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By Susan Marks
The health of the network industry is in a nerve-racking state. It's reeling under some of the largest bankruptcies and mergers ever, scandalized by a few of its members' questionable accounting practices, and is generally enduring its biggest downturn ever. But this severe consolidation, while painful, isn't terminal. It is actually a healthy, natural realignment, say analysts, venture capitalists, investment bankers, vendors and other experts. The athlete's axiom "No pain, no gain" could be the motto for the current condition. These harsh facts show an industry that is contracting:
Yet an abundance of gloomy news is not an apocalypse. Venture capital spending in fact remains far above historic levels, says Kirk Walden, national director of venture capital research for PricewaterhouseCoopers: "Normal was not 1999 and 2000. Those were anomaly years and completely unsustainable." And venture capital invested in start-ups appears to be coming out of its nosedive, according to a special analysis of quarterly venture capital data compiled for Network World by PricewaterhouseCoopers, the National Venture Capital Association and Venture Economics. The amount of these investments leveled off at $4 billion during the fourth quarter of 2001 (Click here for more). While that figure is off 73% from the high-water mark of the Internet boom, it's still roughly double the amount invested before that bubble. Also, the percentage of start-up companies that fail — 40% — is about the same now as it has been for the past five years, says Jesse Reyes, vice president of product management for equity research firm Venture Economics. "The only difference we are seeing now is a lot of those companies are failing in public markets and in the limelight rather than dying a nice quiet death in someone's portfolio," he says. Today's unrest is simply the ebb part of the industry's ebb-and-flow cycles, says Rich Mogull, information security analyst for Gartner. "I don't see this as being any huge crash of the system." Even the telecom industry, struck by lightning in this downturn, hasn't departed from a normal cycle. It consolidates every five to 10 years, and has endured worse, says Christine Heckart, president of TeleChoice. In the early post-Bell breakup years, 1984 to 1988, there were about 3,000 service providers. In late 1987 and 1988 consolidation decimated the ranks by half. At the time, Heckart was with WilTel International (later bought by LDDS, which in turn became WorldCom). Her first project was to find out who was left. "As a provider's provider, we were concerned that the industry was dying," she says.
The reality was that the shakeout was the precursor to growth, as she predicts this one will be. Moreover, what's carnage for some is opportunity for others. In fall 2001, Polycom was flush with cash, so it went shopping, acquiring PictureTel in October. Under normal market conditions, Polycom might have had to fight for the rival videoconferencing equipment maker, says Joe Tort, PricewaterhouseCoopers global partner in networking and computing. Instead, Polycom bought PictureTel for cash and stock worth about $362 million. "Now they are a big strong company in the broadband networking space, and ready to do extraordinarily well," he says. Polycom isn't alone. Long-distance service provider IDT picked up the operating assets of bankrupt competitive local exchange carrier (CLEC) Winstar Communications. Metropolitan Ethernet service provider Cogent Communications bought those of bankrupt PSINet. Still, the industry hasn't hit bottom yet. While the flimsiest Internet companies are gone, the ebb will continue until the remaining companies that should disappear, do. These are companies founded in the 1998-99 boom with lots of investment capital, great ideas, good engineering and solid business plans, but no customers, says Woody Benson, a principal with venture investment firm Lazard Technology Partners. Many of these companies, public and private, targeted their offerings to CLECs and other service providers hardest hit. They have since changed business plans radically or are limping along on decimated capital expenditure budgets, Benson says. Also the pendulum is about to swing back, predicts Richard Dean, program director for infrastructure integration and support services for IDC. He cites inventory management as evidence. During the boom, vendors such as Cisco, Lucent and Nortel couldn't produce product rapidly enough. They increased capacity, which became overcapacity when buying slowed. But excess inventories are slowly balancing, Dean says. He expects 10% to 15% growth of revenue and profits in the second half of the year. Although the big picture shows that the industry is in good health, network executives should still alter tactics for today's harsh realities. A weak global economy has pushed the normal evolution into a worst-case scenario, Heckart says. Many viable companies that might have been acquired have ended bankrupt. "The marketplace is strewn with distressed assets and that doesn't mean that one ought to go and buy them all," says Eugene Lee, Cisco vice president of enterprise marketing. Network executives must perform even more thorough financial checkups on potential vendors, watch current vendors constantly and plan for a vendor's failure, says Harry Jarrett, who, as director of global network technology and architecture, oversees the internal voice and data networks of NCR in Dayton, Ohio. 
In 1999, NCR needed high-speed service for its network of remote offices, so the company turned to CLECs, including Rhythms NetConnections. Rhythms filed for bankruptcy in August 2001 and NCR found itself scrambling. "We were not prepared for it," Jarrett says. Today NCR diligently reviews the finances of its vendors and has fallback plans in case its vendors fail, such as a two-tier VPN management system for high-speed connections to remote offices. Individual offices opt for an ISP of choice, but the VPN components, including client software, are managed by AT&T. AT&T distributes and installs the VPN components, and provides initial support when network problems occur. Smaller vendors: To ditch or keep? In uncertain financial times like these, enterprise buyers tend to move to fewer and larger vendors. The flight to vendor quality is how Jim Hale, senior partner at venture capital firm FTVentures, describes it. This trend leaves smaller vendors scrambling no matter how solid their funding, how good their product or blue-chip their customer list. In some cases, the vendor's only recourse is a merger, he says. A future benefit of the movement toward bigger, established vendors could be better integration of product suites, says Elisabeth Rainge, analyst for IDC. During the go-go acquisition days, companies would buy new network devices that added functionality but often didn't truly integrate them with existing products. She cites the case of Cascade/Ascend/Lucent. Cascade, a provider of WAN products, was acquired by Ascend, which in turn was acquired by Lucent in 1999. "Folks still look to manage those Cascade devices separately," Rainge says. "They don't necessarily integrate with other Lucent products, or in many cases with other Ascend products." With a slower pace of acquisitions, and stable customers, big companies are focusing on refining their existing product lines, including providing the promised integration of technologies purchased in the buying frenzy days. Likewise, enterprise users who might have tried new vendors two years ago, today tend to stick with familiar products, adds Jason Smolek, IDC analyst specializing in enterprise networks and IP VPNs. So emerging market segments such as Gigabit Ethernet see slower adoption rates than pundits once predicted. But no matter how safe the tried and true seems, this isn't always the best buying strategy. Sound smaller vendors may be offering great overall deals "better than the mainstream ones," Smolek says. Whether a recovery is three months or two years away, the industry knows now that a newfangled economy was a myth. Bust always follows boom. But then again, boom follows bust, too. Marks is a freelance writer in Denver. She can be reached at sjmarksco@aol.com. Related links Vendor news Earnings news Venture capital database Merger and acquisition database Apply for your free subscription to Network World. Click here. Send this article to a colleague
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Publicly
traded companies are filing for bankruptcies at an unprecedented
pace, according to Federal Deposit Insurance Corp. and BankruptcyData.com.
In 2000, 176 public companies filed for bankruptcy. In 2001, 257
did, with 34 — about 14% — from the telecom industry.
Already from January through March, 61 public companies have gone
under. Among the recent high-profile cases are international data
carrier Global Crossing; telecommunications carrier McLeodUSA; and
wireless e-mail service provider Motient. (Click 
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