Weighing in with WALL Street

With the Dow Jones venturing into 11,000-point territory, an important question for competitive local exchange carrier stock-watchers is why certain parts of the CLEC sector have not enjoyed comparable appreciation in market valuation. Over the past 12 months, while technology stocks in general have risen considerably, the stock of many CLECs has actually dropped and is only now recovering.

With their stocks relatively flat, second-tier CLEC players need some acquisitions to take place soon. Many also need higher stock valuations to counterbalance their borrowed money and to use as a war chest to finance additional growth by acquisition.

Granted, CLEC market valuations could get a big boost if even one of the larger communications players goes on a CLEC buying spree - and the stock of these larger players has fared better than the CLEC sector as a whole this past year. But so far CLECs as a sector are not so popular with equity investors as they were a year ago. It can be argued that there is an abbreviated shelf life for second-tier CLECs unless they can effectively reposition their infrastructure and operational assets for the upcoming next generation network.

Size - and equipment - matter

CLECs can be grouped by two general parameters: overall size and type of infrastructure. In the CLEC world you are friend, foe or food. That is, you are either partner, competitor or a potential acquisition target. Size is important in that it speaks to whether competitors will be sufficiently large to attract capital, acquire others and achieve economies of scale in the anticipated world of mega carriers.

Infrastructure is important in that it speaks to CLECs' ability to control operating expense, reach customers and build assets valuable to potential suitors. CLECs have chosen three basic infrastructure approaches: the fiber-based approach, the "smart-build" approach and the resale approach. Most CLECs do a mix of all three (Figure 1).

Yet another important parameter is the X factor. The X factor determines whether a CLEC has been "built to sell" or "built to operate." It can be roughly gauged by qualitative measures such as a CLEC's successful investments in back office systems, the quality and tenure of its senior executives, and how it treats its employees and customers. Companies become desirable for partnering or acquisition by becoming great operating companies.

Economies of scale

The largest CLEC players say that they will use next generation "disruptive" technologies such as integrated services delivery via Internet protocol, dense wave division multiplexing (DWDM), fiber and wireless to take costs out of the communications business and compete effectively against incumbents. Larger competitive carriers such as Level 3 Communications and Qwest Communications also flatly state that they will become international operators.

Is size important and just exactly how big is big enough to compete in the world of the next generation network? The next generation network is sure to operate under a set of business models different from today's. It will have many variations on the transport, access and content themes of today's communications business. For example, ever larger IP streams will require new IP peering and handoff arrangements. Scale could play a major factor in IP unit pricing for peering handoffs. Controlling dedicated access to the customer and delivering bundled solutions over national and global coverage may be the key to serving the Fortune 1000. On the other hand, the megaplayers have never been good at addressing the needs of small and medium-sized business customers. We still have regional long-distance carriers serving these customers after years of "carpet bombing" advertisements by the mega long-distance carriers.

To see how the telecom mega carrier battles may play out, we can look at what happened in the airline industry. Ten years after airline deregulation, there is an oligopoly of airline mega carriers. These mega carriers compete on scale factors including the efficiency of their hubs and their reservation systems. Operational scale and efficiencies are very important.

Today, there are still many smaller niche "feeder" airlines focused on geographic regions and niche market services. Both mega carriers and feeder airlines are making money as the volume of air travel has grown enormously. Every so often, a mega carrier gobbles up a feeder airline. Perhaps this is the future model for telecommunications - a set of mega international carriers controlling backbone transport with smaller niche feeder carriers providing access and focusing on customer niche applications.

The pace - or clock speed - of the telecom industry has changed, and nowhere is this more apparent than in the case of CLECs. In "The Third Wave," futurist Alvin Toffler shows how succeeding waves of technology have affected human society in ever faster waves of change (see timeline on page 94). As we move deeper into the information age, the relatively stable business models of telecom are no more. We are moving from staid regulated communications to a fast-paced, high-tech model remarkably like that in Silicon Valley, where succeeding waves of technology render older technologies obsolete on a regular basis.

We are now in the era of "disposable" telecom equipment as clock speeds pick up. Players often have to cannibalize their own profitable customer bases in an effort to keep up. We have seen this already in the proliferation of fax and international long-distance via IP, as well as digital subscriber line and DWDM. The blessings of these more rapid technology rollouts must be countered against customer expectations for network reliability and the goal of nationwide universal service.

Choose infrastructure wisely

The base model for the next generation network is emerging. Unlike past network models, technical momentum - not regulatory actions - is driving the model. This next generation network model can be slowed or sidetracked by regulatory actions or the availability of capital, but it will not be derailed because it is based upon inexorable advances in microprocessing power and photonics. All major equipment vendors and carriers are now actively preparing for a next generation network based upon IP transported over fiber, copper, coaxial and wireless backbones.

Advances in microprocessing and photonics will continue to supercharge efficient and flexible digital packet technologies. The general technical trend for communications is doing more with less. This will mean more communications over a single fiber strand, more communications over a given slice of radio spectrum and more bandwidth and services over a single pair of copper wires.

What does this mean for valuation of CLECs and how does this relate to infrastructure deployment and operational capabilities? Historically, CLECs have been evaluated by Wall Street on access lines deployed, revenue growth, EBITDA, market potential and infrastructure assets.

- Access lines. No clear-cut guidelines have been set on how CLECs should report access lines. There has been tremendous pressure to inflate access line counts and confusion as to what constitutes an access line. In fairness to the CLECs there has been little consistency from Wall Street on how to count access lines. Most recently, analysts have focused on revenue per access line as a more objective measure.

- Revenue. There also has been little direction in how and when CLECs recognize revenues and what they choose to depreciate. To be called "growth" businesses, CLECs have had to show a double-digit revenue growth quarter. CLECs have had major struggles in provisioning and billing "organic" revenues. This motivates them to turn to reciprocal compensation and the sale of assets or other one-time financial events to meet quarterly revenue targets.

- EBITDA. In the CLEC world, construction and start-up costs become operating expenses only when "put into service." This means that items you can depreciate do not show up in measures of EBITDA. Discretionary EBITDA items can include equipment assets, circuits, training, travel, staff and consultants.

With network cost and headcount as the two largest CLEC operating expenses, CLECs are motivated to depreciate as much as possible to get to a positive EBITDA measure.

- Potential market. The potential market for CLECs is derived from the demography of the market area covered. Wall Street uses standard metropolitan area analysis to draw conclusions about the scale of the communications customer opportunities for a CLEC. This type of broad analysis rarely matches up with product delivery realities or the internal capabilities of a carrier. It also does not take into account ongoing changes in the economics of access technologies. Addressable market over time is probably a better measure.

- Infrastructure. The next CLEC value measure assesses CLEC assets and infrastructure in place. CLEC infrastructure approaches have ranged from resale only to smart-build strategies, which use other carriers to aggressively deploy fiber and switches (see sidebar on page 94).

CLEC valuation in 2009

Then how should one value CLECs in the world of the next generation network? What CLEC assets will be most valuable? Second-tier CLECs may never have sufficient scale to play with the mega carriers, but to the extent that they control key communications assets and customer access, they will be attractive acquisitions and have operating advantages (Table 1).

It is probably safe to say that communications real estate and dedicated customer access will be king. Assets such as fiber conduit, co-location space and dedicated high-speed customer access via fiber, coaxial, wireless and copper plant will be very important.

Contrary to many predictions, circuit switches will not go away - at least not immediately. Instead, circuit switching will grow more slowly than packet switching. In five years, the great preponderance of communications traffic will be integrated service offerings via high-speed packet switching. Those CLECs that have focused primarily on voice services will have to rethink their focus in the world of integrated services where voice rides virtually free.

In the competitive world of integrated services delivered via high-speed IP access, world-class backroom capabilities are mandatory both for operating efficiencies and marketing flexibility. Remember MCI's "Friends and Family"? MCI did this with its backroom, not its network. We are now at a point where certain players are acquired just for their backroom excellence. Finally, what has been the operating philosophy of the CLEC? Has it been built to last, or was it thrown together for a speedy sale? Buyers will migrate to quality assets and only quality operations will be viable in the longer term.

CLECs should be repositioning now for the competitive next generation network. They have the choice of selling at fire sale prices or repositioning assets and operations for the new business models of the next generation network. Repositioning is the only way they will garner the long anticipated premiums they hoped to obtain by being first to market.

Competitive local exchange carriers typically use one of three models in building out their infrastructure. In the resale CLEC model, assets and infrastructure are kept to a minimum.

At this point, however, it is probably safe to discount the viability of the straight resale model. The basic premise of the resale strategy was to acquire a base of resale customers and later migrate this customer base onto a CLEC infrastructure. What generally happened was that CLEC resale players garnered insufficient resale margins and found that resale customers were tough to migrate. They also found they had little control over network costs. Many CLEC resellers are already on the ropes.

The basis of the second model, the "smart-build" infrastructure approach, is that there is enough metropolitan area network infrastructure in place that can be used by the smart-build players to deliver service. The best smart-build CLEC can be viewed as a switching and marketing machine. This approach requires relatively modest capital and in the end, the smart-build CLEC actually owns customers and revenue streams. However, the smart-build approach does have its disadvantages because these players have primarily deployed circuit-switched voice services.

The third and most capital-intensive CLEC approach is to build intracity fiber rings, then connect city rings with intercity fiber. Facilities-based CLEC players typically use their own voice and data switches to deliver service to customers.

There are two primary challenges for the facilities-based approach. First, it is very expensive, and in deploying a lot of infrastructure assets, the CLEC will probably end up with a lot of debt. This may make a CLEC less attractive as an acquisition, and eventually it will impact the bottom line.

Second, the focus too often has been on deploying circuit switches. Estimates are that 60% to 70% of CLEC lines to dateare modem lines. With the right reciprocal compensation agreements, CLECs do very well with modem lines as the long hold times for Internet calls increase terminating traffic on their networks. However, within 12 to 24 months, dial-up Internet traffic will bypass Class 5 switches altogether and terminate on a new generation of terminal servers that go directly into the Internet. At the same time, reciprocal compensation is being phased out. In addition, high-speed Internet access via technologies such as digital subscriber line and CATV modems is booming. In the near future, there may be bargain prices on Class 5 switches.