Merrill Lynch (particularly note final paragraph)
4 August 1999
Daniel Reingold, CFA
Ehud Gelblum, PhD
Mark Kastan, CFA
Telecom Services
Spreading the Cream: Rate Rebalancing Proposal is Good
Policy, Good for the RBOCs and Good for LD Carriers
Reason for Report: Joint Proposal to FCC on Access Charge Reform
Investment Highlights:
· Late last week, the Coalition for Affordable Local and Long Distance
Service, consisting of BEL, BLS, T, FON, SBC and GTE, submitted an
access charge reform proposal to the FCC that we believe is beneficial to
both ILECs and long distance companies alike.
· The new proposal calls for reductions in per-minute access charges until the
per-minute access charges are decreased from their current level of about
1.2 cents per minute on each end of a Long Distance call to their actual level
of cost, or about 0.55 cents for the RBOCs and GTE and 0.65 for the other
price-cap ILECs. At that point, per-minute access rates would be frozen.
· In exchange for receiving less per-minute access revenue, the ILECs would
be allowed to raise the Subscriber Line Charge (SLC), a fixed per-line
charge. For the next 4 years, annual NET access charge reductions would
approximate $1B per year – comparable to the last few years and fully
embedded in our forecasts already. Then, those NET cuts would cease – a
big positive for the ILECs.
· We believe that this proposal would be an unqualified positive for the
RBOCs as it reduces their susceptibility to cream-skimming competitors
while spreading out their access revenues ratably over all lines instead of
being concentrated in large corporates and the CBD as they are today.
· We further believe the proposal would benefit the LD carriers as it would
allow them to lower per-minute rates on LD without cutting into their own
net revenues, thereby stimulating increased traffic over their LD networks.
· For the CLEC group, we think the net impact from this proposal will be a
modest negative over time. As access charge “cream” is spread beyond the
CBD, CLEC long-term profit margins will be impacted by the need to
expand geographically – both in local NW deployment and in selling effort.
Fundamental Highlights:
· The proposed solution would raise the maximum fixed line charges to res.
customers from a current average of $5.00/month/ line (a SLC of $3.50 and
a PICC of $1.50) to $5.50 on 1/1/00, $6.25 on 1/1/01, $6.75 on 7/1/02 and
finally to $7.00 on 7/1/03.
· At the current levels of 110.5M res access lines and 690B interlata minutes,
the fixed rev-per-line bucket would go up $3B while the rev-per-minute
bucket would go down $6B over the 3-year period. The net effect would be
a reduction of about $1B/yr for 3 years consistent with current plans.
What Has Changed?
Late last week, the Coalition for Affordable Local and
Long Distance Service, consisting of BEL, BLS, T, FON,
SBC and GTE, submitted an access charge reform
proposal to the FCC that we believe is beneficial to both
ILECs and long distance companies alike. Conspicuously
absent from the coalition are US West and MCIWorldcom.
Proposal Description: The group proposed a continuation
of the current FCC plan which calls for a gradual reduction
in the roughly $10B (690B minutes @ $0.015) of
interLATA per-minute access charges that long distance
customers bill and collect on behalf of the ILECs, partially
offset by a gradual increase in the fixed local rate element
paid on all lines regardless of usage (this is known as the
SLC, subscriber line charge). The new proposal would
continue the planned reductions until the per-minute access
charges are decreased from their current level of about
$0.012 per minute on each end of an LD call to their actual
level of cost, or about $0.0055 for the RBOCs and GTE
and $0.0065 for the other price-cap ILECs (e.g.,
Comonwealth, Citizens and Cincinnati Bell). At that
point, per-minute access rates would be frozen and
ILECswould no longer be forced to reduce access charges
via an inflation minus 6.5% factor. Instead, the “x” factor
would be reduced from 6.5% to the inflation rate,
translating into zero annual reductions – a big positive for
the ILECs given that today (and every year in the past)
they have been forced to reduce rates 3-5% annually.
Over the 5-year program and assuming 1998's minutes-of-use
level of about 690B interLATA minutes per year, the
$10B per-minute access pot would be reduced to about
$3.8B annually. In exchange for receiving less per-minute
access revenue, the ILECs would be allowed to raise the
Subscriber Line Charge (SLC), a fixed per-line charge, by
a partially offsetting amount. The proposed solution
would raise the local telco's maximum fixed line charge
for each residential line, regardless of LD usage, from
today's average of $5.00/month (comprised of the SLC @
$3.50 paid by the end user and a PICC @ $1.50 paid by
the LD co.) to $5.50 on 1/1/00, $6.25 on 1/1/01, $6.75 on
7/1/02 and finally to $7.00 on 7/1/03.
Impact to ILECs: Since the rebalancing of access
revenues is a revenue neutral event, in the near term, there
is little immediate impact. In the longer term, however,
the plan has the effect of redistributing revenues away
from the big high-volume business customers who tend to
make lots of long distance calls, while spreading this
revenue over every access line, $0.50 to a $1.00 at a time,
in the country.
Since the big central business district (CBD) high-volume
users have always been susceptible to competitive cream
skimming tactics (by signing up relatively few large
customers, a CLEC could cream-skim away the per-minute
access revenues associated with those accounts), the new
proposal essentially "spreads the cream" over a wider
basket of customers (indeed over the entire market),
thereby reducing the ILECs' susceptibility to CLEC
cream-skimming and stemming the erosion in market share
in the CBD areas. No longer would the RBOCs' per
minute access charges be overpriced in order to subsidize
low monthly fees and no longer would their access
revenues be stored and easily targeted by competitors in
one easily targeted, geographically concentrated basket.
Furthermore, to the extent that certain RBOCs have
already lost market share to CLECs in the CBD areas, such
as BEL has in Manhattan, the new proposal would – over
time – lower the ILECs' access price umbrella under
which the CLECs today compete and thus would transfer
some of the access revenues currently received by the
CLECs back to whichever local carrier (i.e., the ILEC)
serves the majority of the lines in the region. For these
reasons, we believe this proposal, if adopted in anywhere
near its current form, is an unqualified positive for the
ILEC companies, including the RBOCs and GTE.
Impact to LD Carriers: As per-minute access charges
drop, LD carriers' variable costs decline and thus they can
lower the rates they charge their customers by a similar
amount while maintaining the same net revenue for
themselves. Since demand for an incremental minute of
LD use is highly price elastic (yet demand for fixed local
lines is quite inelastic), these lower per-minute prices
should stimulate higher volume traffic for the LD carriers
thereby making the proposal beneficial to them as well.
Incidently, higher LD volumes benefit local companies as
well, as the number of access minutes increases.
Impact to LD Carriers in the Consumer Local Market:
Since, by the proposal, fixed monthly line charges for
consumers will increase, the pricing umbrella in the
consumer market rises making the economics of offering
local service to lower volume LD users, such as average
consumers, more attractive. In effect, moving access
revenues and profits from large corporate customers and
from downtown to residential areas will entice competitors
to the residential and small business segments. This
should not only benefit incumbent local telcos – which
today serve virtually 100% of residences – but also benefit
AT&T as it invests to upgrade its cable properties to offer
local telephony to residences. Offsetting this positive for
AT&T, however is the negative it creates for AT&T's
business CLEC, Teleport, by making it more difficult for it
to cream-skim the large business accounts. We further
believe that as the cream under the new higher pricing
umbrella moves away from the central business district
(CBD), Teleport and other fiber-based CLECs traditionally
focused on dense business areas, will find value in moving
from the CBDs into lower density areas populated by
lower volume users.
Because AT&T's future is more closely tied to its success
in the residential cable market than it is to the business
market (given its over $100B investment in acquiring TCI
and Media One vs. only $12B for Teleport), this proposal
should be a net positive to T.
In contrast to AT&T, WCOM's long distance revenues
come disproportionately from business customers as do its
local revenues from its MFS and Brooks Fiber CLECs.
Under the current plan, AT&T does better given the
latter's disproportionate share of residential LD and its
future bet on residential local via cable. Of course, this
probably explains MCI Worldcom's reluctance to support
the plan at this point.
We suspect the plan will be modified before the FCC
finalizes it (we expect a final decision in the first half of
2000) with consumer and MCI pressures resulting in a
moderate lowering of the monthly fee (SLC) charged
residential lines offset by a moderate increase in the SLC
paid by each business line.
With respect to Sprint, it's exposure to the local market is
almost exclusively consumer based through its 7M rural
access line ILEC. Therefore, Sprint's incentives to support
this deal are the same as the other ILECs such as BEL,
GTE, BLS and SBC.
Impact to CLECs: For the CLEC group, we think the net
impact from this proposed change in the LD access charge
regime will be a modest negative over time. As the access
charge “cream” is spread beyond the CBD, CLEC long term
profit margins will be impacted by the need to expand
geographically – both local network deployment and
selling effort. However, we think there are 6 factors that
should help to moderate the long term impact on the CLEC
group:
1) 5 year phase in beginning in 2000 clearly limits the
intermediate term impact;
2) Impact on the CLEC current $108B addressable local
market opportunity will be modest as only $3B in LD
access charges will be redistributed - not eliminated -from
per minute to fixed monthly charges;
3) As lower per minute access rates are passed through to
end users in lower per minute LD charges, all LD
players - including the CLECs - will benefit from
higher usage due to price elasticity;
4) This proposed change in the LD access charge regime
will have no impact on the rapidly growing $10B local
data market, a market opportunity that should continue
to be a major value creator for the CLEC group;
5) As the only CLEC focused on the residential market,
RCN Corp. (RCNC, D-2-1-9, $40) is a clear
beneficiary from the favorable impact on the
residential market profitability as a result of these
proposed changes in access charges, and;
6) Least impacted of the CLECs should be those
companies focused on fixed broadband wireless as a
key local market access strategy - NEXTLINK
(NXLK, D-1-1-9, $90 7/8), Teligent (TGNT, D-2-1-9,
$62 7/8) and WinStar. Wireless local broadband
affords these players cost effective, broad local market
coverage and thus should significantly limit the need
to increase spending on local infrastructure and
SG&A.
Conclusions and Commentary: While this plan represents
a terrific path for the industry and for public policy, it is
sure to face strong opposition from consumer advocacy
groups upset over the increase in local phone bills.
However, since the industry has been moving in this
rebalancing direction anyway since 1984 when the first
SLC of $0.60/month was instituted and, in our view,
represents both good public policy and good economics,
we believe the plan – with some revenue neutral
modifications of course – has a very good chance of
passage by the FCC by mid-2000, if not in early 2000.
Finally, we believe that the benefits to the RBOCs of
reducing their risk to cream-skimming competitors far
outweighs the shift of revenues from faster growing per-minute
charges (RBOC access minutes of use grew 5.7%
y/y in 2Q) to slower growing per-line charges (access lines
grew 3.7% y/y in 2Q). We calculate that the rate of total
RBOC revenue growth in year 1 as a result of this plan is
only 0.1% (10 bp) less than if no rate rebalancing were to
take effect – and this is before factoring in the offsetting
effects of the slowdown in share erosion from competitors
as the cream becomes more widely dispersed and more
costly (in terms of time and capital) to serve.
Finally, as pointed out by Mark Kastan, Merrill Lynch's
CLEC analyst, two types of CLECs are particular
beneficiaries of this plan. One is CLECs focused on the
residential market given the proposal to raise local rates
via an increased SLC: RCN is the primary name here and
Mark has reiterated his positive view on that company.
The other category of CLEC beneficiary is the broadband
wireless category including such companies as Teligent,
Nextlink and Winstar – as their wireless technology has
superior economics to fiber in geographically dispersed
and less densely-populated business markets, which is
where we believe this proposal raises fixed monthly
charges and hence the price umbrella. |
