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How Telecom Can Turn Itself Around

By Jane Black Telecom's horrible year finally is at an end. The American Stock Exchange Telecommunications Index (XTC) is up 49% from its Oct. 9 low -- though it still fell nearly 50% for the year. Even as the industry's financial performance and stock prices begin to bottom out, however, it's clear that 2003 could be an even more crucial year for local and long-distance carriers.

Their challenge is twofold: to -- at last -- find a strategy that will guarantee their survival and to deliver new communications services that customers crave. Problem is, there's no consensus among analysts -- or the carriers themselves -- on just how to achieve those goals. A complicating factor is that the two don't always go hand-in-hand. For instance, should carriers abandon their recent financial discipline to invest in new services, a tactic at which they've sometimes failed spectacularly (witness AT&T's ill-fated forays into PCs, mainframes, and cable TV)? Or should they continue to cut costs and stick to their knitting -- knowing full well that no company ever cost-cut its way to greatness?

The only really clear thing is that, if 2003 is to be the first year of a telecom recovery, the carriers have to find a direction -- fast. Instead, over the past six months, phone company execs have wasted untold energy fighting a ferocious lobbying war to get the Federal Communications Commission to issue new rules by February that will rein in upstart competitors (see BW Online, 11/19/02, "A Nationwide Brawl over Local Phones"). Rather than spending so much time and money on a rearguard action, perhaps the Baby Bells -- Verizon (VZ), SBC (SBC), BellSouth (BLS), and Qwest (Q) -- plus the long-distance triumvirate of AT&T (T), Sprint (FON), and WorldCom, which is expected to emerge from bankruptcy next spring, would be better off drawing up plans that will lead to growth and higher profits.

So with that thought in mind, here's a short list of New Year's resolutions the carriers might consider:

Stop Playing the Regulation Game

For six months, the Baby Bells have been on the regulatory warpath. The point of contention is a provision of the 1996 Telecommunications Act that obliges the Bells to sell capacity on their local networks at wholesale rates to all comers -- rates the Bells say are below their costs.

To date, competitive carriers, particularly AT&T, have siphoned off 10 million of the Bells' local customers, eroding their traditional monopoly -- and their cash-cow businesses (see BW Online, 8/21/02, "The Bells' Big Local Headache"). In September, Edward Whitacre, SBC's CEO and chairman, claimed that if his company didn't get relief it would eventually face financial ruin. Sure enough, a month later SBC posted a 6.8% decline in third-quarter revenue and a 14% drop in net income.

The Bells' focus on regulatory relief is misguided, however. For one thing, they're already gaining the power to bundle residential long-distance and local-phone service, which doesn't yet add to profits but does appear to stem customer defections. On Dec. 19, BellSouth became the first Baby Bell to win permission from federal regulators to offer long-distance service throughout its entire nine-state home territory. Four days later, Qwest received approval to offer long distance in nine of its 14 states.

BUNDLED OFFERINGS. No. 1 local carrier Verizon has gotten approval to sell long-distance in all but two states and the District of Columbia, and has already attracted 9.8 million long-distance customers, up 44% in the last year. In its third-quarter earnings conference call, Chief Financial Officer Doreen Toben said Verizon's bundled offerings are the key to stemming its loss of customers, which have been the smallest among the Bells.

Moreover, Blair Levin, a telecom analyst at Legg Mason in Washington, D.C., argues that defections of customers to competitive local exchange carriers, as the new local phone companies are called, are likely to have far less impact on the Bells' bottom lines than will competition from wireless and from new, cheaper voice services, such as voice over Internet protocol. With VOIP, calls are delivered as packets using the Web's backbone instead of over the Bells' older, more expensive copper networks.

To establish stability, not just reverse negative momentum, the phone companies must develop new services in these and other areas. "The long-distance carriers have been far more innovative [in their service offerings] than the Bells. But it took a near-meltdown of their industry to get them to that point," says Jim Andrews, vice-president of Boston-based research firm Adventis. "The Bells have to develop new products, even if it means cannibalizing their own services."

Evolve and Grow

That doesn't necessarily mean the phone companies should spend billions on the latest whiz-bang technology, such as cable TV or Wi-Fi (see BW Online, 12/13/02, "America as Wi-Fi Nation? Not So Fast"). Nor should they only turn inward. Otherwise, they risk falling into the classic "innovative dilemma," where established companies do everything "right" to protect their existing business at the expense of missing new opportunities outside the castle walls.

Instead, the carriers, particularly the Bells, should try a little of each, in moderation: They should nurture small, in-house projects -- or, better yet, fund nimble startups that are better able to develop nascent technologies. For example, the Bells could focus on providing Internet-based virtual private networks (VPN), which allow businesses to send and receive data over the public Internet without fear of interception.

At the moment, the Bells offer VPNs, but over their legacy copper networks. According to Martin Hyman, an independent telecom analyst, corporate chief information officers are demanding Internet-based VPNs, which cost 20% to 40% less to operate and maintain than traditional VPNs. Modernizing their offerings in the VPN market -- already an $8 billion annual business with growth prospects of 33% a year through 2006, according to research firm Cahners In-Stat -- could be a good first step for the phone companies in the migration they'll inevitably have to make to a more modern telecom infrastructure.

SIX INTO THREE. A component of any phone company's evolving thinking must also be consolidation. The one thing analysts do agree on is that bigger really is better in the telecom business, where fixed costs are high and every additional customer improves profitability. The Bells are experienced retail giants, with the infrastructure to manage and bill millions of individual customers. The long-distance carriers, meanwhile, know how to tailor products and services for businesses -- tasks the monopolistic Bells have not, until recently, had to attempt.

"Right now, none of the Big Six carriers is configured to play in a competitive market," says Hyman. "The most important item of business is for each Bell to find a long-distance partner that gives them the scope and scale to be an endgame player. That's going to happen in 2003."

As usual, of course, few can agree on who should merge with whom. Hyman favors this lineup: BellSouth and AT&T; SBC and Sprint; and Verizon and a scandal-free WorldCom. Others would prefer to see SBC hook up with AT&T. Either way, Hyman says, a Bell merger with a long-distance carrier could, over two to three years, bump up annual earnings growth for a combined company to 6% to 7%, vs. just 3% if the Bells continue to go it alone.

The barriers to telecom consolidation are disappearing fast. FCC Chairman Michael Powell, whose agency must approve any merger, has said that no deal that could help lift telecom out of its rut is off the table. Verizon, SBC, and BellSouth have made debt reduction -- a precursor to any big purchase -- a top priority. Verizon slashed its net debt by 18% in the first nine months of 2002, to around $57 billion, and ended the year $55 billion to $56 billion in hock. This, despite the fact that the Bells have underleveraged balance sheets according to textbook metrics, says Bernstein Research telecom analyst Jeffrey Halpern. "The Bells are trying to improve their financial flexibility so that they will be able to buy something," he says.

Reestablish Credibility

Of course, consolidation makes sense only at the right price. After the binge of the '90s, during which AT&T spent $97 billion buying cable-TV properties (that it has since sold to Comcast [CMCSA

] at a loss), SBC spent $56 billion to acquire sister Bell Ameritech, and Verizon (then Bell Atlantic) laid out $52.9 billion to purchase GTE, it's essential that the phone companies spend wisely. For instance, reintegrating local and long-distance service providers into single companies might solve many of the woes of an industry that seems to be overrun with competitors -- but not if it leaves the newly reformulated giants shouldering mountains of unsustainable debt.

Phone company CEOs can also regain investors' confidence by acknowledging the realities of the marketplace. Barring sweeping and unforeseen changes in regulatory policy, competition is here to stay. The Bells will have to lower their costs of providing service -- either by persuading their unions to go along or by migrating to cheaper, more efficient Internet-based technology.

Part of that strategy will require more negotiations with regulators, who must provide incentives for the Bells to slowly but steadily modernize their networks. To date, the Bells have shied away from cheaper technologies, which could wreak havoc on their earnings by lowering the net worth of their assets, upon which some rates are based.

The phone business won't be revived overnight -- or even by the end of 2003. But it's no doubt time to lay the foundation for a new era in telecom, one in which consumers have more choice and phone companies can still turn a profit. If the Bells and the long-distance carriers want to stay in the game, they must take the first steps along the path that leads to that future. Black covers technology for BusinessWeek Online in New York

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