Enemy mine: The data CLEC investment paradox

In today's high-stakes local access market, carriers have been eager to make friends in the most unlikely places. The most recent strategies of established interexchange carriers and fiber network operators have been to buy services from or invest in broadband access start-ups. But in the rush to partner with anybody and everybody, carriers sometimes forge relationships with players that could very likely be their fiercest competitors.

And a carrier cannot be too careful in the choice of its enemies. Because business models are in flux and players are uncertain of how to best position themselves to offer local services, today's strategic broadband alliances are inherently fragile. Post deregulation, the categorical roles of service providers are becoming less meaningful. How do you really define an IXC that rents fiber networks, offers outsourcing and long-distance services, owns ISPs and competitive local exchange carriers (CLECs) and has stakes in a number of broadband service providers? And because no one really knows how these players ultimately will mark their territories, all service providers - eager to steal business from incumbent LECs (ILECs) - cannot entirely trust their strategic partners.

All this corporate bed-hopping makes it difficult for broadband service providers and established carriers to scrutinize each other's real agendas and loyalties, and nowhere is this state of affairs more evident than in the emerging market for DSL services.

It is widely understood that carriers have a sense of urgency about national DSL deployment. In the absence of extensive availability of other last-mile solutions, such as fixed wireless, satellite, fiber to the building and cable modem service, they are funding data CLECs partly to ensure that they will have service to resell (see sidebar on page 28).

Carriers have accelerated DSL service deployment by taking modest stakes in data CLECs that wholesale DSL in key metropolitan areas of the U.S. To ensure that national DSL networks are rapidly built, IXCs and fiber network operators such as AT&T, Global Crossing, Qwest Communications and MCI WorldCom/Sprint have each invested in one or more of the three leading data CLECs: Covad Communications, NorthPoint Communications and Rhythms NetConnections (Table 1).

But they are not alone in forging such partnerships. The RBOCs also are getting into DSL through investments and partnerships. SBC Communications, for example, has a stake in Network Access Solutions, a "super regional" DSL provider that serves New England and the mid-Atlantic states. Even major software and equipment developers such as Microsoft and Intel have been throwing money at data CLECs (see sidebars on pages 34 and 36).

Many of these investments were made by carriers' venture capital groups before the CLECs went public. For example, AT&T's California-based venture capital fund bought a stake in Covad. Both the fund and the company's broadband services groups can benefit from a strategic relationship. But "investments that [AT&T] Ventures makes are not necessarily tied to [AT&T] operations. Ventures has its own agenda," says Manish Malhatra, AT&T's director of broadband Internet services (Table 2). AT&T uses Covad and Rhythms as DSL suppliers and plans to resell DSL from the ILECs in the future.

By investing in and buying DSL from data CLECs, carriers also have contributed significantly to the successful IPOs and current high valuations of national players such as Rhythms, Covad and NorthPoint.

"Carriers' stakes in data CLECs have netted them returns via their successful IPOs," says Stuart Conrad, a telecommunications analyst with Deutsche Bank Alex Brown, New York. "Investors like to see scenarios where start-ups have financial investments from significant players."

But is that all both sides get? Not by a long shot. Many start-ups aspire to survive on their own and become integrated communications providers, which spells trouble for those that have forged complex relationships with their investors and partners. And certainly, established carriers are looking to buy the best of the breed, which is exactly what some data CLECs are hoping for.

Why build when you can buy?

On many levels, carrier investments in data CLECs are mutually beneficial. With the support of established carriers, data CLECs can finance and more rapidly build out their DSL networks and afford the legal expertise required to negotiate and fight for co-location agreements with ILECs. Many established service providers, despite their own ready access to capital and ability to obtain or leverage existing CLEC status, would prefer to fund data CLECs instead of building out their own networks.

Companies such as ICG Communications that had originally planned to offer facilities-based DSL on their own have switched to a buying strategy. ICG already had invested in DSL equipment and was beginning the process of establishing co-location agreements with ILECs when the company discovered how challenging DSL deployment can get. Instead, ICG decided to take a stake in NorthPoint and sell its DSL equipment to the data CLEC.

"Being [a network service provider] to ISPs and DSL all at once was too much to take on," says Shelby Bryan, president and CEO of ICG. "We felt [that] on a pure financial basis, it was good to make an investment in NorthPoint pre-IPO. With the equity investment, we also have a close relationship and a contract [for DSL] with very attractive terms."

Some carriers are establishing significant strategic alliances with data CLECs without taking financial stakes. For example, the UUNet division of MCI WorldCom is one of Covad's largest customers this quarter, says Brent Bracelin, an analyst with Pacific Crest. However, instead of owning a stake in Covad, MCI WorldCom has one in Rhythms. UUNet buys more lines from Covad than it does from Rhythms, Bracelin says. Neither Covad nor UUNet would comment on specific line sales.

Furthermore, carrier investment does not guarantee data CLECs high volumes of DSL sales. Nominal promises of carrier line buys are not binding, says Michael Renegar, a data CLEC analyst with Banc of America Securities. More important, companies such as AT&T and MCI WorldCom have specific criteria for choosing their DSL providers. AT&T uses both Rhythms and Covad as suppliers. The UUNet division of MCI WorldCom uses Rhythms and Covad and is in talks with ILECs. If the data CLECs in which the carriers have invested do not meet their criteria, AT&T and UUNet will not use the suppliers in key markets.

"We have [direct measures of quality] and metrics with which we evaluate data CLECs," AT&T's Malhatra says. These include network performance such as packet loss, latency, response times and installation experience from the customer point of view. Malhatra is quick to point out that, "we have no preferred supplier relationships. We do not have a preferred relationship with Covad. Our job is to meet customer needs."

Carriers will shop for the best suppliers in each metro area where they plan to offer DSL. Most commonly, a carrier selects at least two data CLECs from which to buy its lines. "No one company provides a complete DSL map," says ICG's Byran.

For example, as ILECs become more aggressive DSL wholesalers, data CLECs will compete with each other and directly with ILECs for carriers' business. "We're buying DSL from ILECs; we're talking to all the ILECs in addition to our data CLEC suppliers," says Ralph Monfront, UUNet's director of product marketing services.

In spite of these freewheeling market dynamics, it is in the best interest of traditional carriers to ensure that data CLECs thrive and establish significant national footprints. The alternative would be for carriers to invest in their own DSL network buildouts. Despite the fact that MCI WorldCom and AT&T already are co-located in several central offices (COs) via their CLEC subsidiaries, there is little indication that these carriers will become facilities-based DSL providers on a wide scale.

The tables are turned

At this stage of the DSL market's evolution, data CLECs and their carrier partners and investors enjoy mutually beneficial relationships and serve differentiated and disaggregated roles (Table 3). Data CLECs provide the fat-pipe, last-mile services while carriers provide the higher-margin IP services as part of wireless, long-distance and local broadband communications bundles.

However, the terms and conditions of relationships among data CLECs and their investment partners and strategic partners are tenuous at best. Longer term, even data CLECs with wholesale business models and their strategic investment partners may find themselves at odds over who will build and brand value-added IP services.

Naturally, data CLECs describe their strategic alliances with key customers as strong and without conflicts. However, there is some debate about whether DSL wholesalers will need to compete directly with their customers to avoid the risk of commoditization.

"NorthPoint is strictly a wholesale provider of high-speed access services," says Whitey Bluestein, chief development officer for NorthPoint. "There is no channel conflict. By being flexible, we are not competing with our wholesale customers."

But not everyone agrees. "Inevitably, there will be increasing conflicts between data CLECs and their service provider customers," says Ken Hoexter, telecommunications analyst with Goldman Sachs. "Today, data CLECs can be winners as wholesalers and by building out their national networks. But longer term, data CLECs need to broaden their product offers as their margins shrink."

Each of the three leading data CLECs are expanding their offerings to increase margins with value-added IP services such as virtual private networks, telecommuting and corporate portals. As a result, while established carriers have financial stakes in and are significant customers of data CLECs, these relationships soon could become competitive.

Although data CLECs want to create new value for themselves and their shareholders, they may, in the process, undermine their relationships with their core wholesale customers. "Suppliers can always be your competitors," says UUNet's Monfront, who adds that he will continue to buy DSL from data CLECs and ILECs.

Confusion's the rule

Two important unresolved issues help explain why relationships among service provider partners are so confusing to track. These can be loosely classified as "where are the margins?" and "who owns the customer?"

As service providers expand their offerings and choose to partner and compete, players' roles are becoming increasingly fluid and hard to pin down. In such a volatile and dynamic market, service providers experiment with various approaches to broadband service provisioning and continually change common roles and definitions used today. Service providers are rooting around for business models that will stick and for ways of attracting and retaining valued customers.

While Rhythms continues to layer new services onto its DSL infrastructure, one of its customers and carrier investors claims that a data CLEC's sole role is to provide its carrier customers last-mile access to customers. "Qwest depends on data CLECs for fat-pipe services only," says Brian Wilcov, senior product manager for IP services at Qwest. Rhythms has been offering its own DSL and IP services bundles for its telecommuting program directly to end-user customers such as Cisco Systems. With limited success, it also has been trying to work with its carrier partners to offer the telecommuting component of carriers' larger enterpriseservice bundles.

MCI WorldCom and Qwest already are developing their own branded value-added services menus that include telecommuting and frame relay over DSL. Will IXCs and fiber carriers wholesale IP services from data CLECs? Or with their own very large teams of IP experts on staff, will these players continue to build their own branded value-added services? It is unlikely that a large service provider will share higher-margin value-added service revenues with DSL providers.

One of the most confusing areas is also the most hyped: voice over DSL. Because the technology still is being tested, it remains to be seen if such services will be able to scale. But just who will build, brand and deliver this new service is unclear. Today, voice CLECs and data CLECs are partnering on service trials, but the specific role each carrier will play in distributing and bundling such services is the subject of great debate. Of course, each would like to enjoy higher margins, and an alternative to traditional circuit-switched voice presents a very lucrative opportunity. But because of the high stakes, conflicts among service providers' roles in the delivery of voice over DSL are expected to be fierce.

At the same time, established fiber network operators and long-distance carriers also are expanding their business models. In fact, data CLECs consider their carrier partners strategic partners and competitors. Recent public offering statements (called S-1s) of Covad and Rhythms both cite carriers as competitors.

"These carriers have a large number of existing business and residential customers and enjoy strong brand recognition and as a result represent significant competition...and have secure co-location space from which they could begin to offer competitive DSL service," states Rhythms' S-1 from Aug. 11. In another example, Global Crossing is testing facilities-based DSL in areas where it has CLEC status. At the same time, MCI WorldCom plans to offer facilities-based DSL from at least 150 COs by the end of the year.

"This is the nature of data and telecom services markets today," says Roberta Myers, director of product marketing at MCI WorldCom. In the course of expanding their strategies, many carriers end up competing with their partners, which creates a complex set of strategic challenges, she says.

Death by acquisition

Led by data CLECs, the DSL market is expected to progress through several stages. First is today's aggressive DSL network buildouts funded by carriers, venture capitalists, vendors and IPOs and further fueled by large line purchases. The industry already has seen evidence of the second stage, which is differentiation among data CLECs, such as Covad's ingredient branding strategy and Rhythms' retail strategy. The third stage will see data CLECs experimenting with expanding their service provider roles. The fourth and most ominous stage - and one still hotly debated - is market consolidation.

Many analysts believe it is too soon to talk about market consolidation. "The nature of the strategic relationships [between data CLECs and their service provider customers] will have to change over time, but we are still in the buildout stage," says Goldman Sachs' Hoexter.

But via their financial stakes in data CLECs, carriers already have bought access to these players and, in some cases, seats on their boards of directors. An all-out acquisition would seem the next logical step. "For carriers, their stakes in data CLECs give them a front row seat that allows them to evaluate these companies," says Conrad of Deutsche Bank Alex Brown.

Echoing the thoughts of many carriers, Global Crossing will consider acquiring a national data CLEC, says Jon Russo, broadband services director of Global Crossing. "NorthPoint has been a great partner, and we sit on their advisory board and we would consider buying out the remaining portion of the equity."

That's fine if you want to be acquired, but plenty of CLECs want to go it alone. The challenge for these players is to evolve from being fat-pipe providers into wholesalers and, in some cases, retailers of integrated services. If data CLECs continue to sell broadband access services to the near exclusion of other data solutions, they run the risk of being trapped in the same low-margin commodity markets that fiber network operators are trying to escape today. The next step for data CLECs is to add value to their core offerings incrementally while negotiating strategic customer relationships with established carriers that also are eager to differentiate themselves by offering their own high-margin, value-added services.

In some ways, the best outcome for data CLECs - and the most practical resolution to the emerging conflicts between data CLECs and their carrier investors - might well be death by acquisition.

It's no secret that established long-distance carriers and fiber network operators are eager to enter local markets with communications bundles for consumers and businesses. Local phone service revenues for U.S. small businesses are estimated at $35 billion by IDC, so it's easy to see why local markets are a key carrier target. Increasingly, the ticket to local market entry is DSL.

"Carriers are using data [competitive local exchange carriers' DSL service] as a Trojan horse into local markets for both consumers and businesses," says Brent Bracelin, an analyst with Pacific Crest. By reselling data CLECs' DSL services, many long-distance providers and fiber operators are making their first steps into local consumer and small business markets once owned solely by incumbent LECs.

DSL is a way into small and medium-sized enterprises "with telecom [and data] budgets of $6000 to $50,000 per month," says Jon Russo, broadband services director of Global Crossing. "DSL in and of itself is not a compelling offer. It's part of communications bundles."

Established carriers such as Global Crossing are building communications bundles that include services such as frame relay over DSL. Analysts forecast that DSL subscriber growth will grow aggressively starting next year (see figure).

Software companies' relationships with data competitive local exchange carriers are considerably more straightforward and less mysterious than those of the established carriers. After all, neither Microsoft nor Intel will be offering facilities-based DSL services anytime soon.

Their investments in data CLECs - such as Covad Communications in the case of Intel and NorthPoint Communications, Rhythms NetConnections and DSL.net in the case of Microsoft - are designed to accelerate DSL service deployment. The accompanying table highlights Microsoft's major investments in data CLECs and other telecom carriers.

The hope is that the proliferation of broadband services will drive the sales of their existing products such as customer premises equipment and hardware and software that supports multimedia content delivery. While Intel is eager to drive sales of higher-end chips and broadband access peripherals via its data CLEC investments, Microsoft has methodically built relationships with developers of software that support a broadband infrastructure.

At Microsoft's Partner Solutions Center, third-party developers and service providers test back office and network infrastructure tools that support end-to-end broadband solutions, says Jonathan Usher, marketing director of telecommunications solutions for Microsoft.

The idea is for third party developers to use Microsoft servers and development toolkits to build broadband solutions such as subscription management and operations support systems. At the Partner Solutions Center, service providers - particularly those with which Microsoft has strategic alliances - are encouraged to adopt and resell Microsoft-based solutions. For example, as Rhythms and other data CLECs start to offer virtual private networks and other IP services, Microsoft hopes that they will resell solutions supported by its IP platforms.

The company has established co-branded MSN portals with its data CLEC partners, Usher adds. "Rhythms offers a co-branded portal to its end-user customers; there is no conflict over customer ownership," Usher says. "We brand the portal and our other MSN services such as Hotmail, and Rhythms brands its DSL service on the portal."

Tandy and Microsoft - both of which have stakes in NorthPoint - also announced earlier this month that Microsoft will sell broadband services via Tandy's Radio Shack chain. As part of the deal, Microsoft plans to resell a number of services, including NorthPoint's DSL service to its MSN customers.

Odd as it might seem, Bell Atlantic has decided to strike bargains with "super regional" data competitive local exchange carriers offering DSL in its territory - without wrangling over regulatory issues before state public utility commissions. Given the contentious nature of incumbent LECs and CLECs, such relatively civilized behavior begs the question, will ILECs such as Bell Atlantic acquire regional DSL providers to accelerate their own buildouts?

Although Bell Atlantic has had many legal run-ins with national data CLECs (such as with Covad Communications over patent infringement), the RBOC has worked somewhat amicably with Network Access Solutions and Vitts Networks to establish unbundled network elements (UNE) and co-location agreements. Both NAS - the super regional data CLEC that offers service in New England and the mid-Atlantic states - and Vitts - located in New Hampshire and other parts of New England - are in the process of building out DSL networks in markets within Bell Atlantic's territory.

When it was starting its DSL buildout, Vitts initially had difficulty establishing UNE and co-location agreements with Bell Atlantic's wholesale group, Telecommunications Industry Solutions, says Alan Court, regulatory director in New Hampshire for Bell Atlantic.

"[Bell Atlantic's regional group] facilitated the relationship between TIS and Vitts," Court says. But why would a regional arm of an ILEC help a local CLEC? Vitts' success is in Bell Atlantic's best interests for a few reasons, one of them being that "we have to demonstrate that our network is open in order to offer long-distance," Court says. Furthermore, with the growing intensity of dial-up Internet usage in New Hampshire, "Vitts, [by offering DSL service], is helping Bell Atlantic by moving traffic off the circuit-switched network," Court says.

SBC Communications also has crossed borders into markets outside its territory by investing a small $6 million stake in NAS. Via their strategic relationship, "SBC can leverage NAS to move into its territory to offer services to our customers and NAS can offer services in SBC territory," says Jon Aust, president and CEO of NAS. "Where the investment evolves will take care of itself."

As they attempt to deepen customer relationships within their regions and as they build out beyond their prescribed territories, it is likely that ILECs will invest in and perhaps acquire aggressive super regional data CLECs that will help them more rapidly cross borders.