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Will Monster Mergers Crush Wholesale Suppliers?


WilTel Communications and SBC
Communications Inc. have had a cozy alliance for years, but AT&T Corp. could break up the union under one of the most significant U.S. telecommunications mergers in recent history. That would leave wholesale carrier WilTel with a gigantic gap in sales, underscoring the risks involved when a company relies too heavily on one client and representing a larger reality: Other carriers leasing infrastructure in North America and abroad to the biggest U.S. phone companies could be exposed to shrinking network sales after SBC and other telecom giants seek to realize billions of dollars in savings through the mergers. SBC has promised investors $15 billion in savings through the acquisition of AT&T.

“Someone has to lose revenue for someone to save money,” says Yankee Group Senior Analyst John Romagnoli.

SBC, the second-largest local phone company, plans to move its IP-based and long-distance services to the AT&T network after it acquires Old Ma Bell in a $16 billion pact. Consequently, WilTel could lose most of its network sales in a wholesale communications market that is notorious for excess capacity and razorthin margins. WilTel generates about 70 percent of its network revenue through SBC, according to a Securities and Exchange Commission filing.

“SBC, as WilTel’s primary customer, would be difficult to replace given the capacity excess that exists in the industry,” Fitch Ratings said in a February note lowering the long-term rating on WilTel’s parent, Leucadia National Corp., a New York-based investment company.

Megamergers: By The Numbers
13,000 Job cuts SBC expects following the AT&T acquisition.
7,000 Job cuts Verizon expects under MCI acquisition
12,000  15,000 Job cuts Qwest anticipates if it acquires MCI
$14.8 billion Savings Qwest projects
$7 billion Savings and incremental revenue Verizon anticipates
$15 billion Savings SBC expects
$92.9 billion 2005 estimated revenue of a combined Verizon and MCI based on Wall Street projections, according to Verizon
$10.3 million Amount of severance AT&T Chairman and CEO Dave Dorman would receive if he was terminated ‘without’ case after the merger
1885 The year AT&T was incorporated

Victor Schnee, president of Probe Financial Associates Inc., says he would not be surprised to see Leucadia sell WilTel. “I can’t see the advantage of them putting good money into this industry at this point,” Schnee says. “If I were them, I’d be looking to get rid of it and take my loss.”

WilTel may have some company. Other carriers who rely on a significant portion of revenue from one or two buyer segments are at risk of losing sales in the wake of the megamergers and further consolidation, Romagnoli says, and carriers who have not evolved their traditional voice networks also face negative exposure. Even those safeguards are no guarantee wholesale providers can preserve all their revenue. For instance, SBC will control an extensive IP/MPLS network through the AT&T acquisition eliminating the need to purchase transport from other carriers, the analyst says.

So are other long-distance carriers like Broadwing Communications Inc., Global Crossing Ltd. and Level 3 Communications Inc. under mounting pressure to consolidate in the wake of the megamergers?

“To a large extent they have a lot of duplicative assets and most of them are facing the same … common issue, which is really revenue generation,” Schnee says. “I don’t think there is an obvious merger among the lesser guys that makes a lot of sense at this point.”

Neither SBC nor Verizon, which is leading in a bidding war against Qwest Communications International Inc. to acquire MCI Inc., publicly disclose what they pay third parties for network services.

Verizon uses Level 3 for long-haul services outside its territory, says Verizon spokesman Mark Marchand. “Our emphasis is to continue building our network,” Marchand says.

Scoreboard
Company Annual Revenue Annual Profit/Net Loss Market Value*
AT&T $30.5 billion ($6.1 billion) $14.93 billion
MCI $20.7 billion ($3.9 billion) $8.13 billion
Qwest $13.8 billion ($1.8 billion) $6.61 billion
SBC $40.8 billion $5.9 billion $78.16 billion
Verizon $71.3 billion $7.8 billion $97.48 billion
*Market values as of April 1, 2005

Source: Company reports

The American Antitrust Institute (AAI), a Washington, D.C.-based think tank promoting competition, says Verizon plans to migrate its longdistance traffic to the MCI network. “A foreseeable result of a Verizon-MCI combination, therefore, would be a concomitant weakening of Level 3 and other wholesalers,” AAI research fellow Jonathan Rubin and AAI President Albert Foer wrote in a letter to two U.S. senators overseeing antitrust law. “Such fallout contradicts the simplistic view that because Verizon is not the owner of a Tier 1 IP backbone, a Verizon-MCI combination would have no competitive consequences for this segment of the market.”

Asked for confirmation on whether Verizon planned to move its traffic to the MCI network, Marchand says it “is the type of operational detail we haven’t discussed yet, and won’t until we get closer to closing the acquisition.” As of deadline, Verizon and Qwest were immersed in a fierce bidding battle and war of words over which company would be better suited to acquire MCI.

Some executives in the U.S. wholesale market played down the possible negative ramifications of the pending mergers. “We’re not terribly worried about the business dropping off,” says Dan Moffat, CEO of New Edge Networks, a broadband access provider whose biggest carrier customers include AT&T, MCI and SBC. “No single carrier covers the entire U.S.”

During a fourth-quarter conference call with investors, Level 3 CEO Jim Crowe expressed optimism that the company could benefit from the consolidation. “We believe that any impacts, where perhaps a consolidated entity might want to move traffic to an owned network, are offset by the fact that all of the entities we’re discussing have gross margins in the 50 percent range, plus or minus,” Crowe said. “That means they buy 50 cents of every dollar of network expense from third parties.”

The phone giants involved in the mergers also have relatively large wholesale divisions, but analysts say the regional phone companies’ biggest priorities - integrating AT&T and MCI and courting big corporations and government agencies - could create opportunities for other carriers to grow their wholesale businesses.

“I personally [think] there would be less focus on the wholesale market,” Frost & Sullivan research analyst Vinod Ramanathan says of a combined AT&T and SBC. “This would definitely help companies like Level 3” to grow theirs.

Taher Bouzayen, vice president with ATLANTIC-ACM, the Boston-based research and consulting firm, says carriers already supporting AT&T and MCI could leverage those relationships to form alliances with the Bells and grow sales.

And ATLANTIC-ACM CEO Judy Reed Smith says the mergers could pave the way for Level 3 and other wholesalers to sell network services to wireless operators competing with Verizon Wireless and Cingular Wireless, the joint venture between SBC and BellSouth Corp. Although the regional Bells would control extensive long-distance networks through the acquisitions of AT&T and MCI, wireless carriers like T-Mobile USA may have good reason to look beyond the phone giants for network services. Reed Smith says companies often try to avoid buying network services from rivals if they have choices.

Nevertheless, the pool of national wireless customers is shrinking. Sprint Corp. and Nextel Communications Inc. plan to combine this year. The merger would make Sprint-Nextel the thirdlargest mobile provider behind Cingular and Verizon Wireless and leave the top three U.S. wireless operators carrying about 75 percent of the traffic, according to analyst Jeff Kagan.

BEYOND U.S. BORDERS

Outside of the United States, the megamergers also could deal a blow to wholesale carriers routing phone calls and data traffic around the globe if SBC and Verizon or Qwest move international traffic onto the AT&T and MCI networks.

AT&T has approximately 7,400 dialup locations in 149 countries and owns a 77,000-mile domestic fiberoptic network, plus an ownership interest in 300,000 miles of undersea cable worldwide. And MCI owns a network spanning Africa, Europe, Latin America, North America and the Asia-Pacific region in approximately 140 countries and 2,800 cities.

In an SEC filing, Teleglobe, a large international wholesale provider of voice, put a positive spin on the mergers. “In light of the potential consolidation within the U.S. telecommunications industry, including the pending AT&T and SBC merger, Teleglobe believes that it is well positioned as the only company to focus exclusively on the international wholesale market,” says the carrier, which acquired ITXC Corp. last year. “The company believes this is a key competitive and strategic advantage as its competitors focus on consolidationrelated issues.”

Ofer Gneezy, president and CEO of Teleglobe rival iBasis Inc., says iBasis carries traffic for several telecom giants seeking to participate in the big mergers, including AT&T, MCI, Verizon and Qwest, which is its biggest customer. “The ILECs are likely to use the IXCs they are purchasing to handle their international traffic and we are quite successful in receiving some of the traffic from the IXCs,” he says. “I think we will continue to see traffic they are sending to destinations where they don’t have a very strong footprint on their own.”

TeleGeography Research Director Stephan Beckert says it is hard to quantify the implications of the mergers in the international wholesale market. “Nobody likes to be too upfront about what they are outsourcing,” he says.

Janet Matulia, president of France Telecom Long Distance USA, the wholesale subsidiary of France Telecom, says the company has relationships with all the big U.S. carriers, including AT&T, MCI, Qwest, SBC, Sprint and Verizon. “We’ve developed some strategies …based on who might be merging [with] whom,” she says.

Matulia concedes wholesale carriers could lose business in certain areas as a result of the mergers, but maintains there are more advantages. The upside: the mergers will leave the industry with fewer - and stronger - carriers, reducing the risks of bad debt for wholesale carriers and possibly squashing price declines. “Certainly were hoping the pricing stabilizes,” Matulia says.

Links

ATLANTIC-ACM www.atlantic-acm.com
AT&T Corp. www.att.com
BellSouth Corp. www.bellsouth.com
Cingular Wireless www.cingular.com
France Telecom www.francetelecom.com
Fitch Ratings www.fitchratings.com
Frost & Sullivan www.frost.com
iBasis Inc. www.ibasis.com
Level 3 Communications Inc. www.level3.com
MCI Inc. www.mci.com
New Edge Networks www.newedgenetworks.com
Probe Financial Associates Inc. www.probefin.com
Qwest Communications International Inc. www.qwest.com
SBC Communications Inc. www.sbc.com
TeleGeography www.telegeography.com
Verizon Communications Inc. www.verizon.com
Verizon Wireless www.verizonwireless.com
WilTel Communications www.wiltel.com
Yankee Group www.yankeegroup.com


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