Mice among the elephants: Small carriers roar into niche markets, challenging traditional beliefs

A new group of small competitors is emerging in the telco industry, and they are waging just as fierce a battle as their megacarrier, megamerged brethren. They are mice among elephants, and the elephants are getting nervous.

The giant telcos have started acquiring the start-ups, apparently to assimilate their innovative strategies and restore the cozy concentration of the past. The mergers and acquisitions of the last year-SBC Communications' acquisitions of Pacific Bell and Southern New England Telecommunications, WorldCom's acquisitions of MCI and Brooks Fiber Properties, and Teleport's acquisition of ACC Long Distance and subsequent acquisition by AT&T-have created the illusion of a rapid re-consolidation of the industry.

Obscured by this wave of mergers, however, is a significant, opposite trend. The telecom industry is growing more fragmented, and new entrants are changing the rules of the game.

Few segments of telecom are immune to attacks from new competitors. Traditional beliefs about the value of integration and economies of scale are being challenged. Separate businesses are emerging in physical network operations, service creation and retail distribution (Figure 1). And in each of these areas, it is small, tightly focused competitors-rather than the familiar large ones-that generally are gaining ground.

The monoline competitor New competitors are employing a broad array of strategies, attacking different layers in the value chain, different customer segments and different geographies. But the most successful share an important characteristic: they do one thing well.

Many monoline competitors are challenging incumbent network operators by building their own network facilities.

In the local loop, Teleport has built a successful business by providing private, high-capacity connections to business customers in urban areas. McLeod and Brooks Fiber Properties are building local exchange facilities in secondary and rural markets. Meanwhile, RCN sells access facilities to real estate developers and property managers for high-rise buildings (Table 1).

In the long-haul business, Qwest and Williams are building efficient, low-cost long-distance backbone capacity to sell to other carriers. By focusing on network operations-and avoiding the high costs of retail customer acquisition and customer service-they have created business models that are expected to generate some of the lowest unit costs in the industry.

Monoline long-distance marketing strategies also are emerging. Excel Communications has focused on achieving the lowest cost in customer acquisition, a critical element of the value chain. Excel sells largely through a word-of-mouth, commissioned sales force. Tel-Save Holdings, another long-distance reseller, is building a different model. To minimize its selling costs, it aligns itself with affinity partners such as America Online.

Other resellers have targeted highly specific customer segments, tailoring their business models to serve one segment efficiently. ACC has focused on colleges and universities and on selective markets overseas. U.S. Long Distance has targeted pay phones and the hospitality industry. And numerous competitors are creating prepaid calling cards, which are convenient for travelers and people with relatives outside the U.S.

Specialized competitors have even appeared among Internet service providers. Brigadoon.com, initially a small, regional ISP, now sells its services nationally to schools and non-profit groups.

Twilight of the integrated telco? Cracks are beginning to show in the integrated business model. AT&T, not long ago considered the premier branded telecommunications competitor, has been losing market share at an accelerating rate. What is surprising to many, however, is that neither MCI nor Sprint is picking up that share. They, too, are beginning to struggle. Instead, it is the resellers that have gained ground in long-distance; they now hold more than 15% of the market (Figure 2).

By some estimates, more than 1000 long-distance resellers operate in the U.S. The competitors benefit from a thriving wholesale market for long-distance transport. They can deliver large blocks of traffic to facilities-based network operators.

Stiff competition exists for this traffic between Sprint, WorldCom and emerging carriers' carrier networks such as Qwest and IXC. Consequently, resellers are able to buy from these carriers at wholesale rates that increasingly reflect the marginal cost of incremental capacity. Often, the rates are well below the average full cost of a major carrier's network.

The availability of this low-cost wholesale capacity lets resellers offer retail prices that are 3 cents to 4 cents per minute below those of the integrated carriers. And yet by minimizing their capital investment, the small players are able to maintain attractive returns and raise ample capital to sustain growth.

The inversion of scale The emergence of monoline competitors has been fed by a dramatic shift in traditional notions about scale. All along the value chain, new technologies and simple organizational models have helped small competitors achieve unit costs as low as or lower than those of much larger incumbents.

The cost of telecommunications transmission capacity, for example, has fallen rapidly. New backbone transport technologies can handle four times as much traffic as systems deployed just two years ago, at roughly the same cost.

New technologies for carrying voice via data networks promise to reduce costs even more. The latest network technologies also operate more efficiently and require less labor to provision and maintain. The result is lower unit costs for new entrants despite the incumbents' huge scale advantage.

Traditional scale advantages also are being undermined in the retail part of the value chain. Billing and customer service systems historically have been among the costliest elements of the telecommunications business. Today, however, it is often cheaper on a per customer basis for a small player to build and maintain a modern system than for a large incumbent to upgrade its legacy systems.

The implications of these shifts in scale economics are critical. While the vertically integrated incumbents merge both domestically and globally to add to their scale, their most successful competitors are small and agile. Some of these focused competitors are now being assembled into broader line companies by acquisition, as WorldCom is doing.

Although these new entities promise to combine efficient infrastructure with scale and scope, they risk acquiring the complexity and costs that weigh down the large incumbents. Notwithstanding the urge to merge, the future telecommunications landscape is likely to be far more fragmented than today.

Transforming the enterprise Competing in this environment presents new and unexpected challenges for incumbent telcos. Most established carriers have girded themselves for a full frontal assault from other vertically integrated competitors. In addition, they must now prepare for clashes with smaller competitors on dozens of fronts.

The future will put a premium on flexibility, resourcefulness and focus. Incumbent carriers will need to think big regarding some aspects of their business-for example, creating efficient network platforms to support many products and customers-and small in others-for example, responding to more narrowly defined customer segments and investing in focused platforms for billing and customer service.

Information systems must enable telco managers to monitor competitive developments at an increasingly detailed level. Management must align organizational incentives around competition at this new micro level.

Incumbents can take the first steps by asking critical questions:

* Where are the new competitors drawing competitive boundaries?

* Which segments, geographies and network elements do we need to consider as battlefronts?

* Which of the new competitive boundaries should we choose to defend, and from which should we plan a strategic retreat?

* How can we best align our distribution channels and service offerings with the new competitive boundaries?

* What platforms will best support the newly defined segments?

* Will new, smaller, lower-cost information systems serve these smaller customer groups better?

Established telcos cannot take solace from the fact that the other large carriers are proving less aggressive than previously thought. The battle has begun, and the new competitors are focused, aggressive, nimble and little understood. For the large telcos, the telecom wars ahead may prove to be even more challenging than the initial scenarios suggested.