The Future of the Regional Bells

 

Part II:

The Cost of Doing Business

"For decades, individuals have been willing to pay much more for the privilege of participating in conversations than to receive professional content-expenditures on long-distance and local telephones have been greater than expenditures on newspapers, magazines, broadcast, cable, and movies put together."12

While demand for connectivity to the Internet is increasing, demand for the ILEC's core business, landline telephony, is going down. The rate of up and down motion was not expected by anyone in the industry. Minutes of network use are declining as people substitute other methods of communications: cell phones, cable modems, email and the like. Consider the preliminary evidence:

Demand for residential voice telephone lines is declining for the first time in history. The percentage of copper line has steadily decreased since 1991 in the total number of Working Telecommunications Channels as fiber replaces copper. The total number of central offices (CO) has been declining since 1993.13 Currently, about 2% of residential and business phone lines have been replaced by cellular service and another 2% by Voice over IP (Internet telephony).

This is a bell-weather indicator for long-term problems. "The goodness of the new network on one hand is a nightmare economically on the other ... the incumbents are slowly going bankrupt, some quicker than others... (including the ILECs) because their ... networks have a very high cost of provisioning."14 Voice-grade switching equipment that makes up the ILEC infrastructure is expensive to buy and maintain, relative to many alternative networks. That infrastructure requires an army of employees (despite recent layoffs). Additionally, this model is not the best choice for data transport. New and more cost-effective technologies (wireless or WiFi, fiber optic, etc.) are being deployed whenever and wherever possible to provide access to data services that undermine the long-term well-being of costly ILEC investments.

"Whether they're brand new or a hundred years old, all of these phone companies need to figure out how to increase sales - and, oh, yes, profits - from their data businesses. The older guys must outrun declines in their voice businesses."15

Declines in Core Business: Landline Local Service

4th Qtr, 3 Mo.

12/00 - 12/01

4th Qtr, 12 Mo.

12/00 - 12/01

SBC (3.2%) 3.2%
BellSouth   (2.1%)
Verizon (3.6%) (0.5%)
Qwest (3.0%) (16.4%)

 

Taking a closer look, the future is bleak:

SBC

Discussion of their core business is taking a back page to what's really going on. People want access to the Internet, not voice-grade lines. In SBC's 3rd Quarter16 and Year-End Investor Briefings,17 Operating Revenues from landline local service is steadily declining (Third Quarter declined 0.4%, Fourth Quarter by 2.8%, and down 3.2% for the year.) SBC pulled Cingular Wireless out of their income statement revealing a decline in total revenues of 13.2% (3rd Quarter) and 10.6% (4th Quarter). Why? Total access lines served is showing a decline as well (1.7% and 2.8% respectively). People are getting rid of 2nd phone lines, or substituting cell phones and broadband access for telephone lines. This means SBC is not taking in as much income as it needs to pay off their investments.

BellSouth

Their Fourth Quarter Financials18 show a similar picture: a decline in access lines of 1.9%. Instead, they have an increase in Access Line Equivalents, explained as:

"Access line equivalents represent a conversion of non-switched data circuits to a switched access line basis and is presented for comparability purposes. Equivalents are calculated by converting high-speed/high-capacity circuits to the equivalent of a switched access line based on transport capacity. While the revenues generated by access line equivalents have a directional relationship with these counts, revenue growth rates cannot be compared to line growth rates on an equivalent basis."19

BellSouth would perhaps like us to believe that they can't make a direct comparison between access line equivalents and voice lines, but there is a technological maximum to make the comparison. They are not taking in as much income for Access Line Equivalents as they do for straight Access Lines. In fact, it's much less income. More and more lines are being used for Equivalents than for Access. This is true for all ILECs.

Verizon

The events of September 11, 2001 had a significant affect on Verizon, but were not the entire explanation for Verizon's falling income. From their fourth quarter earnings report,20 we see that the number of switched access lines has remained stable over three months and 12 months. The local services operating revenue from those lines declined by 3.2% for 3 months, .5% for 12 months. Even their network access services changed marginally (-.1% and 1.8% respectively).

Qwest

A dismal picture with different numbers: switched access is down 3% for three months ending Dec 31, 2001, and down 16.4% for the year.21 Significant here: the recent merger between Qwest and US West that caused a huge write-off and resulted in an increase in expensive fixed assets.

"Qwest (Q) on Tuesday reported a loss of $3.31 billion, or $1.99 a share, compared to a reported loss of $121 million, or 14 cents a share, a year earlier. The latest quarter's results included one-time and merger-related pretax charges of $3.72 billion. Excluding these items, the regional telephone company earned $128 million, or eight cents a diluted share, compared with $255 million, or 15 cents a share, a year earlier."22

As with all the ILECs, their income continues to center on data, not voice. To get around this Qwest has engaged in some creative financial deals and as a result has been under investigation on and off over the last few years. Most recently:

"Details of the deal, which was not announced at the time but has been disclosed in recent filings in Enron's bankruptcy case, indicate that the two companies raced to complete the transaction as the third quarter was ending in September. Enron and Qwest valued the transaction at more than $500 million, but analysts said the timing and the valuation would be hard to justify because a glut of fiber optic capacity had sent network prices plummeting."23

Qwest may be the first to go. Qwest's Joseph Nacchio, listed as 1999's CEO with the Largest Options Grants in Fortune's Executive Pay table,24 has cashed out on significant holdings.25 The company's 2001 10-K,26 filed with the SEC on 1 Apr 02, shows anemic earnings. They're borrowing to cover their capital investments in obsolete equipment. They're now under investigation by the SEC for inflating revenues through trades with bankrupt Global Crossing. They face a bleak future at best.

The Hole in the Bottom of the Bell's Boat

Declining income, discussed above, is just the precursor to the dark and stormy night ahead. There is also the problem of stranded assets-lots of them.

"(Incumbent) Phone companies have spent billions over the past several years to build or upgrade their networks to accommodate a ton of new volume generated by the Internet and computer-to-computer traffic. The problem is that they have yet to develop data service that will wean them from reliance on their moribund voice business. And if they do not, they could be crushed by the fixed costs of their massive capital investments."27

The ILECs have for many years been investing in a high-quality, high-cost voice network with high reliability. We've long heard about the five nines: "99.999% reliability" in a network that was technically designed to maximize the quality of voice. It's been expensive: SBC carries a $26 billion debt, BellSouth a $20 billion debt, Qwest has a $25 billion debt, and Verizon a stifling $64 billion debt.28 To cover their investments (some of which is going to buy obsolete voice-based equipment) the ILECs have multi-year loans, and covering expiring loans are new loans for 20 years and more. Many of the loans are written with accelerated paybacks in case of default.

Competing with the high reliability ILEC networks are lower cost, lower reliability alternatives such as fiber, cable and wireless. These workable new networks have an added advantage: flexibility. As technology develops it can be deployed quickly and cost-effectively, in some cases by home users as well as competing carriers. This is in stark contrast to the relatively fixed network of the five nines.

Lessons from Enron

The Enron scandal offers many lessons relevant to the ILECs' interests. Public shareholders are an angry bunch right now, and have shown they can move markets with incredible speed if they collectively lose confidence. Historically, ILECs have been considered safe havens for retirement accounts; assumptions that are about to be challenged again. The industry analysts are starting to take notice of the ILECs' impending troubles.

The SEC, working with new accounting rules in light of Enron's creative financing, has announced investigations on 49 big companies, including Qwest (mentioned above). Additionally, under these new accounting rules companies will not be able to amortize their goodwill and will instead require big write-downs in their next statements. Qwest just bought US West. The cost? "...[A] non-cash charge of between $20 billion and $30 billion in the second quarter...."29

Government policies can have an enormous impact on business activities, in terms of regulation and enforcement, litigation, taxation, and even publicity. Here, a public policy debate is inevitable. The ILECs have arrogantly held their position against the government's policies and against public interest. As their financial situations become apparent, there may be little mercy from any but the most pragmatic hands. In this uncertain economic climate, the ILECs' futures are far from secure: historically bad customer relations, poor balance sheets, a lack of clarity in their future plans, and competitors and technology ready to change their market.

Conclusion

Over time, the telecommunications network has become an essential part of our daily lives. Recognizing this, incumbent ILECs have grown fat and arrogant at our expense. For years, the ILECs have held their monopoly position against the government's policies and against the public interest. The ILECs have maintained their stranglehold on the last mile, or local connections, and with it have foreclosed opportunities by telecommunications service competitors. ILEC profits have come at the cost of investment-backed technological development and innovation.

Continuing public policy debates are inevitable. The ILEC future is uncertain, and with it the stock and retirement money of millions of investors. Serious financial and technical workings are busy undermining the well being of the monopolistic ILECs. The Internet has captured the public's interest, and now challenges the established telephone network's profitability. As the ILECs' financial problems increase, there may be little mercy from any but the most pragmatic hands. We could be witnessing the end of an era.

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