It Ain’t Heavy… It’s My Debt

Michel Bon, chairman of France Telecom, is chatting by cell phone about 3G, a wireless technology on which he has wagered his career and his business. Suddenly, his voice starts to fade and become unclear. Then he disconnects completely. “I’m sorry,” Bon says in his French-inflected English when he rings back a minute later. “My mobile, despite it is an Orange, I can say is not always perfect.” France Telecom, of course, owns the lion’s share of Orange.

If you want to understand why the European telecom industry is throwing more than $230 billion into upgrading to 3G — shorthand for third generation — look no further than Bon’s occasionally dodgy telephone. (Not that the handsets linked up to BT Cellnet or Vodafone are any better.) Though mobiles have come a long way since the days when Gordon Gekko stood on the beach talking to a brick, you still wouldn’t make a call on one if a landline was available. And if voice services are skimming the edge of adequacy, that’s still more than anyone could say of the “mobile Internet.” Even the biggest boosters of wap-based online services compare their current offerings to such famously user-unfriendly products as dos. Telecom operators need to carry more voice and data traffic more reliably just to continue growing and to keep their promises to the stock market. But right now there’s just not enough room on the airwaves.

Enter 3G, which is set to launch in most of Europe by 2003. Running on a new network standard called the Universal Mobile Telecommunications System, or UMTS, 3G devices will have more bandwidth, which will enable faster data transmission. Not only does UMTS help solve the capacity problem for voice, it will allow “always on” Internet access and, eventually, even video and color graphics through your handset. So for consumers, 3G could be seriously cool.

For the big telecom operators and their investors, on the other hand, it looks more like a financial disaster. Bon’s France Telecom has increased its debt to a staggering $55 billion in large part to pay for 3G. Likewise, Deutsche Telekom now owes $50 billion, and British Telecom $43 billion. (It’s not all 3G; these firms have also been on acquisition sprees.) And here’s the scariest part: there’s no guarantee that 3G will fly.

How did the telecom industry get itself into this mess? The birth of UMTS just happened to coincide with the peak of the speculative rage for technology investments. In March 2000, the Spanish government sold some of the first UMTS spectrum licenses to four firms for a total of about $450 million, or roughly $12 for every Spaniard. “The market capitalizations of the companies that got these [licenses] rose by more than they paid for them,” says Falk Müller-Veerse, European research manager for the investment group Durlacher. “So everyone said, ‘We have to get these.'” Put another way, the stock market simply demanded that wireless operators elsewhere get on board the UMTS express. Asked why he paid so much for his UMTS license, one wireless ceo shrugs and says, “Do you know what my board would have done to me if I didn’t?”

The real trouble came in the U.K. and Germany where, unlike Spain, the governments sold their UMTS licenses in auctions. The wireless operators bid prices for bits of the sky up to, well, the sky. Last year the U.K. and Germany won $32 billion and $45 billion respectively, sums that amount to almost $550 per capita. In total, European governments are likely to rake in $108 billion from the sale of UMTS licenses, according to Durlacher research. In hindsight, the telecom operators overpaid, since these days some UMTS airspace is tough to give away. Last month, Belgium found only three bidders for its four licenses.

“It was one of these giant gambles,” says Ken Binmore, a University College London economist who helped design the British auction. “If 3G is worth anything, it is going to be worth immense amounts, but who knows if it will be worth anything?” Binmore — who is delighted with how the auction turned out for British taxpayers — adds that the telecom operators understood this risk going in. If anything, the technological prospects for 3G were even more doubtful a year ago. The big difference between then and now isn’t the technology. It’s the NASDAQ.When Deutsche Telekom, BT and France Telecom were bidding their borrowed billions on licenses last year, it looked like the loans would be a lot easier to pay off than they are today. “We have a plan that will bring our debt down into the range of $27 billion to $36 billion by 2003,” says Bon. A nice plan indeed, but mind the yawning $9 billion gap. (A company worth $9 billion on the London Stock Exchange might qualify for the blue-chip FTSE 100 index.) The reason the numbers are so vague is that the debt reduction plan depends on selling some of the firms’ “non-core” assets, such as stakes in STMicroelectronics and Sprint FON Group. “We can sell more or fewer things or sell at higher or lower prices,” says the France Telecom chief. Right now, fewer and lower look more likely. STM is 50% off its one-year high, while FON has dropped 67%.

And France Telecom may be the relatively lucky one. It’s initial public offering of Orange earlier this year was a bomb, raising far less cash than the firm had initially hoped. Then again, says Standard and Poor’s credit analyst Guy Deslondes, “At least the money is already in the house.” Both BT and Deutsche Telekom have talked about similar public offerings of their wireless divisions to raise cash, but just who’s going to buy all these new tech stocks now?

If IPOs and asset sales won’t do the job, that leaves some pretty tough choices. Analysts speculate that BT might cut dividends or issue more shares at cut-rate prices in a rights offering. (BT did have some good news last week; it is reportedly close to selling its Yell online yellow pages in a private sale worth as much as $4 billion.) Another possibility is that the large telecom operators’ credit ratings might fall into bbb range — the last bracket before junk-bond status — which would make it more expensive for them to finance future investments. Little wonder, perhaps, that some shareholders are calling for the heads of BT chief Peter Bonfield and Deutsche Telekom boss Ron Sommer.

Now imagine that the stock market miraculously recovers next week and everybody gets to cut their debt in half. There’s still the sticky matter of whether 3G is actually going to work as advertised. The phones themselves exist mostly in the minds of engineers. Among the technical concerns is the fact that UMTS will at first be available only in urban centers. So you’ll need a phone that works with existing standards, too, says Durlacher’s Müller-Veerse. Such multiband phones will be more expensive at a time when operators are desperate to get away from subsidizing the cost of handsets. And they’ll require more power, which could mean carrying around extra batteries or lugging a bigger phone.

The danger is that while the lab geeks are perfecting the handsets consumers will find other technologies that suit them just fine, allowing them to put off taking the plunge on 3G until a 4G comes along. John Moroney of Ovum, a consultancy specializing in telecoms, expects it could take five years before 3G becomes a serious consumer business. “There’s already an existing good alternative: second generation voice plus sms text messaging,” Moroney observes. Then there’s so-called 2.5G, which transmits data in a similar fashion to UMTS, but with more limited bandwidth. The innovative Japanese operator NTT DoCoMo, meanwhile, has designs on importing its own version of next-generation wireless to Europe. The really fun stuff like video streaming might come first through something called a wireless LAN, a network available in designated areas like cafés and hotels. Just think of a coffee shop as the new phone booth.

So is it abandon hope, all ye who own BT shares? Maybe not. France Telecom, Deutsche Telekom and BT all trade for less than half of their 52-week highs. So their share prices already reflect a lot — although perhaps not all — of the bad news about 3G. These big operators still have deep resources to help them survive the near-term shock of paying for UMTS. Deutsche Telekom generates billions in cash from operations, and last June was able to issue the largest-ever corporate bond, to the tune of $15 billion. Telekom’s record was broken this year by none other than France Telecom. And 3G could eventually create all kinds of new opportunities for profits. Operators will be able to create unique services — from video games to real-time sports scores — which can reap higher margins than old-fashioned voice.

Just as important, wireless executives are beginning to look for ways to reduce the cost of building the UMTS networks, which Durlacher says could add another $126 billion to the 3G price tag. BT has indicated that it would be interested in sharing costs with other operators.

In Germany, the chief regulator of wireless is reportedly considering allowing some of the winners of that country’s licenses to get together somehow. That’s bad news, by the way, for telecom equipment makers like Nokia, which is on the hook for 3G as well. The firm announced last week that it is loaning $1.8 billion to France Telecom as part of a package to build UMTS networks. Nokia, like its clients, must figure that the only thing more expensive than buying into 3G might be not buying at all.