Commentary: Telecom: To Buy Or To Build?

Why the industry is deeply divided over the best path to growth

There's a great debate among telecom industry leaders these days. Driving the industry consolidation are leaders like SBC Communications (SBC ) Chief Executive Edward E. Whitacre Jr. who see deal-making as the best way to grow quickly. That explains the flurry of talks to buy long-distance companies' still-lucrative yet shrinking business of providing telecom services to big corporate and government customers -- the so-called enterprise market. But execs at Verizon Communications (VZ ) and BellSouth have pursued a very different strategy (BLS ). They seem to think that the way to expand and thrive in today's telecom world is by focusing on growth in the profitable wireless and broadband markets while building up in the enterprise market on their own.

Both sides are plunking down big money to pursue their different strategies. In the "buy growth" camp, SBC has recently agreed to spend $16 billion to acquire AT&T (T ), while Qwest Communications (Q ) International hopes to grab MCI (MCIP ) for $6.3 billion. Conversely, BellSouth and Verizon have so far avoided deals, investing billions instead to build out their state-of-the-art wireless and broadband markets while also trying to expand their enterprise markets internally.

So who's right? SBC and Qwest no doubt have the bolder and more aggressive in-your-face strategy. Snatching up a long-distance company's enterprise business generates huge amounts of cash. And, unlike individual consumers who frequently change providers, big companies can't easily switch to a new phone company: They'd be forced to buy tons of new equipment, an expensive and time-consuming headache. That makes it hard for upstarts like Verizon and BellSouth to steal business from stalwarts like AT&T and MCI.

That hardly means Verizon and BellSouth should try to muscle into an enterprise deal. The problem with Whitacre's strategy is that the enterprise business, though an $85 billion market today, is fading fast. Revenues are shrinking about 10% a year. Profit margins are getting squeezed by stepped-up competition and the advent of Internet technology. In the enterprise market as a whole, operating margins before income, taxes, and depreciation are expected to hit just 22% in 2005, down from 24% in 2004 and 26% in 2003, according to Muayyad Al-Chalabi, a managing director at market analyst RHK Inc. Compare that with the 40% margins sported in wireless and broadband.

To make their deals pay off, SBC and Qwest are banking on a turnaround in the enterprise market within a few years. As they attempt to sell new Internet-based services to their enterprise customers, they foresee big gains. Right now such Web-based services account for only about 10% of the market. But over time, says SBC Chief Financial Officer Richard G. Lindner, "the math is in our favor."

Verizon and BellSouth aren't convinced that the potential for such gains is worth the high price of buying into the enterprise market. They figure there's just so much business to go around -- and they're right. These companies are betting on growth in new technologies: building faster networks to allow them to sell high-speed Internet connections and services to big corporations. Says BellSouth CEO Duane Ackerman: "We are positioning our assets where they can grow."

No one really knows how wireless technology, optical networking, or regulation, for that matter, will alter the competitive landscape. But as broadband wireless technologies such as 3G and WiMax take hold, the definition of a low-cost telecom carrier could change fast. And that could hurt AT&T and MCI as corporate traffic migrates to those technologies. Those risks make it hard to know what long-distance carriers are truly worth. Michael Mahoney, a senior portfolio manager at San Francisco-based hedge fund EGM Capital, has estimated that AT&T is worth half of what SBC thinks.

Qwest and SBC concede that it will be years before they'll reap the benefits of their desired acquisitions. And Verizon and BellSouth may yet decide to take similar risks. But that would be a mistake. SBC will be saddled for years with falling revenue if it takes on AT&T. Verizon and BellSouth can grow internally right now. The growth might be slower, and neither company is likely to ever dominate the market for enterprise services. But they can be successful without being king of that particular hill.

By Steve Rosenbush

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