Tearing Down the Walls in Telecom

In a few years, it will be a sectorless industry, with phone, cable, and even power companies all selling the same communications services

Just four years ago, the world of communications was reassuringly compartmentalized: Customers bought cell-phone service from a wireless phone carrier. Pay TV came from a cable or a satellite company. Local-phone service was provided by -- what else? -- a local-phone company. And Internet access came from an Internet service provider.

Those boundaries have all changed faster than Howard Dean's political career. Local-phone companies now sell long-distance. Long-distance companies sell wireless and Internet access. The situation will only get more confused this year, as cable companies and ISPs such as Earthlink (ELNK ) roll out voice services based on VoIP (voice over Internet protocol) in a big way, and as phone companies begin reselling satellite TV.

Even electric utilities are getting into the act, selling Internet access via wireless technologies or using something called poweline communications technology -- which sends data traffic over electric wires.


  Suddenly, there's no limit to the number or types of companies that can compete for the attention of customers who used to belong to the phone industry. And just as suddenly, phone companies can go after customers who once were captives of some other medium. It all adds up to the most fundamental evolution of the telecommunications business since the breakup of Ma Bell two decades ago, one that will benefit consumers, at least until a shakeout leads to renewed concentration. But that won't happen until after service providers in a variety of communications industries have gone through a wrenching revolution.

Within five years, a relative handful of players might provide TV, phone service, and Net connections -- and some of them may even bill for those along with your electricity, water, and garbage fees, says Jeff Kagan, an independent telecom analyst in Marietta, Ga. Telecom "will be a sectorless industry," he predicts. Industry names like "cable" and "telecom" could eventually be replaced by terms such as CET -- for the cable, entertainment, and telecom industry.

This will be a huge shift -- on par with the sweeping consolidation of car manufacturers and railroads years ago, says Rich Nespola, CEO of The Management Network Group (TMNG ), a telecom consultancy in Overland Park, Kan. The survivors likely will win a huge prize: Control the $200 billion phone business and the $55 billion cable-TV business -- plus associated entertainment businesses.


  This transformation won't happen overnight, of course. But it's starting to look unavoidable, these experts say. It'll be driven partly by shareholders in search of high-growth companies. And it'll be supported by consumers, 80% of whom, according to studies by service providers, now prefer the convenience of buying their TV, phone, and entertainment services from one source -- if the price is right.

At the simplest level, these trends will be the result of a quest for growth. For the past several years, local-phone service providers have seen negative revenue growth vs. single-digit sales increases as recently as the year 2000. In cable TV, growth in subscribers has been stuck at about 1% a year, according to market researcher Gartner -- and it shows no signs of speeding up now that nearly 70% of U.S. households already have pay TV. And cable margins could slip as programming costs creep up. What's a phone or cable company to do?

Increasingly, they're eyeing related businesses, either to hitch a ride on such fast-growing services as broadband access to the Net (where revenues are rising at more than 25% a year) or to add offerings that involve a small incremental cost but have the potential to attract large numbers of new customers at a decent margin. As faster-growing wireless services add up to a larger chunk of their revenues, local-phone giants Verizon (VZ ), SBC (SBC ), and BellSouth (BLS ) will record sales increases of 2% to 4% this year vs. a drop of 1.3% in 2003, estimates Greg Gorbatenko, an analyst with Marquis Investment Research in Chicago.


  Another example is cable operator Cox Communications (COX ) in Atlanta, which is aiming to deliver annual revenue growth in the low double digits by boosting sales from phone service and broadband 10 percentage points, to 45%, of its revenues over the next 18 months, estimates David Mantell, an analyst with Loop Capital Markets in Chicago.

In the dozen markets where it sells phone service, Cox has grabbed a 30% share over the past eight years by undercutting local-phone carriers prices by 10% or more, says Patti Reali, principal analyst at Gartner in Philadelphia. Meanwhile, Verizon has begun reselling DirecTV satellite service to its local and long-distance customers at a $6 monthly discount -- and they're snapping it up, says Marilyn O'Connell, Verizon's senior vice-president for broadband.

A big advantage of selling such bundled services is that it can reduce customer churn by 35% to 50%, according to TMNG. And cutting churn translates into savings of hundreds of dollars per head that would otherwise be spent to acquire new customers. Selling bundles also tends to blunt price competition on individual services, says Maribel Lopez, an analyst with tech consultancy Forrester Research in Cambridge, Mass.


  Even so, price cuts such as those offered by Cox and Verizon provide just a hint of the tidal wave of discounts to come. Sun Prairie Water & Light (SPWL ), a utility in Sun Prairie, Wis., that has built its own fiber and wireless network, provides locals with high-speed Internet access at rates that are only about one-fifth the price charged by the local-phone company, says Gary Sanders, telecom manager for SPWL Telecom.

Analysts expect such price-cutting to accelerate this year across a variety of communications industries. Average prices on the full range of services offered by long-distance companies will fall 20% in 2004 on top of a 17% to 18% decline last year, estimates Dale Lynch, an analyst with Lehman Bros. in Washington.

Of course, growth based on price cutting has one adverse effect -- margin compression. A typical local-phone company enjoys roughly 40% EBITDA (earnings before interest, taxes, depreciation, and amortization) margins. Returns in the faster-growing wireless business hover around 30%, Gorbatenko says. So as wireless becomes a larger percentage of a phone company's sales, its margins will decline.


  Initially, faced with financial difficulties and unable to differentiate their product offerings, many communications companies will likely try to avoid consolidation by entering into reselling partnerships. "Fundamentally, telecoms have been an assets-based industry," says Mike Jenner, enterprise networking vice-president at long-distance heavyweight AT&T (T ). "But now you don't have to own all the assets."

Still, in a lot of cases this may not work. Over the past six months, several long-distance companies have partnered with cable companies, which want to sell voice services. But because in such partnerships the carriers no longer sell to customers directly, the long-distance players have ended up selling their services at wholesale rather than retail rates -- at a 50% discount, says Lehman Bros.' Lynch.

As partnership-based product differentiation fails, consolidation in the cable, ISP, telecom, entertainment, and related industries will kick into high gear. It has already started in the long-distance and wireless businesses, where it's harder to bundle services than in the local-phone or cable-TV businesses.


  That's why, on Feb. 17, wireless service provider AT&T Wireless (AWE ) sold out to SBC's and BellSouth's joint venture, Cingular, for $41 billion plus debt -- making Cingular the nation's largest wireless service provider. Analysts expect further wireless consolidation, perhaps involving Sprint (FON ), which owns long-distance and wireless assets, and Verizon Wireless, or wireless player Nextel (NXTL ). Or, the long-distance industry could see a marriage of AT&T and Sprint, which might allow for major operational efficiencies in providing services and in maintaining networks.

Plenty of other mergers are possible. Long-distance player MCI, due to emerge from Chapter 11 bankruptcy in April, will have little debt. Thus, it could buy a wireless company such as Nextel, says TMNG's Nespola. Or, AT&T might pick up a wireless asset to strengthen its offerings, he speculates. AT&T's Feb. 26 announcement that it might sell its own branded wireless service could be the first step in this direction (until the Cingular-AT&T Wireless merger, AT&T resold AT&T Wireless service). AT&T might resell service from Sprint PCS, instead, say some experts -- which could be the first sign of closer ties between the two companies.

A communications-related acquisition by software giant Microsoft (MSFT ) isn't out of the question, either. Over the past five years, it has bought stakes in multiple cable operators worldwide, including its $1 billion purchase in 1997 of 11.5% of the country's largest cable company, Comcast (CMCSA ). A wireless company could provide Microsoft with a gateway to millions of cell phones and personal digital assistants (PDAs), argues Nespola. Microsoft certainly has the money -- $52.8 billion in cash and short-term investments as of last December.


  Even some ISPs might be interested in merging with long-distance companies. EarthLink, for one, could consider a tighter partnership with -- or an acquisition of -- a long-distance or local-phone company to strengthen its broadband service offerings, says Mike Lunsford, executive vice-president for products at EarthLink in Atlanta. Today, it has partnerships with the likes of MCI and Sprint.

Other mergers -- perhaps with satellite-TV companies -- could strengthen the position of phone companies in video, where they don't have in-house capabilities. Satellite player EchoStar (DISH ) already has agreements with SBC, local-phone company Qwest (Q ), and Earthlink to resell its service. An outfit that acquires EchoStar could, finally, differentiate itself from the pack.

Some communications players may also hunt down valuable content assets, which have the potential to offer them the most differentiation. That's partly what's behind cable company Comcast's bid of $54 billion in February for Walt Disney (DIS ). Disney rejected the offer, but many analysts expect Comcast to up the ante. Such an acquisition could, potentially, allow Comcast to show its subscribers new Disney features early -- or exclusively -- thus providing an incentive for customers to buy its pay-TV service.


  Consolidation among service providers could eventually trickle down into other industries, such as telecom equipment -- though probably not right away. This year, the capital spending of phone companies in North America will be essentially flat -- and that will seem like a vast improvement over last year, when the carriers cut spending on equipment by 20%, says Shing Yin, an analyst with telecom consultancy RHK in San Francisco.

As the phone companies branch into supporting video, they'll need more handholding -- which will create an opportunity to sell them services, says Jim Dondero, a vice-president for wireline marketing at Nortel Networks (NT ). Yet if growth remains elusive, gearmakers could consolidate, says Michael Sophie, chief financial officer at telecom supplier UTStarcom (UTSI ).

For the next few years, before consolidation abates, consumers will be the big winners: Any communications company that wants to survive will have to improve customer service and introduce cheaper and more innovative products. "We'll see Procter & Gamble-type marketing," says Andrei Jezierski, a founder of tech consultancy i2 Partners in New York. "It will be consumer-based, convenience-driven innovation."


  Starting later this year, Verizon will give its wireless customers a cradle that will turn their cell phones into a home phone -- so it'll accept calls to both your cell number and your home number. Starting in the middle of the year, SBC plans to give its customers a single mailbox for e-mail, voice mail, and faxes, which they can reach from any device, be it a PC or a phone, says Jeff Weber, vice-president for corporate planning at SBC. It also wants to eventually put a high-speed Internet connection onto consumers' TV set-top boxes so they can see a phone caller's ID while watching a movie and accept or reject the call using a remote control, he says.

And starting next month, AT&T will allow subscribers to its new CallVantage service to schedule "do not disturb" periods, when their phone will ring directly into voice mail, or to use a "locate me" service that forwards calls to a specified phone or to several phones at once. That's just a glimpse of the new services to come as competition grows.

The extent to which the industry will consolidate will also depend on regulators. And it could take some months for communications industry players to feel the margin pinch that will set many of these forces in motion. For instance, Cox's margins have increased in the past year, thanks to its foray into local-phone services. "We aren't seeing margin pressure, but the war has just begun," says Joseph Rooney, senior vice-president for marketing at Cox.

That's the bottom line: The war has begun, and the telecom, cable, and related industries may be about to enter the bloodiest battle in their history.

By Olga Kharif in Portland, Ore.

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