What will make telecom turn around?

Q: I work for a telecom company and am concerned because I see big losses year after year. What is going to happen and what do you think will make this business turn around?

I can see why you would be concerned. The bankruptcy of the once mighty Nortel should be a wakeup call that spurs the remaining telecom companies in our industry to take action. Many of these companies seem to have forgotten business fundamentals: to create value, not to squander resources. The free economy is efficient and will not permit that behavior to go on for very long. Companies in this space are in a sad state, which is reflected in valuations indicative of distressed properties. Management has no excuse for not taking action for such a long time.

It has been difficult to know the health of these companies for quite some time because they took large inventory write-offs after the bubble and then used the same parts on the books to show nice, but nonexistent, profits.

In effect, the public companies in this space have been squandering the hundreds of millions of dollars they raised on Wall Street during the bubble. Instead of putting the money to productive use, it became a curse that encouraged bad behavior. The management of these companies used the money to slug it out with each other in the marketplace to keep up with revenue expectations. They aggressively lowered prices so they could sell commodity products with little differentiation or competitive advantages and the margins were so thin that no one made money.

This folly can only go on for so long. It is now eight years later, the reserves are running low, and the recent economic slowdown is going to rapidly bring all this to a head. Soon the comedy will evolve into a tragedy; these big companies will fail and their demise could have a ripple effect that brings down many companies in our industry that work with them.

What are these companies to do? We can take a hint from the hundreds of companies that started during the bubble. A small number of privately held companies survived the bubble because they switched gears decisively, in many cases cutting back severely and reinventing themselves by directing core competencies to develop applications in which they could excel. Some of these companies did well by reinventing, while other startups that did not cut back fast enough are long gone.

It seems quite obvious that the choice is either to experience the pain of major surgery or die a slow death. Conceptually, a good business is the result of having core competencies that enable the company to produce highly differentiated products for which customers are willing to pay a fair price. That ability enables the company to sell products at a satisfactory gross margin and earn a profit by properly managing operations. The company can then further strengthen its core competencies and produce additional desirable products that will continue to grow the business.

The bottom line is these companies must scale back drastically to become significantly smaller but solid companies, and then grow with a good business plan. For a public company to follow this path the management has to have wisdom and the guts to take drastic action, and the backbone to deal with the consequences of painful cutbacks and write-offs, and a big drop in its market cap. The good news is this too shall come to pass and some investors may even see the merits of this approach and view the company as a good investment. Let us all hope the management of these companies will wake up before it is too late.