Optical Train Wreck?
To many Americans, at least those born before the age of bullet trains and supersonic travel, those are resonant images. They are, to appropriate the cliché, as American as. . . high-tech stocks.
It’s not all that difficult to view the railroad as an apt metaphor for the optical networking industry. Both businesses are all about transportation. Fiber can stand in for steel rails, while today’s service providers are the 21st century counterparts of outfits like the Erie and the Northern Pacific railroads.
Actually, it’s an all-too-easy comparison to make. And that’s disturbing.
Overvalued stocks, overheated competition, out-of-nowhere startups, over-the-top speculation, fabulously wealthy entrepreneurs and engineers, fierce personal rivalries — all of which led to huge financial losses that sent the U.S. and overseas markets reeling.
Just to be clear, I’m talking history here: the railroad industry from roughly 1860 to 1910.
It’s a history that deserves closer scrutiny, though, particularly to see if we’re headed in the same disastrous direction.
Let’s cue the first clip from the History Channel. It’s the late 1860s. Railroads rule. Uncomfortable and time-consuming as traveling by train is, it beats the covered wagon, stagecoach, horseback, and shoe leather. More important, rail transport is the only reliable way of moving raw materials or getting goods to market, which means the health of the Iron Horse directly affects the health of the new oil, coal, and steel industries — as well as the overall U.S. economy.
All this helps explain the years of so-called railway madness, which saw startups race to lay track, while floating bonds and issuing stock with wild abandon. Speculation pushed valuations to unrealistic heights.
Asked about the real value of his Erie Railroad stock, financier Jay Gould said cynically but candidly, “There is no intrinsic value to it probably; it is speculated here and in London and it has that value.” Gould, along with partners Jim Fisk and Daniel Drew, famously kept a printing press in the basement of their Manhattan offices, so they could churn out worthless share certificates in their endless battles to keep control of their company.
Things aren’t nearly as wild these days, of course. Still, it is sobering to consider the comment of Wu Fu Chen (see Wu-Fu Chen: In It for the Long Haul), the legendary optical networking entrepreneur:
“In the old days people said, 'We make money the old-fashioned way; we earn it.' But in optical networking we say, 'We make money the new-fashioned way — we print it!' "
Let’s get back to the 19th century. September 18, 1873: The collapse of the Northern Pacific railroad causes leading stocks on the NYSE to drop half their value (about 30 to 40 points) within an hour of the opening bell, setting off the Panic of 1873. Northern Pacific’s chief promoter was another Jay — Jay Cooke, the richest man of his day. Cooke controlled the railway through his Philadelphia bank. When he went bust he took a lot of other railways with him, most of which had borrowed heavily and had little to show for it. Sound familiar?
Thousands of other companies also went under. Brokerage houses and banks closed their doors. The NYSE shut down for 10 days. And that was just the beginning. Between 1873 and 1879, European investors lost an estimated $600 million through bankruptcies and frauds; two-fifths of all railroad bonds were in default; and 65 rail networks, capitalized at $234 million, had to be foreclosed.
It’s tempting to see Jay Cooke as the Bill Gates of his day. Certainly he had the cash to qualify for the title. But Microsoft, for all its legal hassles, isn’t about to go under. (Remember the Chrysler bailout?)
Let’s look a bit closer to home. Northern Pacific was heavily leveraged with little to show for the capital — only a third of the line was finished when the company declared bankruptcy. That sounds like any number of optical startups. What about Global Crossing Ltd. (Nasdaq: GBLX) one of the carriers that’s come out of nowhere to become a megaplayer? (It even sounds like a railway company.)
Cooke was a banker. As Light Reading has already noted (see Top 10: Gary Winnick), Gary Winnick, Global Crossing’s founder and chairman, worked with Michael Milken at Drexel Burnham Lambert in the 1980s, raising junk bonds and launching the takeovers that — for better or worse — reinvented corporate America. Winnick has been putting his expertise to work at Global Crossing, rewriting the rule book on financing big telecom projects and, in the process, netting a paper profit for himself of $4.5 billion.
For the record: This isn’t a knock against Global Crossing or any other optical startup. It’s an attempt to see what history has to tell us about our future.
So are we on a clear track to a train wreck?
For starters, the railway industry pretty much was the stock market in 1873. Twenty years later, when another panic ripped through the global exchanges, railways still accounted for 60 percent of the NYSE. These days, we’ve got some major players to sustain the economy, even if the entire optical networking industry tanks: behemoths like AT&T, GE, and GM — to name a few.
Further, high-tech companies account for less than a third of the major indices. And they tend to be well-diversified operations, with solid earnings and strong growth prospects. Optical players represent a still smaller portion of the total, and their weightings decrease as share prices decline. So even if one mondo optical outfit implodes, it’s not going to take the stock market with it. And while investors may move more of their assets into cash, they’re less likely to pull out of the market altogether.
We also live in a far more regulated age than the heyday of boom-or-bust capitalism. Corruption was the norm in the courts and Congress of the 19th century. Threatened with arrest after one of their ventures into creative accounting, Gould and his cronies simply rowed across the Hudson River and resumed operations in Jersey City.
There’s something else to remember. Market downturns offer opportunities to pick up valuable assets cheaply. The Panic of 1873 paved the way for new entrepreneurs, and the Northern Pacific itself was back in play by 1880.
Another difference is that turnaround time between market dropoffs and rebounds is faster, partly because the flow of information that moves markets is instantaneous. What’s more, while a severe crash can’t be ruled out, market corrections occur more frequently.
But can the 19th century offer any insight to carriers and optical investors looking not to get run off the rails?
Again, the parallels are well worth considering. The most obvious is just good business sense: Look for companies capable of establishing a revenue base while expanding their networks and keeping costs low. Being in the right place at the right time always helps. Successful railways tended to stick to heavily populated areas. Similarly, there’s a great deal of interest in optical equipment designed to serve metro markets, where there are high concentrations of people.
Railways favored horizontal rather than vertical integration. They bought into coal mines, for instance, but tended to shy away from companies that manufactured locomotives. Again, it’s easy to spot some similarities. Railways bought into coal mines for the same reasons that carriers hope to become content providers. They were afraid that competition would squeeze margins in the transport business, so they wanted to get a cut of what they were carrying.
After that, it gets a tad more tricky. If service providers are the railways, then manufacturers of optical networking gear are the folks who build the trains. And today’s Wall Street is keener on equipment vendors than service providers, possibly because the former require less capital and possibly because the killer apps for next-generation networks aren’t as obvious as hauling freight or shunting people cross-country. And while a few carriers do invest in equipment manufacturers, it’s far more significant that so much cash is flowing in the opposite direction. Equipment vendors furnish a lot of the financing for service providers. More to the point, the vendors and carriers are funded by the same VCs and investors.
The lesson from the railways? Look for tangible assets, sustainable earnings, and good management. If you’re in it for the long haul (pun intended), trains can still offer some valuable insights. Consider the Norfolk Southern line, which was just another 19th century startup. These days, it’s capitalized at $7 billion with sales of $5.2 billion. It’s currently in the process of integrating 7,200 miles of track formerly owned by Conrail. This gives it new sources of revenue, as well as savings. That’s a pretty impressive track record for a company entering its third century.
The one thing carriers and investors don’t want is to be left standing at the platform watching the train pull out without them. All aboard!
Stephanie Cooke is a freelance financial writer, based in London