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Loeber: Keeping Hermes Europe Railtel on track

01 March 1999

Hermes Europe Railtel was among the first operators to target the pan-European carriers' carrier market. With one of the largest trans-European networks, it has already gained over 50 customers and is expanding rapidly despite increasing competition. Managing director Jan Loeber talks about the operator's long-term ambitions.

Hermes Europe Railtel is an emerging carrier in the pan-European market. The company provides cross-border communication transmission services for other carriers, including incumbent PTOs. It has one of the largest trans-European networks. By the end of 1999 it expects to be in 18 countries and 44 cities with a network of more than 20,000km. The network is based on DWDM (Dense Wave Division Multiplexing) technology. It is a high-capacity platform and enables Hermes to deliver high-end services at high speeds.
Hermes Europe Railtel began operations in 1996. It currently serves more than 50 customers. The company has been leveraging this first to market advantage, as Trent Spiridellis, a telecoms equity analyst at NationsBanc Montgomery Securities explains: "At the beginning of 1998 Hermes along with WorldCom and Ulysses were the only players that actually had broadband seamless communications networks."
As new entrants target the European market, prices may drop dramatically. Spiridellis notes: "I would say that pricing pressure is the greatest challenge that all these companies are going to face. If you look at the price of STM-1 capacity, it is falling dramatically. I think that only those companies that are deploying broadband networks, broadband-owned capacity will be able to compete in this declining price environment. We ultimately think that the European cross-border and long-distance communications markets will resemble that of the US. So with Hermes, the greatest challenge is not necessarily on the cost side of the equation, but really in terms of what prices it can charge for carrier customers, who are now going to have numerous different alternatives. The problem is that KPN/Qwest, Viatel, Global Crossing are also targeting carriers as customers."
The company benefits from operating under the GTS umbrella. GTS, which holds a majority stake in Hermes, recently announced its acquisition of Esprit Telecom and set up a joint venture with FLAG Telecom to build a $1 billion trans-oceanic cable system to carry voice, high-speed data and video traffic at speeds up to 1.28 terabit/s. The recent bout of activity underlines GTS' ambitions to be one of the largest independent carriers in Europe.
In an exclusive interview with Global Telecoms Business, the managing director of Hermes Europe Railtel Jan Loeber talks about the changing nature of the pan-European carriers' carrier market and explains how Hermes aims to keep one step ahead of the new entrants.
Hermes Europe Railtel was one of the first pan-European operators to market. How have you been leveraging that competitive first-to-market advantage? How many new customers do you expect to gain this year?
The first-to-market advantage is a substantial one here, because it is so difficult to create a network in the European environment, where you cannot count on any single kind of infrastructure to stretch from one country to the next. You are forced to work with multiple infrastructures that don't necessarily meet at borders and don't necessarily run uniformly through cities to the points where you need the nodes. Consequently it is a gargantuan task to create a seamless network that is managed under a single operating centre that allows you to provide high quality service and feature transparency throughout the entire network.
First-to-market also means that we have been able to sign up over 50 customers, premier names in the telecoms industry in Europe, who have been using our network now for quite some time.
We actually initiated service in November 1996 and have been rolling out the network ever since up until the 17 city position that we are in today. Our customers have had "soak time", in other words they have seen that when we say that we will roll out a new city by a certain date, we meet this deadline. They see that we deliver the level of availability or quality on the network that we promised. So they are extremely comfortable with our level of service. They like our pricing today, compared to the alternatives available on the market. This means that anyone coming to the market after us will find it extremely difficult to attract the attention of customers that we have already signed.
Our customers also know that our pricing is going to evolve with the market and that we have a cost base in our network that allows us to be competitive with anybody who comes along. So our pricing is going to remain competitive. First-to-market involves us first in a major engineering/integration activity with each customer.
The first mover advantage has this subtle aspect that it starts a close and hopefully long-lasting relationship between the customers we signed and ourselves. As to new customers this year, our growth will come from a combination of increased business from current customers as well as from additional customers - as many as 50 more.
Hermes Europe Railtel has one of the largest trans-European high capacity fibre optic networks. How many cities does it currently cover? What plans do you have for the build-out of the network this year?
Right now we are actively providing several high-capacity SDH transport service offerings to 17 cities throughout Europe. Most recently we added Copenhagen, Stockholm and Berlin. Before that we added Milan. We are in the heart of Europe, covering all the major cities. Next we plan to expand into Spain, where we have just received a licence. We will be adding Madrid in February, Barcelona and Valencia in March. Our original business plan called for reaching 34 cities across eastern and central Europe. But we recently discovered that our cash generation, coupled with our ability to support debt and build human resources, enable us to expand that roll-out. So we now aim to reach 44 cities this year in about 19 countries, including access to the US.
The country list includes three new countries beyond the original plan: Portugal, Norway and Finland. By the time we have added those countries we will cover 20,000km of fibre route. We will expand to 25,000km in the year 2000 reaching over 50 cities in about 22 countries.
Why have you targeted exclusively the wholesale market? How does your arrangement with Carrier1 to supply SDH transmission work? Do you have certain non-compete clauses?
Our focus on the trans-border wholesale market was a strategic choice. It has served us very well. By selecting this course, we have avoided attacking our customers' end-user base and his home market.
Therefore, even without any non-compete agreements, every carrier that we work with has a sense of comfort that we are facilitating their trans-European operations, instead of competing with them.
Our network is specifically designed to meet carriers needs. For example, carrier locations are very much inner city locations, whereas end users tend to be distributed all over industrial parks. Aware that our customers are carriers and service providers, it is very clear where we need to deploy our network to serve our carrier market. We can be very focused in putting the resources into the best possible connectivity to those locations. Secondly our pricing is aimed at somebody who is using our network as an architectural element and sells services to end users. So it involves special pricing that allows our customers to generate a good margin, as they sell on to end users.
Our arrangement with Carrier1 illustrates the fact that the Hermes Europe Railtel (HER) network is a facilitator of competition in Europe. Carrier1 could be in business from a cold start over a five-month period actually offering end-to-end services for the following reason. In addition to their aggressive management of the elements they needed to assemble, HER was able to provide inter-city links. We were also ready to provide local access connectivity from our nodes to their nodes. Without a network like HER in place, this would absolutely be impossible for any new European competitor to do. This is why we call ourselves a facilitator of competition. I think it is safe to say that, just as INTEL is inside most computer devices, almost everyone who is offering trans-European inter-city services has the HER network inside. Even WorldCom!
Why did you decide to use DWDM technologies?
The choice of DWDM is driven by the favourable economics of these technologies compared to the use of a lot of fibres. If you are running a long-distance network and can choose between building and lighting a 96-fibre bundle or acquiring two fibre pairs on 40 wavelength DWDM, the economics always, and by an absolutely massive margin, favour the creation of capacity on few fibre pairs.
When you perform the technical analysis, the cross-over comes very quickly: it occurs whenever a network segment is longer than about 100km and you are lighting two wavelengths or more, which is 5 gigabits. We reach that point pretty quickly on all our network segments. And the economics works ten times to one better using DWDM, than lighting multiple fibres. Also the quality is higher, because you are actually deploying far fewer hardware devices, thereby reducing exposure to device failure.
For example, if you used 40 600km fibre pairs and lit each of them, every 60km you would have regenerators/fibres and you would have terminating equipment at the end of every fibre. So you have all this equipment (880 boxes). On one fibre pair, with DWDM, we support 40 channels (22 boxes) providing the same capacity as 40 pairs.
Why did you choose Ciena as your supplier?
There is always the right vendor at the right time. When we made the vendor decision we had certain criteria. We wanted, without fail, a delivery promise by June 1998. We made the decision sometime in February. We put out a tender to the top five producers of DWDM. Only one of them could deliver us a working system for our labs, so that we could take it through its paces. So that gave us confidence. At the time they also had the highest capacity system supporting 40 wavelengths on 2.5 gigabits fibre. Their European support team has provided excellent service and support.
Similarly, what are the benefits of Alcatel as supplier of SDH transmission equipment?
We decided back in 1995 to work with Alcatel. They competed with the other big guys, Siemens, AT&T (now Lucent), Ericsson and others. At the end of the day they were among the top three contenders, who were fully compliant on a technical basis. As we were a new pan-European company, Alcatel was attractive, since they had the most widely and uniformly deployed resources throughout Europe. In other words, they had substantial support companies in every country in which we would operate. So we felt comfortable about their on-the ground resources to support us. In addition, their commercial proposal was very competitive. Their equipment has been performing extremely well.
How much did the network cost to build? When will it be completed? Do you have any plans to extend the network reach outside Europe or will the company remain Europe-focused for the foreseeable future?
We are witnessing an expansion of our European network to new countries and cities. We don't necessarily see the construction of terrestrial capabilities on other continents. We have decided to integrate trans-oceanic capacity into our service offerings. You are probably aware that the HER parent company, GTS, has completed a 50/50 joint venture with FLAG to form FLAG Atlantic-1. This will be the world's first terabit cable across the Atlantic. And this will have about 20-30 times the capacity that all transatlantic cables today have cumulatively.
So this represents a huge advance and implies an extremely aggressive and low cost base. GTS is doing this to enable HER to be in a better position to serve US-based customers that have an interest in moving traffic in and around Europe. We can pick them up in their back yard, namely at twin New York FA-1 nodes. We can then deliver the traffic to any of our European cities through the Hermes network.
It also provides us with an opportunity to contemplate interesting alliances or commercial arrangements with major US carriers to provide city-to-city services, looking at the range of US cities across to the range of European cities.
For such trans-oceanic city-to-city services we would focus on building an IP highway, an Internet protocol-based environment. This is a highly efficient protocol in terms of optimizing the utilization of this trans-oceanic capacity to support the fastest growing segment of the telecoms market, the Internet traffic streams.
Building the network through zero will have required almost $1 billion in investment. Maintaining, growing and upgrading will require $200 million annually. We will continually keep pace with emerging customer requirements and emerging market opportunities.
What is your projected EBITDA target for 1999?
As we are associated with a public company, GTS, listed on the Nasdaq and Easdaq exchanges as GTSG, we cannot offer projections on such issues. Let me just say that from a performance level we have been EBITDA positive since May 1998, which is extraordinarily fast for an infrastructure-based company such as ourselves. We have been meeting or exceeding our financial goals steadily. We are extremely heartened and are in fact very surprised by the robustness of demand.
We have installed by now well over three times the number of circuits that we had initially projected in our business plan. We have accelerated our DWDM deployment by almost two years to be able to deliver in line with requested demand from our customers. So our business is enjoying considerable growth. Owing to this growth and the very strong revenue uptake and cash inflow, we have been able to take the decision to substantially expand our roll-out. From a financial standpoint we have enjoyed an excellent environment of strong customer demand, which we expect to continue.
Do you expect to return to the markets for additional funding?
Not at the HER level. As you may be aware, we recently closed a second high-yield bond issue for almost $200 million, plus almost 100 million euro ($112 million) to accommodate the planned acceleration that we are able to sustain. So we are now in an excellent position cash-wise to execute the increased roll-out objectives that we have, plus some. DLJ has been very effective at leading both this and the previous $265 million financing.
If we can now turn to your acquisition strategy. How has the acquisition of Ebone improved your strategic position? Do you believe that HER will make further acquisitions in 1999?
HER is part of a larger GTS Group, called Carrier Services. Carrier Services will make further acquisitions. HER may also do so. Ebone was a very ingenious HER deal. It was a win-win situation for both seller and buyer. It actually was a deal where the controlling interest that we achieved, namely 75% of Ebone, was purchased in exchange for HER service. HER service replaces systematically the entire backbone network of Ebone and, in fact, reduces the cost base of Ebone by more than 50%. This means that Ebone will be able to translate those benefits, in terms of pricing and the quality of the HER network, to the benefit of their ISP customers. Ebone has about 85 major top tier ISP customers.
As you probably know, Ebone is a transit provider. They are therefore a carriers' carrier as we are ourselves and they serve ISPs. Their strategic value to HER is that we instantly acquire a knowledge and experience base in what we call the "Internet space". And that is very valuable, because the Internet is a focus for us. Much of the future acquisition activity that you mentioned will occur in the Internet space.
There is a third element of the Carrier Services Group in addition to trans-oceanic systems and HER. The third is what we call the IP Services companies: that is, Internet Provider Services. We are pursuing three objectives which we believe to be avenues in the Internet space which will generate and draw traffic into our network structures. One of them relates to the development of advanced Internet services.
Another is web hosting and the third is voice-over-IP capabilities. We have just announced at HER the controlled introduction of a new IP transport highway, which operates directly on optical interfaces. These three new IP Services areas will function aver and alongside this new highway.
As a pan-European operator, how do you view the regulatory environment in Europe? Do you think that the European Commission has done an effective job in liberalizing the telecoms markets in Europe?
The development of a regulatory environment supporting liberalization in Europe has been progressing more or less as anticipated and mandated by the EU. As we developed our network across Europe, the licensing regimes have been materializing more or less on time for our deployment. I believe that the EU has been instrumental in causing that to be possible. The EU enabling function has been very helpful to new competitors across Europe.
The huge remaining problem area for every new competitor in the European space is at the local access level. I am sure that you have heard this a thousand times from everybody else that you have talked to. Our local access issue is private circuit connectivity between our node and where our customers are located. The pricing of those connections and the lead time over which circuits can be made available are totally unsatisfactory in Europe in most cases. In any case we see an extremely mixed bag of the ability or willingness of the incumbents to be responsive on timely delivery and the willingness to be reasonable on price. Increased competition is the only answer.
As you probably know, we have an arrangement with COLT to provide local access in the cities that we both serve. That has been working very well. Wherever COLT and other competitive access providers are, we see competition causing the incumbent to react and be more responsive on availability and price.
Which service offerings will enable HER to distinguish itself from the competition?
Let me just start this discussion with my view of how the market is structured. If you look at the range of possible carriers' carrier transport capabilities, at the low end of the value chain is what I call the real estate business. In other words, people who build fibre and sell dark fibre or sell cheap point-to-point IRUs (indefeasible rights of use). We are not in that business. Dark fibre is the raw material that we build or lease and integrate into our network.
If you look at the other end of the value spectrum, you see the wholesale minutes business, which is also a wholesale business, but on a message level. We are not in that business either. We are in the mid-range business of the wholesale transport services continuum.
We differentiate ourselves in this industry by packaging value-added services in the transport environment. For example, among the SDH services that we offer, one of them is clearly structured and priced for the requirements of a new carrier which needs very high-quality services, with full redundancy. It is called "Point-to-Point" service. This is point-to-point in the context of our total network environment and provides 100% redundancy, so that the same traffic travels on two separate routes. If one route is damaged, the customer will never notice it.
It is not a trivial task to be able to provide that. It takes a lot of engineering and human resources to support that service. The second service, named the "Ring" service, is aimed at existing incumbents or operators which have their own networks and network architecture and engineers. This service covers three or four cities on a ring or sets of inter-locking rings that a PTT, for example, can use as a network element and integrate into their own network, providing for their own redundancies. It is very aggressively priced and is very popular.
Thirdly we provide a service for the Internet Service Provider that involves the capabilities of Ebone and its peering relationships with other European Internet carriers and providers, as well as US Internet providers. We assemble the use of that peering relationship, Ebone router capability, our core network and trans-atlantic capacity and we are able to offer an end-to-end IP service over SDH that spans from any Ebone or HER city in Europe through to a New York Internet provider outside Ebone's Internet exchange pop.
These three structures of service are focused on specific customer needs. In terms of the economics, the provision of value-added transport solutions to the fibre and the equipment that lights and manages it, represents only about 10-15% of the company's total resources. The rest is invested in the engineering resources, back office resources, customer services and the marketing and service development resources required to deliver these services. We do not consider companies selling IRUs as being in our competitive space. Selling an IRU is selling an asset. We are leasing advanced services with all the long-term support and development commitment that accompanies a long-term commitment to a customer relationship.
With more competitors coming to market, how is HER going to react to pricing pressure from its rivals? Do you think that prices for cross-border services will significantly decline over the next two years?
Absolutely. They will continue to decline. Users will want larger and larger tranches of bandwidth to run their services on, as they are becoming more and more inventive and less bandwidth sensitive about the services that they provide. Prices will go down with the leverage of technology and increased competition. We are more than prepared to respond to that. We have probably the lowest cost base in the industry.
Anybody new that comes into this game at this late date faces a huge challenge to be cost competitive for the following reasons. It is not just the efficiency of the technology that causes costs to be low. Everyone can have new technology. It is how well you fill your network pipe. If you take a fibre pair, for example, and you light it up with DWDM and make a two and a half gigabit pipe into a 100 gigabit pipe, with 40 wavelength DWDM, you have not gained any economic efficiency if you fail to fill the pipe.
So HER has loaded 40-50 mega-carriers operating across Europe onto its network, filling these pipes and only lighting them fast enough, four wavelengths at a time, to keep the size of the pipe bigger than demand, but not that much bigger. We are actually achieving phenomenal fill factors with these huge traffic streams. We are achieving extremely low equivalent E-1 costs. We expect to be able to keep up with everything and anything that happens in terms of price movement in the European market in our value-added services space.
Viatel has won considerable plaudits in the industry owing to its willingness to post prices on its web site. Will HER follow suit? If not, why not?
It is possible to post prices on a web site, if you are selling, for example, a point-to-point IRU. Then you can say what you get and how much it costs. In our value-added service space we are in a different business. We do not and will not sell dark fibre or virtually unmanaged service. For example, when we do a 40 million Euro deal with a carrier, we are discussing whether it should be a one-year contract or a ten-year pay in advance, lease, or a five-year contract. Should the payment be quarterly, monthly, annually or in advance? Exactly which cities and which kinds of provisions for growth in the number of cities or in the capacity over time will they want? Which service package or combination of packages do they want? Do they want local access integrated in the near-end, the far-end or both (75% do want it)? This is not something that you can post on the Internet. Ours is a highly tailored response that is customized to every customer's different needs.
Do you plan to compete on price with companies such as Viatel or quality of services? For example will you undercut Viatel for the price of STM-1 capacity?
We would not expect to lose a deal to a competitor on price where we have an equivalent service offering. An STM-1 can be provisioned in many ways (for example with or without integrated local access). Some of our competitors try to get mileage from citing our price for a one-year contract on a fully redundant E-1 circuit with bundled local access both ends and compare it with their single node-to-node equivalent E-1 price provisioned as an STM-1 on an annualized basis, assuming 20 years IRU pricing! We are selling the customer a proposition that the customer can see has value that he is willing to pay for and that is available now, not six months from now.
There will clearly be instances where somebody wants to buy simple point-to-point solutions. I would say that this leaves room for commodity suppliers to have a business. I would add that it is just not where we intend to do business, it is not how we want to position ourselves. We are in the solutions business and the value-added services business. We will constantly be climbing the value-added chain. We will provide typically multi-city solutions, rather than linked point-to-point solutions. In other words, we provide virtual network spaces that have various service packages.
How do you benefit from being under the GTS umbrella? How does its acquisition of Esprit Telecom affect your operations? Will the new acquisition lead to conflicts of interests in terms of clients?
I don't think so for the following reason: the avoidance of a conflict of interest is under our control. I have agreed with the GTS leadership that we will regard each other across the various lines of business, as operating at arms' length. In other words, whether GTS' new local access business, called Access Services, or their Business Services business, where Esprit is resident along with Netsource, we at Carrier Services will relate to these companies just as we do to any of our customers, such as COLT or Demon. The pricing that we will offer them and they will offer us will reflect how we would behave towards any other customer in the market. Across those lines of business we will not have pricing that differs in any way for the tenor of the contract, the volume of the commitment that is made and the service that is offered from the same contract that we offer to our other customers.
In your view how many carriers' carriers can survive in the European market? How do you see the European telecoms landscape changing over the next two-three years?
First of all, the landscape is going to be like the surface of the earth in the first million years of its formation: a boiling pot of bubbling lava. Some will harden into mountains, while others will just burst and some will swallow up others. When you have 16-20 countries, which are almost simultaneously liberalizing telecoms - emerging from an environment where there was one incumbent to where there might be, as in the UK, hundreds of licensed carriers - it is indeed a boiling pot of competitive activity. We will see new companies forming every day. The whole Internet environment is a key driver of that activity, as well as traffic growth.
Voice also continues to be very important in this evolution. While new enterprises continually pop up, we will also see consolidation. Some companies will get into trouble because they won't be properly financed. Or there may be a hiccup in the economy from time to time and they will become ripe for acquisition. So we will see a tremendously changing environment due to a variety of factors.
How many will survive? There is an old adage in business that states: all markets go to three. I think that we have seen it in many environments. In the US we have had a fairly competitive long-distance market for a number of years. We saw AT&T, MCI and Sprint on top and a whole bunch of others who were less prominent. We saw the same thing in the computer and automotive industries in the US. I think that in an equilibrium situation, which may be a number of years away in Europe, maybe beyond our lifetimes, we may see three or maybe four significant global players.