1994. Network investment is
expressed as the percentage of Bell telephone company operating
cash flow used to acquire wireline network plant and equipment.
Unlike reported earnings, which are subject to the vagaries of
different financial and regulatory accounting practices, operating
cash flow provides an accurate measure of cash that a business
generates after it pays its out-of-pocket operating expenses,
taxes, and interest on its debt.4
Besides financing the acquisition of new plant and equipment for
their regulated wireline networks, local Bell telephone companies
principally use their operating cash flow in one of two ways: to
pay dividends to their regional holding company shareholders, or to
finance investment opportunities outside local networks. The ratio
of wireline network investment to cash flow from local telephone
operations, therefore, is a good comparative measure of how the
individual companies—and their shareholders—view the
relative attractiveness of using available cash flow to upgrade
their local network facilities.5
This is particularly true of the RBCs, since they currently finance
nearly all capital expenditures (and pay all dividends) with
internally generated funds (e.g., operating cash flow).
Figure 1 also depicts cumulative changes in total shareholder
returns for each of the regional Bell companies between 1988 and
1994. Total shareholder returns include the percentage change in
the price of an individual stock plus its dividend yield (i.e.,
dividends paid divided by the price of the stock at the time). For
purposes of this analysis, cumulative shareholder returns are based
on monthly returns and assume that all dividends paid on a
particular stock are immediately reinvested in that stock.
Figure 1 highlights a definite inverse relationship between the
ratio of network investment to operating cash flow from local
telephone operations and total shareholder return. Differences in
shareholder returns between the individual regional companies over
the 1988–94 period also were quite substantial.
•
If a shareholder had invested $1,000 in a market
weighted portfolio containing all seven RBC stocks on January 1,
1988, and reinvested all dividends paid, the portfolio would have
increased in value to $2,407 on December 31, 1994. This represents
a gain of 141 percent, as compared with a cumulative return of 132
percent on the S&P 500. During this period, the seven RBCs
reinvested 65.6 percent of their combined cash flow from their
local telephone companies operations back into their regulated
wireline networks.
•
Between 1988 and 1994, three of the seven regional
Bell companies—US West, BellSouth, and NYNEX—reinvested
71.3 percent of their local telephone companies' combined operating
cash flow in wireline network plant and equipment. Had the same
shareholder invested $1,000 in these three stocks on January 1,
1988, this market weighted portfolio would have increased in value
(assuming dividend reinvestment) to $2,055, for a gain of 105
percent.
•
During the same seven-year period, three other
RBCs—Ameritech, Pacific Telesis, and Southwestern
Bell—reinvested only 58.7 percent of their combined cash flow
from local telephone operations in their respective regulated
wireline networks. Had $1,000 been invested in these three stocks
on January 1, 1988, the value of this market weighted portfolio
would have increased to $3,019 by December 31, 1994, for a gain of
202 percent.
Given the size of the RBCs and the capital intensity of their
local telephone operations, these differences in shareholder
returns—and the emergence of an inverse relationship between
capital spending on wireline network plant and equipment and
shareholder returns—could have an important bearing on future
investment in local network facilities. If the recent past is
prologue, the level of discretionary capital spending on local
wireline networks (i.e., capital expenditures over and above those
required to maintain the quality of local telephone service at
current levels) also will determine how rapidly broadband
multimedia and other advanced service features are brought to the
market.
Page 47
Relationships Between Capital Spending
on Local Telephone Plant andEquipment and the Deployment of
Advanced Network Technologies
Tables 1 and 2 highlight the degree to which differences in
wireline network investment among the seven RBCs are reflected in
how rapidly each of the regional companies upgraded their
respective local wireline networks. The tables depict penetration
rates and substitution ratios, respectively, for ten advanced
network technologies that the Federal Communications Commission
routinely tracks through its ARMIS Infrastructure Reports.6 The RBCs and GTE file these
statistics with the Commission annually, and they are currently
available for 1989–93.
Figure 1
(Top) RHC Network Investment. Percent of Bell Telephone Company
operating
cashflow reinvested in local wireline networks between 1988 and
1994.
(Bottom) RHCshareholder return index, 1988–94.
SOURCE: Compustat and One Source.
Penetration rates shown in Table 1 represent the percentage of a
company's total number of switches, access lines, and
communications channels equipped with a particular technology
(e.g., ISDN, Signaling System 7, digital stored program control,
fiber optics, etc.). Substitution ratios are based on the
Fisher-Pry model commonly used to project ongoing increases in the
penetration of new technologies expressed as a percentage of total
usage.7
Technologies depicted in Table 2 also are categorized in three
broad groupings designed to provide comparative measures of the
following:
•
Digital connectivity, which includes
digital stored program control access lines, ISDN access lines,
digital interoffice links, and fiber-equipped channels;
•
Deployment of fiber optic capacity, which
includes interoffice fiber links and fiber-equipped channels;
and
Page 48
•
Overall network modernization, which
reflects the deployment of all digital connectivity and fiber-optic
technologies plus Signaling System 7 equipped access lines.
Substitution ratios for each of these groups were calculated by
averaging the substitution ratios for the individual technologies
that make up that group. These composite measures of technology
deployment are presented along with the ratio of network investment
to operating cash flow, and cumulative shareholder returns for the
1988–94 period.
Figure 2
(Top) Network Modernization Index, 1988 to 1993. (Bottom)
Cumulative Shareholder
Index, 1988 to 1994. NOTE: Substitution rates measure how rapidly
new network
technologies replace old ones. Network Modernization Index is the
average of
substitution rates for the following technologies: Digital-SPC
Access Lines, SS7-317
Access Lines, ISDN Access-Line Capacity, Fiber and Digital Links,
and Fiber-
Equipment Channels. SOURCE: FCC ARMIS Reports, Compustat, and One
Source.
fifth in cumulative shareholder returns for the 1988–94
period.8 Southwestern Bell, on the
other hand, ranked last among the Bell companies in overall network
modernization but first in cumulative shareholder returns.
These relationships, of course, do not imply that shareholders
have some inherent aversion to the Bell companies upgrading their
portion of the nation's information infrastructure. What the data
suggest, however, is that new or incremental revenue and earnings
opportunities that investors expected to result from the deployment
of wideband and broadband technologies have not been large enough,
at least in recent years, to compensate for the capital cost and
financial risk of installing these facilities sooner rather than
later. This has been true even though the RBCs' local telephone
operations accounted for roughly 86 percent of their total revenues
between 1988 and 1994, 89 percent of their combined operating cash
flow, 95 percent of their total earnings before extraordinary
charges (e.g., write-offs of obsolete telephone plant and
equipment), and 94 percent of their net income. (See Table 3.)
Figure 3
Bandwidth available on wireline and wireless networks, 1995 to
2005
SOURCE: The WEFA Group.
one knows whether such forecasts will prove to be at all
accurate, there is little question that the Internet will continue
to expand at unprecedented rates for the foreseeable future.
Internet growth is of particular interest to local telephone
companies for three key reasons. The first, as referenced above,
has to do with prospects that significant amounts of voice and data
traffic that traditionally have been carried over the PSTN could
conceivably be routed over the Internet. Because use of the
Internet today is effectively free, this shift would enable
consumers to bypass the system of usage-based pricing arrangements
and subsidies that the telecommunications industry has long relied
on to recover its costs while keeping basic residential telephone
rates at universally affordable levels (i.e., below cost).
At the same time, Internet traffic rides on network capacity
leased from facilities-based telecommunications carriers. As such,
growth in demand for services like the WWW also represents new
market opportunities for local telephone companies. Routing
Internet traffic should result in more intensive and more efficient
use of embedded network facilities. If priced properly, it also
could help recoup the cost of deploying
