CLEC: Tower of Babel
by Andy Pelander
July 31, 2001
From the August 2001 issue of UPSIDE magazine
David Stehlin's 75-year-old mother complains about her dial-up Internet connection and wants a cable modem.
"That, to me, says telecom is pervasive," concludes Stehlin, an industry veteran and chief executive officer of Princeton, N.J.-based fiber optics supplier OnePath Networks.
Stehlin likes to hand it to the proverbial telecom revolution for growing as quickly as it has since the dawning of the flawed, yet functional, Telecommunications Act of 1996, which was designed to deregulate the local telephone industry. He is struck by how convincingly we've grown dependent on broadband technology in just a few short years.
"Here we are building this high-speed network, and it's happened right under our nose, and we don't even know it," he says.
Telecom surges ahead
Stehlin would argue that, in the five years since the passage of the Telecom Act, the progress made installing broadband in this country has been spurred by public-policy snafus and stock-market acrobatics, rather than stifled.
In spite of fair-market naysayers sore from the current oft-perceived telecom-market stalemate, there are those, like Stehlin, who are pleased with the fruits of the industry's labor to date.
But even Stehlin has felt the sting of the widespread telecom downturn, specifically that of many competitive local-exchange carriers (CLECs), the companies born out of the Telecom Act to compete with local Bell companies.
OnePath Networks has built a customer base rich in CLECs, many of which have faded away and are either no longer in business or not placing the orders they said they would.
In late April, OnePath announced a 50-person layoff, citing poor market conditions. "There's a regrouping at work," Stehlin says, "and I think many of the grand schemes that have been planned have been pulled back." Still, he is impressed by the rate at which broadband technology has seeped into homes and businesses. And its growth has been relatively subtle, he adds.
Broadband's silent approach
In the 1920s, the United States cast its collective gaze outward and upward as telephone poles were hoisted off flatbeds and inserted into an earth eager to receive them and the communication phenomenon they would bring. In the '30s, towns watched as a burgeoning national highway system arrived at their doorsteps, one truckload of asphalt at a time.
Residents likely lost interest weeks into the decade it would take for the sprawling black veins of roadway to creep across the United States, connecting one state to another. The nation's electrical grid, cable TV and mini-malls also entailed a highly visible and often disruptive installation.
But broadband has appeared on our desktops discreetly and seemingly overnight, as if delivered by stork -- whether by cable and wire already underground or through satellites fixed overhead -- and nary a stock-market plummet or deregulatory quandary has stopped this from happening.
Since the Telecom Act's promise to grant CLECs access to local loops -- the copper lines that connect every home and business to a dial tone -- controlled by Regional Bell Operating Companies (RBOCs), hundreds of companies of every size have cropped up, offering the option of broadband services to nearly 65 million U.S. homes and thousands of businesses.
According to broadband market-research firm Kinetic Strategies, there have been 7.8 million residential takers so far, most of whom are cable-modem subscribers. All other home-based Internet users are left strolling in cyberspace with 56K modems, which are now the laughingstock of Web connections.
Grabbing the small biz sector
Allegiance Telecom (ALGX) was one such CLEC that struck while the iron was hot: Allegiance was founded within a year of the Telecom Act and now reigns supreme in the small and medium business (SMB) sector.
Allegiance Chairman and CEO Royce Holland's eyes glaze over when he's asked about the market opportunity in a competitive local-exchange environment and the relative ease with which he has capitalized on the large, underserved SMB niche.
"The opportunity is really as good as, or better than, ever," he beams. Contrary to the default opinion of today, Holland says that the opportunity for business success in the telecom industry has not slipped an inch, and that the Telecom Act, which lesser-funded CLECs are quick to blame for business woes, is one smoothly operating masterpiece, penned with near-poetic eloquence.
Whether bloated or modest, Holland's enthusiasm for telecom-market opportunities and business in general is not without considerable cause.
For starters, Allegiance, which he co-founded, is arguably the love child of the Telecom Act and Wall Street, namely because MFS Communications, the local exchange carrier Holland co-founded prior to Allegiance, was used as a model for the legislation.
In fact, the Telecom Act's competitive checklist was lifted fresh off the imprint left by the first major interconnection agreement between a CLEC and a Bell company: the January 1995 sharing deal between MFS and Nynex.
Prior to the Telecom Act, MFS Communications, originally called Metropolitan Fiber Systems, was really the only game in town going head-to-head with the RBOCs created by the 1984 federally mandated breakup of AT&T (T).
Before and after
As president of MFS from 1990 to 1996, Holland had a rare glimpse of the CLEC market before and after the Telecom Act, providing him with a unique perspective. Holland says he's been on both sides of the equation and credits market leverage, the significant benefits of the Telecom Act, and the explosive growth of the Web for his decision to begin Allegiance.
"With MFS, we had to go in and cut up streets, get permits and install networks before we could turn a first customer," Holland recalls. "That front-loaded a lot of your cash investment before you saw any revenue at all."
As a result of the Telecom Act, Allegiance could lease transport capacity in the early stages and hit the market running, hailing customers in roughly a third of the time required pre-1996.
"Once we'd built traffic, we went in and installed our own fiber [optic networks] to replace lease capacity," Holland says. Today, Allegiance is in 30 cities, and it expects to be in 36 cities by 2002.
Because Holland opted not to retire on the proceeds from MFS' $14 billion sale to WorldCom (WCOM) in late 1996, analysts, investors and lobbyists followed him to Allegiance to keep a close watch.
Robert Saunders, a senior analyst with Eastern Management Group, says analysts often track innovative company heads as they move from one venture to the next, because they tend to reflect where the market is going. "Holland is a good example," Saunders says. Even the sitting chairman of the Federal Communications Commission at the time of the Telecom Act, Reed Hundt, pledged allegiance in 1998 by joining Holland's Dallas-based company's board of directors, where he remains today.
It's odd that more fellow carrier companies haven't followed Holland's every move. From the looks of the recent telecom-market carnage -- wrought with Nasdaq delistings, bankruptcy-protection filings and profit famine after a five-year run of nothing but stock-market love -- few have mimicked his example, whether intentionally or otherwise.
But Holland says that all of the tools necessary to compete in today's market are nestled in the furrows of the Telecom Act. "The keys to success were in our control then and still are today," Holland says. "We saw a huge pent-up demand for broadband in the SMB market, and the Telecom Act made it possible to go after it."
Debts, shakeouts and golf courses
Instead of watching Holland, who is one in a handful of positive role models for aspiring CLECs, many of those failed and failing companies are now watching the market shed old skin -- theirs in particular.
"There's a shakeout taking place, and not an unusual one," Holland says. "But it's probably a painful one if you're one of the ones shaking out." What Federal Reserve Chairman Alan Greenspan once called times of "irrational exuberance," when inept management teams and poorly written business models didn't prevent a company from getting funded -- "grub staked," in Holland's words -- are history.
But not because the opportunity has dried up, or the Telecom Act is bunk, Holland argues. "I think a lot of the wounds are self-inflicted," he says, which begs the question: Can competitive local-exchange carriers, with few notable exceptions, hold true to their moniker and be genuinely competitive?
It seems that error within the telecom market has been impartial so far. The mistakes made across the industry were made by the biggest fish and the smallest minnows alike. AT&T is sitting on roughly $48 billion in debt, accrued largely during a string of cable-company acquisitions aimed at turning it into a one-stop broadband outlet, and the company reported a first-quarter net loss of $373 million, down from earnings of $1.74 billion a year ago.
In the 15 years since the AT&T breakup, its share of the long-distance market has dropped from 90 percent to less than 40 percent. In fiscal despair, AT&T Chairman of the Board and CEO C. Michael Armstrong has announced plans to divide the company into three separate entities: broadband, business and long-distance. Meanwhile, WorldCom stock is down 65 percent this year, and Sprint (FON) is close behind.
The world's largest equipment manufacturers are hosting a similar party. Lucent Technologies (LU) -- currently in the throes of selling not just network gear but also its $40 million corporate golf course, Hamilton Farm Golf Club in New Jersey -- reported a second-quarter loss of $3.7 billion. Lucent has said it will cut 16,000 jobs by the end of the year, and it is trying to convince investors it is not going out of business, despite Wall Street rumors to the contrary.
Nortel Networks (NT) and Cisco Systems (CSCO) also cower at the sight of their second-quarter earnings, and all of them managed to cite those pesky market conditions for their bum market karma.
Minor leagues
The smaller victims of a market that once poured hundreds of billions of dollars into telecom are too numerous to list. With more than 300 local carriers at the frenzy's peak, including DSL providers, fewer than a dozen of the existing local carriers have a significant national presence, which is widely viewed as a critical ingredient for survival.
It's estimated that roughly 100 small carriers have bought the farm since December. By the close of the first quarter of this year, six of the three dozen public carriers had filed for bankruptcy protection under Chapter 11, including Winstar Communications and ICG Communications, and all of them were trading at share prices that read more like gas prices than stock values.
DSL provider Rhythms NetConnections' (RTHM.OB) shares, which went for $93.13 apiece soon after the company's 1999 IPO, were trading for 25 cents in late April, when earnings were announced.
"When I talk to CLECs, a lot of them do blame Wall Street," Saunders says. "But the reality is that there were a lot of bad business plans. These companies just couldn't provision."
Sure, in some instances, Wall Street hyped companies it knew had unsustainable business plans. But Saunders believes that, in many cases, the CLECs that popped up after 1996 simply failed in their attempt to replicate the incumbent model because they couldn't make it selling local voice services.
"Local telecom is much harder than anyone thought -- much harder than long-distance or Internet," he says. "So, today, many are trying to generate revenue by blaming incumbents for their problems. That won't pay the bills either."
Legislative loopholes
In theory, the CLECs had it pretty easy going in. They had a Telecom Act scripted in their honor that allowed for one of their greatest -- and most overlooked -- advantages: the ability to "cream skim," or choose to extend services only to profitable regions. On the other hand, incumbents -- AT&T, Sprint and WorldCom -- have historically been required by federal law to stay in a market even if it's not profitable.
Also, the loop-sharing arrangement, which told RBOCs -- Verizon Communications (VZ), Qwest Communications (Q), SBC Communications (SBC) and Pacific Bell -- that they had to offer a reasonably priced leasing plan on residential and business fiber connections to any CLEC that wanted it, allowed scrappy startups to enter a cook-off for RBOC customers using RBOC chili.
But, soon, a Garden of Eden effect took place, whereby CLECs were convinced they could eat of the once-forbidden fruit and become omnipotent like the incumbents. But access to the loop came with a price, and, for many now-defunct carriers, it was called reciprocal compensation.
Reciprocal compensation, or "recip comp," as it's called in the "tel biz," is the money RBOCs were supposed to give to CLECs when RBOC customers placed calls to ISPs on CLEC networks. And, when RBOCs were reluctant to pay what was owed with any frequency, CLECs that had built 40 percent to 70 percent of their revenue models on recip comp were done for.
Many subsidized the price of services, assuming the RBOCs would pay them. "Clearly, anyone with a business plan focused on reciprocal compensation, or not built to scale, should never have been funded in the first place," says Mike Rouleau, senior vice president of marketing and business development for Time Warner Telecom (TWTC).
"A plan based on recip comp is not sustainable. Services must be sold based on what it costs to deliver them to the customer, not on what some third party may or may not decide to pay you."
Some feel the Telecom Act is flawed because it doesn't amply address specific issues such as "reasonably priced" loop-leasing arrangements or reciprocal compensation. "The Telecom Act was not the nirvana we had hoped for local competition," Rouleau says. "Any time you have a specific piece of regulation, it's not going to be perfect."
To compensate, Time Warner has managed -- very successfully -- to put the bulk of its revenue on its own network, which allows it to monitor its margins and therefore sustain business. Denver-based Time Warner offers T1 and above broadband connections, local and long-distance voice services, and other products to business-only customers, and generates 80 percent of its revenue on 100 percent of its network, switches and fiber. In the first quarter of this year, that revenue totaled $173.1 million, with net losses of $28.7 million.
Trunking
Still, Time Warner's voice switch must be connected to RBOC switches so that traffic can be exchanged through a process called "trunking" or "hot cutting." Rouleau says RBOCs often do not move as fast as he would like them to when trunking and settling accounts. "Some people say it's strategic incompetence," he jokes. "I say there is nothing strategic about it."
One would think that working for a top-five CLEC like Time Warner -- often juxtaposed with other elite carriers like Allegiance, XO Communications (XOXO), McLeodUSA (MCLD), and, until recently, Winstar -- Rouleau would be just as quick to credit RBOCs as he is to poke fun at them.
After all, the Bells had to gut networks older than dirt to shoulder the added weight of data traffic and allow access by outside companies. Bells and incumbents like Verizon have had to virtually disrobe by opening their lines, switches and networks for near-public display just so they could lose money to competitors they've spent money to keep up with. Or have they?
Tom Maguire, Verizon's vice president of wholesale services, says, "The reason [wholesale is] around is because the CLECs don't have direct access to the legacy systems we have. I have a vested interest in seeing the CLECs succeed and stick around for a while."
However, words come cheap when cast opposite pricey system upgrades. Bells own about 88 percent of the nation's local lines, and some experts contend they only upgrade their back-end support systems when they feel like it, and, when competitors fold, the pressure is lessened. It's no industry myth that Bells move at their own pace, having embraced a tortoise-and-hare mentality since the mid-'90s, content to play spectator while telecom underlings burn too hot and too fast and disgrace themselves in the marketplace. And, while Maguire holds that CLECs are customers before they're competitors, should remaining CLECs go south -- like so many already have -- it's doubtful that bereaved Bells will mourn the loss too extensively.
Rouleau says Time Warner was wise to tailor its business plan, based on core business principles, to allow for circumstances beyond its control, including Bell company whims. "Clearly, a solid business plan addresses growth in sustainable areas," Rouleau says.
"We have to continue to run our business with an eye on the bottom line and on return on investment. Why these things are surprises to some people, at this point in the game, is beyond me," Holland agrees. If telecom is to reach a truly competitive state, it's high time the media quit targeting the telecom travesty and failed CLECs stopped pointing their bankrupt fingers at everything but themselves. "Anyone struggling in the general market is not going to want to look in the mirror," Holland says, "but perhaps they ought to."
Money without management
There was a time when venture capitalists and anyone with an E-Trade (ET) account invested in telecom, because it was sexy, a word that somehow found itself on the short list of terms used to validate stock purchases. The market is where it is today, by and large, because, when investors and executives should have been asking how technology companies were going to get paid, they were giddy over tip-top materials, like Grade A fiber optics, instead.
Johnny-come-lately CLECs were spending VC dough on top-dollar data networks previously owned only by incumbents and Bells, because they anticipated that customer traffic would demand such large pipes. Traffic, or "take rates," never reached desired levels, and networks designed for action sat idle, OnePath's Stehlin laments. "The CLEC needs to be very targeted," he says.
"Only pay for expensive components when you have a live, paying customer on the other end."
According to Eastern Management Group's Saunders, the companies that did not overspend, despite backers' urgings, were the ones that said to investors, "'We know how to run a telephone company, and you know how to front cash, so let's each do our jobs.' Those are the companies still around."
Not surprisingly, those same companies are the ones that avoided unsustainable business plans dependent on revenue streams like reciprocal compensation from intermediaries, managed to not bet it all on a single technology like DSL, and adopted stable financial structures characterized by fiscal restraint. "Too many said, 'I'll go raise enough capital to fund me for six months, and, when I run out, I'll ask for more,'" Holland observes. "Well, when the music stopped, they didn't have a chair to sit in."
ICG Communications is where it is today, in part, because it depended too much on reciprocal compensation, Saunders says. NorthPoint Communications (NPNTQ.OB) shut down partially because of a single-technology mentality that relied too heavily on Bells that should have been opening their networks to DSL providers but were too busy lowering prices to capture market share (those prices are now rising as competition weakens).
Too many telecom startups were run by inventors with great ideas instead of by businesspeople, a reality the dotcom sector had previously called its own.
"There's a blueprint out there for running a good business, and most of the rules are what you'd expect them to be," Saunders says. Pick up any business-school textbook, he adds, and it will tell you that good management, financial discipline, solid technology and the ability to forecast and evolve -- to see one, two and five years out -- are the keys to entrepreneurial glee. "Not enough CLECs have the discipline to step out of a market if it's not going to serve them," he says.
But, for the cream of the CLEC crop, like Allegiance and Time Warner, the Energizer bunny is still going, because Bells and incumbents are losing voice customers, as evidenced by a rash of long-distance applications now under review by the FCC. SBC, Qwest, Verizon and Pacific Bell have all applied to the FCC for permission to offer long-distance service.
And one of the largest qualifiers for long-distance provision is the level of cooperation Bells have maintained in opening their local loops. So, naturally, Verizon, currently the largest local voice provider in the country and the fourth-largest long-distance carrier, is making sure its wholesale arm is playing well with others. "My approach to dealing with the CLECs is that they're almost like an offshoot of our company," chirps Verizon's Maguire.
Fighting to the finish
Telecom executives, no matter what their public-policy leanings are, will admit that competition is good for a lot of reasons: It lowers cost, adds value and increases consumer choice. And, in many respects, the time elapsed since the Telecom Act was unveiled has fostered competition, albeit in raw form.
But, in truth, it remains the devil's fight out there, with no holds barred -- boots and eye gouging permitted. "I think, at the federal level, people understand the concept of competition, but, when competition showed up at people's doorsteps, it wasn't completely understood," says Valerie Haertel, senior vice president of investor relations for residential cable provider RCN (RCNC). "The intent was good, but it was not as well-understood -- by the regulatory bodies at large -- as it could have been. There was a misassumption that an upgrade would be easy."
So will the CLECs survive, and, if so, how? "Absolutely," Haertel says. "In a datacentric world, a company that moves data quickly and inexpensively will win the 'broadband war,' if you will."
Eastern Management Group's Saunders says the market will go the way of the "next-generation" CLEC, and names Telseon, an optics company that received $175 million in VC money in February; Cbeyond Communications, which raised $141 million in second-quarter 2000; and IP Communications, which struck gold in late 2000 with a $312 million second round.
What makes them next-generation? Most notably, rather than manipulating the cumbersome and grossly expensive industry-standard classified switch to fit their needs, the new CLECs are paying a fraction of the cost and adopting a software-based switch, called a soft switch, which runs entirely on an Internet protocol network, as opposed to analog.
But that's just the beginning, Saunders says. The next generation of carriers will have paid close attention to the industry's current failings. "They will say to themselves, 'We have to be successful, and this is what we have to do to be successful,' much like your top-tier CLECs of today have done," he says.
As a potential role model for future CLEC executives, Holland exudes confidence. When the sun sets in Texas each day, he knows he's taken a bit more market share from the big guys, and the only things deeper than his warm Southern drawl are his pockets.
"We've got a huge market now," he says, "and a big chunk of that has been a monopoly for 80 years. People say opportunity has waned and the Telecom Act isn't working.
"I don't think that's the truth."
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