Telecom: To Buy or To Build?


By Steve Rosenbush Editor's Note: On Feb. 14, 2005, Verizon announced it was acquiring MCI in a deal worth $6.7 billion.

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 other leaders such as BellSouth (BSL) CEO F. Duane Ackerman have pursued a very different strategy. 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 (see BW Online, 2/10/05, "Will BellSouth Stay on the Sidelines?").

AVOIDING DEALS. 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, while Qwest Communications (Q) hopes to grab MCI (MCIP) for $6.3 billion. Even Verizon Communications (VZ), which has favored organic growth up until now may jump into the bidding for MCI. Verizon has made an "informal offer" of similar value for MCI, The Wall Street Journal reported Feb. 10. 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 which approach is right? There's something to be said for a 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 a big acquisition 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 OUR FAVOR." 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, local phone companies 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."

Skeptics like Ackerman 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 Ackerman: "We are positioning our assets where they can grow."

YEARS TO A PAYOFF. 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.

That's why Verizon's reported bid for MCI was greeted with some skepticism. Verizon shares closed down 2 cents, at $36.04, on Feb. 10. And telecom analyst Blake Bath of Lehman Brothers warned in a report that "while synergies alone could pay for the $6 billion price tag in three to five years, we believe Verizon's deviation from its aggressive wireless strategy would dilute growth." An MCI acquisition would reduce Verizon's revenue growth rate to 1.4% from 3.6%, he said.

Qwest and SBC concede that it'll be years before they'll reap the benefits of their desired acquisitions. The rest of the industry may follow down the same path. But that would be a mistake. SBC will be saddled for years with falling revenue if it takes on AT&T. Local phone companies 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. Rosenbush is a senior writer for BusinessWeek Online in New York


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