The new guys in town

Companies entering the local telephone service market are a diverse group. In addition to long-distance carriers and cable operators that plan to expand their service scope, dozens of other companies are entering the local arena. Some of these organizations have been offering competitive access services for a decade, while others arrived on the scene only in the last few years as regulators began to open up the local exchange business to competition.

The strategies these competitive local exchange carriers (CLECs) plan to follow are even more diverse. One thing the companies seem to agree on, though, is that true competition will not exist until they are able to build substantial network infrastructure of their own.

"A facilities-based [approach] is the only way to control the economics," says a spokesman for Brooks Fiber Properties, St. Louis. A company reselling the incumbent LEC's services might offer customers a 5% discount on services it buys at a 20% discount, he says. "With a 15% margin before selling expenses, you're not going to make any money and you can't sell on reliability. You're held hostage if you're reselling," he says.

Stephanie Comfort, a telecom industry analyst for Morgan Stanley & Co. Inc., agrees with that resale profit estimate. In contrast, a CLEC with its own network can make a gross margin of 70% or higher, she says, while a strategy based on purchasing unbundled network elements from the LEC would yield a margin of 40% to 60%.

"Long term, facilities-based is the way to go," she says.

Infrastructure choices The infrastructure currently used by incumbent telcos to provide local service was built over many decades. Thousands of central offices, each containing one or more switches, dot the landscape, with each CO typically serving customers within a 18,000-foot radius. Calls from outside the immediate area are routed to a local switch through a tandem switch that serves multiple COs.

New competitors, however, will choose a different architecture - one that takes advantage of more modern technology and is designed to serve a smaller number of customers who may be less geographically scattered. This strategy sometimes depends on purchasing certain network elements from the incumbent LEC - and requires that the new competitor be able to connect to the incumbent somewhere in the network so that calls can pass back and forth between the two networks.

Many competitive carriers have built fiber rings around metropolitan areas. Some of these have existed for a decade or more and initially were built to provide access to long-distance networks for businesses with sufficient long-distance traffic to justify dedicated trunks into their PBX systems.

MFS, which was recently purchased by WorldCom, and Teleport Communications Group, built billion-dollar and multimillion-dollar businesses, respectively, by bypassing LECs and undercutting the prices charged to IXCs to connect calls to and from local customers. Numerous smaller companies, including Intermedia Communications and ICG Communications, also have been operating as competitive access providers.

Virtually all these CAPs are entering the local services market. With fiber already in place, a CAP only has to add switches to its rings and interconnect at some point with the incumbent local carrier to deliver local service. Interconnection often occurs at the tandem switch or at a local CO. Typically, a CLEC uses a single switch to serve an entire metropolitan area.

A CLEC's best prospects for local service are companies in buildings directly connected to its fiber because they can be served most economically. Most CLECs, however, also expect to purchase some unbundled loops from the incumbent provider.

In this scenario, customers not located on the CLEC's fiber ring or one of its tributaries are served through the CO of the incumbent LEC. At the CO, customer lines served by the CLEC are aggregated onto a digital facility that is connected to the CLEC's switch.

"As a CAP, we're able to address a $6 billion market. As a CLEC, we address a $20 billion-plus market," says Rich Gerstemeier, senior vice president of product marketing for ICG. The transition, however, is not as simple as it sounds, he says.

"Previously, we dealt with a few thousand customers. That was all the law allowed us to do. Now we must scale everything we've built in the last three to five years. We were processing five to 10 orders a day. Now it's 100.

ICG currently has thousands of buildings on its network and there are thousands more that are very close, says Gerstemeier. "Where we [have to], we'll look at unbundled loops.

Like many other CAPs, ICG has plans to expand into new markets. While acknowledging that construction will last for years, "ICG is committed to building its own networks," Gerstemeier says. "Having all the underlying facilities enables [us] to control the quality and reliability of service.

ICG has found a creative way to address one of the biggest challenges facing CLECs that are installing fiber: Through partnerships with a number of utility companies, it has obtained valuable rights of way. In some instances, ICG pulls fiber through the local utility company's existing ductwork.

In other cases, it has been able to acquire fiber that the utility already has in place for internal communications. Partnership with a utility company can reduce the time required to enter a market from as much as 18 months to as little as three, says Gerstemeier.

So you want to be a CLEC Newcomers have an even bigger task ahead of them than companies that emerged from the CAP market. Nextlink, for example, was formed in late 1994. Craig McCaw, who built his cellular operation into one of the nation's largest before selling to AT&T a few years ago, is a major shareholder. Although the company, which now offers dial tone in 12 markets, has installed some fiber and switches, it relies heavily on unbundled elements from the incumbents.

"By the end of the year, 60% of our customers will attach via some local element from the phone company," says Nextlink President Jim Voelker. "We hope we'll shift the other way. Once we have some solid business, it will justify the build.

American Communications Services Inc. began operations in 1993 and has built fiber rings in several markets where it already offers transport and data services, and it is beginning to add switches.

"One of our strategies is to build off the infrastructure that we have in place to drive customers to the most cost-effective [solution]," says Jack Reich, ACSI president and chief executive officer. For example, some customers initially might be served via an unbundled loop, then moved onto the ACSI network when a fiber tributary is extended to their building.

"It's most important to acquire customers and build density in the cities we're in and drive our top and bottom line," says Reich.

Several companies are turning to wireless solutions to quickly enter the local exchange business. A number of companies, including WinStar Communications, have 38 GHz licenses that enable them to offer voice and data services to customers over a wireless connection to the local network, eliminating the need to purchase unbundled loops. The service is installed on a building-by-building basis through what a company spokeswoman describes as "a pizza-sized dish" mounted on the roof or side of the building.

"The technology is working," says Comfort of Morgan Stanley. "Most people don't even realize they're on wireless." The drawback to the technology is that it depends on the line of sight from the dish to the network-side transceiver, she says.

AT&T Wireless caused a stir when it announced that it would offer wireless local loop in the personal communication services range of 1.9 GHz (Telephony, March 3, page 6).

McLeodUSA, a Cedar Rapids, Iowa-based CLEC, also holds several PCS licenses in the D/E block - mostly in Iowa and Illinois. To date, the company has not deployed much of its own infrastructure, other than a single switch that operates as a PBX for research and development purposes.

In the short term, the company is reselling Centrex services from the incumbents. In 1999, however, McLeod expects to begin offering local service over its own network. Will wireless local loop be part of those plans? "Wireline and wireless will converge," says Stephen Gray, McLeod's president and chief operating officer. And there will be another facility to the customer besides the one from the incumbent carrier. "That could be a CLEC, a cable company, a utility or a combination of the above. And it could be wireless or wireline.

Other options New Paradigm Resources, a Chicago-based consultancy, estimates that as of 1996, CLECs had installed 47,000 miles of fiber and 139 switches nationwide (Table 1).

One strategy for entering the local service market might be to install only switches and to lease transport facilities from other carriers, according to Craig Clausen, New Paradigm's senior vice president. Features that can be delivered from a switch can generate substantial revenue.

"Fiber is pretty [readily] available now. It's like office space in Chicago. There's an abundance and rates have come way down," he says.

Intermedia Communications might consider a switch-only strategy in certain markets, says Bruce Forsyth, vice president of marketing for voice services. "It would depend on the value we thought the market had, and if we could get a good enough price, there's no need to build our own.

Intermedia originally operated as a CAP, then acquired an IXC and later began to offer local service. The company has made an interesting infrastructure choice that may prove to be an advantage: It uses a single switch to provide both local and long-distance services.

This architecture should make operations more efficient and shouldn't have any major disadvantages, observes Morgan Stanley's Comfort. The reason major IXCs entering the local service market don't adopt this approach is that they have higher capacity requirements, which precludes this option. Instead, they must install their own fiber and switches - or lease those elements from a local carrier (see sidebar).

That situation opens up a lucrative opportunity for CLECs. Several of them, including Brooks, ICG and ACSI, will help finance their infrastructure investment by reselling services and unbundled network elements to IXCs.

The recent departure of several key executives from AT&T Wireless to form OneComm, a new firm that will offer management services to Nextlink, may indicate that AT&T plans to use Nextlink's networks - perhaps in combination with wireless local loop technology - for local service delivery (Telephony, May 12, page 7). OneComm's principal shareholders include Steve Hooper and Wayne Perry, formerly of AT&T Wireless, as well as Craig McCaw.

Purchasing services or network elements from CLECs enables IXCs to enter markets quickly and reduce their risk. And IXCs often may prefer to deal with a new competitor, minimizing their dependence on incumbents.

IXC/CLEC partnerships are forcing some CLECs to modify their investment strategy. Brooks Fiber's initial focus, for example, was on smaller metropolitan areas. When the company began to forge deals with IXCs to offer local services for them, however, it became possible to justify the infrastructure investment in larger cities such as Minneapolis, says a company spokesman.

And while most CLECs plan to focus on the business market, they may pick up some residential business indirectly through IXC partnerships. MCI has an agreement to use ACSI's switches in 10 cities, says ACSI's Reich, adding, "MCI has lots of residential customers and we have the opportunity to add some residential business while focusing our own distribution strategies on the business customer.

Marketing Although their infrastructure plans are quite diverse, CLECs seem to agree when it comes to their marketing strategies: Many say they plan to focus on small to medium-sized businesses.

Voelker says Nextlink has targeted this group because the services these businesses require line up well with the company's own skill set. The company has packaged a full range of local and long-distance services and has already received a lot of interest, he says.

"You can't underestimate how this culture roots against a monopolist," says Voelker, referring to the small and medium-sized business niche.

Intermedia also has found the most success with small and medium-sized businesses, says Forsyth. "With Fortune 500 companies, the incumbents will do anything to keep the business," he says.

The Intermedia service package includes local, inbound toll-free, calling cards, long-distance and international long-distance. A company receives a discount based on the dollar volume across all services.

Businesses like the idea of having a single point of contact, says ICG's Gerstemeier. The company's CAP base is primarily larger companies, but it is focusing on small and medium-size organizations as well. Traditionally, says Gerstemeier, the Bell companies have had one sales group involved with PBX services, another that focuses on the network connection and possibly a third that handles very sophisticated network deals.

"Some [salespeople] were in the regulated business and couldn't talk to the non-regulated side," says Gerstemeier. "When you add long-distance to the mix, you add one more rep." As an alternative, ICG uses a single sales force to sell a package that includes a wide range of services that may even include terminal equipment, says Gerstemeier.

One of the most novel marketing approaches among CLECs is the one adopted by McLeod USA. The company owns an operation that publishes telephone directories that are distributed in 17 states, including markets where McLeod offers local service.

In markets served by McLeod, the first 10 pages of the book describe the company's offerings, says Gray. In telephone conversations, McLeod service representatives can ask customers and potential customers to turn to a specific page in the directory to review a service and how it works.

Que sera The Federal Communications Commission's recent ruling to reduce access charges for long-distance networks was generally good news for CLECs. Because it will be phased in over several years, companies that offer CAP services will have sufficient time to find new revenue streams. Perhaps more important, the ruling reduced uncertainty.

Several other issues critical to local service competition remain uncertain. Negotiating interconnection agreements, for example - particularly with certain incumbents - can be painfully slow.

And even when agreements are in place, the interconnection process itself can take a long time. "The biggest issue is provisioning," says Morgan Stanley's Comfort. "Right now a lot of time is spent by the CLECs getting unbundled loops. It can take weeks.

Still to be resolved are long-term pricing guidelines for unbundled network elements. The FCC's interconnection guidelines were challenged by GTE and several other incumbents, which argued that those decisions should be left to the states. The Eighth Circuit Court of Appeals had not ruled on that issue at press time.

Theoretically, the Bell companies are eager to have some competition because they will not be allowed to enter the lucrative long-distance market until they do. CLECs, however, are skeptical about just how warmly the incumbents are really embracing competition.

"We must have a very vigilant nature to make certain the big guys don't deal their way into a situation where there is not true local competition," says ACSI's Reich. "The LECs are clearly a monopoly and must be watched closely."