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The communication revolution that is under way is surely one of the most complex ever. When Gutenberg invented the printing press, or Alexander Bell the telephone, they were quite separate events. It was a specific singular episode that took a long time for its effects to be felt around the world. But this one is different. We are experiencing dramatic changes in TV and telephony at the same time as a whole new medium, the Internet, has become available. How can we possibly make sense of all these developments and, more importantly, formulate an investment strategy to take advantage of them?
Note that we are making no differentiation between different parts of the DCSH. Land line telephone calls, mobile phone calls, the Internet and digital TV are all an integral part of this medium and all four systems are, or will be, interchangeable to some extent.
Marconi (LSE: MNI)
British Telecommunications (LSE: BT.A)
Freeserve (LSE: FRE)
Well, I am going to attempt that. At a stroke I am going to simplify the whole complex issue into one concept. And that issue is simply bandwidth on the digital communication superhighway, which I'm going to call the DCSH.
Non-technical investors might think that this a rock group consisting solely of fat musicians. But no, bandwidth is a measure of how much data can be transferred between electronic communication devices. Traditionally this would be telephone cable or radio and TV signals, and it would be in analogue form. Moreover, the medium would only be capable of dealing with one signal at a time. In other words the line could only deal with one telephone call or TV signal at once.
That is the process that is changing dramatically. By switching to digital transmission, and by using such things as fibre optic cables and WAP technology, it is possible for these media to transfer huge amounts of data at the same time. This ability is called broadband, and the old, one-at-a-time, systems are known as narrow band.
OK, if bandwidth is the crucial element of the DCSH, is it possible to subdivide the industry to see where the crucial value points are? Well, yes I think it is. In my view the business of the DCSH has three components:
Having made this distinction we can start pigeonholing companies in the one of the three groups. So this is my categorisation, and it is not exhaustive.
Makers
Arm (LSE: ARM)
Filtronic (LSE: FTC)
Imagination Technologies (LSE: IMG)
Psion (LSE: PSON)
Nokia (NASDAQ: NOK)
Ericsson (NASDAQ: ERICY)
Motorola (NYSE: MOT)
Dell (NASDAQ: DELL)
Pace (LSE: PIC)
Owners
Vodafone AirTouch (LSE: VOD)
Colt (LSE: CTM)
Redstone Telecom (LSE: RED)
Cable & Wireless (LSE: CW.)
Telewest (LSE: TWT)
Users
Pearson (LSE: PON)
Carlton (LSE: CTM)
United News & Media (LSE: UNMS)
BSkyB (LSE: BSY)
QXL.com (LSE: QXL)
365 Corporation (LSE: TSF)
AOL (NASDAQ: AOL)
Amazon.com (NASDAQ: AMZN)
Yahoo! (NASDAQ: YHOO)
Emap (LSE: EMA)
WPP (LSE: WPP)
And many, many more.
At the moment the market is enthusiastically throwing money at all three groups with seemingly little discrimination. But if we think a little about the economics of it we can perhaps make some fairly broad assumptions. Economics tells us that if something is in great demand its price will go up. And the price will go up until it attracts new supply, and/or purchasers refuse to pay the higher prices so that eventually demand falls. In the case of the DCSH the crucial price is that of bandwidth and because it is in such great demand owners are expanding it as fast as they can. While this is clearly good news for the manufacturers making stuff to get on the highway, it is not such good news for the owners. Companies like Telewest and Colt are incurring heavy funding costs, as their debt-laden balance sheets show.
Now at some point I would have thought that we would have enough bandwidth, but the techies here at Fool HQ tell me that won't be the case for years to come because so many new applications are being found for the DCSH. So for the foreseeable future the makers look as if they will continue to experience very good demand for their products. And the best thing about these guys is that they have very high barriers to entry. I mean, to start a company making these things requires ultra clean rooms and lots of experience in putting very fiddly little widgets together. And that is not the sort of thing that new companies can come along and do straight away. Besides, you have to be pretty smart to design RISC chips for Arm, and that rules out 99% of the population. So equipment makers and designers look not only fairly well placed, but also relatively secure.
However, I am not so sure the same applies to owners of the DCSH, basically the telephone and cable companies. The rapid expansion of the highway must bring down the toll charges, and it is clear from the likes of BT that unit revenues are declining. The bulls argue of course that higher volume will compensate for lower prices and that is certainly the case so far. Moreover, there are huge barriers to entry. No one is going to lay another set of telephone cables to compete with BT, or launch a satellite to take on BSkyB.
However, there will shortly be a huge increase in wireless capacity as the 3G standard is rolled out later this year. And everyone knows that the prices of mobile phone calls are dropping rapidly. Owners of the highway have still got some good years ahead of them, but life will get increasingly tougher for many. Especially, I think, for operators like Redstone that just piggyback on existing capacity and take a margin on it.
Finally, we come to the users of the highway; companies such as Emap with FHM, Freeserve, QXL.com and the TV companies. The problem these businesses have is getting revenue in, because this is the one bit with virtually no barriers to entry. Start-up costs are low and there seems to be no limit to the amount of equity capital that is seeking to fund those costs. Mind you it seems that most of that money goes straight into advertising, so maybe the real winners are the advertisers like WPP. At this early stage in the game I am still struggling to see how all these users will survive. Obviously TV companies and online shopping will prosper, but I am less sure how businesses like Freeserve and 365 will convert all their visitors into profitable clients. Even though I am a technology investor, I am still old-fashioned enough to want things like profits and cash flow.
So, at this stage of the game, while the digital communication super highway is still under construction, my money is on the builders, although I do have a small investment in the media sector to get some exposure to the user of the DCSH.
Anyway, that is my attempt to make some sense of what is going on. But I'm sure lots of Fools have got their own, and probably different, interpretations. So let us know what you think on the Fool's Eye View message board. Incidentally, this article was inspired the discussion we had this week to try and select the next stock for the TMF investment club, so these things are useful after all. Well, I think they are.
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