Creatures: Competitive local exchange carriers evolve into fierce competitors as the 1996 Telecom Act starts to empower the little guys

Is there competition in local telephone markets? Some legislators in Washington answer with a resounding "no" as their fingers drum impatiently and point accusedly. Two years after landmark legislation promised choices in local service, the politicians expected more.

But private-sector telecommunications executives and analysts across the country say competition exists-if you look in the right places. In their view, the Telecommunications Act of 1996 is starting to work.

"Progress has been made, but in very tiny steps," says Steve Trotman, director of local services for the Telecommunications Resellers Association, Washington. "It hasn't come easy. The incumbents are still in control."

In control, but yielding some ground. The five Bell regional holding companies and GTE have signed 2400 interconnection agreements and lost more than 1.5 million access lines to new rivals, says the United States Telephone Association, the Washington-based trade group for local telcos.

The big players still control 97% to 98% of the $103 billion local market, but the other 2% to 3% are morphing into fearsome competitors.

Every creature from national competitive local exchange carriers (CLECs) to small Internet service providers is jumping into the fray with abandon. About 100 major local service competitors are raising millions, building out like crazy and marketing with passion. Although once considered insignificant threats, they are starting to give entrenched monopolies a run for their money.

"It's only two years after the fact. No one should get their shorts tied in a knot," says Terry Barnich, president of New Paradigm Resources Group Inc., a Chicago consulting firm. It takes time for regulatory barriers to fall, for capital investment to be made and for infrastructure to be built.

Competition now focuses on the business market in large urban areas such as New York, Chicago, Atlanta and San Francisco. New York alone has 11 local phone companies, according to The Strategis Group Inc., a Washington-based research and consulting firm.

With few exceptions, residential customers and those in small cities and rural areas have no choice of local carrier. New rivals cite two reasons: It's harder to wire homes that are spread out than densely built office buildings, and households don't generate the payoff that business customers do.

"I would not have expected residential competition to be big at this point," says Daniel Ernst, an analyst at The Strategis Group. Noticeable competition in residential is four to five years off, he says.

Yet all signs point to a healthy local telecommunications market. The number of access lines and revenues are expected to grow, fed by rising demand for Internet access, residential second lines, wireless phones and high-bandwidth data services (Table 1).

And as the market grows, market shares will change, analysts say. Incumbent local exchange carriers' lock on local markets will inevitably shrink, albeit slowly at first. In 2000, incumbent LECs will control 88.9% of the local exchange market; interexchange carriers, 7.5%; and CLECs, 3.6%, predicts The Yankee Group, a Boston consulting firm (Figure 1).

While incumbents will remain dominant, their growth will slow. Incumbent LEC revenues are expected to grow just 2% between 1996 and 2000, compared with an astounding 367% for CLECs, according to estimates from The Strategis Group and Decision Resources Inc., Boston (Table 2).

Something for everyone Today's local phone competition is characterized by a smorgasbord of entry strategies, business plans and technologies. Who will succeed remains to be seen.

"It's not like any strategy is bad. They're all working," says Royce J. Holland, chairman and CEO of Allegiance Telecom Inc., a year-old CLEC in Dallas.

For every nugget of conventional wisdom, there's an exception that seems to work:

* Resale of incumbent LEC services isn't considered a viable long-term strategy, but Chicago-based USN Communications Inc. uses only that method to sell bundled local, long-distance, Internet and other services to small and medium-sized business in five states. The secret is being first to market with volume discounts.

* CLECs generally favor business customers, but RCN Corp., Princeton, N.J., focuses squarely on 9 million homes along the Boston-Washington corridor. As of Dec. 31, the carrier had nearly 268,000 phone, cable, video and Internet connections in New York, Boston, Washington and Pennsylvania's Lehigh Valley region.

* Cable companies aren't interested in local telephony because they can't afford to upgrade their systems. But Cablevision Systems Corp.'s Lightpath subsidiary sells packaged services to nearly 900 businesses and an undisclosed number of its 3.5 million cable customers in the New York area.

Even the definition of CLEC is starting to blur as the industry consolidates through mergers and acquisitions, as start-ups and joint ventures arise and as carriers add services in the new chase for local service dollars. Most are still classified by their original line of business.

The oldest CLECs, which originated as competitive access providers, have a head start because they've built private-line networks for a decade or more and have a solid base of business customers for long-distance access and high-speed data services. Pioneers such as Teleport Communications Group (which is being bought by AT&T) and WorldCom Inc. are literally building on their successes by laying more fiber and installing digital switches to add dial tone to their service mix.

A slew of second generation CLECs, begun in the past five years or so-especially in the two years since the telecom act passed-also has emerged. Companies such as Allegiance, Nextlink Communications Inc. and WinStar Communications Inc. have proved adept at raising money on Wall Street to finance network deployment market by market. Most target small and medium-sized businesses in large cities.

The big IXCs-AT&T, MCI and Sprint-were once expected to be local service powerhouses, but legal and regulatory barriers have forced them to retrench and rethink their entry strategies.

"We're as disappointed as any," says Ray Allieri, senior vice president of local services at MCI, which has spent nearly $2 billion building local networks in 31 cities. The near-term solution: a $37 billion megamerger with WorldCom that will propel it into 100 markets across the United States.

"The combined company can expand further and faster into local service areas now dominated by [incumbent LECs] than either company could on a stand-alone basis," states an MCI shareholder report.

The new MCI WorldCom projects it will save $1.2 billion by 2002 on local market expansion through lower administrative costs, reduced network spending and more efficient capital investment.

The company will continue to build new local networks, although it hasn't yet decided how much to invest in which cities over what period of time, Allieri says. "There's only so much you can afford to invest at a time." The ultimate goal is to sell local service to MCI's 20 million long-distance customers.

Rounding out the CLEC array are cable TV companies, ISPs and the Bell companies themselves-each of which has its own approach. So far, these industries' local service efforts are too small to have much influence.

About 80 incumbent LECs are also certified as CLECs, according to the USTA. For example, Ameritech is beta testing a local and long-distance package in St. Louis and Cape Girardeau, Mo.-adjacent to its five-state Midwestern territory-and plans a product launch by July. Another RHC, SBC Communications, sells service in its home state of Texas but in GTE's region.

Although several major cable companies, including Cox Cable Communications and Jones Intercable, sell local phone service, in total they serve fewer than 10,000 customers nationwide, according to a Yankee Group report.

The trouble with resale As important as who's entering local markets is how they do it. The telecom act lays out three basic entry strategies: reselling incumbents' services at discounts off retail prices set by state regulators, leasing unbundled network elements such as local loops, and building one's own network facilities.

Most executives and analysts say the facilities-based approach is the way to go.

"When it's all said and done, that will impact the market," says Ernst of The Strategis Group. A carrier that controls its own networks can bypass the incumbent LECs, avoid access charges and earn higher profits.

If it were only that easy.

"Building a network is much more complicated" than the other options because it involves years-long, capital-intensive investment, says Steven G. Chrust, vice chairman of WinStar, a New York-based CLEC that plans to have its fixed wireless system in 30 cities by the end of the year.

Negotiating rights of way and building leases is another necessity. For that reason, many CLECs initially resell services as they build out. This strategy provides revenues that partially offset the millions of dollars spent on infrastructure. "It's a time-to-market issue," says David C. Ruberg, chairman, president and CEO of Intermedia Communications Inc., a Tampa-based CLEC that sells data and voice services in 10 Southeastern cities. It resells one-third of its 81,349 lines, he says.

Still, "resale doesn't represent competition by any stretch of the imagination," says MCI's Allieri. The incumbent, through state regulators, sets the rates. Services can't be enhanced. "The competitor using [total services resale] ends up, in effect, acting as a sales agent for the [incumbent's] network," according to a report by The Yankee Group.

Then there's the bottom line. The margins don't exist after factoring in marketing and other overhead costs, says New Paradigm's Barnich. The gross margin for pure resale is about 15%, vs. 50% to 60% for a leased local loop combined with one's own facilities and compared with 70% to 80% for strictly one's own facilities, CLEC executives say.

No wonder AT&T Chairman and CEO C. Michael Armstrong calls resale a "fool's errand." AT&T, MCI and Sprint stopped actively selling local service via resale last year because they couldn't make money on it. AT&T says it's losing an average of $3 a month on each customer, which, at 300,000 residential customers in six states, works out to a stunning $10.8 million a year.

AT&T will continue to serve its resale customers while it investigates other options, a spokesman says. The company hopes to close the $11.3 billion stock purchase of Teleport this fall, giving it instant access to businesses in 66 markets. In Chicago, the IXC expects to complete a fiber optic network by the end of April and will run a customer test of a fixed wireless system later this year.

Resale could remain popular among a few niche players, says the TRA's Trotman. "Once the markets are truly open, and CLECs have networks in place, that will drive discounts higher and make resale more attractive," he says.

Unbundled elements also have their problems, mainly legal ones. This platform lets new rivals lease the facilities they need from incumbents-at cost plus a reasonable profit. In theory, it provides flexibility from market to market, allows add-on products and services and yields a higher profit than total resale. Many CLECs are installing their own switches while leasing transport capacity to reach customers.

But practically speaking, "unbundled resale is stopped in its tracks," says analyst Scott Cleland of Legg Mason Precursor Group, Washington. The 8th Circuit Court of Appeals in October ruled that incumbent LECs don't have to reassemble unbundled elements; they can leave that work for their competitors. To many CLECs, this legal "remedy" makes the unbundled elements approach costly and unworkable.

Ultimately, it's a power issue, Trotman says: "The [Bell companies] don't want to start leasing out their networks. Then they start losing control."

To be fair, the RHCs have followed the law. The Bell companies and GTE have sold more than 140,000 loops and more than 480,000 interconnection trunks, according to the USTA. But so far, their lawyers are mightier than their rivals.

What's for sale Beyond where and how to sell is what to sell. Bundling-mixing and matching various voice and data services-works well, but no one package is right for every customer, executives say.

"The whole market doesn't want bundled services. The whole market doesn't want a la carte services," says WinStar's Chrust. "Different companies will succeed using those strategies in different ways."

"Being able to bundle local and long-distance today is a very significant advantage," he adds.

Here, the CLECs have the upper hand because no RHC has been approved to sell long-distance in its territory. But that's just a matter of time.

Generally speaking, households and small businesses want an all-in-one package, although some observers say the sticker shock of a large monthly bill could scare off some. Large businesses-the top 20%, says Ernst-are more likely to have the in-house expertise to shop around for the best deal on each component of their telecom service.

What services do customers want? According to a Strategis Group survey, 67% want two or three services bundled, with the most popular combinations consisting of local and long-distance phone plus cable. However, 47% of businesses, presumably smaller ones, wanted five or six services from one vendor. Possible add-ons include Internet access, paging and cellular service. The pitch: The more you buy, the more you save.

Both incumbent and competitive LECs have started or bought their way into expanded service offerings. More than 400 local telcos also sell cable, 200 sell long-distance (as resellers) and 250 are in the Internet business, according to the USTA. ISPs are being bought up like crazy. Recent deals include Intermedia Communications' purchase of Digex Inc., and RCN's purchase of UltraNet Communications Inc. and Erol's Internet Inc.

Obstacles remain Despite the activity, obstacles remain to making local competition a true, widespread reality. Spurring residential choice is one of federal regulators' top priorities this year.

Getting there won't be easy. Both technical and legal barriers must be overcome, experts say.

On the technical side, the biggest obstacle is the operations support system (OSS). "The CLECs still have some work to do themselves," says Allegiance Telecom's Holland.

The RHCs and GTE have spent more than $4 billion to set up complex new systems that process about 8000 competitive orders daily, according to the USTA. For example, U S West has invested $400 million in network interfaces, hardware and software and has committed 600 staff members to work with new rivals.

But CLECs still complain of errors, delays, manual processing and other problems that prevent them from offering service parity with the incumbents.

"It's getting better. It's still got a long way to go," Holland says. Getting there, through consistent performance standards and other measures, is important because the service must be seamless and transparent to the end user before true competition can occur.

Even if the OSS worked perfectly, it still takes time for new rivals to get up and running in each market. "It takes nine months to install a switch," says Chrust. "You've got to get through the physical buildout. You've got to get through the testing."

On the legal side, a series of court rulings have thrown uncertainty into the marketplace. The question of who has authority over interconnection pricing-state or federal regulators-is to be argued before the U.S. Supreme Court this fall.

The constitutionality of the telecom act's requirements for RHCs to enter the long-distance market is also up in the air. Its resolution, or lack thereof, could determine how quickly the Bell companies open their local markets.

On top of those major lawsuits are numerous lesser disputes over number portability, dialing parity and interconnection agreements. It's all part of the messy process of deregulation. The result is a damper on some competitors' decisions and investments.

The near-term future of local phone competition is determined by one indisputable fact: He who controls the wires to homes and offices wins. For the time being, that's the province of the incumbents.

"In the next couple of years, things will not change very much," says Dwight Davies, director of business development for Deloitte & Touche's telecom practice. "Changes in market share will take longer than most people expect."

In the long run, most experts predict continued consolidation and restructuring that will result in at least four "megaplayers"-large carriers that sell local and other services throughout the United States and abroad. Companies such as AT&T, WorldCom, GTE and some of the RHCs could fall in this camp.

A second tier of regional players will operate in certain parts of the country. Below them, hundreds of small players that specialize in particular services will find their niche. Ideally, each RHC territory will have four or five competitors.

"There's going to have to be massive consolidation because in the end, this is a scale business," says Cleland of Legg Mason Precursor Group. Long-distance carriers and GTE will buy CLECs and ISPs to broaden their local service offerings, he says. And the Bell companies may buy out-of-region Independent telcos, much as Texas-based SBC Communications recently bought Southern New England Telecommunications in Connecticut.

As proud as they are of their independence, CLECs won't shy from the right offer, executives say. "It's going to be an eat-or-be-eaten environment. This is business, not religion. If someone writes a big enough check, we'll say, 'Thank you,'" says Holland.

He ought to know. He used to be president of MFS Communications Co., one of the original CLECs. The company was sold to WorldCom for $13 billion in 1996.