The path to the U.S. fiber cable glut

Built at a cost of some $90 billion, about 39 million miles of fiber-optic cable run below U.S. soil. But more than 97 percent of that capacity lies idle--and may never be used.

DENVER--As he rushed to lace America with fiber-optic cable, James Crowe wasn't the sort to let anything stand in his way--not the Rocky Mountains and certainly not his cross-town rival, Joseph Nacchio.

By 1999, when Mr. Crowe's Level 3 Communications started digging a line connecting Denver and Salt Lake City, Mr. Nacchio's Qwest Communications International had already threaded its own cable through the most direct route, a seven-mile railway passage through the granite of the Continental Divide. Undeterred, Level 3 swerved an extra 70 miles through southern Wyoming, installing fiber at a blistering 19-mile-per-day pace.

But now, Level 3 has hit a wall even Mr. Crowe may have trouble overcoming. The company's original ambition--to build history's largest, most advanced fiber-optic network to carry exploding amounts of Internet traffic--is now part of one of the biggest gluts the country has ever seen.

All told, about 39 million miles of fiber-optic cable stretch underneath U.S. railroad beds, cornfields, natural-gas lines and roads, enough to circle the earth 1,566 times. Companies racing to build or expand nationwide networks laid some $90 billion of fiber during the past four years. Merrill Lynch & Co. estimates that only 2.6 percent of the capacity is actually in use. Much of it may remain dark forever.

The fiber glut underlies much of the uncertainty plaguing the telecom sector--and has even spilled over into the economy at large. Billions of dollars in shareholder value have evaporated in some of the biggest owners of fiber networks, including Global Crossing, Williams Communications Group and Genuity. Many are struggling with massive debt: On Friday, 360networks said it was delaying a $10.9 million interest payment while it studies ways to preserve cash (see article).

The carnage has spread to suppliers such as fiber-maker Corning and Lucent Technologies. Also on Friday, Nortel Networks, which makes gear for the Internet and telecom sectors, predicted a staggering $19.2 billion loss for the second quarter.

Level 3, meanwhile, is fast retrenching. Its stock is off 94 percent from its high, and executives are expected Monday to announce plans to lay off as much as 20 percent of the work force, among other cost-cutting moves. The company's game plan: Live off its stockpile of cash--some of it raised from Omaha construction magnate Walter Scott Jr., a close friend of investor Warren Buffett--until competitors die off and demand returns.

"The shake-out that is occurring is good for Level 3 in the long term, although it is awfully hard to convince someone who is sitting in a dentist's chair being drilled that this is a good thing," says Mr. Crowe. "It hurts."

Level 3's troubles represent an even bigger threat to the economy than the first round of the dot-com meltdown because the telecom companies involved are so much bigger. As a group, telecoms have gorged on some $650 billion in debt and are now failing in record numbers for the industry. The debacle is shaping up to be one of the biggest financial fiascoes ever, with losses to investors expected to approach the $150 billion government cleanup of the savings-and-loan industry a decade ago. And as more companies recognize the depth of their problems, the damage is likely to get worse.

Cases in point
To understand the origins of the mess, it helps to take a close look at two of the industry's pioneers, Qwest and Level 3. Located just miles apart in the Rocky Mountain foothills, each sprang from the ambitions of an old-style Western billionaire. Each dazzled investors early on with visions of rapidly expanding demand for telecommunications bandwidth, only to run into difficulties when Internet usage didn't soar as expected. But in the end, only one of the companies would figure out a way to shelter itself against the coming storm.

It has been said that the fiber glut bears a striking resemblance to the overbuilding of the railroads in the late 1800s. So perhaps it's fitting that one of the first to launch a nationwide network to compete with the long-distance companies was Philip Anschutz, a Denver railroad and mining baron whose net worth last year was put by Forbes Magazine at $18 billion.

By the mid-1990s, when Mr. Anschutz turned his attention to the industry, most of the nation's fiber was owned by AT&T, Sprint and MCI, along with a few upstarts. The hair-thin strands of superclear glass carry infrared light generated by tiny lasers that blink on and off billions of times per second, in a code that transmits voice calls or data traffic. Fiber dramatically increased the number of calls that could be handled at one time, making it far cheaper to use than coaxial cable, which is made of copper wire encased in plastic and aluminum.

Mr. Anschutz first became intrigued with the business through his ownership of Southern Pacific Rail, which had a construction subsidiary that installed fiber along railroad tracks for other customers. When he sold Southern Pacific to Union Pacific in 1996, he retained the subsidiary, SP Telecom.

Laying fiber isn't technically difficult. Networks are built by burying plastic pipes, or conduits, in the ground and then literally blowing the fibers through with compressed air. One recurring problem is obtaining the right-of-way from property owners. It was there that Mr. Anschutz seized on his advantage: SP Telecom was already armed with the go-ahead to build along much of the nation's railroad tracks. He decided to build a newfangled network specifically designed to carry increasing amounts of data traffic--with the goal of renting space to other telecommunications companies that needed long-distance capacity. In industry lingo, he would become a carrier's carrier.

Mr. Anschutz called the company Qwest and in January 1997 hired Mr. Nacchio, an engineer by training who was then head of AT&T's huge consumer unit, to bring it public. A compulsive workaholic who once finished the New York City marathon with a badly bleeding foot, the 51-year-old Mr. Nacchio left his family in New Jersey and commuted to the Denver headquarters, routinely working until 11 at night.

When Mr. Nacchio took over Qwest, he immediately bumped up the plan to build a 13,000-mile U.S. network to 18,500 miles. It looked like a financial stretch at first. Qwest had $150 million in seed money from Mr. Anschutz, but the rest came slowly. After a two-week road show in March 1997, Mr. Nacchio secured $300 million in debt at a relatively stiff 11.875 percent interest rate. Three months later, Qwest went public, raising $318 million.

But before long, business took off. As one of the first entrants to the market, Qwest was able to reel in some early telecom clients. GTE, Frontier and WorldCom bought about half the fibers on Qwest's network for about $3.6 billion, enough to cover about 90 percent of the cost of building its entire network. Within six months, Qwest's stock price had doubled.

The success wasn't lost on one of Qwest's board members, a telecom visionary in his own right named Jim Crowe. A former WorldCom chairman, Mr. Crowe was fixed for life financially and testing out retirement.

But he was growing antsy and wanted back in the game. He had long toyed with the idea of setting up a long-distance fiber network himself. And he had a billionaire of his own to back him up: Mr. Scott, his former boss at Peter Kiewit & Sons, the closely held Omaha construction giant.

Mr. Scott was receptive to the idea. At a 1995 gathering in Ireland of executives close to Mr. Buffett, Mr. Scott had been dazzled by a talk by Bill Gates. The Microsoft chairman told the audience that the Internet "was radically going to change the world," Mr. Scott recalls. And Mr. Crowe already had a stellar track record: A few years earlier, he had built a Kiewit telecom spin-off, MFS Communications, and sold it to WorldCom for $14 billion.

So in 1997, Mr. Crowe told Mr. Anschutz that he was planning to leave the Qwest board at the end of the year. "I said that I might start a company and it might be competitive," says Mr. Crowe.

The move, when it came, caught Mr. Nacchio by surprise. He says he knew Mr. Crowe was drumming up a plan but believed he would focus on the local-phone business. "Jim asked me, 'What is the best place to locate a company?' I said Denver," says Mr. Nacchio. "I didn't know he was going to be a direct competitor. If I'd known that, I would have said Pennsylvania."

Mr. Crowe started Level 3 with $3 billion from Kiewit and a select group of investors, including Mr. Scott, who became Level 3's chairman. Instead of having an IPO, Level 3 simply took over a tracking stock held by Kiewit and was listed on the Nasdaq in April of 1998. He located the company in Broomfield--just 14 miles from Qwest's Denver headquarters--a spot Mr. Crowe says he picked after a national study about where high-tech talent wanted to live.

The 51-year-old Mr. Crowe, an imposing figure who could pass for a high-school football coach, started with plans for an ambitious global network. He broke ground for a 16,000-mile U.S. route in Schulenberg, Texas, in July 1998, and then drew up plans for a 4,750-mile network in Europe. Tapping an Omaha connection, Union Pacific head Richard Davidson, Mr. Crowe got permission to build on the railroad's lines for some of its routes. Before long, the company was working in 20 different time zones, with 250 crews digging at once in North America alone.

The sniping begins
The sniping between Qwest and Level 3 started almost immediately. A clearly hurt Mr. Nacchio groused that Mr. Crowe was pursuing a "copycat strategy" and openly wondered whether his rival had unfairly gained insights during his time on the Qwest board. "At the end of the day, I have always questioned why he would join," he says. "I'll bet you he learned something being on our board."

Mr. Crowe, who insists he was up-front at all times with Messrs. Anschutz and Nacchio, retorted that Level 3's network would be a technological leap beyond Qwest's. Level 3's innovation was to lay 12 conduits in each leg of the network, against Qwest's two. Only one might have any fiber blown through it at first, with the rest to come as demand warranted. Since one of the biggest costs in laying networks was the digging, Level 3 figured it could save money in the long run by doing it just once. It would also be able to adapt quickly as new kinds of fiber became available.

"Qwest is a fine company and I like Joe. However, we have a big disagreement," says Mr. Crowe. "Our goal is not simply to deploy one generation but to build an entirely new model that assumes technology will change quickly, and at times, unpredictably."

Mr. Crowe quickly attracted an almost cult-like following with his theories of how the Internet would revolutionize the stodgy world of communications. One of his best-known principles, and one of the main reasons he built such a large network, was known as disruptive pricing--using low prices to stimulate Internet demand. "For every one percent you drop price, you get a greater than one percent increase in demand," Mr. Crowe said again and again.

He also had little patience for vertically integrated companies that try to do it all. Instead, he argued, communications would eventually drift toward a high-tech model, where each of the most successful companies carves out its own niche.

Investors ate it up, especially in Omaha, where the Peter Kiewit name was legend. Generations of engineers had already become wealthy through an employee stock ownership plan, and when Level 3 was spun off, the workers' paper profits soared. The fact that Mr. Scott sits on the board of Berkshire Hathaway, and Berkshire's legendary leader, Mr. Buffett, keeps his offices on the 14th floor of Kiewit Plaza, only added to the allure. "A lot of people thought this was the next coming, the next Berkshire Hathaway. They loaded all their assets in," says Marc LeFebvre, a stock broker in the Omaha office of Dain Rauscher who, along with his father, once worked at Kiewit.

By February 2001, Level 3 had managed to raise $13 billion, enough to finance building its entire network and--according to its plans--keep it going until it achieved profitability. Derek Scarth, an equity analyst with Berger Funds, remembers Mr. Crowe's pitch boiled down to this: "If you build it, they will come."

But it wasn't customers who came so much as it was competitors, lured by the easy availability of funding. J.P. Morgan and McKinsey & Co. figure at least 50 companies, offering a range of Internet backbone services, joined the gold rush by the end of 2000.

"There was a time in 1998 and 1999 where we were getting five offerings a week, just in telecom," says Brian Hayward, head of telecom investing for Invesco Capital Management. The pile of prospectuses on his floor was two feet high.

Mr. Nacchio marvels at how easily the money flowed. In the fall of 1998, he remembers coming up with a second round of financing in a 10-minute call with bankers while driving to his son's soccer game. "Before the game was over, we had subscribed for a billion bucks at 8.9 percent interest," says Mr. Nacchio. "To me, we had arrived."

Once the big dig was set in motion, it was hard for any one player to scale back. Each had raised money by promising investors a new fiber-optic network, and each felt compelled to forge ahead to get revenue flowing as soon as possible. Mr. Crowe, who watched competitors creep up behind him much as he had crept up on Qwest, consoled himself with the conviction that his network would be superior. And he and all the others stood firm in the belief that Internet traffic--whether e-mail, or pay-per-view movies or the frenetic transactions of day traders--would soon be gushing so fast that it would engulf all their pipelines and more.

Major miscalculations
In retrospect, the executives--and Wall Street--made some major miscalculations. Too many companies focused on the easy part of building a network: the long-distance loops that cut mostly through rural areas. Too little money went into widening the pipes that run into homes and offices, an extremely expensive undertaking complicated by the fact that the Baby Bells already own such "last-mile" connections. With high-speed access slow to reach businesses and consumers, development of the sort of "killer applications" that might spur new usage dwindled.

Some analysts tried to sound a warning. In October 1998, an Internet researcher at AT&T Labs named Andrew M. Odlyzko published a paper debunking the widely held view that Internet traffic was doubling every three months. Mr. Odlyzko laid out an argument that in fact Internet use was doubling only once a year. "It was an extremely convenient myth," says Mr. Odlyzko. "Every entrepreneur who was getting financing could quote it."

With the flood of investment money continuing unabated, few in the business paid him any heed. But Mr. Nacchio was starting to get rattled. With so many new entrants, he figured, life as a carrier's carrier might get tough. The entire wholesale market, Mr. Nacchio calculated, was roughly $9 billion a year. "There wasn't enough revenue to go around," he says. So Mr. Nacchio began converting Qwest into a retail company instead, acquiring LCI Communications, which made Qwest into the nation's fourth-largest long-distance company.

In June 1999, he dropped a bombshell by making a bid for U S West, the Denver-based Baby Bell. Coming as it did in the midst of America's Internet euphoria, the move stunned investors, who wondered why Qwest would buy such a traditional, slow-growing company. Mr. Nacchio even had trouble persuading Mr. Anschutz that the move was justified. "All I knew is that we were not going to succeed by being a one-trick pony," says Mr. Nacchio.

Whatever the justification, the stock market wasn't buying it. Qwest's shares plunged, but the $35 billion deal still went through. Mr. Crowe, for the time being, was looking brilliant. Level 3 stock surpassed $130 per share in March 2000. Dangling fat stock options, Level 3 poached Qwest employees, sometimes driving Mr. Nacchio to distraction.

Even though Level 3 was still more than a year away from completing its network, it managed to grab headlines. In October 1999, the company snagged a key piece of America Online's business from WorldCom. Analysts estimated that Level 3 undercut WorldCom's price by 50 percent. Mr. Crowe's theory of disruptive pricing was having an impact.

But Mr. Nacchio had some disruptions of his own in mind. Angered by the defections and worried about market share, the executive ordered his sales teams not to lose any contracts to competitors. The project, code-named "Operation Clean Sweep," turned the tide back in Qwest's favor.

It also kicked off a deflationary spiral the likes of which few industries have ever seen. In the wholesale market--the business of selling network space to other phone and Internet companies--prices are expected to plunge at least 60 percent this year.

It's even worse for so-called dark fiber, which hasn't yet been connected to the expensive electronic equipment needed to make it usable. A major brokerage house, say, that wanted to purchase its own strand of fiber could pick it up for $1,200 a mile, down from as much as $5,000 in 1997, according to Qwest.

Such sales are becoming increasingly rare, however, because few companies are in a position to invest in the equipment needed to connect the fiber into a network. That equipment, including the ultra-fast switches called routers, costs many times more than the fiber itself.

The pricing collapse, combined with the bursting of the Internet bubble, has left the fiber industry gasping for air--and Mr. Nacchio looking like a genius.

Saved by the Baby Bell
Thanks to the constant trickle of money from plain-vanilla local phone service, Qwest is projecting revenue of as much as $21.7 billion this year, up from $19 billion in 2000. It lost $81 million last year and won't be profitable anytime soon, but its stock price has been holding steady lately at around $33 on the New York Stock Exchange. That's down 48 percent from its high but still well above the initial offering price, adjusted for a split, of $5.50.

Life isn't so easy for Mr. Crowe. After trading as high as $130 in March of last year, the company's stock closed Friday on the Nasdaq Stock Market at $7.62, off 34 cents, or 4.3 percent. By some estimates, investors in the Omaha area alone have suffered paper losses of as much as $20 billion, leading to plenty of grumbling around town.

Tom Dowd, an Omaha attorney, is kicking himself for not selling his Level 3 shares earlier, but he still has faith the situation will improve. "Walter Scott has his reputation on the line with all these people getting it in the teeth," he says. "He doesn't want his legacy to be a foul ball."

It will take some doing to turn Level 3 back into a hit. Due to some environmental problems in California--the digging was disrupted temporarily by regulators when a trout turned up dead near the route--the network isn't quite finished. Of the 96 fibers in Level 3's first conduit, only two are currently lit.

And, despite winning high-profile customers such as Yahoo and XO Communications , Level 3 recently lowered its projection of communications revenue for this year to as little as $1.4 billion from $1.7 billion. In 2000, the company reported a net loss of $1.45 billion on revenue of $1.18 billion, including $200 million in revenue from mining operations.

Some acquaintances have noticed that Mr. Crowe seems more subdued these days. But in public the executive remains the picture of confidence. He stresses that the company still has $4 billion in cash and says it will emerge from the shakeout.

"A year ago we were in a hothouse environment where every plant, regardless of its strength, prospered," he says. "Now, we are outside in the cold world. It is a better environment, as painful as it is."