The CLEC Train Wreck

Most industry observers agree that the United States is now witnessing a competitive local exchange carrier train wreck of gigantic proportions. Even the most optimistic analysts predict that fewer than 60 of more than 300 CLECs will survive the next few years. As 200+ failing service providers succumb, the aftershocks throughout the telecommunications industry will be enormous. More disconcerting than the reality of this carnage is the fact that it could have been avoided.

WHAT IS A CLEC? A CLEC is a telephone company regulated by the same rules and regulations as the local operating company presently serving the community. It is a Competitive Local Exchange Carrier in competition with the ILEC or Incumbent Local Exchange Carrier (usually the Regional Bell Operating Company (RBOC) or other Independent Telephone Company such as GTE, ALLTEL etc ). The CLEC offers the same type of services to its customers as previously provided by the ILEC. --from Solunet's Frequently Asked Questions about CLECs

In reality, the CLEC industry never really had a chance. Despite the laudable intentions of the Telecommunications Act of 1996 to quickly stimulate competition for local telephone service, legislators and the federal regulators responsible for the Act failed to make several of the hard decisions necessary to help CLECs realize their vision.

Perhaps the most critical of these decisions involved how to create a competitive local exchange marketplace in which both incumbents and new entrants could earn adequate returns. On this important issue, policy makers defaulted to political expediency and did not mandate an infrastructure resale pricing program that would enable CLECs to build a business based on sharing incumbent networks. The consequences of this failure threaten thousands of employees and many billions of dollars of investment.

There is no doubt that pricing for resale of the incumbent infrastructure (bundled and unbundled) was a hotly contested issue. Incumbents claimed that low resale prices (the result of an incremental cost approach) would not allow them to recover their investments and would create disincentives to invest in advanced network infrastructure. New entrants argued that high network resale costs (based on full-cost recovery) would not allow them to build viable businesses based on using the incumbent infrastructure.

The thin resale margins available to CLECs have forced them to build their own infrastructures, creating capital requirements and long development cycles that investors are unwilling to support.

After five years, at least one thing is clear: The thin resale margins available to CLECs have forced them to build their own infrastructures, creating capital requirements and long development cycles that investors are unwilling to support. Frustrated by the failure of the original CLEC reseller model and the inevitably slow pace of network buildout initiatives, potential funders are taking their money elsewhere–leaving fragile CLECs with insufficient capital in search of alternative business models that will work under current capital market conditions.

How did we get into this mess?

There is an overabundance of analysis, opinions, excuses and justifications for the CLEC failures. Certainly there were poor business plans and failed executions, fueled by the excessive exuberance of capital and debt markets. But there are also many good companies, led by experienced industry executives that are not likely to survive. Is this simply survival of the fittest, or evidence of a lack of policy leadership?

For new entrants to be able to leverage existing local infrastructure, resale prices had to allow them to build viable businesses. Unfortunately, there was no resale price that would allow new entrants to succeed and also enable incumbents to remain viable. An analysis of industry data, supplemented by research with front-line policy makers and analysts, suggests that the great debate over resale prices failed to address the fundamental issue.

By focusing on arguments about resale discounts and pricing methodologies the real issue driving the viability of local competition was largely ignored. There was simply no way to arrive at a workable resale pricing structure as long as the baseline local rates did not reflect the real cost of doing business.

When transitioning from a regulated monopoly, where pricing for individual services is based more on social policy than on costs... adjustments must be made for competition to succeed.

Following the Bell breakup of 1984, long-distance subsidies of local rates were replaced by temporary long-distance access charges, but the basic local rate structure was never adjusted to reflect the real cost of local service. In the CLEC arena, regulators attempted to apply resale discounts to rates that were artificially depressed to meet public policy objectives. In other words, the debate on resale pricing focused on costs of access to infrastructure that could not possibly be sustained in a truly competitive marketplace.

It is hard to believe that CLEC and Incumbent local exchange carrier (ILEC) executives did not understand that a resale pricing system could work for both sides only if local rates were increased. Pessimists would say the ILECs understood, but believed they had enough political power to win at the CLECs’ expense (which they did). Neither side could afford to take a position for higher local rates. This same political reality probably kept knowledgeable regulators quiet as well.

If local rates had increased 50%, for example, the average local bill might have gone from $25 to $37 a month--a large percentage increase, but a relatively small one in absolute dollars. Under this scenario incumbents could have accepted a larger discount, and infrastructure resale could have offered a viable approach to bringing competition to local markets relatively quickly.

It’s easy to see why no elected official would want to take this on, but the fact that the rate conundrum was never fully resolved has left the CLEC industry in a tailspin--and the United States nowhere near achieving the competitive vision behind in the 1996 Act. In fact, competition is supposed to produce lower rates, not rate increases. When transitioning from a regulated monopoly, where pricing for individual services is based more on social policy than on costs, however, adjustments must be made for competition to succeed.

The impact of relatively new network equipment from more than 200 CLECs flooding the market-- with prices ranging from 10-50% of the original purchase price-- will be devastating.

To be fair, there were other alternatives to local rate increases. For example, policy makers and regulators could have mandated structural separation in the local service marketplace, forcing players to choose which side of the fence--infrastructure or service provision, wholesale or retail--they wanted to compete on.

NARUC commissioners raised this option but no one really pursued it at the time. This approach would have created a different version of local service competition-- one in which resale prices could have been less tightly regulated. But based on the Bell break-up experience, structural realignment would have been time-consuming--and might also have led to increasing local rates, at least initially. Bell Atlantic, for example, debated structural separation in Pennsylvania for nearly two years before the issue was defeated, and estimated that its cost to comply would have been $1 billion.

FROM OUR ARCHIVES Hollings bill is a disaster-in-waiting by Glenn Bischoff Telephony, Aug 13, 2001 Cranking the debate Dan O'Shea Online Exclusive, Aug 8 2001 An altered state by Dan O'Shea Telephony, Jun 18, 2001 LogOn: Division revisited It's deja vu all over again as structural separation is back on the table as the search for true local competition continues Dan O'Shea TelecomClick, Apr 2 2001 ON THE WEB From The Cato Institute Structural Separation of the Bells - An Idea Whose Time Has Passed August 20, 2001 by Adam Thierer and Wayne Crews S.1364 Telecommunications Fair Competition Enforcement Act of 2001 (Introduced in the Senate)

Another alternative is to continue the track we’re on--waiting for competitors to build their own infrastructure and grow to the scale necessary to support that investment. This approach is the most likely course given the consumer resistance to higher rates and the reluctance of the current regulatory regime to restructure the ground rules of local competition.

For the present course to produce a healthy competitive environment over the long term, however, alternative new last-mile technologies will have to mature and prove their economic viability. That approach could result in lower rates, but it, too, will be a long time coming.

If we assume we’re in the mess we’re in for the foreseeable future, what are the implications for current service providers and the equipment manufacturers that supply them? All indications point to a bleak picture over the near term.

First, nearly eight out of every 10 CLECs are likely to fail in the next few years. Unless an infrastructure-based CLEC is operating with $1 billion to $2 billion in revenues--and only three are right now--it will be hard-pressed to turn a sustainable profit. Local network infrastructure, operations support systems and business support systems, sales and marketing infrastructure and real estate costs are simply too high to allow sustainable profits below the $1 billion revenue threshold.

To achieve the scale necessary, many CLECs are pursuing other businesses such as directory publishing, wholesale services and value-added reseller (VAR) packages of communications equipment. Unfortunately, none of these are sure things.

To make matters worse, another aftershock of the CLEC disaster is already beginning to ripple through the equipment industry. The impact of relatively new network equipment from more than 200 CLECs flooding the market--with prices ranging from 10-50% of the original purchase price--will be devastating. Not only are equipment manufacturers already finding it harder to sell new inventory, they also face significant losses from the credit they’ve been extending to CLEC start-ups over the past five years. Tens of thousands of CLEC workers will be on the street-–dragging their manufacturing counterparts with them.

The CLEC train wreck is unfolding before us every day. Under-funded companies are laying off their workforces and scrambling to reduce costs. They are fighting a battle they are unlikely to win, but hopefully this train wreck will ultimately precipitate a new determination to get on with true deregulation.

For the new anti-interventionist philosophy of the FCC to work, regulators must remove the legacy of social policy in local access rate structures and allow local rates to be determined by the marketplace. Otherwise regulators will be hamstrung by the complexity of adjudicating blame and devising new rules and fines to stop the continuing failure of new competitors. Unless everyone is willing to confront the reality that local market basic service rates are still set under cost, there will be little significant local exchange competition in the immediate future.
Ron Hubert is a Partner at Deloitte Consulting, Los Angeles, CA. He can be reached at rhubert@dc.com. Copyright 2001 Deloitte Consulting L.P.

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