The New Torchbearers

The competitive telecommunications industry has taken a beating of late. Layoffs, service reductions and bankruptcies have hit competitive local exchange carriers (CLECs) with disheartening regularity. CLECs point the finger of blame at investors and analysts but above all, at the RBOCs.

Like some elder sibling that always knows the right time to bully without being caught, the regional Bell operating companies have cleverly slowed the rush to competition to a slow walk, throttling the CLECs and ignoring the demands of non-urban customers. This customer base suffers as the RBOCs delay the general introduction of advanced services, the goal of the landmark Telecommunications Act of 1996.

CIOCs are ILECs that hold monopoly telephone franchises in thinly populated areas across the U.S. and are fundamentally profitable. Many have been operating more than 50 years and are privately held.

CIOCs: Hybrid Carriers

While CLECs and RBOCs have been busy making accusations, a new breed of carrier has emerged on the market fringes, quietly and without fanfare. Competitive Independent operating companies (CIOCs) have successfully entered new markets and are seizing market share from the RBOCs. CIOCs are hybrid carriers that have emerged out of the community of 1300 Independent local exchange carriers (ILECs) across the U.S. Over 100 of these ILECs have added competitive operations to their services.

Typically, CIOCs are ILECs that hold monopoly telephone franchises in thinly populated areas across the U.S. and are fundamentally profitable. Many have been operating more than 50 years and are privately held.

Until the Telecommunications Act of 1996, these carriers were confined to their existing franchises and experienced consistent but limited growth potential. Since the Telecommunications Act of 1996, over 100 ILECs have begun to broaden their horizons by entering new markets in competition with an RBOC to boost their bottom line by transforming themselves into CIOCs.

CIOCs’ hybrid nature makes them highly efficient competitors. Many of the hurdles faced by the CLECs are minimized or altogether overcome by their corporate synergy. CIOC financing is a case in point. The captive revenue stream that flows from franchise markets anchors CIOC expansion.

These markets are unattractive competitive targets as only 15-25% of the access lines are business lines. Additionally, CIOCs enjoy regulatory protections within their established markets that create high barriers to entry for would be competitors. Moreover, CIOCs’ revenue in these markets is supported by the Universal Service Fund, which subsidizes high-cost access lines. CIOCs’ franchise markets are a reliable and secure revenue source with which to fund competitive activities.

Table 1 CIOC Competitive Synergies
ILEC Asset	CIOC Benefit
Switching	Digital Facilities Minimal Use of Resale
OSS	Complete Legacy System
Infrastructure	Proven Administrative Capability
Human Resources	Pool of Skilled Technicians Local Sales and Marketing
Management	Experienced LEC-Focused Team
Financing	Captive Revenue Stream[1] Low Interest Loans[2]
Philosophy	Community-Centric Long-Term View Focused on Service
Branding	Positive Local Reputation Reliability and Longevity
Regulation	Strong Political Allies Favorable Regulatory Position
Source: New Paradigm Resources Group, Inc.

When it comes to capital expenditure and access to funding, CIOCs are able to call upon many low cost sources of capital including the Rural Utilities Service (RUS), Rural Telephone Bank (RTB), and for some CIOCs, cooperative banks such as CoBank. CIOCs typically are able to receive 10- to 20-year loans with interest rates between 5% and 7%. 

While governmental sources like the RUS and RTB restrict the usage of such funds to the CIOC’s monopoly infrastructure, this is not an obstacle as CIOCs typically employ existing infrastructure to provision service to customers in competitive markets.

Edging Out

CIOCs employ an edge out strategy that capitalizes upon their operating synergies. CIOCs target markets that are adjacent to their existing franchise for expansion. Due to geographies and demographic considerations, many of these markets are Tier Five.^[3] By expanding into proximate areas, CIOCs minimize expansion costs by incrementally growing their existing infrastructure into the new market.

Another criterion CIOCs use in evaluating potential expansion markets is the established name recognition of the existing incumbent. CIOCs choose to compete against an RBOC rather than another ILEC. Their reasoning for this choice is quite sound. CIOCs enjoy strong brand recognition and score consistently high in state customer service rankings.

RBOCs are apparently unconcerned by the competitive efforts of the CIOCs, being far more focused on the CLECs that are trying to gain market share among the revenue generating business customers in urban markets.

ILECs enjoy similar advantages, but RBOCs have generally poor reputations in non-urban areas. Slow service, impersonal customer relations, and older network technology all make RBOC markets vulnerable to the customer-focused competition of the CIOCs. LECs have avoided competing with smaller ILECs because of the low density of business customers in these service territories.

By employing an edge out strategy and overbuilding wireline infrastructure, CIOCs are able to target both business and residential customers. CIOCs' strong market synergies allow them to regularly seize over 30% of a market’s total access lines. The edge out strategy also makes use of all of the CIOCs business synergies from financing to branding making them highly effective competitors.

RBOC Reaction: Competitive Indifference

What are the RBOCs doing about this market poaching? Largely nothing. RBOCs are apparently unconcerned by the competitive efforts of the CIOCs, being far more focused on the CLECs that are trying to gain market share among the revenue generating business customers in urban markets.

RBOCs such as Verizon, SBC, and Qwest have, in fact, been quietly selling off their non-urban assets. With their attention focused on urban business customers from whom they generate the majority of their revenue, RBOCs are only too eager to divest themselves of their less profitable markets.

RBOCs also have little incentive to mount a fight over these markets. The tactics they employed so effectively against the CLECs to drain them of time and money are largely ineffective against the CIOCs given the latter’s captive revenue stream. With their profitable core business and long industry experience, CIOCs are unfazed by the legal obstacles set before them by the RBOCs.

CIOCs also enjoy strong political support on both federal and state levels. Thus, RBOCs targeting CIOCs are liable to receive negative reactions in legislative and regulatory arenas at a time when they are striving for more freedom from the restrictions placed on them by the Telecommunications Act of 1996.

FROM THE FCC 271 Applications Filed with the FCC Under section 271 of the Communications Act of 1934, as amended, the Bell Operating Companies must file applications with the FCC on a state-by-state basis in order to provide in-region interLATA services.  CLICK HERE to view a list of states that have filed to date.

As non-threatening competitors, CIOCs actually provide the RBOCs with a critical advantage before regulators. When petitioning state Public Utility Commissions for permission to carry long distance, so-called “271 approval,” RBOCs must show evidence that they have opened their markets to competition.

By showcasing the markets that CIOCs have successfully entered and the competitive market penetration rates, RBOCs are able to claim that they have indeed opened their markets. The small size and low revenue potential of these markets are topics left unmentioned and undiscussed.

The Future of CIOCs

Unlike other telecommunication providers, which are experiencing slowing growth, CIOCs are enjoying strong growth in today’s difficult economic times. CIOCs’ core ILEC franchises are resilient and provide a relatively recession-proof revenue stream for operations. CIOCs will also have continued easy access to capital from governmental, private, and market sources to fuel growth initiatives.

In September 2001, the FCC began discussing the possibility of removing even more restrictions from ILECs seeking to engage in competitive activities and given the legislative clout of the ILECs, this is likely to move forward. 

With the proven edge out strategy and the lure of enhanced revenues, additional ILECs will make the transition from ILEC to CIOC. NPRG anticipates the number of CIOCs will double to over two hundred by 2003. Revenue and capital expenditure will double by 2004 to over $2 billion and $1 billion, respectively (see Figure).

SPECIAL REPORT August 20, 2001 Alltel's big Adventure

Consolidation

Merger and acquisition activity is sweeping this market segment. The July 2001 announcement of the NTELOS-CEI merger; ALLTEL’s August offer to acquire CenturyTel; Citizens Communications’ debt placement of $1.75 billion; and TDS’s buyback of 1.2 million shares all show that the larger CIOCs are moving toward consolidation. At the same time, the RBOCs are accelerating their divestiture of assets in non-urban markets. Despite this acceleration, the average price per access line is rising rapidly showing that demand for these markets is outpacing a steadily increasing supply.

Table 2Representative List of CIOC Line Acquisition Activity 1993-2000
Date	Seller	Buyer	Avg. Cost Per Access Line
1993	GTE Corp.	Citizens Utilities Corp.	$2,186
1994	ALLTEL Corp.	Citizens Utilities Corp.	$2,564
1994	Citizens Utilities Corp.	ALLTEL Corp.	$2,778
1995	US West	Hickory Tech Corp.	$2,824
1996	US West	Inter-Community Telephone Company	$3,357
1997	US West	Pacific Telecom	$3,815
1997	GTE North, Inc.	Pacific Telecom	$2,833
1998	Century Telephone Enterprises	ALEC Acquisition Corp.	$3,523
1998	Ameritech	Century Telephone Enterprises	$2,528
1998	Sprint Corp.	Madison River Telephone Co.	$2,500
1998	Alliant Communications, Inc.	ALLTEL Corp.	$5,263
1999	GTE	Citizens Communications	$2,836
1999	Coastal Communications	Madison River Telephone Co.	$3,421
1999	GTE	Citizens Communications	$3,344
1999	GTE	Century Telephone Enterprises	$3,000
1999	GTE	Telephone USA	$2,742
1999	GTE	Century Telephone Enterprises	$3,941
1999	GTE	Spectra Communications	$2,500
1999	US West	Citizens Communications	$3,113
1999	GTE	Citizens Communications	$3,570
1999	Century Telephone Enterprises	Alaska Communication Systems	$2,552
1999	Gulf Coast Services, Inc.	Madison River Telephone Co.	$6,260
1999	Union Telephone	FairPoint Communications, Inc.	$5,000
1999	Columbus Grove Telephone	FairPoint Communications, Inc.	$2,778
1999	Ravenswood Communications, Inc.	FairPoint Communications, Inc.	$4,750
2000	Chorus Communications	TDS, Inc.	$5,096
2000	Global Crossing, Ltd.	Citizens Communications	$3,318
2000	R&B Communications	CFW Communications	$8,213
2000	Hager Telecom, Inc.	Hector Communications	$4,550
2000	Fremont Telephone Co.	FairPoint Communications, Inc.	$5,698
2000	TPG Communications, Inc.	FairPoint Communications, Inc.	$4,118
2000	Peoples Mutual Telephone Company	FairPoint Communications, Inc.	$4,487
Source: New Paradigm Resources Group, Inc., Legg Mason

The pace of this consolidation shows no signs of slowing down. Some privately held CIOCs, such as Fairpoint and Madison River, have publicly stated that they are interested in additional acquisitions. There is a broad shift toward consolidation among non-urban service providers combined with an RBOC exodus from these same markets. Within five years we are likely to see a number of consolidated regional non-urban service providers.

We see U.S. telecommunications breaking out into a number of distinct market segments. In urban environments, the RBOCs and CLECs will compete for business and multi-unit residential access^[4]. In rural areas, CIOCs will displace RBOCs and uncompetitive ILECs.

These CIOCs will consolidate to improve profitability by attaining more advantageous economies of scale. Between city and country is where the real battles will take place. RBOCs and CIOCs will be competing for both business and residential customers. RBOCs will defend these areas to maintain a buffer between CIOCs and valuable urban markets.

However, the CIOCs will prove to be tenacious opponents with multiple competitive advantages that nullify many strategies used by RBOCs in the past. RBOCs will likely be compelled to change and take on attributes of the CIOCs. In the end, it is the customers in these areas who truly win by realizing the promise of universal broadband deployment implicit in the Telecommunications Act of 1996.
Edrick Harris and John Laprise are analysts with New Paradigm Resources Group, Inc. (NPRG).

Visit NPRG online.

---

[1] Captive Revenue Stream refers to the earned revenue from the CIOC’s ILEC franchise, which operates as a monopoly.

[2] CIOCs’ ILEC operations are eligible for low interest loans from the Rural Utilities Service and the Rural Telephone Bank. These loans must be used for service improvements of the ILEC facilities. However, CIOCs’ competitive operations consequently derive benefit from these improvements as a side effect.

[3] Markets are defined in terms of population thusly:

Tier One	Tier Two	Tier Three	Tier Four	Tier Five
1,000,000+	250,000-1,000,000	100,000-250,000	50,000-100,000	Up to 50,000

[4] See, for instance, broadband access trends discussed in NPRG’s Broadband Last Mile Report™.

return to top