The ILECs

The ILECs have had a tumultuous ride since their inception in 1984, following the divestiture of AT&T. At that time, AT&T, through its negotiated settlement with the Justice Department, fought to retain control of its Western Electric manufacturing arm and spin off the local service providers because it was clear at the time that the real money was in hardware and that the local telephone companies would not be long for the world. In retrospect, perhaps they should have kept the local telephone companies (the Regional Bell Operating Companies, or RBOCs) and divested themselves of Western Electric. Amazing thing, 20-20 hindsight.

Today, of course, we know that the ILECs are in positions of significant market power. The four that remain—Verizon, SBC, Bellsouth, and Qwest—control 90 percent of the roughly 200 million access lines in the United States today. The remainder of these lines are served by CLECs—small independent telephone companies, cable providers, and wireless providers. Much to the chagrin of the ILECs, that 90 percent market share that they enjoy is declining at the rate of about 2.1 percent per year, and has been for the last couple of years, while “lineshare” for the other sectors has increased incrementally—but increased. It is critical that the incumbent telephone companies stop focusing on numbers of access lines and preservation of minutes of use, and start focusing on preservation of customers. That is the only winning measure.

Timeline Highlights
■	1963:81 million subscriber lines in United States; 159 million worldwide.
■	1966: First optical cable used for voice transmission.
■	1976: First digital switch installed by AT&T.
■	1984: AT&T is divested; at time of divestiture it has more than one million employees and is worth $155 billion.
■	1988: First transatlantic optical cable is completed.
■	1989:138 million subscriber lines in United States; 496 million worldwide.
■	1991: Bell Labs develops photonic (optical) switching capability.
■	2000: International voice traffic quadruples in 10 years to 132.7 billion minutes—but revenue only doubles to $70 billion.
■	2002: U.S. residential cable modem subscribers: 7.7 million; DSL: 4.4 million; data traffic passes voice at 200,000 TB/day; also in 2002, IP surpasses all other traffic in volume.

Contrary to popular belief, the most significant challenge faced by the ILECs is cable, not the threat posed by the CLECs. Cable companies are beginning to take on a more strategic role in the industry at large. After years of competing with satellite providers for “eyeshare,” cable providers are finally beginning to enjoy price stability for the services they provide over their almost completely digital broadband networks. Furthermore, they are beginning to offer a variety of value-added services in addition to their traditional distributive entertainment content, such as high-speed cable modem Internet access and Internet-based telephony—both of which have become significant revenue producers as well as disruptive forces among their new competitors, the ILECs. Furthermore, the recently upgraded cable modem standards (DOCSIS 2.0) add significantly to the capabilities of broadband cable. These companies are now offering what has come to be known as the quadruple play—voice, video, data, and wireless—all packaged as a single, converged, and very lucrative bundle.

The fact is that the ILECs are under siege on multiple fronts. One of the critical questions that now comes up routinely in strategy discussions is this: Should the big three (Verizon, SBC, and Bellsouth) stop spending so much on capital outlay to build out their own networks and instead start spending their cash on the acquisition of preexisting assets? Companies like WorldCom, Cingular, Nextel, and Sprint PCS are, by many measures, undervalued at the moment; and because the ILECs have a recurring revenue stream, they have relatively easy access to capital compared to some of their competitors. One of the biggest challenges they face is that they have very high fixed costs and very low variable costs—which makes it difficult for them to make major adjustments in their cost base without drastic changes (like huge headcount reductions). The danger is that as they begin to lose access lines to competitors—such as cable MSOs, wireless providers, and CLECs—at what point do they lose critical mass and begin to collapse under the weight of their own infrastructure? Furthermore, as ARPU levels decline without a closely tied reduction in costs, the hole gets deeper.

Consider that between 1998 and 2002 alone Bellsouth, Verizon, and SBC spent $140 billion in CAPEX on their networks, a move that yielded less than one percent revenue growth. In 2003 they made combined profits of $20 billion on a collective market value of $240 billion. Clearly they want these numbers to increase. In 1998, ILEC CAPEX was 30 to 33 percent of revenues; today it is far lower, about 14 percent.

What steps have they taken to remedy the ongoing revenue shortfall? The first steps they took involved a direct attack on the FCC with a petition to reenter the long-distance market, referred to by regulators as Section 271 relief. Section 271 of the 1996 Telecommunications Act allows the remaining ILECs (Qwest, Verizon, SBC, and BellSouth) to enter the long-distance market if they can prove that they have sufficiently opened up their local markets to competition. As you know from your readings, they have aggressively pursued this course of action; so, suffice it to say that the ILECs universally fought for long-distance relief in response to local telephony entry by their competitors and have in fact been granted large entry concessions. Verizon, for example, replaced Sprint as the third largest long-distance provider in terms of customer count. The originally stated reason for long-distance entry was incremental revenue, since the cost to an ILEC for in-region entry was near zero. However, while the ILECs doubled the number of long-distance customers they serve, the revenues from the long-distance lines of business they established declined 6 percent as the bandwidth glut and the magic of declining ARPUs took effect. Clearly, ILEC entry into long dis- tance has bought them precious little if any margin relief as they watch their local services revenues decline.

So what must they do? There are a number of steps that service providers can take to shore up their falling revenue targets. They include acceleration of the circuit-to-packet migration, which facilitates convergence; marshalling a renewed focus on the importance of the metro marketplace; aggressive revamping of their overall network infrastructures; a much stronger focus on both element and network management; an aggressive examination of the services that customers actually want and a plan to deliver them cost effectively; and a strong focus on both enterprise and residence customer requirements.

Circuit-to-Packet

The circuit-to-packet migration plan stems from the convergence activity that is underway throughout the greater industry. There is no question that circuit-based services such as voice, ATM, and frame relay will be around for some time to come, but there is aggressive movement going on with regard to packet migration. Companies are rapidly developing and rolling out service packages that rely on IP, softswitch technology, and packet-based services, including voice. The VoIP marketplace for wireless, Centrex, and PBX service alone is enormous. Now that the industry is back on its feet and money is moving in, this trend will accelerate. VoIP is a critical success component and not simply because it helps the telco reduce costs. It is critical because it facilitates the delivery of a new suite of converged applications and services that represent new revenue streams for the telco. There is nothing more important than that.

Metro Markets

Because of the diverse, multiprotocol nature of the metro marketplace and the ongoing evolution of the corporation—from operating out of a single metro-based location to a distributed corporate architecture with offices scattered throughout customer locations—metro has become one of the fastest growing market sectors for service providers. And because optical technology has taken root in the metro rather effectively, with low-cost, multichannel DWDM technology offering lower cost solutions due to optical’s ability to reduce the total number of network elements under management control, it garners attention. Today, ILECs control more than 60 percent of all metro spending; this is a significant percentage of the overall market and deserves the attention it attracts. Furthermore, the fundamental local-loop technology for the metro is Gigabit Ethernet, and to be even more granular, switched Gigabit Ethernet. Service providers can simply drop a fiber connection in the basement of a metro office building, terminate it on a high-volume Ethernet switch, and deliver a broad range of high-bandwidth services to multiple customers in the building.

Network Revamp

Today the typical ILEC operates a wide array of disparate and functionally unrelated networks: the PSTN, the IP network, the ATM network, the frame-relay network, the ISDN overlay, the DSL overlay, the wireless network, the high-speed Ethernet access and transport network, and so on. Recent technological advances such as Multiprotocol Label Switching (MPLS) and Resilient Packet Ring (RPR) allow for many of these network infrastructures to be converged onto a reduced set of protocols and physical networks, a move that dramatically simplifies the complex management task that ILECs face. This complexity translates into revenue barriers because of service delays, QoS issues, and billing discrepancies. Anything that can be done to simplify “the cloud” is a step in the proper direction because it reduces overall operating cost and stands a good chance of increasing customer service levels because of reduced network complexity.

The move to an IP infrastructure is clearly underway, but in many cases the telcos are reluctant to make big moves in that direction because of uncertainty over the business reasons for such a radical migration. In fact, there are relatively few valid business reasons for the migration to IP. The first is obsolescence: If a telco is facing a situation in which a switch in a central office is nearing obsolescence, then an IP overlay is probably worth considering. Or, if the telco is about to offer service in a greenfield (new, devoid of services) market, then IP is worth considering. Alternatively, if the service provider is facing a situation in which a switch is nearing capacity and will potentially require real estate expansion to accommodate the new equipment required, then IP is worth considering because of its reduced floor space requirements. Finally, if the service provider is operating in a region with a high degree of business penetration, or is in an area where fiber-to-the-home (FTTH) is being considered, then IP represents a serious advantage and should be considered as a key infrastructure component.

Management

Network and element management, like staff training, are often the first things cut from the budget and the last things implemented. Perhaps that’s a bit harsh, but not by much. One of the loudest complaints voiced by customers, especially enterprise customers, is billing complexity. Customers claim to want a single, simple-to-understand bill^[1] for all of their network services. And because of the diverse and logically disconnected nature of the network elements that come into play when provisioning customer services, the actual provisioning process is often slow, inaccurate, and expensive. Reduction of managed elements and the creation of an aggressively accurate and capable management interface must be of paramount importance to incumbent service providers.

Furthermore, there is ample evidence to suggest that the management systems operated by service providers since time began will soon be inadequate to handle the evolving demands of the services marketplace. Those systems are based on a model of predictable, recurring charges as well as a few nonrecurring charges every month. The market model, however, is beginning to embrace a more transaction-oriented billing model, which means that the OSS systems operated by the traditional telco will no longer suffice. It is critical that these companies actively evolve their internal systems to meet the needs of the changing customer base.

Another factor is physical deployment. The operating expenses incurred by ILECs to deploy DSL, for example, are inordinately high because it often requires multiple “truck rolls” (installation technician dispatches) to make it work. Not only is this expensive in terms of real dollars, it’s frustrating for customers.

Services

Next on the wish list is an aggressive examination of the services that customers actually want and a plan to deliver them cost-effectively. Service providers are now putting into place data-mining and knowledge-management applications to help them better understand the evolving needs of their customers and make them more capable of responding to demands for service, perhaps even before the customer realizes the need. Most important is the aforementioned understanding: At the risk of sounding simplistic, it is absolutely critical that service providers offer services the customers actually want rather than the services that they think they want or that are based on the technologies that happen to be available at the time.

Finally, related to the last item, it is important that service providers carefully differentiate between enterprise and residence customer requirements, as much for the commonalities of demand as for the differences.

So what are these additional services? Many believe that the key to enhanced market success lies in a well-planned entry on the part of the ILECs into the video services market, offering content and interactive video-based services. This could also lead to enhanced success for broadband wireless technologies such as the Local Multipoint Distribution Service (LMDS), WiMAX, and the Multipoint, Multichannel Distribution Service (MMDS). Some service providers are already looking at content delivery; consider, for example, Telus in western Canada. Telus was the first service provider in North America to deploy a regionwide IP backbone, one of the first to offer IP-based voice services, and now offers Telus TV, which is the equivalent of cable content delivered over DSL. Industry analysts continue to examine the viability of ILEC/satellite provider alliances, which would give ILECs an enormous footprint for service delivery and potential access to far-ranging content, and the satellite company access to a large collection of potential subscribers. And while this combination may not be ideal, it is worth considering in the future. Consider SBC’s recent interest in DirecTV. Today, 11 service providers control 85 percent of the global telecommunications marketplace, and ILECs are responsible for 85 percent of all equipment spending. So, they are without question a force to be reckoned with.

ILEC Summary

So, what are the primary challenges facing the ILECs? First, they are experiencing declining revenues brought on by wireless substitution, cable incursion and broadband IP voice in both the enterprise and end user sectors. Second, because of OPEX issues, they often lose money on DSL deployment. Third, their debt load is high. Finally, uncertainty associated with regulatory decisions leaves them with a number of unanswered questions. Nevertheless, the market is currently theirs to lose because they do own the bulk of the customers. However, they must refocus their efforts on both cost reduction and customer-specific service delivery if they are to hold on to their advantage, and must also develop the logical infrastructure required to offer, deploy, and bill for converged service packages.

We now move our attention to the much-maligned CLECs.