Will telecoms ride cycle better than property?

The nightmare spooking the financial markets is price destruction in telecommunications
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The Independent Online

Are telecommunications the new property?

Are telecommunications the new property?

In every downturn some sectors are hit harder than others. Most frequently the sector to head down most precipitously has been property. There are a number of reasons why this should be so.

For a start, it takes several years to plan and contract a building. Given the lag, there is a decent chance that by the time the thing is finished the market has turned. In addition, the interest rate cycle tends to work against property: you can only raise the finance ahead of a boom when rates are relatively low, but the chances are that before the project is completed rates will have risen and increased the financing costs. Finally, once you are in a project you have to go on and complete it because until you do so you get no rental income. So even if the economics look dreadful it is better to carry on than pull the plug - but since everyone does the same, the over-supply of buildings is all the greater and returns collapse.

One of the reasons why people have suggested that the coming downturn will be less marked than previous ones is that the economy as a whole has become more responsive to swings such as the property cycle. Inventories are shorter, service industries are more responsive than manufacturing, and the property business is becoming more canny at laying off risks. You could add the fact that in a low inflation world the uncertainties inherent in long-tail investments such as property are much lower than they would be in a high-inflation world.

But a low-inflation world faced with rapid technological change brings risks of its own, and the particular nightmare spooking the financial markets at the moment is price destruction - particularly in telecommunications.

Consider the parallels with property. Telecoms require enormous up-front investment, not just in the kit - the fibre-optic cables, the mobile phone transmitters - but also in the licences. Very nice for the British taxpayers to be £22.5bn better off as a result of the phone auction, but not so nice for telecom shareholders. You can raise finance in the early stages of the investment, but if the interest-rate cycle turns it becomes hard to carry on financing the investment. But once you have started building a system and paid for those licences, you have to go on, even if the business case for the initial investment looks iffy - so there is oversupply of services and the price collapses.

I could, perhaps, add a further parallel: the lack of experience in both industries of a sudden shock. In the case of the property companies it was inflation. They were accustomed to stable returns. In the early days of high inflation they were helped by windfall gains. But as interest rates rose to combat the inflation they were suddenly in what was for them an entirely new game: bumpy property values and dreadful financing costs. And so even experienced property companies went under and banks that had lent them money became the unwilling owners of empty office blocks.

Now look at the telecoms. Their past experience has been one of reasonable stability: many were nationalised industries. During the last 15 years they have faced a rapid rise in demand for their services and though they also faced steadily falling prices, demand more than compensated for this decline. The more established companies received a windfall gain from their tied subscriber base. Most recently of all, they have seen a sudden spurt in demand both for fixed-line bandwidth and for mobile telephony, which they met. But - and this is the parallel with property - they also face the reaction to that demand, plunging prices. This has never happened to them before - and it has happened just at the moment their borrowing costs are soaring.

You can see the pincer movement from the graphs. On the left is the cost of cash for high-yield telecoms in the US over the past two years. True, these are not the top end of the market - they are the scruffs. But look at what their paper is yielding: nine months ago the rate was 11.5 per cent, high but not ridiculous. Now it is more than 16 per cent - which was about the peak hit by gilts in 1976 when everyone worried that the UK government was about to go bust.

Now look at the other graph. That shows what has been happening to the real price of telephone services over the past decade. Until 1997 prices rose a bit, then fell a bit but there was no real trend. In the last two years prices have fallen off a cliff. These prices, by the way, are US domestic services. I suspect were one to look at European services, where international is a larger part of the mix and deregulation has been more recent, the plunge would be far steeper.

If you look at the yields on corporate bonds in general, they are almost as high as they were in 1990, the last peak. But inflation then was significantly higher. And deflation, such as is being experienced by the telecoms, unknown.

What conclusions should one draw? The graphs come from the research consultancy GFC Economics. Their view is that there is the possibility there will be a default by a large telecom group. The market has swirling with rumours about one such company, and it discounts those. But that is not the point. There will be a string of rumours about telecoms during this economic cycle, just as there were rumours about property companies in the early 1990s. The greater the rumours, the harder it will be for cash-hungry companies to roll over debt, and the harder that is, the greater the danger of a default.

Where will all this end? The balance of probability must surely be that several large telecom groups will have to renegotiate their debts. Whether this could rank as defaults is open. The big ones may well be able to scramble through without breaching any covenants, but some smaller ones may well have to be rescued. The trouble is, we need some companies to go under to take capacity out of the market. The longer the misery continues the greater the price destruction, which may be great for phone users but is lousy for phone company shareholders.

It is a very unscientific comment, but turning points are frequently marked by large defaults. Were a telecom group to go under, that might even be a signal that the upturn (which will come eventually) could be round the corner. Meanwhile, expect more misery - unless you like hitting the phone.