The great divide: Experiences in other deregulated industries illustrate the kind of changes telcos can expect

The telecommunications industry around the world is bracing for a structural change more profound than any it has seen before. For most of this century, telcos have thrived in a regulated, integrated value delivery chain. Now, regulatory changes, new technologies and a host of new competitors are separating the network from the customer-oriented parts of the business.

Many industry observers see the value chain breaking into two competitive arenas-a network business and a retail distribution business. But experience from other industries suggests a more complex outcome. At least three distinct businesses will emerge, with a new wholesale services business developing in the space between the network and retail distribution.

These businesses will have profoundly different strategies and investment priorities, and each will require distinct and often new management styles, skills and organizational structures.

The value chain Other industries affected by deregulation and technology changes-from financial services to airlines-illustrate the kinds of changes telcos can expect (Figure 1).

Initially, new competitors with lower costs enter the market by attacking the high-return segments of the business. Those segments may be based on products, geography or customer behavior.

These new entrants force incumbents to offer comparable unbundled products at competitive prices. Incumbents lose their profit sanctuaries and must make each segment competitive and profitable, obtain explicit social subsidies or exit.

New intermediaries emerge to stake out positions between suppliers and their customers. In the process, they reduce the products and services offered by the upstream-or network-suppliers to commodities.

These changes fragment the value chain-new layers develop, each supporting specialized competitors. Competing within a layer is often more effective than competing across layers.

Accelerated innovation and price-cutting expand the market substantially. Product cycles shorten, and new innovation-based players appear. Winners will actively embrace new positions rather than defend old ones.

The securities industry provides a good example. Before deregulation, investment advice, trade execution and retail sales functions were offered together in the high-priced retail brokerage service. Deregulation triggered the entry of discounters such as Charles Schwab that unbundled simple trades from high-touch direct sales and investment research, enabling customers to buy from lower-cost specialists only what they needed. This model quickly grew to command 25% of the market, and Schwab has become one of the major financial institutions in the U.S.

In telecommunications, the established prices of services hide the complexities of a profit structure that varies widely across products, geography and customer groups. New competitors will target the most attractive market segments, leaving incumbents with the low-return segments (Figure 2).

New competitors also will target the most attractive layers in the value chain, employing focused strategies that reflect the unique economics of each layer. For example, WorldCom and Sprint are building efficient long-haul telecom networks based on new technologies and selling large blocks of capacity to resellers.

As a result, they can sell long-distance minutes profitably at prices that are roughly half the current retail price. The resellers have developed new marketing models that enable them to retail long-distance services profitably at prices well below those established by the integrated telcos. Because these resellers don't have the huge embedded asset base and fixed costs of traditional carriers, they can earn attractive returns at much lower gross margins.

Established carriers must be prepared to compete with specialists in each important segment of the business. Traditional carriers that continue to operate from the perspective of an integrated value chain will find themselves at a perpetual disadvantage.

A layered approach New entrants will create new market layers. In health care, for example, HMOs have created an entirely new layer in the delivery chain, separating doctors and hospitals from their customers-patients. HMOs deliver lower total prices by using their buying power to reduce prices upstream and by creating managed care products that deliver health care more efficiently.

In the process, companies such as Kaiser Permanente and Columbia Health Care have created powerful brands and customer relationships while reducing the ability of doctors and hospitals to influence patient care choices.

The same tendency to turn the products of upstream players into commodities is visible in banking, where intermediaries such as Intuit's Quicken software are laying claim to customer relationships traditionally held by banks. This trend is further evident in the brokerage business, where Schwab's OneSource now resells mutual funds that previously were sold directly to investors, thus creating a new layer in the value chain.

New middle-layer players are also likely in telecom (Table 1). Regulatory and competitive forces are enabling the formation of a new service layer based heavily on software. Competitors in this layer will perform a true wholesale function, adding value to the underlying network by developing new services, many based on computer telephony technologies. Competitors will sell them through large-scale retail operators-and directly to select customers.

For instance, sophisticated voice-recognition and call-routing software has enabled Wildfire to create a powerful voice mail platform that it sells through telco retailers. The most successful entrants in the new service layer will establish embedded brands, similar to Intel Inside, and thereby claim a generous slice of the total value in the business.

The new service creation layer has important implications for telcos. They will need to identify which technology investments can be differentiated successfully-networking solutions for multisite enterprises, for example-and which are likely to become commodity platforms for value-added resellers. They also will need to find ways to develop products more rapidly in what promises to be a fast-changing entrepreneurial marketplace.

The payoff from all this change will be growth. In virtually every case of deregulation, the resulting innovation and greater value for the customer have spawned rapid market expansion.

In the airline business, lower prices, new service strategies and a burst of new routes led to an annual 25% per year increase in passenger miles flown from 1980 to 1990-although price-cutting caused some competitors to fail along the way.

The power of innovation also can be seen in the Internet's tremendous growth. Innovation will drive dramatic volume growth in the telecom industry as well. Today's integrated telcos have a great deal of work to do before they can find success in the new environment, however.

They must decide where along the value chain they will compete and where they will exit. More important, they must begin to view each layer of the value chain as their competitors will-as a distinct business with unique economics.

This will mean learning to view resellers, interconnectors and repackagers not as rivals but as powerful new sales agents. It will also mean embracing an open network architecture that allows multiple players to invest with confidence in complementary, rather than competing, facilities.

Telecom retail organizations must begin to think in terms of added value vs. added cost, without the network asset allocations of the past. Retailers must find ways to create sustainable differentiation through means such as service levels, cost advantage or retail brand positioning.

Success in the service layer will require still other strategies. Innovation and speed will far outweigh the economies of scale that have driven advantage in the traditional telco business. Telcos and PTTs will need to develop organizational models that foster rapid creation of value-added services.

An unprecedented era of growth and innovation in telecommunications is beginning. New businesses will emerge, and great brands and fortunes will be built. Victory will belong to those who identify the opportunities and look only ahead.