How Connected Are the Baby Bells?

While they're fairly well-positioned, they still need to woo corporate customers, fight off cable operators, and avoid wireless cannibalization

By Jane Black

For the phone business, 2001 was the equivalent of a 10-car pileup on a fog-shrouded freeway. Upstart competitive local exchange carriers (CLECs) such as PSINet and 360networks were totaled. The three major long-distance carriers -- AT&T (T ), WorldCom (WCOM ), and Sprint (FON ) -- were battered by rising debt that now threatens their financial stability.

That leaves the four surviving Baby Bells of the original seven -- Verizon (VZ ), SBC Communications (SBC ), BellSouth (BLS ), and Qwest Communications (Q ). Even including Qwest, whose accounting practices are being investigated by the Securities & Exchange Commission, the Bells look like the best-positioned of the breed. After swallowing up their other three brethren, these giants have strong balance sheets, powerful lobbyists to fend off new regulation, and a monopoly where it really matters: the last mile of wire to the consumer.


 Certainly, no one is going to push the Bells into a ditch over the next 12 to 18 months. In fact, the big money is betting that the old-school telcos will grow by pushing into long-distance markets and high-speed data services. Verizon, the largest of the Bells, already offers long-distance in six states, across which it has grabbed about a 20% market share. SBC sells long-distance in five states, and BellSouth will soon offer service in Louisiana and Georgia. All are important beachheads in an $80 billion market.

The Bells, however, will remain dominant over the long-term only if they meet three significant challenges:

• They need to woo corporate long-distance customers, not just the residential consumers they depend on today.

• They need to fend off cable operators, which already have cornered two-thirds of a broadband data market and had revenues of $6 billion to $6.5 billion in 2001, according to research firm ARS.

• They need to figure out how to deal effectively with wireless cannibalization -- and/or maintain control of their semi-independent wireless units, Verizon Wireless and Cingular, a consortium formed by SBC and BellSouth.

They also need to stay relentlessly focused on those goals, no matter what. "Contrary to conventional wisdom, the Baby Bells' triumph over their competition is an illusion," says Marty Hyman, a senior telecom partner at consultants Booz Allen Hamilton. "Their prospects for growth in revenues and earnings are anything but guaranteed."


  For proof, look no further than the latest round of earnings reports. SBC posted a first-quarter net loss of $81 million, or 2 cents a share, compared with a profit of $1.85 billion, or 54 cents, a year ago. Revenues fell 6%, to $10.5 billion from $11.9 billion. The loss was due in part to the decline in value of a recent acquisition, business software maker Sterling Commerce.

Excluding gains from asset sales, BellSouth earned $1.01 billion, or 54 cents, about the same as in the year-ago period, while revenues dropped 1%, to $7.08 billion. Verizon, the No. 1 Bell, lost $500 million, equal to 18 cents a share, compared with net income of $1.6 billion, or 58 cents, a year ago. Revenues were $16.4 billion, down 0.7%.

These are small losses considering the scale of the telecom debacle. Even so, the results reflect a problem bigger than just the tough environment. Verizon has failed to show significant growth in local, long-distance, or network-access services since early 1999. Revenue from local services, the cash cow of all the Baby Bells, has risen just 5% since 1999, from $20.7 billion to $21.9 billion in 2001. Verizon's long-distance revenues fell from $3.18 billion in 1999 to $3.1 billion in 2001. The remainder of 2002 also looks weak, with full-year revenues for SBC, BellSouth, and Verizon expected to grow 1% to 3%, down from earlier estimates of 3% to 5%.


  So where will the Bells find growth? The answer used to be long-distance, but the pot at the end of that rainbow is proving elusive. For one thing, the Bells are still awaiting regulatory relief to allow them to offer long-distance service nationwide. Until that arrives, it will be virtually impossible to attract corporate customers, which need a provider that offers service from Seattle to Miami, not just to locations in the individual Bells' home regions.

Business service is where the money is. According to one insider, 20% to 30% of AT&T's 50 million-plus residential long-distance customers don't make a single call in any given month. Yet AT&T spends millions to maintain and improve its network and offer customer service in the event that they do -- all made possible by the $28 billion in annual revenue it gets from corporate customers.

That explains why, so far, the Baby Bells have yet to see much of a return on long-distance despite their rising market share. Although Verizon added more than 800,000 new long-distance customers in the first quarter, its long-distance operating revenues fell 1% from last year's fourth quarter, to $779 million. Year-over-year, such revenues rose 2.2%. Verizon says the stagnation is a result of falling rates for regional calls.


  Spokesman Jim Wagner argues that market-share growth in long-distance will offset losses in the regional market. But long-distance rates are falling, too. Already, carriers including MCI are offering flat rates for unlimited long-distance calling. "The Bells are stuck in residential, which is being eroded by wireless and by voracious price competition from entrenched long-distance players," says Rich Nespola, president and CEO of TMNG, a Kansas City telecom consultant.

Even when the Bells get the green light to sell to corporate accounts, it won't be easy to win them. Whatever their financial woes, AT&T, WorldCom, and Sprint have a long head start in tailoring products and services for businesses -- tasks the monopolistic Bells never really have had to attempt. As of now, the Bells are still largely offering one-size-fits-all plans for small businesses, according to Nancy Kaplan, vice-president at Adventis, a telecom strategy and consulting firm.

But in the world of Big Business, a financial-services firm has different needs than a manufacturing company. "The Bells still tend to think geographically, and businesses aren't run that way anymore," says Kaplan.


  Making headway in broadband looks like an even taller order. The CLECs by and large have been vanquished, although some, such as Covad Communications (COVD ), have emerged from bankruptcy. But the threat from cable-TV companies is escalating. In the fourth quarter of 2001, the cable industry added nearly twice as many broadband subscribers -- 923,000, vs. 540,000 -- as did the Bells for their comparable high-speed Internet service, DSL (digital subscriber line).

Moreover, cable operators don't have to invest as much in their infrastructure as the phone companies do to offer widespread broadband service. According to research firm Insight, North American telecoms will spend $4.8 billion to enable high-speed access by 2007. Cable operators will have to shell out only $660 million.

Cable also is slowly but surely eating into the local-phone market. As part of its $68 billion purchase of AT&T's cable operations, Comcast (CMCSK ) bought not only subscribers but telephony expertise. Cox Cable (COX ) is also aggressively pushing phone service: As of March, it had more than 500,000 residential phone customers with 640,000 lines, making it the 12th-largest phone company nationwide and the second-largest in many of the states in which it offers phone service.

"If you ask [Verizon CEO Ivan] Seidenberg, [SBC CEO Edward] Whitacre, or [Bell South CEO F. Duane] Ackerman what their biggest threat is to long-term growth, they'll tell you it's cable," says TMNG's Nespola.


  Finally, there's the rising problem of wireless communications eroding traditional local-phone service. According to research firm Yankee Group, about 3% of Americans have already cut off their traditional phone service and rely entirely on cell phones. It makes sense. The newest wireless plans offer "buckets" of minutes that consumers can use to call anywhere -- not just locally. Yankee Group expects yearly U.S. wireless usage to nearly double by 2005, to 1 trillion minutes from 549 billion in 2002. By contrast, it predicts that wireline minutes will drop 22%, to 1.4 trillion in 2005 from 1.8 trillion in 2002.

The good news is that the Baby Bells have stakes in the most popular wireless ventures. Verizon Wireless is a joint venture of Verizon and European mobile-phone company Vodafone. And Cingular is a partnership of SBC and BellSouth. Still, analyst Hyman says the autonomy of these wireless units may come back to haunt the Bells: "They all saw the glitter of gold in wireless and spun off their operations" into publicly traded tracking stocks. "But the market turned against them. Now they don't have full ownership -- or the financial benefits of a spin-off."

That said, the coming consolidation in telecom could benefit the Bells. As long-distance profits continue to collapse, thanks to vicious price wars, companies such WorldCom become more attractive takeover targets. Indeed, for an outfit that could stomach taking on WorldCom's $30 billion in debt, buying that troubled giant would be an easy way into the corporate long-distance business. Qwest (formerly U S West), which has spent billions building fiber networks, also will likely be rolled into one of the three stronger Bells, bringing wider long-distance and data capabilities to its new owner.

Still, swallowing a troubled telecom won't be a simple transaction, even for a Baby Bell. The Bells' CEOs have all sold Wall Street a story of imminent and continuing growth. And they'll be loath to admit that to achieve it they need to wade into a sea of debt. That's why analysts say the Bells should take nothing for granted. They've avoided the first smash-up of the deregulated phone business. But they still have miles to go before they're home free.

By Jane Black in New York

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