Break up to break out

The competitive wave has hit. Local exchange carriers, interexchange carriers and others are racing to win in a business being redefined by growing customer sophistication, deregulation and alternative technologies.

Consumer appetite for new broadband and wireless services is real, but supply is exploding at a rate that is likely to exceed demand for the next seven to 10 years. Excess capacity from the Internet, broadband cable and new wireless bandwidth, including broadband wireless, will drive the battle for market share. Price levels for commodity services-dial tone, basic cable, long-distance and Internet access-will fall to historic lows, placing enormous pressure on the profitability of the industry in general and LECs in particular.

LECs will not be able to keep all their customers or remain competitive in all aspects of their regulated business. Mergers may provide opportunities to build scale, tap new capabilities and create new services; however, they won't, in and of themselves, assure success in the new environment. To win, LECs will need to rethink their strategies from scratch, judging each piece of their business on its own merits. The old integrated telco business model is, in short, a thing of the past. Telephone companies may need to break up to break out.

The LECs' "regulated business" is really four businesses-the last-mile plant business, the network management business, the service design business and the service retailing business-each with strikingly different competitive challenges, economics and requirements for success. Because of the diverse characteristics of the four businesses, their future attractiveness varies greatly (Figure 1). Can a single LEC win in all four? Perhaps, but not likely. Will it even want to play in all these businesses in the future? Not necessarily. The key is to bet on the eagles, not the albatrosses.

Last-mile plant: problem child The "last-mile" business is a cash-hungry, fallen star that has the challenge of economically migrating from obsolete, high-cost, copper plant to broadband or wireless facilities in an era of industry oversupply. Within 10 years, attractive urban and suburban markets will have numerous "pipes" into the home-two to three wireline and four to eight wireless-but demand will not grow quickly enough to cover the full cost of infrastructure investment for all players.

Is this business doomed to weak returns, or is there a path to profitability? Cost will dictate survival. Despite recent improvements, gains in wireline operating efficiencies continue to lag behind those of cable and wireless. Focused deployment of broadband plant could improve performance, but more fundamental changes are needed to build a truly competitive organization. LECs must break free of their traditional culture and design new processes, policies and procedures that deliver more value to the customer for every dollar spent.

In addition, LECs need a demand-driven investment strategy that assesses where it makes economic sense to deploy different types of infrastructure. For the next seven to 10 years, only about a third of LEC customers will be attractive candidates for emergent value-added services. Focused buildout strategies will boost return on investment.

Of course, a focused investment strategy flies in the face of universal service. If regulatory constraints or a "we do everything" mind-set drives providers to across-the-board investments that are economically unwise, the last-mile business will become a cash trap, with the LECs investing more money for less return while providing little funding for other businesses with greater profit potential. Unfortunately, regulators are unlikely to see this until it is too late, thereby damaging telco prospects to grow more favorably positioned businesses.

The bottom line is that the last-mile business will be difficult to make profitable in a regulated environment. However, an unregulated, agile subsidiary, or spinoff, with ruthless cost management skills-a kind of last-mile "squeezer"-could eke out minimal returns if the regulatory regime recognizes the dilemma facing this business.

Backbone network management The backbone network management business is a sleeper powerhouse and may be the single most important key to future LEC growth and profitability. This business is true LEC turf. LECs currently own in excess of 80% of the community's wide area network business.

Evolution of computing/transport capability, network server architecture and software applications promises a rich future of new intelligent services with good growth and profit potential, including personal communication services networks, video services and high-speed local area networks.

The backbone castle is under siege, however. Microsoft and Netscape Communications Corp. are betting that decentralized solutions using smart, off-network servers for a variety of applications will prove to be faster, better and cheaper for end users. If a standardized Internet service delivered by Microsoft and Netscape has the capacity to handle all the switched traffic on the LEC network at a lower cost-albeit a lower quality service level-the LEC could be repositioned as a "dumb" player in a low-return commodity transport business.

The powerful LEC counteroffensive is to give end users superior network performance and application versatility, something they don't have today. An open Advanced Intelligent Network environment would partition switching hardware and software from other applications to protect the switched network's integrity while allowing outside applications-airline reservations and financial transactions, for example-to be homed on the LEC backbone.

A software equivalent of DOS would be used for communicating between the switch and outside vendor applications. With AIN, the LEC would be well-positioned to dominate applications where customers need technical superiority in terms of real-time transmission, downtime and ubiquitous connectivity. A company that provides a super backbone "WAN-opoly" would be the leader in the marketing and development of an open backbone with common standards. Competitive advantage would be created by first mover advantage in attracting high-volume applications that would be resold by many retailers and distributed across a variety of leased facilities. WAN-opoly players could also resell services to telcos or players that choose not to specialize in this capability.

For LECs, the first major strategic challenge in the network management business will be to actively embrace the open architecture paradigm and abandon the view that the network must be protected from invaders. They must reach out to new players who can exploit the capabilities of the platform. Inclusiveness and partnering will be an important mantra if common standards are to be established.

The second challenge will be to separate the last-mile plant business from the network backbone business. The skills needed and opportunities that lie ahead for each of these businesses are largely unrelated. The backbone business may be best advantaged if it can lease or purchase last-mile facilities from a variety of suppliers.

Of course, some LECs may not be able to strike a deal with regulators to subsidize their societal obligations and will have no choice but to manage the last-mile business for cash. In this case, aggressive re-engineering, combined with the outsourcing of high-cost activities to lower-cost subsidiaries, may be the only way to maintain cost-competitiveness.

Innovation required With the emergence of an open backbone, the market for new services will explode, creating a new type of business: the service design house. The mission of this business will be to shape, package and link network capabilities with outside vendors to produce and package new applications for wholesale distribution to service resellers and retailers, or for retail sale to end users under a proprietary brand name.

From a wholesale standpoint, market space is available for a network applications and solutions specialist. This competitor will focus its resources on creating high value-added applications for a variety of retailers and resellers through superior capabilities in network systems integration and applications software development. LECs pursuing this path could outsource retail, exit the last-mile business through spinoff, lease backbone real estate and focus on developing wholesale applications businesses like national voice/e-mail integration or telephony billing service bureaus that integrate wireline, wireless and international service.

On the retail front, technology and deregulation will allow LECs to integrate services and provide consumers with a more complete communications product. These retail designers would be the ones to give high-contact business executives a seamless personal network that integrates wireline and wireless connectivity with an application-rich software environment to conduct business across different countries, network types and end user devices. The potential is enormous.

Mercer Management Consulting research indicates that demand for emerging communications services in the consumer market alone represents more than $40 billion in real revenue growth over the next seven to 10 years, presuming significant, but not fundamental, shifts in customer behavior. If new applications can fundamentally alter consumer behavior in areas such as commuting, health care and education, two to three times this revenue could be up for grabs.

Capitalizing on this opportunity will require the development of creative new products that deliver fundamental value to end users-enhanced security, better information and more fun. For example, an LEC could use an AIN platform to create a dominant community network for residential and business customers supported by e-mail, videoconferencing and other software to provide users with news, advertising/classifieds, directory information, community bulletin boards and chat groups.

Such concepts will require substantial software and systems integration skills to link products supplied by different network and non-network players using a variety of infrastructures, end-device protocols and communications standards. Moreover, software creativity will need to be guided by superior customer understanding, marketing know-how and new product development skills-not the traditional strengths of LECs. This is a maverick business.

Building on brand It can be argued that the greatest competitive strength of the LECs is their brand names, although they sometimes get little respect. The trust, reliability and comfort associated with a local LEC name is often stronger than that accorded to the top long-distance brands and is worth enormous share in a competitive marketplace. But this advantage will prove ephemeral if the LECs do not invest heavily in retail brand-building as the competitive landscape and product palette change.

Like the Sears, Roebuck and Co. of old, LECs could have their franchise nibbled to death by the Gaps, Victoria's Secrets and Banana Republics of the future multimedia world. LECs must be able to identify a core franchise of customers who are both attractive to serve and possible to defend. Today's LEC customers vary from the wildly profitable to the cash drains. Financial success will hinge on development of good customer profitability measurement systems to know the good from the bad. Many of today's highest revenue consumers are also some of the least brand loyal or most costly to serve.

LECs must understand which customers to defend, which to develop and which to give away. The successful retailer becomes so by using market knowledge to focus on an economically viable customer franchise. Circuit City, for example, has focused on a product space while Nordstrom has focused on a customer demographic space and Best Buy has focused on a customer attitudinal space. LECs will have to "de-average" their customers into segments with distinct needs, attitudes, behaviors and service economics in order to position themselves attractively against the new competition.

Those with a clear view of their desired customer franchise will be able to create a retail concept with a distinct product assortment, distribution channel character, service proposition and brand that provides target customers with a better value proposition than competitors and assures shareholders attractive economic returns.

The challenge is to take advantage of the LEC brand franchise and invest in brand-building to assure viability in new areas.

For LECs with the desire and resources to pursue the service design business, there may be benefits to having design and retailing share the same corporate parentage-particularly if both units share information on customer behavior and economics to develop a seamless design-to-market process.

Integration is not necessary, however. There are many "pure" design businesses that do fine as stand-alone businesses, developing finely tuned sales channel strategies involving a variety of retailers. Moreover, eliminating fixed ties between the service design and retailing businesses can help ensure that the retailer sources what target customers want rather than pushing what an in-house group has to sell.

Crafting a winning strategy Given the vast differences in these four businesses, choosing carefully will be crucial. Good portfolio strategy requires that LECs focus on those businesses that offer the strongest economic potential and then ask whether other, less attractive parts of the portfolio could provide attractive adjuncts.

Is there value in an integrated concept? Maybe, but business units must have the freedom to independently buy and sell services in an open market. The challenge for LECs is to leverage internal capabilities and knowledge across business units without forcing uneconomic decisions on a good business unit to shore up a weak sibling. Market-based transfer pricing, competitive benchmarking and profitability measurement and management systems will be critical tools to ensure that the LEC business portfolio is managed economically.

The existing LEC business portfolio is too rich with possibilities, and therein lies the risk. The temptation will be to play everywhere and not place the kinds of focused bets that will create individual business leadership. Success will hinge on evaluating individual business options and making wise choices on where to invest and prune for the competitive battle ahead.

P. William Bane is Vice President and Group Head, and Debra B. McMahon is Vice President and Washington, D.C., Office Head for Mercer Management Consulting, Washington, D.C.