ILECs at a crossroads

The U.S. ILECs--especially their wireline telco operations--are at a strategic crossroads. They have won nearly all of the competitive battles they have chosen to fight, including the right to offer long-distance services (mostly), fended off CLECs and IXC local service entities, eliminated most DSL competition and marginalized the ISPs and IP-based carriers that were seen as a strategic threat to the highly profitable $100 billion voice business. In addition, ILECs have cornered most of the wireless market, thus creating an unregulated alternative to the regulated wireline voice business.

Despite these victories, the wireline business units still face some troubling issues. Customer access lines are declining for the first time since the 1930s. Wireless phones are heavily impacting second lines and the highly profitable public telephone business. Fax lines that gave the access line business a late-life kicker in the 1980s are being abandoned in favor of e-mail. MSOs are winning the broadband Internet access battle by a 2:1 advantage.

Furthermore, the regulatory environment tends to be skewed in favor of MSOs and IXCs. MSOs can provide entertainment, telephone service and Internet access with minimal regulatory oversight and IXCs provide Internet and IP services with none. ILECs, on the other hand, cannot provide IP services and entertainment except under very restrictive arms-length rules and their telephony services are pervasively regulated.

Most disheartening of all is TELRIC (total element long run incremental cost)- the rule for pricing wholesale services or service components. TELRIC uses a forward-looking method to set the price ILECs must charge their competitors for wholesale services. Since telecom technology unit costs are exponentially declining, the rule guarantees that investments in facilities used by competitors will never produce a return.

Building the long-distance telephone business and seeking regulatory change are worth pursuing regardless of what future strategic direction ILECs choose. ILECs should create wireless, local and long-distance service bundles to enhance their strategic position among the most attractive customer segments. They need only fear each other; no IXG, CLEG or MSO could offer a similar package. They also could wipe out these already-weakened competitors by offering a simple minute plan similar to the Sprint PCS plan, which prices all long-distance and local calls at 10 cents per minute. ILECs could sustain a price well under 5 cents a minute using their substantial PSTN infrastructures.

Three regulatory initiatives should be pursued: market-based service pricing, changing the punitive wholesale pricing scheme to a public mandate to replace all copper plant with fiber, and gaining the right to offer Internet and entertainment services on equal terms with MSOs.

The third initiative is difficult: Nearly all ILEC infrastructure is based on digital circuit switches (1960s designs) and twisted-pair copper (1890s designs). It's time to gracefully exit or renew the infrastructure. ILECs could use their mature wireline infrastructure as a source of cash to diversify into more attractive industries as the steel, tobacco and liquor industries have before them--or they could use the cash produced by these mature assets to create a 21st century network.

Tactics needed to create cash for diversification include minimizing new investment, cutting the operations staff to the bone and maintaining high prices for near-monopoly services such as Ti lines, telephone access lines and intra-LATA telephone services. Prices also should be kept very high for DSL service and all wholesale offers; little or no new investment should be made in these areas. Finally, unprofitable franchises (e.g., rural towns) should be divested and bad debt be controlled through highly restrictive credit policies.

Tactics needed to build 21st century infrastructure should follow a kick-'em-while-they're-down approach by building infrastructure that IXCs, CLECs and MSOs, with their limited capital resources, cannot match. For example, a timetable should be established for retirement of all copper plant analogous to the commitments made in the 1980s to eliminate all analog switches and party lines. New service offers should be equally preemptive, such as digital cinema (much better than HDTV), 100 Mbps Ethernet at Ti prices for enterprises and IP/MPLS at megabit speeds but priced like frame relay.

I believe most ILECs will choose to wait at the crossroads rather than boldly follow either of these courses. Despite being positioned to capture major shares of IXC business, they are likely to pursue incremental change. I do not expect a preemptive entertainment initiative either, despite the weakened state of Comcast (formerly AT&T Broadband) and AOL Time Warner, which account for a large majority of cable TV business.

If the ILECs wait at the crossroads or pursue the diversification strategy, capex spending in 2003 and 2004 will suffer, which could spell doom for major equipment vendors and start-ups alike. New technologies such as FTTH (fiber-to-the-home) and IP/MPLS would be squelched until the next round of venture funding, and product deployment pushed out to late in the decade.

Michael Kennedy is co-founder and managing partner of Network Strategy Partners, LLC (NSP)--management consultants to the networking industry (mkennedy@nspllc.com).

COPYRIGHT 2002 Horizon House Publications, Inc.
COPYRIGHT 2003 Gale Group