What's Alarming the Bells

Rivals are finally cutting into their local-phone monopolies

By any conventional measure, the Telecommunications Act of 1996 was a failure. The landmark law was supposed to dismantle the nation's last great monopoly by opening the residential local-phone market to competition. But after brief forays that produced hundreds of millions of dollars in losses, contenders such as AT&T (T ) fled the $50 billion local market. Today, the Bells still dominate, with a 95%-plus share.

Their iron grip, however, is finally loosening. Since the beginning of this year, under the much-derided aegis of the Telecom Act, regulators in a dozen states including California, New Jersey, and New York are finally forcing the Bells to lower wholesale rates for local service. That includes the phone lines that rivals lease from the Bells and resell under their own names. As a result, competitors like AT&T have charged back into the market, accompanied by upstarts such as Talk America, Z-Tel Communications, and Supra Telecom. And together, they will more than double their total share of local phone lines captured from the Bells under the new pricing system, to 7.2% this year, according to UBS Warburg telecom analyst John Hodulik.

Competition, if it can be sustained, will be a boon to consumers and a catalyst for growth and innovation in this troubled sector. And it will also crimp the Bells financially. Forced to rely more on low-margin long-distance revenues, they'll have to aggressively roll out new services like high-speed Internet access. Says C. Michael Armstrong, the out-going AT&T CEO and chairman: "The Telecom Act is beginning to work."

Riveted by the bankruptcies and scandals shaking WorldCom Inc. (WCOEQ ), Global Crossing Ltd. (GBLXQ ), and others, many on Wall Street missed the dawn of competition in local services. The wake-up call came with the Bells' second-quarter earnings' reports, which revealed a big increase in the number of residential phone lines lost to rivals--most notably to AT&T. In total, the Bells surrendered 1.1 million lines, up from a loss of 700,000 in the first quarter. And they are expected to lose 1.6 million lines in the third quarter and 2.1 million in the fourth quarter as AT&T expands its local operations into more states.

The winners in this early round are a diverse crew. The biggest is AT&T, which has reentered the local market this year in eight states, gaining more than 1.5 million customers at the Bells' expense. Then there's troubled WorldCom, which is operating in bankruptcy but continues to offer residential local service in 33 states. And should WorldCom disappear, newcomers will quickly take its place. Tiny Supra Telecom captured 120,000 lines in Florida during the second quarter alone. And Talk America Inc. boosted the number of subscribers by 50,000 to 244,000 in the second quarter.

The new competition is a bitter pill for the Bells to swallow. "In its current form, [competition] will end up destabilizing the network providers," warns SBC Communications President William M. Daley. Bell companies, he notes, are responsible for nearly all the capital costs associated with phone lines. Furthermore, says Warburg's Hodulik, the Bells must win five long-distance customers for every local customer they lose if they're to retain their current 30% operating margins. Warburg expects Bell earnings to fall 1.8% next year instead of rising 2.6% as initially forecast.

Indeed, the Bells are fighting back. SBC (SBC ) has asked regulators in Ohio to allow it to raise the wholesale price it charges competitors who lease its lines. It claims that the $13.22 monthly rate set by state regulators is 67% below the retail rate that competitors can charge customers. If they lose their appeals at the regulatory level, they can file suit in state or federal court, or seek relief from the Federal Communications Commission. "This is not real competition. It's a freebie for [our rivals]. It's a tremendous, great arbitrage game for them," Daley says. The courts, however, are usually reluctant to step on regulators' toes. This time around, it is unlikely that the Bells can turn back the tide of competition.

By Steve Rosenbush in New York, with Roger O. Crockett in Chicago

— With assistance by Roger O Crockett

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