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AUGUST 21, 2002 STREET WISE By Jane Black The Bells' Big Local Headache New competition is eroding their one-time monopoly business, and long-distance and data services aren't picking up the slack
"We feel a rebound will occur, but not in 2002," Verizon Chief Financial Officer Doreen Toben told investors matter-of-factly on July 31 as she reported that revenues had slipped to $16.8 billion from $16.9 billion for 2002's second quarter and that operating earnings were flat at $2.1 billion. She added: "We really don't know what 2003 is going to bring." Blaming the economy is a logical tactic in what may go down in history as the worst of times for the telecommunications business with a wide variety of companies slide into the doldrums or bankruptcy. The problem is that just as the economy alone fails to explain the entire industry's distress, neither can it account entirely for the tarnished outlook for the Bells, which investors have been depending on as the strongest telecom players. THREE DOWNGRADES. True, the recession has cost the Bells lots of high-profit corporate contracts. But their bigger problem is that rising competition in local-phone service -- which remains their core business -- is quietly eroding their traditional monopolies and substantially damaging their chances for long-term revenue and profit growth. This dilemma -- created largely by deregulation provisions in the Telecommunications Act of 1996 -- almost certainly will linger long after the economy revives. On Aug. 20, UBS Warburg, which has underwritten deals for the Bells, downgraded all three from buy to hold, warning that incursions by competitors in the local-phone business will proliferate in the second half. The 1996 law cleared the way for the creation of so-called competitive local exchange carriers (CLECs), unregulated local-phone companies that attracted large amounts of venture funding in the late 1990s and installed the newest and best fiber-optic phone networks. RIDING ON THE BELLS. These networks are faster and cheaper to operate than the older-generation networks installed years ago by the Bells. Verizon alone carries its network on its books as a $74 billion asset. In theory, the CLECs could provide the same service as the Bells while underpricing them. After the bubble burst and the capital markets dried up, the CLECs changed their business plans. Instead of building their own facilities, many took advantage of rules that required the Bells to sell the upstarts space on the Bells' networks. Thus MCI, a unit of bankrupt WorldCom, has launched a program called the Neighborhood that offers consumers unlimited local and long-distance calling for a flat rate of $50 per month. The CLECs have sailed a turbulent sea, dipping in and out of Chapter 11 bankruptcy in several cases. Yet, enough of them have survived to grab a 10% share of local-phone service since 1996 -- a serious assault on businesses that typically account for more than 50% of the Bells' revenues and generate margins before taxes, depreciation, and amortization of more than 40%. FALLING EARNINGS. So, even as top Bell executives blame the economy for their shortfalls, their local-phone business is eroding much faster than most observers realize. In the second quarter, the total number of local-phone lines that Verizon provides dropped 3.3%. SBC suffered a 3.8% decline, and Bell South 2.1% falloff. Over time, such losses could have a significant impact on the bottom line. The local-phone business has fixed costs. So any loss of lines means revenues fall, but costs don't. UBS Warburg analyst John Hodulik estimates that 2003 earnings for the Bells as a group will decline by 1.8%, a far cry from the historical 2% to 3% growth. The slippage in the Bells' local business looks even more foreboding when you dig into the details behind the numbers. Increasingly, the sales the Bells are making are UNE-P (for unbundled network element platform) lines -- the local capacity the Bells are required to provide all comers so that they, in turn, can sell local service. SYPHONING SHARE. The law requires the Bells to sell these lines at a price set by state regulators, which is based on what it costs to provide and maintain each line. According to Bernstein Research in New York, that's about half the price the Bells would charge their retail customers. On average, the Bells sell a residential UNE-P line to companies such as MCI and Allegiance Telecom (ALGX ) for $15 a month, vs. the $37 they charge retail customers. They sell a business line for $22, vs. the $55 they charge their business customers. The CLECs that buy these lines then compete with the Bells -- and syphon away market share. Overall, the number of UNE-P lines the Bells sell is skyrocketing. In the June 30 quarter, purchases of UNE-P lines hit SBC and Bell South particularly hard. SBC's total UNE-P lines rose to 3.4 million, up 25% from the first quarter of 2002. Bell South added 239,000, boosting its total by 30%, to 1.1 million. Only Verizon sidestepped the trend: Its total grew just 4%, to 2.4 million. "ONE LOSER." UNE-P lines now account for 4.8% of all the local lines the three Bells provide. "The total number of lines [the Bells sell] are dropping, and at the same time the mix of lines is becoming much less profitable," says Phil Jacobson, an analyst at Network Conceptions, an Arlington (Va.) telecom consultancy. Worse, the current regulatory structure requires the Bells to sell the UNE-P lines at a loss in many areas -- or so they claim. Verizon says it sells UNE-P lines for an average of about $20, even though it swears its average cost per line is $50. "In that situation, there's one loser," says Don Evans, Verizon's vice-president for federal regulatory advocacy. "That's us." The future looks even bleaker to some experts. According to UBS Warburg analyst Hodulik, the Bells will hand over an additional 1.6 million lines to UNE-P in the third quarter, up from 1.1 million in the second. All told, he estimates, wholesale lines, which also include those resold by third parties, will account for more than 12% of the local lines the Bells provide by the end of 2003, and more than 17% by 2005. OUT OF BALANCE. Other observers are yet more bearish. Analyst Jeff Halpern at Bernstein Research forecasts that wholesale lines will rise to 13.9% of Verizon's total and 23.2% of SBC's by 2007. That would lower the Bells' average revenue per line by 3.2% to 3.7% per year, Halpern estimates. Those declines would be surmountable if the Bells were growing elsewhere. But both long-distance and data transmission have proved disappointing for them so far. The Bells have had great success gaining market share in long-distance -- Verizon added 800,000 new customers in the second quarter alone -- but they've yet to make money on the service, since prices are low and to date the Bells have largely attracted low-usage customers. So far, says Network Conception's Jacobson, long-distance has served mainly to help the Bells retain local-phone service customers. Growth in data services has been similarly lackluster. Data revenue for all three Bells totaled $5.4 billion at the end of the second quarter, up 3% from the same quarter a year ago. LOBBYING HARD. Not everyone is convinced that the current trouble spells doom for the Bells. Bernstein's Halpern believes that long-term growth in digital subscriber lines (DSL) and corporate data services will offset the declines in local business. (Neither Halpern nor his firm hold positions in the Bells.) Despite his bearish forecasts, Halpern still expects Verizon and SBC to deliver up to 2% revenue and profit growth in their core wireline franchises over the next five years, with additional boosts to the top line from wireless and international business. In short, he expects the two larger Bells to grow at the same rate as gross domestic product. It's also clear that the Bells aren't accepting their dilemma passively. They're lobbying federal regulators to roll back the requirement that they make UNE-P lines available in all of their service areas. Verizon's Evans argues that the situation is bad not only for the bottom line but for the entire U.S. telecommunications sector. "NO INNOVATION." "Congress' goal in the 1996 Telecommunications Act was competition, not just in services but in features and capabilities," he says. "When everyone uses the same network, all you get is price competition. There's no innovation." To date, Federal Communications Commission Chairman Michael Powell has been sympathetic to the Bells. But powerful legislators, such as Senator Ernest Hollings (D-S.C.), oppose any changes in the law. The FCC is now analyzing comments from all parties on the growing use of UNE-P lines, and it hopes to make a decision by yearend on whether the Bells should be forced to continue selling them in all markets. Either way, the Bells are already suffering earnings damage, which can only complicate their efforts to work off their combined $112.7 billion in debt. NOW THEY NOTICE. "Everyone wants to look the other way on this, just like they did with long-distance companies like WorldCom," says Susan Kalla, an analyst at Friedman Billings & Ramsey in Arlington, Va., who says neither she nor her firm have holdings in the Bells. Or at least, few noticed until UBS Warburg's Hodulik lowered his stock-price targets on the three Bells, sending the shares of all three down on Aug. 20 by 5% to 7%. Indeed, investors should take note the economy isn't hurting the Bells as much as competition is. And that isn't likely to change soon.  Black is a technology reporter for BusinessWeek Online in New York Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | AUGUST |
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