The Baby Bells Learn A Nasty New Word: Competition

When Pacific Bell President Philip J. Quigley looks out his 18th-floor window his view of the San Francisco skyline is spoiled by a jarring sight. Nearly every big office building is crowned with what look like large, white snare drums. The drums, tilted on their sides, are microwave antennas that tenants of those buildings use to send phone calls across town and to long-distance carriers--bypassing the Pacific Bell phone system. "It's a whole new ball game," says Quigley. "There's serious competition out there, and it looks us in the eye each day."

Quigley is witnessing the beginning of a new era in telecommunications: After sweeping the long-distance business in the 1980s, competition is headed for local phone service. The regional monopolies of Pacific Bell, New York Telephone, Illinois Bell, and other local phone companies are beginning to be undermined by such technologies as microwaves, fiber optics, and wireless phone systems. Long-distance carriers and cable-TV companies are trying to grab some of the market for local communications. And government officials are questioning the need to maintain the century-old system of regulated local phone monopolies. All that, says Joel D. Gross, an analyst for Donaldson, Lufkin & Jenrette Securities Corp., makes competition in local phone service "the biggest telecommunications issue of the 1990s."

Indeed, competition in local phone service could have an even greater impact than competition in long distance has had. The local phone industry comprises some 1,300 companies that reach almost every U. S. home and business, employ 650,000 workers, and generate more than $90 billion a year in revenue. That's three times as much as all the long-distance companies combined.

BIG BUSINESS. As was the case in long distance, competition in local phone service is being billed as a way to improve service and quickly adopt technologies needed to keep U. S. telecommunications on the cutting edge. Competition, advocates say, will force local phone companies to be more innovative and responsive than they have been as monopolies. The end result: increased telephone use, improved efficiency, and eventually, lower costs--something like what has happened in long distance.

But there's a hitch: Local phone companies complain that they're not yet free to compete. Partly to achieve social goals, such as universal phone service, state and federal regulators have kept certain rates below cost and others above. Phone companies say that, in effect, rate-setters force them to subsidize rural phone service at the expense of urban; residential service at the expense of business; and local calling at the expense of long distance.

Those subsidies were fine when phone companies were insulated from market forces. But now, phone company executives complain, newcomers are using new technology and low prices to skim the most profitable business customers, leaving local phone companies to take care of the rest. New York Telephone says it can't fully respond to market forces because of losses in residential service: The company says it costs $21 a month to provide the core residential service that customers pay $7 for.

If regulators abolish subsidies too quickly, rates for residential and rural customers could leap. But if they keep the subsidy system intact, businesses will flock to alternative phone networks, and the old monopolies will be stranded with less desirable customers--and not enough money to keep the network humming.

There's little danger of the phone monopolies crumbling overnight: They still have more than 99% of the local phone market. Still, veterans of the 1984 Bell System breakup know how quickly--and drastically--things can change. "I've had a lot of calls from the local exchange companies about this," says one telecommunications market researcher. "And they're panicked, really panicked."

ALL COMERS. But panic isn't the only reaction among the seven Baby Bells--the regional holding companies created in the American Telephone & Telegraph Co. breakup. Some Baby Bell executives are seizing on the nascent competition to justify deregulation. William L. Weiss, chairman of Ameritech, the Chicago-based Baby Bell, says he's willing to take on all comers if he's allowed to set rates any way he wants. He also wants to get into areas such as computerized information services, long distance, and telecom equipment manufacturing--businesses that regulators have forbidden Baby Bells to enter. Powerful forces, including cable-TV companies and newspaper publishers, are eager to keep phone companies out of their markets.

The current phone monopolies took root in the early 1900s, when AT&T convinced government officials that the best way to provide nearly universal telephone service was to create regulated monopolies, similar to the local electric and gas companies. Having two local phone networks, they reasoned, was as inefficient as having two electric utilities, both stringing wires to every home and business in the community.

That setup, critics say, is as outdated as the copper-wire technology that then prevailed. With new technologies, it's no longer so impractical to have multiple local carriers. Fiber-optic lines can cram so much phone traffic into so little space that underground conduits and shafts in buildings can fit competing cables. Microwave transmission systems take up only a slice of the airwaves, as do wireless phone networks that may begin to spread in the second half of the 1990s.

Computer technology, undreamed of when phone monopolies were formed, could undo any local phone company's strongest hold on its customers--control over the only route to their phone numbers. With the computerized network that's taking shape, customers will be able to switch carriers without changing phone numbers because each phone call will be delivered to a computer. The computer will then look up where the recipient is and by which local carrier he or she wants to get the call. The technology will also let people have one phone number for life and be reached through it wherever they roam.

The challengers who claim they will make all this happen are not a formidable lot--yet. For example, the combined revenue of the alternate-access companies--fiber-optic and microwave--will be $150 million this year, says Yankee Group Inc., a Boston-based research firm. All but one of the upstarts are losing money. But they have on their side the awesome power of an idea whose time has come: competition.

Already, regulators are beginning to hand down rulings that challenge the monopoly system. In 1988, for example, the Federal Communications Commission issued a precedent-setting ruling that softens the previously rigid geographic boundaries of local phone companies. It allowed Southwestern Bell Telephone Co. to provide phone service to an Atlantic Richfield Co. research center in Plano, Tex., in an area served by a GTE Corp. phone company. Similar border crossings are probably happening quietly all over the country, speculates Robert H. Glaser, executive vice-president of the Southwestern Bell Corp. subsidiary.

NEW GENERATION. To date, the states have outdone the FCC in promoting competition--particularly New York, where Manhattan's financial services businesses have cried out for alternatives to New York Telephone Co. Companies such as Staten Island-based Teleport Communications Group Inc., an operator of a fiber-optic alternative-access network, are winning key regulatory battles. "We are de-monopolizing New York Telephone in the New York metropolitan region," declares Gail Garfield Schwartz, deputy chairman of New York's Public Service Commission. Last year, under pressure from the state, New York Telephone agreed to let companies such as Teleport connect directly into its formerly sacrosanct central switches.

New York State's procompetition stand has turned the dense canyons of Wall Street into something like a telecommunications free-fire zone. Alternate-access services are growing rapidly, led by Teleport and Metropolitan Fiber Systems Inc. in Oak Brook Terrace, Ill. These companies string cables from a corporate customer directly to its long-distance carrier, bypassing the local phone network. That deprives New York Telephone of the access fees it usually gets for completing those long-distance calls. The company collected $2.3 billion in such charges last year. Bypassers also can connect two businesses locally. Their biggest business so far has been connecting local hubs of long-distance companies to each other.

Businesses such as Bear Stearns, Chemical Bank, and Merrill Lynch--which owns 95% of Teleport--have good reason to bet on the upstarts. At a minimum, they get backup for critical connections. The best of the new carriers also provide better service than the conventional local phone companies, according to a survey of customers conducted by Yankee Group.

By the end of the decade, small businesses and even residential customers may have some choice in local phone services, too. That is, if new wireless phones, called personal communications networks (PCNs), live up to their promise. Companies such as New York-based Millicom Inc. are testing PCNs for installation starting around 1995. They resemble cellular phone systems but have the potential to accommodate more customers at a lower price. Backers say that PCNs could actually form a second phone system paralleling the wired system.

Not surprisingly, the Baby Bell holding companies are eager to seize control of PCNs. In a move that could undermine the local wired system, some are seeking to operate PCNs themselves, rather than through their regulated telephone companies. By keeping PCNs out of the regulated units, the holding companies could boost corporate earnings--instead of seeing PCN profits go to subsidize residential customers on the wired network.

'TWO BIASES.' But there are regulatory and financial hurdles to overcome. FCC Chairman Alfred C. Sikes says he doesn't think phone companies should automatically get licenses to provide PCNs and favors an auction of airwaves for the new service. "I've got two biases," says Sikes. "I think the spectrum should be bought, not given away. And more competition is better than less competition." Moreover, despite widespread enthusiasm for the new PCN technology, questions remain about its cost and market appeal.

A more immediate threat to the phone monopolies could come from the cable-TV industry, whose wires already can reach into nearly 90% of U. S. homes. If phone companies gain admittance to the cable-TV business--as they have been lobbying for permission to do--several cable-TV companies are poised to counterattack. Three companies have received licenses from the FCC to experiment with using their cables to carry PCN signals between transmitting antennas. On Mar. 7, Time Warner Inc. announced plans to install a fiber-optic network in parts of Queens and Brooklyn, N. Y., that will offer up to 150 channels of cable TV and let viewers "talk back." With added hardware, such two-way systems could handle phone calls.

Even as competition appears, however, business customers complain that the local phone companies still behave like monopoly public utilities. Donaldson Lufkin Jenrette's Gross likens them to dinosaurs: "slow, cumbersome creatures of great size and power but little intellect." Indeed, Gross and other critics contend that the bypass movement has its roots in the phone companies' failure to meet the needs of big business for better service. "If New York Tel had been more responsive, Teleport wouldn't exist today," contends Allan Poretsky, a former New York Telephone engineer who now works for Teleport.

According to some critics, the Baby Bells largely ignored the local phone business. In the seven years since the Bell breakup, they have pumped millions into other businesses--from furniture stores to ventures in Eastern Europe. But they underinvested in technology to improve service and profits in their core businesses, says Victor Schnee, president of Probe Research Inc., a market researcher in Cedar Knolls, N. J. In 1989, according to Probe, the Baby Bells actually generated slightly more cash flow from depreciation than they spent on new investments. In effect, says Schnee, they treated their core businesses as cash cows.

HIGH-WIRE ACT. Meanwhile, the new competitors continued to attack with derring-do. R. Craig Roos of Local Area Telecommunications Inc. recalls climbing out on a walkway on the 108th floor of New York's World Trade Center in February, 1983, to hand wrenches to the men putting up Locate's first microwave antenna. Says Roos: "I was scared to death." Metropolitan Fiber Chief Executive Royce J. Holland tells his people: "If there are any barriers in the way, you kick `em down."

Traditional phone companies just don't work that way. John Lockton Jr. served as executive vice-president at Pacific Bell and is now president of EasyPhone Inc., a wireless-phone startup in San Mateo, Calif. The difference in corporate culture, he says, is immense: "You don't find a company the size of Pacific Bell coming to decisions quickly on the say of an individual." Today, says Lockton, "I am having a ball."

Before the newcomers can seriously challenge the monopolies, they need to firm up their foundations. The costs of building alternative phone networks are huge. As a result, Teleport is the only bypasser now making a profit. But Merrill Lynch is looking for a new partner to help fund its ambitious expansion plans. "The good news," says Teleport CEO Robert Annunziata, "is lots of people are interested." One bypasser, Dallas-based DFW MetroLink Inc., filed for Chapter 7 liquidation under federal bankruptcy laws in February. Several others have folded or curtailed expansion plans. Consolidation could accelerate if the phone companies are freed from rate regulations and start slashing prices.

As a result, the gutsy newcomers have found that it's hard to raise venture capital. They're hoping that cable-TV companies or foreign investors, seeking long-term strategic investments rather than quick profits, will pony up. MCI Communications Corp. Chairman William G. McGowan says he doesn't envy the new monopoly-busters, who he says face a more uncertain payback than the young MCI sought when it challenged AT&T's long-distance monopoly. "The economics and technology are so vastly different," he warns.

Competition may evolve slowly--or it may come with lightning speed. Probe Research's Schnee says the local phone monopolies could break up almost overnight if the Baby Bells realize that competition can be their salvation. By relinquishing their monopolies, he says, the Bells could gain permission to enter the information-providing businesses now ruled off-limits by U. S. District Judge Harold H. Greene, who oversees the regional phone companies. Such a bold move, says Schnee, could be orchestrated by an outsider who takes over a Baby Bell or, more intriguingly, by someone who rises up from within a Baby Bell to dismantle the sclerotic old system.However quickly competition comes, the direction is certain. "The tide is rolling in," says Robert C. Atkinson, senior vice-president for regulatory and external affairs at Teleport. "Regulators can try to build a wall around their little sand castle. But you can only keep the tide out for so long, then the whole thing collapses." The walls, indeed, are tumbling down.

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