Telecom: The Bells Aren't Ringing

Economic and telecom woes show up on their bottom lines

Just a few months back, the Bell phone companies were the aircraft carriers riding calm above the roiling seas of the telecom market. While the rest of the industry foundered, the Bells steamed ahead during the telecom turmoil of 2000 and the first half of 2001. Upstarts such as 360networks and WinStar filed for bankruptcy protection, and long-distance carriers AT&T (T )and WorldCom (WCOM ) saw their stocks plunge. All the while, the Bells cranked out profits, revenues steadily increased, and their stocks held up. "The Bells were the survivors," says Scott Cleland, CEO of researcher Precursor Group. "They were the only things that hadn't sunk."

Now, they're starting to list. With the release of their third-quarter financial reports, BellSouth (BLS ), Verizon (VZ ), Qwest (Q ), and SBC (SBC ) have shown that they are more vulnerable than many analysts had expected. Their revenue growth is slowing, profits are declining sharply, and their stocks, as a group, are down 25% from their peak last year. Most worrisome, their core businesses, which were supposed to be so steady, are starting to shrink. The number of local phone lines declined about 1.3% in the third quarter. And the average number of minutes customers used each line fell just less than 1%, according to Morgan Stanley Dean Witter & Co. figures.

On top of that, growth in the Bells' new businesses is slowing. Local phone companies added 432,000 new digital-subscriber-line (DSL) customers during the third quarter, down from a peak of 559,000 during the fourth quarter of last year. Revenues from data traffic grew 18% during the third quarter. Not bad, but it's a marked slowdown from the peak of 25% during the fourth quarter of 2000. Even wireless service is looking less like the superstar. The Bells' wireless businesses grew by 942,000 new customers during the third quarter, compared with 2.1 million during the fourth quarter of 2000.

SEA CHANGE. Certainly, the downturn in the economy is affecting the Bells. But the economy alone can't account for all their troubles, particularly in the core local phone businesses. What's happening is that, after 100 years of steady growth, the local phone business is going through a sea change. New technologies--wireless phones, e-mail, instant messaging, and cable modems --are siphoning business off of the old telephone networks. Consultant Eastern Management Group estimates that new technologies account for 10% to 15% of communications that would have traveled over the traditional phone network two or three years ago, and that figure will grow over time. "A reduction in [Bell access lines] may begin to characterize the industry from now on," says Robert A. Saunders, a senior analyst at Eastern Management.

The shift could cost the Bells their position as leaders of the telecom industry. Today, Verizon and SBC have market capitalizations of $134 billion and $128 billion, respectively--more than twice as much as AT&T's, which, at $55 billion, is the largest of the long-distance players. Many experts anticipate that the Bells will buy up these Big Three long-distance companies over the next year or two. But if the Bells' core businesses continue to shrink and their wireless and data businesses grow more slowly, they may not be able to pull off the acquisitions. The Bells may revert to performing like sleepy utilities, with single-digit revenue growth. If the stock market begins to reward fast-growth companies again, the Bells will lose their positions of relative strength. "The Bells only looked good because the telecom landscape around them was so devastated," says Mark Herskovitz, senior sector manager for telecom investments at mutual-fund giant Dreyfus Corp. who is reducing his Bell investments. "But when the larger telecom sector begins to come back, the Bells will look stodgy again, and their stocks will wilt."

Hogwash, say Bell execs. The softness, they argue, is due mostly to the economy. Although there is a fundamental shift in communications under way, they maintain that money coming out of one Bell pocket is simply going into another. People may use the traditional telephone networks less, but the Bells have 45% of the wireless market. Verizon Wireless is the largest provider of wireless service in the country, with 25% of the market. The Bells also reap revenues from new data services, including speedy Net access using DSL technology. "We're riding the wave of substitutable technology, which I think makes a lot of sense," says Ivan Seidenberg, president and co-CEO of Verizon Communications.

EROSION. It isn't that simple. The Bells have a near-monopoly on their local telephone businesses, where gross margins are about 45%. In the wireless market, competition is fierce, and gross margins are about 35%. This means that, even if the Bells get the same share of the wireless business that they have on the wireline side, their profits will suffer. That business "isn't coming back," says telecom analyst Simon Flannery of Morgan Stanley Dean Witter & Co.

A similar erosion is taking place in Internet services. In the past, when consumers started using the Net, they often bought second and third phone lines. That helped drive the growth of local phone lines to 4.5% in 1999 and 1.1% in 2000. Now, many U.S. households are signing up for high-speed Net access--more than 10 million have broadband connections so far. That creates a problem for the Bells on two fronts. First, about half of all high-speed Net surfers disconnect their second phone lines, Flannery says. What's more, the Bells are getting trounced in the broadband game. The cable companies are grabbing two new broadband customers for each one the Bells get, analysts estimate. "In the long run, that's an issue for [the Bells]," says Austan Goolsbee, a professor at the University of Chicago's Graduate School of Business.

The Bells may not wind up the winners of the telecom wars after all.

By Charles Haddad in Atlanta

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