Here Comes the Real Fun for Telecom

This will be the year that long-distance and local calling get reunited in one business. And that's sure to transform the industry

At first glance, America's largest telecommunications companies seem to be staring at the same old quandary. Only the largest Baby Bell, Verizon (VZ ), managed to deliver a net profit in 2002's fourth quarter -- a slim 1.2% margin -- thanks in part to its wireless subsidiary. No. 2 SBC Communications (SBC ) and No. 3 BellSouth (BLS ) reported that rising competition would continue to chip away at revenues and profits. AT&T's (T ) revenues slid last year, and execs at the largest U.S. long-distance carrier aren't even predicting what might happen next. Barring a miracle, 2003 for the telecom industry seems to be shaping up much like 2002 -- which wasn't pretty.

Beneath the surface, however, major change is afoot: This year will go down as the one in which the worlds of long-distance and local calling are finally reunited into one business that industry executives already have given a catchy new name: all-distance telecom. In 2003, federal regulations that forced customers to pay one company to call around the corner and another to call around the world will be taken off the books. Nearly 20 years after the Justice Dept. broke up Ma Bell, Humpty Dumpty is being put back together again, albeit in the form of several big phone companies instead of just one.

"It's clear that the ability to integrate and incorporate all the customer's needs -- wireless and wireline, local and long-distance, even broadband -- will be the cornerstone of any strategy to compete," says Duane Ackerman, chairman and CEO of BellSouth. Reasonably soon, if not this year, that realization could set off a series of monster mergers in the industry.


  The introduction of all-distance wireless calling plans in the late 1990s set the wheels in motion by providing consumers a way to make both long-distance and local calls using service plans for which they paid a set monthly fee, rather than traditional per-minute charges. Then last year, WorldCom's (WCOEQ ) MCI unit introduced its "Neighborhood" plan for traditional, nonwireless customers, becoming the first major phone company to offer unlimited local and long-distance phone service for a flat rate of $49 to $59 per month.

To date, more than a million customers have signed on. Across the country, other carriers have mirrored that plan at varying prices. Meanwhile, a new technology called voice over Internet protocol (VOIP) is making phone calling possible using the same cable-TV network that delivers The Sopranos -- as well as over DSL lines that link PCs to the Internet. VOIP startup Vonage in Edison, N.J., has lured 10,000 customers to its $40 per month unlimited calling plan, which routes calls over the customer's cable or DSL broadband connection.

Given the financial pressures on the industry after the worst three years in its history, it's no surprise that the phone companies are embracing all-distance. The continuing fallout from WorldCom's $9 billion accounting fraud, disappointing financial results across the industry, and declines of as much as 90% in telecom stocks, have had the effect of forcing carriers to scratch for ways to prosper in a down market -- principally by selling more services to each customer and making more efficient use of their networks.


  That explains the ferocious lobbying that has preceded a Feb. 13 Federal Communications Commission (FCC) decision, which among other things, will decide the terms under which the regional Bell companies are required to sell space on their networks to new competitors in the local-phone business -- including AT&T and WorldCom. The Bells claim that the current policy mandates that they sell network access below cost, adding to the financial turmoil of a slow economy and the popped Internet bubble.

Preliminary indications are that the FCC will phase out that requirement, a change that would make it harder for the big long-distance carriers, such as AT&T, to increase the number of local customers they serve -- at the same time that the Bells are signing up tens of millions of long-distance customers.

Still, a regulatory victory alone won't "obviate the need for a strategy to counteract the erosion of [the Bells'] traditional business by wireless and e-mail," says Blair Levin, a telecom analyst at investment firm Legg Mason. That's why the Bells are embracing the all-distance calling model with a vengeance. Verizon is pushing its "Veriations" package, which offers consumers local, long-distance, wireless, and DSL service for a flat fee of about $150 per month. Just six months after it introduced the program, more than 560,000 customers have signed up.


  SBC, however, is still awaiting long-distance approval in several key states. "We want to integrate wireless and wireline," says Forrest Miller, SBC's group president for corporate planning. "We want to integrate Wi-Fi so that customers on the road get Internet service no matter where they are. There's a sizable segment of the high-end market that values integration. That's where the battle is."

The same thing is happening in the market for business customers. Both Verizon and SBC have begun new initiatives aimed at selling additional services -- including long-distance voice, network management, and data storage -- to their existing business customers. On Jan. 27, SBC announced the hiring of 1,000 new salespeople to peddle its PremierSERV package of such services. And Verizon has spent $30 million to install fiber links in three metro areas -- Dallas, Seattle, and Los Angeles -- that are outside of its regional stronghold.

That bet has paid off. By the end of 2002, Verizon says it served 65% of the corporate offices in Los Angeles. As part of the conditions of its merger with Ameritech in 1999, SBC has has installed fiber networks in 30 markets outside its region, including Denver, Miami, and Las Vegas.


  Of course, $30 million isn't "field of dreams" money -- especially for a company with Verizon's $67 billion in annual revenue. These are cautious, targeted investments that are meant to connect the islands of service the company historically has offered. But Verizon execs point to them as just one example of how undoing the legal separation of various services will unleash growth and innovation in communications markets. "If restrictions hadn't been imposed on the original [seven] Bells, there would be multiple business-service providers, and the government wouldn't find itself worried about keeping a company like WorldCom in business," says Bruce Gordon, Verizon's president for retail markets.

Still, not every company can offer every service to every customer. And so the all-distance world will also usher in another, often-predicted trend in telecom: consolidation. Few can agree on just when the mergers might begin, but analysts say wireless, where Deutsche Telekom's (DT ) T Mobil is already on the block, is the first candidate. Additional mergers in the wireline business could come as early as the end of this year, or as late as 2005.

"Will there be a merger between a Bell and a long-distance company? I don't know," says BellSouth's Ackerman, who declines to comment on speculation that his company might make a bid for AT&T. "What I do know is that there are too many players for this market to support. If we fast-forward 10 years, we won't see a structure that remotely resembles what we have today."


  In theory, consolidation would produce much-needed stability for the survivors. It would help shore up balance sheets and relieve constraints on investment. But would it deliver innovation? "It's not terribly clear how rolling up long-distance and local voice [into combined companies] will lead telcos to innovate," says Martin Hyman, an independent telecom analyst.

Here's why: With their copper networks, the Bells (or their heirs) will still be at a disadvantage technologically to cable, which already has digital pipes running into millions of customer homes. Over the past 10 years, the cable industry spent $60 billion collectively to upgrade those pipes to enable them to stream more channels to each customer. (The latest digital-compression technology allows 8 to 12 digital channels to be streamed in the same space required for one analog channel.) As it turns out, the upgrade let the cable operators improve their traditional businesses and also offer new digital services, such as high-speed Internet access, video on demand, and, eventually VOIP.

The phone companies, by contrast, won't enjoy any improvement in their traditional business if they lay out the $50 billion or more it would take to build a national broadband network. Worse, Hyman says, the Bells are tied to a profit stream from legacy services such as frame-relay transmission (used by corporate networks) and second lines in homes, which deliver margins as high as 70%: "The Bells' network worked because business customers created the profit, while consumers created the scale that allowed the Bells to deploy ubiquitously," Hyman says. "The same doesn't apply to broadband."


  The phone companies could be forced to innovate, however, if VOIP takes off. True, the technology still lacks critical mass in the consumer market. But VOIP is getting lots of buzz because it's cheaper than most traditional voice while offering better features. For example, VOIP customers can choose to have any area code as part of their phone number --not just the one that represents the region where they live, giving them a "virtual presence" in important business centers such as New York or Chicago.

Moreover, their calls -- and voice mail, too-- will follow them wherever they log in. "VOIP allows integration between your phone and your desktop," says Louis Holder, executive vice-president for product development at VOIP startup Vonage.

Just when cable operators will turn up the heat on the Bells isn't clear. They haven't yet embraced VOIP -- a surprise in light of their apparent aspirations in the local-phone business and of Comcast's (CMCSA ) purchase of AT&T Broadband last fall. AT&T's Broadband's phone expertise -- and its 1.3 million telephone customers -- supposedly were two of the reasons for the deal. But Comcast CEO Brian Roberts has signaled that he isn't ready to move aggressively into voice.


  One reason could be that phone service is a regulated industry, which would require cable operators to meet quality-of-service requirements set by state and federal regulators, as well as provide access to their lines for law-enforcement authorities. Comcast has only one VOIP pilot test under way, in its headquarters city of Philadelphia -- and it says it has no plans for larger tests.

No. 4 cable operator Cox Communications (COX ), which has long been bullish about the idea of bundling voice with its video services, still provides circuit-switched voice services to its 651,000 customers. Says Legg Mason's Levin: "VOIP doesn't take off until Brian Roberts says so. And he's got other things on his mind" -- most prominently, upgrading AT&T Broadband's older cable-TV facilities and rolling out video on demand.

Skeptics fear that by letting the Bells sell long-distance, local-phone calling, and data services, they'll simply solidify their positions as big regional monopolies withouth providing any benefits to consumers. But the momentum toward an all-distance phone industry is already so strong that nothing is likely to stop it. As anyone with a cell phone already knows, the distinctions between a local and a long-distance call are rapidly fading into memory. Eventually, so will the differences between phone, cable, and satellite operators.

Seven years after the Telecommunications Act of 1996 mandated a new age of communications, the revolution's first signs are finally visible.

By Jane Black in New York

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