Feb 19, 2007 12:00 PM,

Ready for some peace and quiet

By Carol Wilson

The wholesale side of the telephony business has been rocking and rolling for almost a decade. It began with the go-go buildup of the late 1990s, followed by the crash of 2000 and years of predatory pricing and bankruptcies. It ended with last year's massive consolidation that thinned the number of larger wholesalers.

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Now, industry executives say it's time to buy that home in the suburbs and park a mini-van in the driveway. Wholesale is looking for stability — and a little respect.

“It has been relatively quiet,” said Cindy Whelen, wholesale services analyst for Current Analysis. But, she added, that doesn't mean there isn't a lot going on.

In fact, with pricing stability and growing bandwidth demand, wholesale services are becoming significant contributors — if not spectacular profit engines — to the bottom line of major telecom players.

A number of factors are contributing to that change, Whalen said. Last year's consolidation (see chart) helped eliminate some weaker players and made the now-larger operators more robust.

“As the market consolidates, and there are fewer players, the players that are in place are trying to differentiate themselves in value and not just compete on price,” she said, citing Verizon's 2005 announcement of service level agreements for some wholesale services. “What this will do is help get the pricing where it needs to be.”

Another factor is the move away from legacy wholesale services, such as local and long-distance voice, and toward more advanced data services and converged voice and data offerings, Whelan said. Wholesale operators are focused on developing the next-generation services their customers are demanding.

That shift is already visible in the 2006 financial results at Qwest, where wholesale revenues were down 10.6% in local voice and 1.1% in long-distance, but up 14% in Internet and data services — translating into an overall 3% increase in wholesale revenues to $801 million. This comes after Qwest, like many other players, decided in 2004 to stop pursuing low-cost traffic and take a more disciplined approach to its wholesale channels.

“We will continue to effectively manage our wholesale channel for profitability,” Richard Notebaert, Qwest chairman and CEO, told analysts.

Industry players point to another factor in wholesale-industry stability that seems to run contrary to conventional wisdom. They say consolidation hasn't eliminated the business that carrier customers do with each other. While every consolidation is followed by a period of integration, which includes combining two networks into one and eliminating duplicative facilities, even a company such as Level 3 Communications, which bought six different companies in 2005-2006, still buys capacity from other wholesalers.

“Level 3 is a very big customer of ours and a very valued customer of ours,” said David Small, president of Verizon Partner Solutions. “Our focus is to give them all the incentive in the world to keep them on our network.”

Verizon does see some movement of traffic off the Verizon Business network onto Level 3 as its acquired properties, most recently Broadwing, are consolidated. But it's not as universal as many might believe, Small said.

“Verizon Business does have contracts and commitments from all carriers such that there are incentives for them to leave some traffic on the Verizon Business network,” he said. “For one thing, you would get a much higher degree of diversity. Verizon Business is legacy MCI, which is also legacy WorldCom, UUNet and legacy Verizon Enterprise Network Services, so it's very well-positioned to provide a high degree of diversity.”

Similarly, Level 3 finds that industry consolidation “absorbs some capacity but also creates demand. Where they need to tie networks together, there is demand for more capacity,” said Glenn Russo, vice president of product delivery for Level 3 Wholesale Markets. “Plus, a lot of people have plenty of uses for their capital, and they are making choices where they want to spend it — and it is not necessarily to fund network expansions.”

As for its own network consolidation decisions, Russo said they are primarily driven by economics and customer needs. “First, we have to think of customer service and what would be a great customer experience,” he said. “Then, it's economics.”

Much of the economic decision is driven by the equipment on a specific route: whether it is at the end of its life cycle and needs to be replaced or can continue to function longer.

“If we can go out and buy a lot of new technology today and move traffic over, that's one thing, but generally, technology gets cheaper, Russo said. “So if you can wait a year, sometimes that's a cost savings.”

The rise in IP traffic also helps to drive the wholesale business, particularly on the long-haul side.

“We are seeing usage increases and greater bandwidth demand,” said Ernie Ortega, president of carrier services for XO Communications, which bucked the industry trend by lighting up dark fibers on Level 3's network last year to directly compete in the wholesale arena. “A lot of the demand is coming from the result of the increased content that is being driven by IP applications.”

One area of growth for XO is in the cable industry, where the success of service bundles is prompting further network build-outs, Ortega said.

“Streaming videos, IPTV, on-demand videos — it is all driving more and more content, which drives greater bandwidth demand,” he said. “What TV stations are finding is that it's getting difficult to compress high-definition technology. They are having to buy more bandwidth because sending out an HD signal is consuming much more bandwidth, and compression of HD signals has not been perfected just yet.”

Cogent Communications also is seeing significant growth in IP traffic. CEO Dave Schaeffer said it is growing even faster than the 75% pace at which IP traffic is increasing.

“We continue to grow at a rate of 2.5 times the growth of the underlying Internet,” Schaeffer said. “We see two things happening: IP is becoming a more and more dominant means of transmission; and as the Internet becomes more robust and more sustainable, people gain greater confidence, and you see a greater percentage of traffic that used to pass over private networks be put over the Internet cloud and be encrypted.”

The industry's rush to Ethernet is not only producing greater bandwidth demands, given Ethernet's ability to scale well beyond the traditional T-1 and DS-3 bandwidth levels, but it's also giving service providers a chance to differentiate their services.

“We are seeing pretty significant increases in Ethernet-based services,” Small said. “We are working hard with technology-based folks and lab folks to make sure our Ethernet service is very robust. Our view is that we want to be able to offer the bandwidth and the protocol and the handoff technology that our wholesale customers will need to be successful.”

Recently, he added, Verizon has seen a big spike in demand for OC-3, or concatenated services, which can support 100-megabit Ethernet.

“We are seeing Ethernet mapped over traditional services, but also fast-growing pure Ethernet,” Small said.

Level 3 also is seeing an Ethernet spike, Russo said, and a faster move to converged services as more companies sell voice over IP as well as data.

Cogent, launched in the late 1990s using Ethernet as its access method, continues to do so because “it is the lowest cost and most easily managed customer interface,” Schaeffer said.

Wireless is a major growth force for AT&T's wholesale efforts, according to Sherry Charles, vice president of AT&T wholesale marketing for AT&T operations.

“One area of the market that is contributing to wholesale demand is the mobile sector,” she said in an e-mail response to questions. “Wireless providers are looking for more international minutes, both fixed and wireless. For example, in Asia-Pac, we have observed that prepaid-card service providers and mobile carriers are growing voice traffic rapidly.”

What wholesale industry executives say they are not seeing is the kind of cutthroat price competition that characterized the post-bubble era.

“We don't see prices going up, but we don't see it continually going down like it was. What we do see is stabilization in the market,” said XO's Ortega.

In the long-haul business, in particular, a lot of the overhanging capacity is drying up,” Russo said. “And that has led to a natural stabilization of pricing. We still see price compression, but we think some of that is good because lower prices lead to more demand.

At Cogent, pricing has never been an issue — the company has stuck to the revolutionary $10-per-megabit pricing it launched with.

“We have seen the average price per direct Internet access fall among our competitors from $300 down to about $45,” for connections at a major carrier-neutral facility such as a carrier hotel, Schaeffer said. “We have been consistent throughout that period at $10 a megabit. Now, you may get some more aggressive carriers down to $25 to $35 a meg, and the less aggressive ones will be at $70 to $80.”

Even with some stabilization, wholesale players are still competing on price. “It keeps us on our toes,” Verizon's Small said.

The pricing concerns also push wholesalers to be more efficient, said analyst Whalen, particularly as they integrate acquisitions and try to drive down their costs. “There is definitely a premium today on running your organization efficiently,” she said.

One thing Verizon has done in that regard is launch “an aggressive automation initiative designed to reduce cycle time for our customers,” Small said. As part of that process, it looks at ways to help customers submit “clean” orders that can move quickly through the provisioning process, conducts workshops with customers that address gaps in the process, and gives customers online tools and other aids, he said.

Something as simple as giving technicians hand-held PDAs rather than laptop computers can enable them to provide order status on a real-time basis, wherever they are, he said. “Any minute that is extra in the provisioning process is a minute that our end users have to wait,” he said. “The PDA also makes it easier for them to kick off testing within the Verizon network, and it gives them more insight into what's going on with a particular order.”

The immediate future for wholesaling looks like calmer sailing, if not entirely smooth. No one is certain whether consolidation will continue, although most agree it won't occur at the same pace as in 2005 — at least where large players are concerned. And although pricing stability also seems a relatively safe bet, there are no guarantees.

“It is going to take time for these things to settle down,” Whalen said. “There's no way Level 3 is through integration on all of the companies it bought. AT&T is still integrating BellSouth. All these companies have gone through these acquisition processes — it will take time to settle down and stabilize.

“The key is the consolidation will help create mature players. These players will be able to develop the services and also command, perhaps, a higher price for these services.”