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JULY 23, 2002 STREET WISE By Jane Black The Bells: Apocalypse Now -- or Later? Like WorldCom, Ma Bell's hurting brood also face an uncertain future. The FCC's Powell has to figure how bad -- and how fast it'll get here
Investors and politicians want action -- and fast. Many eyes on Wall Street and in Washington are trained on Federal Communications Commission Chairman Michael Powell, the man charged with regulating the beleaguered telecom industry. On July 16, Powell promised that the FCC was working hard to prevent the catastrophe at WorldCom from spreading: "No sector needed less to be kicked in the gut," he said. But "we continue to be focused on what policy can do to ensure the economic viability of competitors and the competitive vision that were imagined by Congress and the 1996 [Telecommunications] Act." Just what steps Powell should take to ensure stability in the short run and competition in the long run depend on how the sector shakes out -- and how quickly. Two divergent views are circulating, and both scenarios see continued turmoil, not only for WorldCom but also for the incumbent local-phone carriers Verizon (VZ ), SBC Communications (SBC ), and Bell South (BLS ), also known as the Baby Bells. BACK TO THE FUTURE? Under the so-called Apocalypse Now scenario, technological innovation and its economic consequences are propelling the Bells, like the long-distance carriers before them, toward bankruptcy. The new generation of networking technology is undermining the Bells' business model at the precise moment that demand for their services is beginning to erode, making it impossible to pay off tens of billions of dollars of debt on time. Under the second view, the "evolutionary" one, the Bells are permitted to merge with long-distance rivals WorldCom, Sprint (FON ), and AT&T (T ). It's a back-to-the-future scenario, but with one key difference. As part of the deal, the Bells would lose their local monopolies and face growing competition from cable, wireless -- and each other. Top regulators at the FCC are, for now, in the evolutionary camp. They believe, with the right supervision, that competition will thrive, and the most nimble Bells will survive. "Of course the Bells will use the current financial situation as an excuse to roll back competition," says one source close to the regulatory discussions. "But that doesn't mean regulators will roll over and play dead. We would have to change the law to roll back competition." TITANIC + LUSITANIA. Powell has indicated that he's ready to let evolution take its course. In his July 16 remarks, the chairman stressed that a July 15 report published in The Wall Street Journal that he was now open to a merger between WorldCom and a Baby Bell has in fact been his position all along. But that's precisely what scares the doomsayers. "Huge size brought down the players, and here he is proposing something even bigger. He's lashing the Titanic to the Lusitania," warns Gordon Cook, an independent telecom analyst and editor of the Cook Report. The Apocalypse Now camp comprises tech-savvy network and financial experts, many of whom are former Bell employees. One of the ringleaders is financial analyst Roxanne Googin, who edits industry newsletter High Tech Investor. Googin has been warning about an implosion in the telecom sector since September, 2000, a year before Wall Street became aware of the problem's severity. Now she cautions that the crisis isn't limited to telecom upstarts. The problem is the Baby Bells, she says. Here's why: When AT&T was split up and the Baby Bells were created in 1984, regulators ruled that the new companies would be allowed to earn a profit in proportion to the assets under their control. As a result, the Bells came up with an extremely expensive technical architecture and guaranteed customers 99.99%-reliable service to justify the cost. Under this new arrangement, the Bells took out 20- or 25-year bonds to finance the equipment, figuring that nothing would prevent them from paying back the money. GRIM PROSPECT. Things have changed dramatically, however. And the next generation of telecom equipment, based on the Internet protocol standard, is expected to cut prices by as much as 90%, making the delivery of voice and data a commodity service. Worse, the Bells are already seeing their traditional local-phone business erode. In 2001, all three saw the number of phone lines they provide drop from 1% to 3%. The number of minutes Bell customers spend on the phone also is falling. In 2001, total Bell South long-distance minutes dropped 4.4%, and Verizon's fell 1%. Only SBC reported an increase -- of 0.6%. High equipment costs and eroding revenues greatly increase the risk that the Bells could default on some of their loans, Googin says. That's a grim prospect: Verizon has $60 billion in debt, SBC has about $30 billion, and Bell South has just under $20 billion. "The return the Bells can get on invested capital is declining. EBITDA [earnings before interest, taxation, depreciation, and amortization] is going down year over year. And the cost of borrowing is increasing. It's Economics 101," says Cook. "The only question is how long it will take before you no longer have a viable business." That's where the "evolutionists" come in. They don't deny that these forces are at work, but they say it will take 5 years to 10 years before the Baby Bells face extinction. "The spectacular collapse of some carriers was the result of the irrational overinvestment during the Internet bubble," says Andrew Odlyzko, director of the Digital Technology Center at the University of Minnesota. "These companies did not have a stable customer base and were in markets with low barriers to entry. Neither of these applies to the Bells." "UNNATURAL SEPARATION." The evolutionists believe that Verizon, SBC, and Bell South have time to turn their ships around. The first step would be for each Bell to link up with one of the three flagging long-distance players: WorldCom, Sprint, and AT&T. The relinkage of local and long-distance service would give the Bells the scale they need to compete -- against cable, wireless, and each other. "It's the unnatural separation of local and long-distance business that made the Bells' business model obsolete, not the other way around," says Marty Hyman, vice-president of Booz Allen Hamilton's telecom practice. It's understandable why Powell finds the evolutionists' argument more palatable. The Bells' survival likely would help calm the markets in the short term and, if all goes according to plan, set the stage for competition which, after all, is his mandate. But Powell ignores the doomsayers at his peril. The Bells seem to have kept competition at arm's length since their formation in 1984. Take what happened after SBC purchased former Midwestern Bell company Ameritech in 1998. To gain approval for the merger, SBC promised that it would compete for local customers in 30 new markets within 30 months or pay fines up to $1.2 billion. SOFT LANDING? SBC went through the motions, leasing space and buying expensive telecom equipment, but it soon gave up, according to TeleTruth, a New York-based consumer advocacy group. In March, TeleTruth requested congressional hearings to investigate both SBC's alleged failure to follow through and the FCC's failure to punish the company. SBC maintains it has met the requirements. Clearly, Powell has a tough job ahead. Dewayne Hendricks, CEO of telecom consultants Dandin Group, says the chairman's job is akin to being an air-traffic controller trying to orchestrate soft landings for jumbo jets careening out of control. The first step is to close the airport so new planes -- competitors -- can't take off. The next step is to do everything to prevent any more violent crashes. "The problem is the planes have to come down sometime," says Hendricks. It may be better to ease the speed of the descent but not waste valuable resources trying to prevent the inevitable, he says. After all, uncertainty is more upsetting to the markets than knowing that something has to end so something else can take its place.  Black covers technology for BusinessWeek Online in New York Edited by Beth Belton 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. 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