Qwest: going global through acquisitions and alliances

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Qwest Communications International, founded in 1988 as a subsidiary of SP Telecom, is already a major global communications company. It has sold a 10% stake to BellSouth for $3.5 billion and is completing the build of one of the most advanced fibre-optic networks. Chairman and CEO Joseph Nacchio talks to Global Telecoms Business about the operator's plans.

Qwest Communications International was founded in 1988 by Phil Anschutz, owner of Southern Pacific railroad. In 1997 Joseph Nacchio was appointed CEO. Since then the company has been transformed into a leading global multimedia communications company through a number of acquisitions and alliances. In March 1998 Qwest acquired LCI, the fourth largest long-distance company in the US. In April it bought EUnet International, an ISP with branches in 14 European countries. In November Qwest announced the formation of a joint venture with KPN, the incumbent operator in the Netherlands.

It has also secured alliances with Microsoft to create a seamless LAN/WAN network and stimulate IP-VPNs and E-commerce and with Netscape to faciliate the provision of one-stop shopping to consumers for telecoms and IP.

At the same time the operator has been building a nation-wide fibre-optic network that will stretch for almost 19,000 miles. In April 1999 the company sold a 10% stake to BellSouth for $3.5 billion.

Following the deal with BellSouth, it has been rumoured that the RBOC could acquire Qwest. However, David Barden, a telecoms equity analyst at JP Morgan, believes that this is unlikely to happen soon: "I think that we are many steps away from a potential acquisition and I think not least of which, Philip Anschutz and the rest of the Qwest management team still hold a very substantial stake in the company and are all very bullish on the company's prospects. I think that the partnership with BellSouth is advantageous for Qwest. Clearly Qwest has received a healthy equity/capital injection. It is cash that will give them substantial financial flexibility in the market. They secure a partnership with one of the largest end-user connectivity players in the US. I think that the benefits are going to take some time to accrue financially. But it certainly helps strategically with the company. It remains to be seen if we are going to see an ownership situation involving BellSouth/Qwest."

Barden believes that the JV with KPN was a very good move: "I think that Qwest's partnership with KPN, a player which had advanced plans in the facilities-based market, was a good one. I think that eventually it will be possible to spin off the company, which will be able to become an independent entity, if that it is going to be the best way to realize value. I think that it will certainly be in a position to do that. I think the question for Qwest to become a global player is to knit the pieces together into a unified strategy."

The management team led by Joe Nacchio, formerly of AT&T, is one of the most respected in the business. Barden notes: "I think that there is no doubt that the Qwest management team has executed at and above expectations. The company was a pioneer in this competitive backbone space. People looked at them as if they were crazy when they were going around trying to tell people that they were going to build two conduits and 96 fibres in the US market. That was only four years ago. They have built a substantial presence in the US."

He continues: "I think that their network build speaks for itself in terms of the customer base and the partnerships which they have secured. I think their business strategy is meant to address the largest possible revenue base in the market today. Other companies have taken different strategies and it is perhaps too early to say whether other companies have chosen a successful strategy, but I think it is clear that Qwest has to this point demonstrated that at least it has a successful strategy."

In an interview with Global Telecoms Business, the chairman and CEO of Qwest Joseph Nacchio talks about the deal with BellSouth, the JV with KPN, the completion of its network build in the US and its ambitions to become market leader.

What led to the sale of a 10% stake of Qwest to BellSouth for $3.5 billion? Could this mark the first step towards the acquisition of Qwest? Do you believe that the company will still be independent in two-three years?

BellSouth bought a 10% stake in Qwest to cement a strategic relationship with the company. In the US the Bells are constrained, prior to achieving some regulatory thresholds, about whether they can participate in long-distance or wide-area data networking. We have a fairly comprehensive marketing and sales agreement with BellSouth that has constraints prior to regulatory relief and a more integrated approach post that regulatory relief.

That was the essence, the real essence, of the deal to cement the relationship, because BellSouth believed that Qwest was both doing the right thing and wanted to participate in value creation. They believed that the relationship with us would accelerate value creation. They wanted to have a piece of our equity, so that they could ride the appreciation. As the current law in the US places a 10% limit, the purchase was really made to cement the relationship and let them achieve some value accretion based on what Qwest does.

I think that this has led to the question that you asked in parts B and C which is: Wow, why would BellSouth spend $3.5 billion in cash in Qwest, if they did not have greater designs on the company?

First of all, legally they could not have those designs today. Secondly, Duane Ackerman, their chairman and CEO, has repeatedly said that we should not read more into this than the actual transaction. I don't mean to speak for Duane. So let me come back and discuss the issue as to whether we will be independent or not in three years. I think that this is going to be decided, based on the choices that my board and I have and - as those choices make themselves available - based on our assessment as to how we can create better value for our shareholders.

I think that the question of standing alone or being bought or merged with another company ultimately has to be decided by your judgement as to how you would create more value for your shareholder base. So I think that it is problematic to try and guess whether we would be independent or not in three years. That is a function of how well we do and the choices that are presented to us.

In a recent interview with Global Telecoms Business, James Crowe talked about the difficulties of incumbents with 70-80 year-old cultures based on outdated telephony models. Do you believe that this opinion is fair?

Well, first of all, in highly competitive markets that are being stimulated to change both by technology and current global economic conditions, the issue of incumbency and culture constitutes only one of the elements that will ultimately either hold you back or determine whether you succeed.

So I think that Jim's answer is perhaps a bit narrow. There are many things other than the fact that I am new and have new technology which allows you to win. They are two important components, but you also have to put down customer relationships and these don't happen overnight. You have to put down financial strength. You have to put down systems.

I think that it is too simple to say that the incumbents lose and all the new guys win. I do think that there is clearly a bias and advantage that newer companies have, but it is more than a single dimension of technology or culture.

Where is Qwest in the build-out of its 18,500 mile network? How much is the network costing to build? What do you believe to be Qwest's competitive advantages?

I would just like to draw a distinction with Level 3: our network is actually being completed in the US. We will have the 18,500 miles finished and in service by June 30. We are also constructing through a joint venture with KPN, the Dutch telecoms company, a 9,100 mile fibre-optic network in Europe.

As a matter of fact, my European team is there today with the bond agency guys in London, because we are going to raise the necessary debt financing to complete the 9,000 miles. We have already built about 2,100 miles. We are also building in Mexico.

That network should probably be completed in the third or fourth quarter of this year. We are part of the two undersea consortia building new digital cables across the Atlantic, TAT-14 and new digital cables across the Pacific, called the US/Japan consortium. Both of those cables should be in service by late 2000.

Level 3 Communications' network is based purely on packet switching, whereas Qwest's network is based on packet and circuit switching. What is the reasoning behind your approach?

The demand for traditional transmission technologies, such as circuit-switched, ATM and frame relay, is still very high and is experiencing impressive market growth. We can't ignore the tremendous amount of shareholder value that these technologies provide. Internet Protocol-based applications and services are emerging. They are expected to become a very large market and Qwest is ready to take customers into the new millennium with the newest and best technology available.

Can you describe your relationship with Cisco and Nortel?

Cisco and Nortel are both important technology partners for us. We have strong technology partnerships with Microsoft and others besides Cisco and Nortel. Our philosophy is always to be on the cutting edge of technology. It is also to build flexible systems so that we can integrate them, because technology lifecycle curves are a lot shorter than they were five years ago. So we think of an 80/20, 70/30 relationship with multiple vendors, using the same technology so that we can keep the flexibility in our design.

At this time Nortel is our principal supplier of optical electronics, while Cisco is our principal supplier of backbone routers. We also use other edge routers and we use ATM frame technology that is now part of Lucent. With edge routers, we are looking at several companies. We are also testing some of the newest technologies, particularly in the data space that basically come out of the upstart Silicon Valley firms.

Is it true that suppliers are failing to move as rapidly as you would like in terms of management capabilities that are independent of vendor-specific products? Which suppliers are furthest ahead?

Yes. One of the things that I think we are helping to drive in the industry is the pace of technological innovation on the equipment side for two reasons.

Firstly, the amount of information capacity we can carry on fibre is limited by the components of technology such as the routers, servers and operating systems that are presently available.

Secondly, in the launch industry we believe that the balance of capturing value has to be shifted more towards the service providers and away from the equipment manufacturers that tend to put their hardware operating systems and application software in a very vertically integrated package or bundle. We like to separate those layers, so that we can extract more value back to our industry and can have open architectures that enable us to accelerate the pace of innovation.

As to which suppliers are furthest ahead: it all depends. There isn't really a clear leader or a clear laggard. It depends. At any given moment in time, you have to try to figure out which supplier has the manufacturing and delivery capability to handle a large-scale job.

Yet at the same time, at the opposite end of the extreme, you can consider which supplier has really got the cutting edge technology. If you take one good example, Cisco is certainly the industrial strength router company at present in the industry. However, you can go to a lot of upstart companies and find much higher speed routers with better network management capabilities, but they can't handle an 18,500 mile network and a large order in terms of manufacturing, installation and support. So you have to trade off on those different criteria.

How do you view Level 3 Communications? Is there not a danger that both operators could be upstaged in a couple of years by an upstart telco which can build a faster network at a lower cost? How will Qwest maintain a technological advantage over other new operators?

I think that you have to be very articulate in separating the layers of the technology value chain. If you look at our network, we have two conduits with 48 fibres. But with today's technology, whether it is optical electronics, router or wave division multiplexing, we are using on the existing fibres less than 1% of the capacity. So if there was a breakthrough on optical electronics or there was a breakthrough combining the office and the router layer, we would simply light up another window on our capacity. Therefore we would be able to roll to whatever the new price performance level is.

So you have to come back and ask: what is the common element? It is easy to move between electronics. It is very hard to dig up the ground and go through the Rocky Mountains. We have got in place what I would call the foundation of the home with enormous expandable capacity. We can pull another thousand fibres in our conduits. With WDM we can already handle on our network all the traffic in the world, if you could route it on our network.

But with the way WDM is going, we can expand that by a factor of four or five. So we own what I like to refer to as the physical layer. I think that we are dominant there. As we have so much of it, we can move very quickly on the new components, so that if there are significant price performance gains to be had, we can switch very rapidly to that new architecture. We can move a lot more quickly, from one router to the next, one operating system to the next, than you can by digging up the US to put in new fundamental transport capability.

At the Merrill Lynch CEO conference in March, Global Crossing and Frontier referred to their new venture as Qwest senior. Similarly, Bob Annunziata claimed in a subsequent interview that the new venture was addressing the $450 billlion telecom market world-wide, adding: "So, we actually have a little bigger reach, I think, than Joe is looking at." How do you react to these statements?

The only thing that Global Crossing has more than us is the number of vice-chairmen in the firm. I grant that they will have a higher SG&A. I think that he was taking enormous liberties. When you get back down to it, Global Crossing has a couple of cables under the ocean at much lower capacity than we have.

Secondly, even the piece of the US terrestrial network that they are purchasing through the acquisition of Frontier is less than a third to a quarter of the size of my own network. Finally, most of what they bought with Frontier is a local telephone company in upstate New York.

So when they talk about global reach, maybe they can go from Rochester to Schenectady better than we can, but I think they are really extrapolating that they have a much stronger reach than we do. Let us look at the facts in Europe again.

We have already built more physical route miles in Europe than anyone, I think, even including MCI WorldCom, much less Global Crossing. In the US we are certainly the grandfather in terms of sizeable networks. Frontier - which was one of our original clients for dark fibre - has a relatively small piece of our total network capability.

To Bob's credit, he was marketing to the investment community, but I don't believe that he was factually accurate. But I would grant that they have more vice-chairmen than we have.

Why do you think that Europe has so far failed to create new entrants such as Qwest and Level 3 Communications? Would you attribute this situation to a lack of entrepreneurial flair in European incumbents or an inability to access capital markets in Europe?

You know, I think that you are on a much bigger question that deals with the philosophy of business development in the US compared to Europe. I think that Europe has come along enormously over the past 7-8 years.

But at the end of the day pure unbridled innovation and capitalism is the lifeblood of the US economy, which is very different even from Europe as a collective entity, much less some of its individual countries.

So I think that you are seeing a manifestation of that very different macro-economic philosophy. That is why you see entrepreneurial companies such as Qwest, which were essentially nowhere and nothing two years ago, become companies with a market capitalization of $35 billion and a global player in less than two years. You don't see that type of speed. It isn't dependent on capital markets, because you have to remember that capital markets are global.

If you are a European firm, you are going to borrow through the New York Stock Exchange or Nasdaq as well as the London exchange. If you look at what we are doing on a high-yield offering right now, we are doing a week in Europe and a week in the US. I think that we could sell all the equity and debt we ever needed for KPN/Qwest in either market.

So it is really not a question of capital flows. I think that it is more a question of long-term differences in the business and political climate and the embrace of what I would call free market capitalism. Make no mistake, I think that Europe is moving in the right direction. This is why we entered the market. But I do think that the US has a head start and spawns more companies like Qwest than you would see spawned out of Europe.

We recently spoke to Wim Dik of KPN about the JV between the two companies. From your perspective, what made KPN such an attractive partner to attack the European market?

I think that it is the same answer for both questions. Firstly KPN in particular, as the domestic telephone company in the Netherlands, realized that they were an incumbent that could probably not play in the global game without expanding beyond their borders. They were internationalist in perspective.

Secondly, from my point of view, at the end of the day, people believe that Qwest is an American company, while KPN is a European company. If you want to be successful in Europe, I think you need to be a European company.

So we wanted a European company which understood the culture, politics and business relationships better than we could learn, because you need to respect that to play into that environment. They threw at us both an attitude and a recognition that they needed to grow outside their borders.

They tended historically to be very international in their perspective as a country and as a trading nation state so to speak. They were European and they had a good influence, but they weren't one of the big players, such as Deutsche Telekom or British Telecom. Therefore, they tended to be more of an honest broker - if I could use that term in an assessment of all the other players of Europe - which was important as we grow.

Finally, and this is probably what puts it over the top, at the end of the day the two companies have to be able to work together. As I worked with senior officers from KPN, such as Joop Dreschel and then Wim Dik, I was delighted to discover that, while we were culturally different, we were like-minded, could collaborate, work together and compromise. In the pre-deal making phase, building that relationship was important.

Which operators do you perceive to be your main competitors in Europe? What will be the JV's competitive advantages? Which technologies will you deploy?

I think that KPN would tell you that we are patenting this JV to follow the Qwest model. So what is our competitive advantage? We are going to put in place enormous broadband capacity and the latest technology. We are going to focus very much on IP and Internet technologies. That is why we purchased EUnet a year ago and rolled it into the venture.

We are very much going to play the change agent role, where technology enables us to create capabilities that the incumbent does not have and where technology enables us to achieve significantly better price performance capability than the incumbents.

We are very much going to have an Internet/multimedia orientation as compared to a telephony orientation. In addition we are entrepreneurial in terms of culture and the way in which we drive shareholder value. Of course we have experience doing that, so that also gives us a leg up.

Now when it comes to technology, we will use the latest kind of fibre. We will use WDM. We use IP routers. We will probably put some ATM in there for customers that have legacy systems and need to carry out the transition.

Ultimately, we will probably build our hosting centres much like we are doing in the US. We will create open architectures, all the same things. If you look at the Qwest playbook, we will probably just pretty much replicate it.

What is the significance of your agreements with Rhythm NetConnections and Covad Communications? Why have you decided to accelerate your entrance into the DSL market?

Anything that creates broadband local connectivity is good for our company, the network and shareholders. The last mile must not be a bottleneck. A good example is that AT&T cut that big deal today (Microsoft invested $5 billion). Our stock has gone up $5. Most people would ask: why did that happen? Well that happens, because any time broadband connectivity is pushed into the local loop, it is good to create the primary demand that utilizes the capabilities of Qwest's technology and network.

We may invest in Rhythm NetConnections and Covad Communications, as we think that DSL is an important technology, as it is readily adaptable to the existing physical plant of local loop and twisted wire pair. A twisted pair of even 144kts to 5-10 Mbts - that is enormous capacity which allows our network to move information end-to-end much more effectively.

So we are going to do whatever we can to stimulate local loop development. In the US we are building in cities now with fibre and we will go with fibre right to buildings, because fibre wins on any other choice of technology when you can get right to the premise.

In April Qwest obtained a $1 billion syndicated line of credit from Bank of America, First Union Bank of New York and Citibank. How do you plan to invest these funds?

It is interesting, as we were looking for that bank line of credit basically for working capital. We were negotiating with BellSouth at the same time. Of course we secured the line of credit before we announced the BellSouth deal. When the BellSouth deal consummates itself over the next 40-45 days, we will pick up another $2 billion in cash.

So I am not sure that we will use that much of the bank facility, because we will have enough cash on hand. But the basic answer is that the cash at our disposal will be used to further develop our network infrastructure, particularly pushing it out to the local loop, as I mentioned a moment ago.

Could you describe the new venture with Microsoft announced in December 1998? What benefits do you derive from this venture? Similarly, what are the advantages of your partnership with Netscape?

The Microsoft venture - where they invested $200 million in Qwest - was principally set up to generate web hosting services and a seamless LAN/WAN network, using NT as an operating system on both sides, to stimulate the deployment of IP - Virtual Private Networks, as well as E-commerce. We are well along that path. The first products will be coming out shortly this summer.

Also we gained the benefit through that venture of having access to the Microsoft value-added resellers, the VAR channels which are 88,000 strong, so that we can move Qwest products through that VAR channel. The Netscape deal was to address consumers and provide them with one-stop shopping for telecoms and IP all through a browser, portal - point of reference.

What are your views on the potential of E-commerce? Could you tell us about your E-commerce offerings? A recent report by Forrester Research predicted that E-commerce sales would grow from $7.8 billion in 1998 to $108 billion by 2003. What percentage of this market would you hope to have in 2003?

Well we don't have very specific market share objectives other than we intend to be the largest player. I think that we have a significant head start in both owing to our enormous broadband network capabilities.

We are also constructing very large cyber centres in the US which will be the centres where we put the servers to host the applications on E-commerce. In our opinion, this is principally the area of growth that transforms Qwest from an interesting growing new company into the market leader.

Now those E-commerce numbers that you quoted are probably somewhat conservative. We have seen other numbers that suggest that the E-commerce market could range anywhere from $300 billion to a trillion dollars in that time frame.

Could you tell us about your involvement in the Abilene project?

Qwest is the backbone provider for the Abilene project, which is the farthest reaching Internet2 project in the US. The Abilene network is essentially a test-bed for the brightest minds in academia and education to develop and test the high-speed networking applications of the future.

Just as technology from the original Internet evolved from the education/research field to the commercial space, it is inevitable that what is developed through Abilene will be passed on to everyone's benefit.

Huge amounts of bandwidth are coming on-line. Is the demand there from customers? In your opinion which applications will prove especially popular in the corporate sector?

There is definitely a huge demand for high-speed, reliable, scalable, high-capacity bandwidth today. We will continue to see that demand well into the future. This demand is fuelled by the popularity of high bandwidth applications, such as real-time video, video conferencing and large volumes of data.

What is the take-up for your data hosting, VPN, dial-up Internet access and other data services? What percentage of the US corporate market use your services? Which additional benefits do you offer corporate users that provide Qwest with a competitive advantage?

I won't get into the specific market share and marketing strategies for obvious competitive reasons. But we are penetrating right now across our general service line: 48 of the top 50 Fortune companies are customers of Qwest.

We have put proposals to 250-300 other firms. The benefits for these companies can be split into two categories. Firstly, we are the only ones with these enormous backbone web hosting capabilities which gives them flexible design capital avenues designing an enterprise network when they have some stuff on the premise, some stuff embedded in the network. Secondly, owing to our new technology and low-cost position, they get enormous price performance gains if they use Qwest rather than one of the largest incumbents.

When we spoke last year, you said: 'I think that Qwest will end up in 5-10 years time as one of the major players in the US, if not globally." Is it fair to say that even in five years' time Qwest is unlikely to be an independent entity?

I think that it is unfair to draw that conclusion, if we come back to the earlier answer to the question that I gave you about where I thought that we would be in two or three years. Let me point out that when we spoke a year ago, Qwest as a corporate entity was valued at about $8 billion in terms of market capitalization. One year later we are valued at about $34 billion.

My prediction that we could be market leader in ten years may have sounded extraordinary a year ago. Well if you look at the increase in value in one year, our revenues went from $700 million to $3 billion. Our market capitalization went from $8 billion to $34 billion. I had an annual shareholder meeting in Denver.

I pointed out to the shareholders that if they had invested $100 in Qwest at the time of our IPO in June 1997, it was now worth $800. If they had invested in the S and P, it was worth $150. So you should look at that growth rate and the distance that we have covered over the past 12 months.

Twelve months ago, we had nothing in Europe. We didn't have undersea cables. We didn't have the Microsoft alliance. We didn't have the Netscape alliance. We had not bought four of the companies that we have acquired. Certainly, we didn't have the relationship with BellSouth. This has all happened over the past 12 months. If you take nine more years of that, I will bet you that the big companies that you know will be thinking twice about who their principal competitor is.

So what is going to happen over the next 12 months?

An equally profound change is going to happen over the next 12 months. There is one thing that I would add. It relates to a person I just hired away from British Telecom that you know.

I think one of the things that makes Qwest go is that we have a very strong, smart, aggressive and relatively young senior management team. This week we announced that Afshin Mohebbi, the managing director of the UK markets for BT, had joined us as President and COO which further strengthens our team.

So I would tell you that at the end of the day it is about technology. But it is also about great people and aggressive leadership of a company in an industry. So we are very pleased that we have found a formula that seems to have worked so far. Hopefully I am not too bold, when I suggest that the formula will continue to work for us going forward.