Econ Focus

A few years ago, Richard Thayer couldn't drive down a major street in Washington, D.C., without encountering at least one trench.

"Each telecommunications company was laying fiber next to what was put there last month," recalls Thayer, a telecom consultant in Chevy Chase, Md. So much asphalt was being torn up to install new optical cable that Mayor Anthony Williams imposed a moratorium on trenching to reduce interruptions to traffic flow and commerce.

From Baltimore, Md., to Columbia, S.C., similar scenes of telecommunications development could be found throughout the Fifth District during the late 1990s. At the same time, the economic impact of the industry burgeoned. Telecom companies based in the region increased their sales from $18.9 billion in 1995 to $29.7 billion in 2000, while their work forces grew from 88,000 to 142,000 over the same period.

"It was an Internet gold rush," says Steve Cox, president of the North Carolina Telecommunications Industry Association. "Industry officials were citing growth statistics that said the Internet was doubling every 90 days. ... Capital was readily available."

Then, the cold water of reality doused the telecom sector in 2000. Carriers that had rushed to build high-speed, high-capacity networks — and the investors who supported their aggressive expansion plans — discovered there weren't enough customers to go around.

"[The Internet] was growing about 100 percent per year, which is still good growth but not enough to provide traffic to all the new players. ... [Telecom companies] started to cut prices to build market share," describes Cox. "The reduced prices cut into profit margins, stock prices dropped, and the availability of capital dried up. Some companies were forced into bankruptcy." Humbled executives put the brakes on their companies' growth and started shedding debt, less-profitable customers, and redundant operations.

While the industry's woes have frequently made headlines, an important distinction hasn't been made as often. Most of the overbuilding occurred on long haul networks, which span hundreds of miles to connect major metropolitan areas such as Baltimore, Washington, D.C., and Charlotte.

Overcapacity isn't as much of a problem with short haul networks, which connect local loops within a metropolitan area. As for the local loops, commonly referred to as "last mile" connections, the deployment of broadband service to homes and businesses has been a mixed bag. Some communities in the Fifth District have easy, inexpensive access to the latest voice and data services, while others don't.

Consequently, service providers in different sectors of the telecommunications industry find themselves at varying levels of distress and recovery. Industry analysts and executives don't know how long it will take for the industry to regain its footing. When it does, there will likely be fewer suppliers standing, but they will hopefully be better aligned with the needs of the market.

Disconnect Between Supply and Demand
How did the telecommunications market become bogged down in long haul capacity? Part of it was due to the industry's capital-intensive nature, and part of it was driven by the boundless optimism of executives and investors.

Typically, a new entrant in the telecom industry sinks a lot of money into its infrastructure. The rationale is that once a company acquires or builds communication lines, switching facilities, and networking equipment, these items become fixed costs. Then, customers can be added with only incremental increases in operating expenses, such as salespeople and customer service representatives.

Therefore, the surge in infrastructure development during the late 1990s didn't surprise economist Shane Greenstein. The real problem was with carriers focusing on getting big fast in order to gain a market advantage. "You had multiple firms making large, up-front capital investments in an uncoordinated way. All of them anticipated a huge amount of demand," explains Greenstein, associate professor of management and strategy at Northwestern University.

For many telecom companies, the drive to establish a national footprint was based on the seemingly limitless potential of the Internet and other technological advances to change the business world. They saw a huge opportunity to serve customers that were dissatisfied with the capacity, quality, and reliability of their communications, notes Robert Atkinson, director of policy research at the Columbia Institute for Tele-Information at Columbia University.

But voice and data traffic didn't grow as fast as the amount of new supply entering the telecom market. This sparked a desperate fight for market share. Long haul carriers boosted their selling, general, and administrative expenses and slashed their prices to compete for customers. This increased volume, but carriers weren't earning enough revenue to offset their operating costs and repay the debt incurred to establish their networks.

Normally, a business continues to add customers until the incremental increase in cost exceeds the incremental gain in revenue. Instead, many carriers jumped this economic barrier.

Some analysts blame the Telecommunications Act of 1996 for encouraging this risky behavior. As noted in a February 2001 article written by Atkinson and Columbia University economics and finance professor Eli Noam, the law codified the myriad of policies and standards used by state public utility commissions to regulate local phone companies. "This centralization satisfied investors' desire for greater 'certainty' and 'predictability' [in the industry], unleashing a torrent of inexpensive capital," wrote Atkinson and Noam.

Others have asserted that the Telecommunications Act favored new competitors by providing low-cost access to the networks operated by incumbent local exchange carriers and making it difficult for incumbents to expand into long distance markets.

Solveig Singleton, a lawyer and policy analyst with the Competitive Enterprise Institute, takes this assertion a step further. She believes many startup firms figured Uncle Sam would continue to subsidize their business models in the name of encouraging competition. "Again and again, regulators sent a message to investors through their words and actions that they would protect weak competitors from economic reality," stated Singleton in a Sept. 20, 2002, speech. "Ultimately, the economy as a whole paid the price."

Getchya Long Distance Cheap
In fact, the glut in long haul networks has produced both positive and negative economic results.

It is a buyer's market for long haul capacity. A high-speed fiber-optic link between Los Angeles and New York would have cost $1.8 million a year in 2000, according to Washington, D.C.-based TeleGeography Inc. That same connection sold for $590,000 a year in 2001 and just $194,000 in 2002.

Not surprisingly, this has been bad news for the owners of long haul networks. Nationwide carriers like Global Crossing Ltd., local exchange carriers like Herndon, Va.-based Net2000 Communications Inc. that built their own networks to offer long distance in addition to local phone service, and wholesalers such as Williams Communications Group have been struggling to increase their cash flow.

A few firms — including Global, Net2000, and Williams — filed for bankruptcy to give them more time to pay down debt and reduce expenses. As some of these companies re-emerge, they may add pressure to the long haul market when they sell excess capacity or start offering low-priced services to win back market share.

For opportunists in the telecom industry, however, the bounty of long haul fiber has been a good thing. They have been able to expand at a low cost, positioning them for future growth in Internet usage and bandwidth demand.

US LEC, for example, has taken advantage of market conditions to expand its 11-state network, which covers most of the Fifth District except for West Virginia. According to CEO Frank Jules, the Charlotte, N.C., company first determines where its customers want to communicate and leases capacity to facilitate this traffic. Then, it evaluates these leased lines until demand reaches a certain point where customers can be profitably transferred onto its own network.

But telecom consultant Thayer cautions that growth in traffic doesn't always yield growth in profits. "Getting utility and value out of the increased capabilities of the telecommunications infrastructure is a big problem," says Thayer. "Part of it has to be addressed economically in the pricing of services." For instance, he thinks companies should start charging spammers for sending broadcast e-mail messages.

Short Haul Falls Short
US LEC is just one of the hundreds of competitive local exchange carriers (CLECs) that emerged after the Telecommunications Act of 1996 aimed to create new competition in local phone markets.

Most CLECs were as ambitious as the long haul carriers in establishing a major market presence in the Fifth District, prompting the regional Bell operating companies (RBOCs) and other incumbent providers to respond to this competitive threat. Yet the development of local telecom infrastructure has been more uneven than the rapid expansion of long haul networks.

The main reason is that CLECs usually focus on narrow niches. Earl Bishop, executive vice president of the Virginia Telecommunications Industry Association, says many of the companies that applied to provide local phone service in the Old Dominion ended up offering data services. "They used [the CLEC designation] as a means to further their Internet service provider activities," he asserts. "True voice competition has been very slow to get off the ground in any significant way." For example, Bishop says that Cavalier Telephone is one of the few CLECs that provide both voice and data services in the Richmond, Va., metropolitan area.

Competition in the Fifth District's residential markets also has grown slowly. Many CLECs don't offer voice service to residential customers because "the profit isn't there," notes Bishop. "The regulatory environment sets the standards and everybody has to provide the same level of service; therefore, your only product differentiation is price."

Smaller enterprises have been neglected as well. For many CLECs, the incremental cost to service these customers would be greater than the incremental revenue they would gain. "If you go after smaller customers that need just one to five lines, you need ... more call center staff to answer incoming calls, more people to send out bills, and more salespeople to acquire those customers," explains US LEC's Jules.

Finally, CLECs have tended to clump in metropolitan areas where the population of businesses and residences is dense and near existing networks. "You don't see many [CLECs] getting into the rural areas; they are going where they can make the least investment and have the biggest opportunities to win business," argues H. Stan Cavendish, executive director of corporate and public affairs at Verizon West Virginia, a subsidiary of RBOC Verizon Communications Inc.

Cavendish says Verizon faces less competition in the Mountain State's local markets than the company has seen elsewhere. While most telecom providers wire population centers like Charleston and Morgantown, Verizon West Virginia provides vital connections between rural communities and long haul networks. "If a company wants to locate a call center or some kind of telecommunications-intensive business in an out-of-the-way location, [it] will lease the facilities from us to haul the information back to where their point of presence is," explains Cavendish.

The ability to purchase short haul capacity from incumbents like Verizon at discounted prices — plus easy access to capital — has enabled CLECs to saturate the local phone markets that they serve. But in the sparsely populated communities and small business markets that CLECs have tended to ignore, there is far less competition. In fact, some rural areas are served only by an RBOC, a small incumbent, or a regional telephone cooperative.

With fewer suppliers in these markets, access to the latest voice and data services is still available, but it doesn't come cheap. "Ninety-six percent of rural areas throughout the country do not have affordable high-speed access," notes Thayer. "This access can sell for 10 to 20 times the price of similar service in urban areas." (See "Going the Extra Mile")

On the Wireless Front
Some telecom firms have tried to use a combination of fiber and wireless technology to make money in smaller markets, according to Earl Bishop. For example, Vienna, Va.-based Teligent Inc. used antennas to transmit voice and data signals to fixed receivers on buildings. Then, the receivers sent the information over wires to telephones and computers. But before the company could finish its fixed wireless network, the capital markets dried up for the telecom sector, and the company was forced into bankruptcy for 16 months.

There are many other wireless networks up and running in the Fifth District, but they tend to serve densely populated areas. Not only is it more profitable to serve these regions, wireless signals can't reach every rural hamlet. "The terrain in Virginia, especially the western part of the state, does not accommodate wireless real well," says Bishop. Mountains, vegetation, and weather conditions can impact the reliability of wireless service.

Reliability and breadth of coverage are still major concerns of wireless customers. According to a survey of 2,500 cell phone users conducted by the Yankee Group, 20 percent of respondents said improvements in coverage would prevent them from switching carriers.

Therefore, Bishop believes that wireless carriers should improve their reliability and build brand loyalty as more suppliers crowd metropolitan markets. Companies have already used special introductory offers to entice new subscribers and have slashed per-minute charges, from an average of 44 cents in 1994 to 12 cents in 2001.

Verizon Wireless invested $8 billion in network enhancements over the last two years to help retain its customers nationwide, including Washington, D.C., Maryland, Virginia, and the Carolinas. "Competing on price is not a sustainable business model," says spokesman Howard Waterman. "There are six to eight competitors in virtually every market in the country. ... The key is to differentiate yourself in the marketplace."

In Pursuit of Profits
Telecom analysts agree the industry's future growth can't rely on capturing large numbers of new customers with low-margin services. Instead, carriers must pursue new services that generate more revenue per customer while utilizing as much of their existing capacity as possible.

Many companies are bundling various combinations of voice and data services. For instance, Allegiance Telecom Inc.'s Independence Plan enables small and medium-sized businesses in 36 cities, including Washington, D.C., and Baltimore, to call their branch offices without being charged long distance rates. In addition, voice and data services can be customized for each branch. Birch Telecom offers a bundle to residences in the Carolinas and seven other states that includes local phone service, a menu of features like caller ID and call waiting, and up to 90 minutes of long distance service per month.

The goal of these bundles, says Columbia University's Atkinson, is to lure customers with low-priced offerings while earning additional revenue from premium-priced services. Some services could even be offered for free because it would help make customers "stickier" or more likely to keep doing business with the same carrier.

Bundling must be done with care, notes Helen Lee. "It takes longer to close the sale because there is more to explain and that could increase the cost of customer acquisition," says Lee, chief financial officer of Washington, D.C.-based Cogent Communications. At the same time, operating expenses can be reduced by consolidating the administrative functions required for each service. "You might increase average revenue per customer by adding additional services, but companies have to think hard about ... what that does to their cost of customer acquisition and operating expenses," adds Lee.

Telecom service providers also are pursuing new types of broadband services. Such offerings include high-speed Internet access over landlines and so-called 3G wireless technology that would enable cell phone users to send pictures to each other, play games, and download information from the World Wide Web no matter where they are.

However, like any business introducing something new, service providers face the old chicken-and-egg dilemma. Before they spend money to activate the available excess long haul fiber, acquire additional fiber, and hire salespeople, companies want to be sure that people will use new services at a sufficient level to justify these investments.

"Unless you've got customers waiting at the door that you can start selling a service to, it's very difficult to make a business case to deploy some of these broadband technologies," says Bishop. "Even in metropolitan areas where DSL [digital subscriber lines] and cable modems have been available for several years, they generally don't get more than 10 percent of the market."

And, that lack of enthusiasm is partly due to the price sensitivity of telecom users. "There is a strong consumer resistance to telecom services at a certain price point," says Atkinson. "Once you get to within 20 percent of that price point, the market explodes." That's why companies have been unsuccessfully marketing video on demand and videoconferencing for years. "People will not be interested [in new services] at a very high price."

In the future, Atkinson and other industry observers believe that the telecommunications industry's painful but necessary retrenchment will enable companies to lower the prices of new services while still boosting profit margins. "The silver lining of the serial bankruptcies is that companies can buy assets for one cent on the dollar," says Atkinson.

The U.S. economy depends on the efficient flow of information, so demand for telecommunications services will continue to grow strongly. But balance in the market won't be restored until the excess supply is taken care of. "Since the capacity isn't going to go away and will get cheaper, the industry will turn the corner when there are relatively fewer suppliers," concludes Atkinson.