CLECs Stack Up

US LEC, a competitive local exchange carrier based in North Carolina, bills itself as a “super-regional carrier,” boasting that it has steadily doubled its customer base in the past two years. But if US LEC is super-regional, it's unclear how to describe NuVox Communications, another CLEC based in the same state, which recently grew its customer base through acquisition to twice the size of US LEC's. Perhaps another superlative entirely is needed to describe ITC^DeltaCom, the biggest CLEC focused on BellSouth territory, which recently followed up a year-ago merger with BTI Telecom by announcing a three-way merger with Network Telephone and FDN Communications. ITC has plans for at least two more mergers on the horizon. It's all part of the rapidly shifting and intensely competitive telecom market in the Southeastern United States. Through mergers and other means, CLECs are growing faster than cotton in BellSouth's backyard, and they're far from through.

“What we've seen in the last two years we expect to see over the next two to three years,” said James Akerhielm, CEO of NuVox. “Fewer competitors and every one of us stronger than we were.”

CLEC consolidation hasn't been confined to the Southeast. This year saw the combinations of national players, for example, Allegiance Telecom with XO Communications and Broadwing Communications with Focal Communications. But if there is particular activity in BellSouth territory as of late, it may be in part because the region is more crowded with competitors than other places. Georgia is served by 26 facilities-based CLECs, according to New Paradigm Resources Group, whereas Michigan and Ohio, which are each more populous, claim only 14 and 22 CLECs, respectively. Florida also has 26 CLECs, surpassing the more populous Texas (which has 23) and California (20). There are multiple theories about why this might be, from the region's insular calling habits to the self-feeding history of CLECs there. Theories on where it's headed, however, are more uniform: Merger will beget merger. The herd is already thinning.

In May, North Carolina CLEC NuVox Communications closed its merger with NewSouth Communications, effectively doubling its market share and ending up with more than 40,000 business customers, more than 600,000 access lines and more than $300 million in annual sales, according to NuVox. In September, ITC^DeltaCom — which acquired one of its biggest competitors, BTI Telecom, only last year — announced a rare three-way merger with Network Telephone and Florida's FDN Communications. With the addition of 55,000 FDN customers and 17,000 Network Telephone customers, the merger will leave ITC with 120,000 customers across 45 Southeastern markets and annual revenue of $800 million.

Like NuVox's merger, ITC's includes a lot of overlap, which is why ITC expects to save $25 million to $30 million in operational synergies once the three companies are integrated. ITC is also eager to use FDN's coveted operations support system to transfer unbundled network element (UNE) platform lines to UNE loop lines much more quickly and smoothly than ITC could have done by itself.

Driving ITC's and NuVox's merger and acquisition is the belief that, in order to achieve long-term survivability, they must attain 20% to 30% of their markets, which consist mainly of small and medium-sized businesses. Though ITC claimed to have more than 15% market share in some cities — more cities with the merger, of course — CEO Larry Williams wants to acquire at least two more Southeastern CLECs, growing revenues another 50% to nearly 90%, from the $800 million it will have after the current merger to between $1.2 billion and $1.5 billion.

“It could be done in the next couple years if all the marbles come together,” Williams said.

Because ITC is looking to boost market share, it is especially likely to acquire competitors whose footprints greatly overlap ITC's.

NuVox's Akerhielm has similar ambitions, and he knows the clock is ticking.

“Two to five years from now, can a market like Orlando sustain five players or three?” he asked, referring specifically to the small and medium-sized business segment. “It certainly can support three and not more than five. You've got to make sure you're a one, two or three player. We think it's a reasonable objective for us to establish that position within three years.”

US LEC, by contrast, is pursuing a strategy of decidedly organic growth. It issued a press release last month boasting that it had won its 20,000th customer, just two years after its 10,000th. Though US LEC acquired a small company called Fastnet last year, the target was chiefly Fastnet's high-end data products, not its footprint or access lines, said US LEC CEO Aaron Cowell. The combined company recently refinanced its debt with a $150 million private placement of notes, but although Cowell plans to grow his company substantially over the next few years, most of it will come organically, he said, and future acquisitions will resemble that of Fastnet more than ITC's or NuVox's.

US LEC will invest in “making sure we build the right team and trajectory so that five or six years from now we have a much bigger organization,” Cowell said. “Are we going to use these funds and newfound flexibility to go on an acquisition war path? The answer's no.”

The downside of organic growth is that it requires a lot of cash, said ITC's Williams, who has fueled ITC's mergers with stock instead. Part of the reason organic growth is so expensive, he said, is because of the bitter fight that goes into winning each business client, which drives up customer acquisition costs.

With powerful bundles and an early foot in the door, BellSouth doesn't give up business customers without a fight. The company's revenue from small and medium-sized businesses grew between 4% and 5% in each of this year's first two quarters, thanks to sales of DSL and long-distance but also largely because of relentless customer retention efforts. Williams has called BellSouth “the most aggressive win-backer in the South.” Typical BellSouth win-back efforts offer customers 30% discounts if they agree to three-year commitments. That forces ITC to offer even lower prices for similar contracts.

“It's hard to take customers without some price advantage going in,” Williams said. “If we sign someone up for a three-year contract, we still have to be more attractive in pricing, as well as give better customer service and hold the customer's hand a little bit more than BellSouth.”

Williams plans to apply the added muscle ITC gets from its mergers to broaden product offerings and bolster customer care to hold hands even more tightly. US LEC counters BellSouth's win-back offers with the opposite enticement, offering freedom from commitment.

“Every customer has an unlimited satisfaction guarantee,” Cowell said. “For the entire life of their contract, if we're not performing, they can rip up their contract and go away.”

US LEC, which claims to average roughly 8% of the T-1-and-up market across its footprint, also claims to have kept customer churn between 0.6% and 0.7% for years. And it fights price erosion by selling more products to each customer. “If you go back to the world of, say, 1999 to 2000, for what you're selling today, the same revenue that may have been for one product then is for five products now,” Cowell said. “Our job is to get our current number of products per customer, which is north of four, continuing to grow to the five range.”

Some analysts say they don't expect BellSouth to worry much about the mergers of super-regional CLECs that are a fraction of its size.

“Even combined, they're still relatively small,” said Parker Hunter research analyst Wayne Homren, pointing out that the $800 million in revenue ITC is expecting post-merger is meager compared with BellSouth's $22 billion. “When they're combined, one plus one equals two, not four or five.”

Still, BellSouth claims to take these smaller competitors very seriously.

“We usually line up with the big guys — AT&T and MCI,” said Phil Hinson, BellSouth senior director. “But we always have our eye on the smaller guys as well because they can hurt us in a very dramatic way very quickly. If [ITC] takes the best of all three of those companies [it's merging with] to the marketplace, we face a formidable new competitor with deeper pockets and a broader customer base.”

And what happens if BellSouth one-ups the CLECs with its own merger, combining with one of the major interexchange carriers?

“I would probably root and celebrate because it would probably screw them up for several years,” Williams said. “That's what's made BellSouth the most competitive. They haven't gone through integration things that have distracted them like GTE did for Verizon or Ameritech and Pacific Bell did for SBC. These guys have done nothing but focus on keeping their existing customers and winning them back. I think a little distraction would be pleasant.”