Batten the Hatches

Posted: 12/1998

Batten the Hatches
IXCs Take Local Loop by Storm

By Gary Kim

Although the
tornado of long distance carrier entry into local services hasn’t yet touched down,
competing carriers are well-advised to board up their windows. For despite the fact that
some of the biggest carriers have scaled back their efforts, the onslaught is certain to
come. And it’s fear–not greed–that will drive it.

"As soon as the big players start to lose customer share because competitors are
bundling local services, they’ll move," argues Dr. Judy Reed Smith, CEO of
Atlantic-ACM Inc., Boston.

Make no mistake, reduced churn is the carrot. Whatever the margin contribution from
local services, the bigger value is the enhanced ability to retain a customer the long
distance carrier already has, especially business customers. "It’s very much
worthwhile for a long distance player to bundle local with long distance to reduce churn,
especially in the business market," says Reed Smith.

To be sure, there’s an offensive element as well. Long distance carriers ultimately
must move into local services to offset certain losses once the regional Bell operating
companies (RBOCs) are cleared to compete in the long-haul market. But the dynamics for
each sector are quite different.

Based on experience to date, local carriers will decimate interexchange carrier (IXC)
market share in the consumer segment, despite some surveys that suggest the contrary.

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Image: Exhibit 1

"Southern New England [Telecommunications Corp.] got 60 percent take rates"
when it bundled local with long distance, says Reed Smith. "When the RBOCs come in
[to the long distance market], you’re dead if you don’t have local."

Even in years prior to the telecommunications reform (1991 to 1996), smaller incumbent
local exchange carriers (ILECs) were getting long distance market share in excess of 30
percent after about three years. So RBOC or ILEC long distance entry is more a growth
strategy than a "defend-share" strategy.

In contrast, a 1996 survey by J.D. Power & Associates, Agoura Hills, Calif.,
suggests "long distance carriers may acquire more than one-third of the local
telephone markets as well as retain a majority share of their own industry." The
survey also reveals that 65 percent of households would prefer a single provider for all
services, and suggests the majority of households would choose their long distance carrier
as the provider.

That’s a contention hotly disputed by Atlantic-ACM’s Reed Smith. "Whoever owns the
local customer can get the long distance with very little additional marketing," she
says. No matter what the surveys say, the marketplace shows the RBOCs win when they bundle
long distance, she argues. (See Exhibits 1 and 2, "Average ILEC Share of Long

Matters are reversed for the long distance carriers, especially AT&T Corp., which
has the largest share of residential customers. Evidence to date suggests that ILECs will
gain more than they lose as the local and long distance industries collide and,
conversely, that IXCs will lose more than they gain.

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Image: Exhibit 2

So local entry is a defensive, churn-reduction strategy, above all else. The objective
is to slow the rate of customer defection, to hold existing account base and revenues,
more than to attract new customers. And share shifts in the local markets have been
slight, to date. U.S. competitive local exchange carriers (CLECs), for example, have
snared only about 5 percent of the local business communications market and $3.3 billion
annual revenue since 1994, according to analysts with Washington-based Strategis Group
Inc. CLEC share of the residential markets is nil. (See Exhibit 3, "U.S. CLEC
Business Market Share, 1994-2003.")

Based on such figures, some observers think IXCs may have advantages, however. New
York-based Goldman Sachs & Co. telecom analyst Richard Klugman, for example, has
argued in the past that RBOCs are at a significant disadvantage to the IXCs, for several
reasons. For starters, their customers are highly concentrated.

"The 306 metropolitan statistical areas (MSAs) cover only 20 percent of the land
area, but serve 75 percent of the population and account for nearly 85 percent of the
telephone lines," he says, explaining that their high concentration makes them easier
for competitors to target.

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Image: Exhibit 3

As CLECs have discovered, business lines generate "twice as much revenue as
residential lines and are less expensive to serve," Klugman has argued. Indeed, as
many CLECs point out, some 20 percent of U.S. switches account for more than 80 percent of
total calling volume. GTE Corp., Stamford, Conn., for example, though it serves
residential customers disproportionately more than a typical RBOC, serves 50 percent of
its customers from only 10 percent of its switches.

Klugman also argues that RBOCs need to gain four times the market share in long
distance business to offset the losses in local services. Local is simply a bigger target
than long distance, and local is more profitable than long distance, at least for business

Margins for facilities-based carriers can be in the 45 percent range for local,
compared to 35 percent for long distance, Klugman says. "When density is considered,
RBOCs probably earn close to 100 percent of their profits from a mere 5 percent of their
geography, the downtown business districts where rates and usage are highest and cost to
serve is lowest."

That and similar dissenting views aside, low margins for resold services, not simply
strategic considerations, have kept IXCs in a low-profile local services mode up to this
point. "If that was your only business, it would be tough," says Bill Frommelt,
local services director for Convergent Communications Inc., Englewood, Colo. Until they
have their own facilities in place, IXCs must rely on ILEC or CLEC facilities to connect
customers, and the incentives to rapidly acquire a local customer base are vastly reduced
when resold facilities are the only option, he says.

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Image: Exhibit 4

Slim profit margins are the main problem with resale. With wholesale discounts in the
17 percent to 22 percent range, there’s little room for profit, carriers and resellers
have discovered. "I don’t know that you can fully make the business case today,"
says Ken Hoexter, Goldman Sachs telecom analyst. That, in large part, is the thinking that
drove AT&T to acquire cable giant Tele-Communications Inc., Englewood Colo., which
would allow AT&T to avoid uneconomic local loop resale, says Michael Ma, Deutsche
Morgan Grenfell analyst.

As several resellers already have discovered, resold local service is a tough
proposition on its own. "In California the resale discount is 17 percent," says
Derek Gietzen, CEO of Genesis Communications International Inc., San Diego. "Bad debt
for local resale is north of 10 percent."

On top of that the CLEC has to offer a price discount. Unfortunately, that leaves no
margin, says Gietzen. Gietzen thought the slim margins in local would be offset by higher
overall margins in long distance and other services. But Genesis never realized the gains.
"Long distance never covered our losses in local services," he says.

Even in a bundled services scenario, local is a modest cash contributor, in many cases.
For a typical small business customer, a $76 monthly revenue stream for each employee
includes only about $10 a month in actual revenue, says Clint Wilson, telephony services
director for Convergent. (See Exhibit 4, "Monthly Bundled Services Revenue.")

Long distance usage growth also continues to gallop along at double-digit rates, making
a focus on the core business quite rational, especially given the high startup costs for
local services. Growth rates for the whole IXC business were nearly 12 percent in 1997,
and may be in the 11 percent range this year, according to Goldman Sachs analysts. Upstart
carriers such as Qwest Communications International Inc., Denver, (which has acquired all
assets of McLean, Va.-based LCI International Inc.) and WorldCom Inc. (pre-MCI) pace the
growth, but even AT&T Corp., with the most to lose, will grow at 5 percent.

Indeed, in its year-end report, AT&T noted that long distance calling volume was up
8.7 percent for 1997, led by strong demand for toll-free and outbound service for business
customers. Revenue failed to keep pace, however, largely the result of access charge
reductions that were passed along to consumers, and movement of high-use residential
customers to lower per-minute price plans.

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Image: Exhibit 5

And second-quarter 1998 IXC growth was highly positive on the traffic side, though less
so on the revenue side, notes analyst William Deatherage from Bear Stearns & Co. Inc,
New York. (See Exhibit 5, "IXC Second Quarter 1998 Growth.")

Though pricing pressures continue, primarily caused by lower revenue per minute, 1998
revenue growth could accelerate compared to 1997. Upstarts will do far better, growing at
20 percent-plus rates. Where revenue growth was 5.4 percent in 1997, it will hover in the
6.2 percent range in 1998, say Goldman Sachs analysts.

Sooner or later, though, IXCs will start feeling the pinch of lost share. And as has
been the case in the core long distance markets, resale will be a factor. MCI WorldCom
Inc.’s recent introduction of wholesale local services in all markets where it has local
facilities is one underpinning of the coming assault.

A major force in the long distance wholesale market, MCI WorldCom wants to make resale
of a bundle including local services a key part of its future business as well. Using the
CLEC facilities it acquired from Brooks Fiber Properties and MFS Communications Co. Inc.,
for example, WorldCom plans to provide a local/long distance wholesale bundle everywhere
it owns facilities by the end of 1999.

Look for MCI WorldCom to establish new resale price points on its way to recasting the
resale market. Where the typical range of RBOC wholesale discounts has been in the 17
percent to 22 percent range, MCI WorldCom’s wholesale marketing director Dale Thompson
says his firm’s wholesale discounts "start at 30 percent to 35 percent and go up from
there based on volume and term agreements."

MCI WorldCom also is making available its entire private-line portfolio, including the
standard T1 and digital signal Level 3 (DS3) circuits, across the nation, adds company
Senior Manager Tracy Webb.

"We believe our moves will cause the ILECs to re-evaluate their wholesale tariffs
as they see our resellers taking small business and high-end residential end-user traffic
away," Thompson predicts.

Altogether, MCI WorldCom owns 9,000 route miles worth of CLEC facilities in more than
100 U.S. cities. Some 30,000 business sites are connected to those facilities.
Private-line services also will be made available for wholesale customers, says John
Barnett, CEO of MCI WorldCom’s Wholesale Services business.

And though it has kept a low profile, AT&T during 1997 added 41 local
interconnection agreements and 15 total service resale agreements. But revenue from
AT&T’s "Digital Link" service for business customers as well as local resale
amounted to a paltry $37 million worth of 1997 revenue, up from $4 million in the first
quarter of 1997. The company has ceased marketing of local resale service, however, after
acquiring about 400,000 customers.

Look for a windstorm of long distance activity in the local services arena once
significant long distance market share begins to shift because competitors are offering
local services. Expect massive movement into local services once the RBOCs are themselves
allowed into long distance. And look for the dominant carriers to focus attention on their
business customer base.

A frequent contributor to PHONE+, Gary Kim is strategic research director for
Convergent Communications Inc., Englewood, Colo. He can be reached at + 1 303 749 3061.

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