Embarq: Year Two

Heading into its second year as a standalone company, the former Sprint operation is building a business on fixed/mobile convergence. But with revenue and access lines still declining, can it reinvent itself fast enough?

Dan Hesse is pushing his way through the crowd in the Apple Store on Chicago's famed Michigan Avenue with his two sons, who are 8 and 12 years old. It's the first Saturday in August, and the place is packed. But at 6'5", Hesse has a better view than most.

He gets a kick out of watching his kids devour the latest gadgetry, partly because they have an instant, easy rapport with these machines. They have no more need of instruction manuals here than Hesse, at their age, would have needed instructions for a football. Watching them, he's struck by the simple elegance of the gear on display: an iPod, an iPhone, an iMac. Two mobile devices — one wireless, one not — and a wired hub, allowing users to easily drag a variety of content from one to the next and walk away with it. And all three fed by a terrestrial broadband connection. This is the future, Hesse thinks to himself, and it's one in which old local phone companies — like Embarq, the one he leads as CEO — play an integral part.

“Whether it's music or videos or what have you,” Hesse said, “you'll get it off your computer, high-speed from DSL, and then you'll move it — not to your ‘wireless’ device because the iPod's not wireless — to your mobile device, whatever that might be.”

For more than a year now, Hesse has been working to transform his old local phone company into an innovator within that smooth, facile nexus of mobile and landline services on display in the Apple Store. He has to hurry, though, because every week another 10,000 or so of those all-important landlines on his network disappear. “We have to make [mobile service] work seamlessly with that home phone,” Hesse said, “and we're not there yet.”

FRESH EYES

Another reason Hesse likes the Apple Store: Whenever possible, he likes to see things from an outsider's perspective, especially innovators in adjacent industries. “There's some advantage to having tangential experience,” he said. “You can look at things with a fresh set of eyes.”

It's why he insisted that no one on Embarq's board of directors come from the telecom services industry. (“Between my senior leadership team and myself, we had like two centuries of telecom services experience,” he said. “We didn't need any more.”) It's why he regularly leads his senior team on what he calls “trips to shamelessly steal good ideas.” They go to Europe to meet with innovative carriers and vendors, or sometimes to independent telcos in the U.S. — but especially non-telecom companies.

“We meet with Internet companies to pick their brains on where we could take this business,” Hesse said. “You'll notice the partnerships companies like ours will develop and the kinds of services we'll bring to the market will be very different from what you see today.”

Hesse gained respect for the vantage point of outsiders in his 23 years at AT&T, where he often played that role. As part of Ma Bell's management program, he was shuffled around to a new, unfamiliar assignment every year or two for several years. After AT&T's divestiture in the 1980s, he was put in charge of the company's access strategy: a $22 billion operation where his own background in sales didn't help.

“They said, ‘Here, you're responsible for the company's access strategy. We have no strategy. We have a blank sheet of paper. It's yours. Go fix it.’” Hesse recalled. “I didn't know anything about access. I was 30 years old.”

He did well in this environment — having to perpetually start over, in ignorance — perhaps as a result of his peripatetic childhood. Moving wherever the military stationed his father, Hesse attended 10 different schools before he turned 18. When he moved to the Netherlands to run AT&T's sagging equipment division, which later became Lucent Technologies, he had never been in the equipment business. When he agreed to lead AT&T Wireless, he'd never worked in wireless before. When he took on its Internet business, he said, he barely knew what the Internet was. And he liked it that way. “I was always looking for an opportunity to change the game,” he said.

He wasn't always successful. In 2000, he took the helm of free space optics firm Terabeam amid expectations that it would revolutionize broadband. It didn't.

At Embarq, changing the game is not just Hesse's opportunity, it's his imperative. Before the company split off from Sprint in May 2006, all its most important metrics — revenue and access lines, for example — were accelerating toward doom. More than a year later, earnings and cash flow are still below industry benchmarks.

Hesse knows his business depends on new, innovative services, and marketing surveys have told him that people don't want to buy new, innovative services from their local phone company. That's one reason Embarq declined to adopt the well-established red diamond logo that Sprint offered to leave behind as it merged with Nextel. Hesse opted again for the blank piece of paper, picking a green color scheme (not, as some have suggested, in loyalty to his alma mater, Notre Dame) because no other carrier had one.

RAIDERS

Ever present in Embarq's transformation is the ticking clock of access line loss. In the first four quarters of its independence from Sprint, Embarq lost around 421,000 access lines, about 6% of its total. The company claims progress in having slowed the bleeding (marking each quarterly loss as smaller than year-earlier numbers), and it recently revised its outlook on line loss for this year from a high 6% to a low 6%.

But the company's optimism hasn't changed how focused Embarq's leaders are on the problem. Just outside Hesse's office on the 10th floor of corporate headquarters hangs a fake movie poster created for a manager meeting in the consumer division. The movie is called “Raiders of the Lost Access Line,” and it stars the Embarq management team, including a fedora-wearing Hesse in the role of you-know-who.

The plan to raid lost access lines involves more than just bundling services; it entails creating new services in the space between those bundles. In particular, data services will be the force that pushes back hardest against wireline erosion, Hesse believes, because when it comes to things like Internet services, wires will always be at least 10 times faster than wireless — and cheaper. As the Apple Store illustrated, people will use each medium when it makes sense. “If I need it right now, I'll pull it right off the air,” Hesse said. “If I don't need it right now, I can get it cheaper and faster by plugging it into whatever my dock is at home. I think that's the real place that landline will always play.”

Hesse never forgot a lesson he learned a decade ago while CEO of AT&T Wireless. At the time, the company's most successful product was a brand new one called Wireless Office, which in the two years before Hesse's departure accumulated a few hundred customers and zero churn. For Wireless Office, the company installed picocells in offices so that, as users entered the building, their mobile phones automatically switched over to the in-building network, which was linked to AT&T's own landline. It was a hit partly because, especially back then, indoor wireless service was notoriously spotty. But the epiphany it held for Hesse was that it used existing wireline networks to offer a wireless service. Not only did that free up capacity on AT&T's wireless network, customers liked getting it all on one bill.

“That's the holy grail that we had 10 years ago,” Hesse said. “We knew, as a wireless company, if you could ever get landline and wireless networks to work together, you had a home run. It was a huge ‘ah-hah!’”

Embarq brought a similar fixed/mobile convergence (FMC) service, SmartConnect, to its business customers in two markets just weeks after its spin-off from Sprint. The consumer wireless market in particular would require an FMC strategy. With no wireless network, Embarq relies on Sprint as a wholesaler to offer consumer wireless. Because it can't compete with national wireless providers that way, it must make use of its landlines to offer FMC services that are greater than the sum of their parts. Embarq began by offering, for example, integrated voicemail and free calling between mobile and home phones. But it intends to do much more.

In July, Embarq brought features to five top markets that were meant to convince consumers of the value in retaining both landlines and mobile phones. One is a find-me/follow-me service that forwards calls to the user's device of choice (mobile or landline) based on how consumers program that feature (for example, setting policies dependent on time of day). Another new service lets users transfer a live call from their mobile phone to a landline, or vice versa, in case they are talking while in a car and want to continue the conversation once they arrive at home, with the quality and lower cost that a landline offers.

The next wave of services Embarq is planning gives landline phones the kind of features people enjoy on their mobile phones, such as address books and Web-delivered news, sports and weather.

In the meantime, analysts say the company is off to a good start. “Embarq is looking very good,” said David Hold, an analyst for Current Analysis, counting their early FMC efforts as “very good strategic moves.”

Embarq is fighting access line erosion on other fronts, too. To compete with low-priced introductory offers from cable, it offered a DSL “price for life.” This summer it sealed a pact with six other mid-sized telcos to refer customers to one another as they relocate from one telco's footprint to another. Customers canceling their service will be asked where they're moving, and they immediately will be transferred to the incumbent telco in that area — a collusion to keep cable competitors out of the loop.

Another big ah-hah moment for Hesse during his time at AT&T Wireless was the market's reaction to its One Rate offer — another game-changer. While most carriers were charging different rates for nights, weekends and roaming, AT&T erased all that complexity with a single rate. “[Average revenue per user] went through the roof,” Hesse said. “Customers started spending a lot more. They paid a premium for simplicity. As there's more complexity, customers want more simplicity. If [Embarq] can deliver that, I think we can be really successful.”

VIDEO

The company expects access lines to continue declining but at a reduced rate, hoping to slow that rate enough to allow the gains made in revenue per household to eventually yield overall growth on the top line. The stated goal is to return to top-line growth in 2009, which makes the next 18 months a critical period in the company's history.

It's especially challenging because Embarq's employees aren't used to worrying about the top line. As part of Sprint, the incumbent local exchange division generated steady cash flow, which the wireless side of Sprint invested in growing revenue on its end. Hesse aimed to change that mind-set by tying 40% of employee bonuses — for all 19,000 employees, including Hesse — to revenue performance, a first for employees of the local telco.

Another big initiative to curb customer erosion is Embarq's video offering, through satellite partner Echostar. As Embarq pays down its debt (it has paid down $1 billion in the past year), and the cash flow that once poured into Sprint is now Embarq's to use, the question often comes up whether the company will deploy its own fiber access networks for terrestrial video, to make video not just a defensive play but a contributor to the top line. But without the teledensity of AT&T or Verizon, Embarq is waiting for fiber economics to evolve first. As an investment, Hesse said of fiber to the x, “We'd be better off putting that money in a savings account.”

Over time, however, he knows equipment costs will come down and compression technologies will improve broadband capacity. All the while, Embarq can watch AT&T and Verizon to learn which competitive tactics work best. “All of a sudden, the business case might look positive in a couple years where today it doesn't,” Hesse said. “That's what we're kind of waiting for.”

Next year, the company plans to field-test an IPTV service that would integrate satellite service with DSL. (One company technician says the tests Embarq is running appear to focus largely on on-demand offerings.) Also next year, Embarq will deploy fiber to 50,000 newly built homes.

For the foreseeable future, however, even an improved business case for fiber would likely only apply to the densest third of Embarq's network, Hesse said. “Even if you go out 10 or 20 years, two thirds of our market is going to be satellite,” he added.

‘THINQ’

Embarq's creation (and that of Windstream Communications, Alltel's rural wireline spin-off) led many to predict widespread consolidation in the rural telco space. Some suspect Qwest Communications could roll up companies such as Embarq and others — a prospect challenged by Qwest's considerable debt that resurfaced in industry chatter as the company recently installed a new CEO. Some suspect Embarq or its brethren might roll up small telcos one by one. And Embarq executives are looking at possible acquisitions, but they'll tell you: Don't assume those targets are other telcos.

“They could be application companies, they could be alarm companies, they could be geek squads,” Hesse said. “Let's think out of the box.”

Looking outside the telecom sector again, Hesse noted with interest that Cintas, the company that delivers Embarq's technician uniforms, recently started putting paper shredders in the back of their delivery trucks. As long as they were dropping off uniforms to business customers, they figured, they might as well offer something else those customers could use. As Hesse sees it, Embarq's 6.5 million or so landlines are like a massive fleet of trucks — and whatever he decides to put in them will be delivered right to his customers' door.

This spring, Embarq essentially fired EarthLink as its Internet service provider and began doing the job itself, creating a new Web portal that includes features such as calendars, e-mail and a host of other customizable content. In addition to cutting costs and earning revenue that once went to EarthLink, Hesse said, “We have a portal that's a great user interface for all our communications and an opportunity for new revenue streams — advertising and other revenue streams we haven't thought about yet.”

Next year, Embarq executives will spend a lot more time thinking about what they haven't yet, hoping to find their next ah-hah.