Ken, All,
An Article from X-Change Magazine that addresses the new breed of Data CLECs, defining their roles, and the perceptions they may be eliciting from the investment community.
x-changemag.com
Enjoy, Frank C.
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Defining the CLEC - Simple Descriptions May Elude Potential Investors
By Gary Kim
The emergence of a new breed of "data-centric" competitive local
exchange carriers (CLECs) such as Covad Communications Co. and
NorthPoint Communications Inc. is but the latest example of how the
U.S. CLEC industry is reshaping the telecommunications landscape.
Both firms also are examples of investments from non-traditional CLEC
sources in the carrier side of the business and further illustrate continued
evolution of CLEC business strategies.
At the simplest level, both firms have picked a niche--high-speed Internet
access for smaller businesses--and plan to dominate their segment of the
services market. The carrot? "Roughly 40 [million] to 50 million users
now connected to the Internet, growing at a rate of 60 percent a year,"
notes Susan Passoni, Cowen & Co. telecom analyst.
About 25 million of those users were connected to online services in June
1997, the balance--15 million to 25 million--to Internet service providers
(ISPs), according to Stamford, Conn.-based research firm
Cowles/Simba.
That translates into robust growth for ISPs, and, so the thinking goes, for
providers of high-speed connections. According to Cowles/Simba, online
service providers earned $3.4 billion in 1996 and will earn $14.9 billion
in 2002. New York-based researcher Jupiter Communications predicts a
separate ISP market of $8 billion by 2002.
Both firms use digital subscriber line (DSL) technology, running over
leased copper local loops, to provide high-speed connectivity on a
wholesale basis to ISPs. So the new firms are in several niches. They are
wholesalers. They use the DSL platform. They eschew voice and
specialize in data connections.
Covad Chairman Charles McMinn calls his company a "packet CLEC."
"We're a PC (personal computer) data networking company, not a
telecommunications company," he says.
The niche concept isn't new. Indeed, the entire development of the
CLEC industry is a search for defensible niches. The original competitive
access providers (CAPs) sold private-line connections linking large
businesses with their long distance company customers. With the passage
of the Telecommunications Act of 1996, CAPs transformed themselves,
entering the much-larger market for switched services (dial tone), and
becoming CLECs. With the continuing explosion in data services,
carriers began to adopt an "integrated communications provider" (ICP)
model, bundling local, long distance and data services. Using the leased
access provisions of the Telecom Act, as well as gobs of new local fiber
laid by the first generation of CAPs and CLECs, carriers began to move
to a "smart build" strategy, in which owned switches run over leased
fiber. Then the "wireless CLECs" also entered the fray, using microwave
technology to circumvent local loop bandwidth limitations.
And despite the trend toward bundling packages of services, some
providers focus on local-only or wholesale-only operations. At least one
CLEC is a systems integration and premises networking specialist that,
"Oh, by the way," also can handle public networking needs.
Some firms tilt toward rural markets. Many emphasize smaller markets or
a regional concentration. Most focus on the smaller and medium-sized
business segment. But a few are taking on the high end of the consumer
market as well, especially the small office/home office segment.
The clear drivers are market size and relative inattention by other
carriers.
"This is a market that has been traditionally ignored by the regional Bell
operating companies (RBOCs) and long distance companies," says
Passoni.
The small and medium business services market was worth $76 billion in
1996 and will grow to $116 billion by 2000, Cowen projects.
The New World
So if there is no "grand" CLEC strategy, what are we to make of industry
diversity? In what way can we capture the logic of competitive carrier
development, positioning and strategy? Why does it make sense for
investment bankers to pour billions into firms with such a plethora of
strategies and niches?
For the answer, we must look to the larger transformation occurring
within the entire telecommunications industry. For it is not simply
technology or the regulatory environment which is mutating. Indeed, the
entire business structure of the industry is in flux.
Think back to the world as it was. Industries were tightly regulated by
type of customer, by geographic franchise and by service. Cable TV
companies, as well as local, long distance, cellular, paging and private
networks, could sell only certain services, to certain customers, in certain
areas.
It was a "vertical" world in which boundaries between industries were
clear and service functions were integrated. An RBOC might be limited
to local service, an AT&T Corp. to long distance, a
Tele-Communications Inc. to video--but each type of carrier internally
handled its own provisioning, sales, distribution, transport and
service-grooming functions. Think of grain silos and you've got the
picture.
The new, competitive world is fundamentally "horizontal." Think of a
layer cake or Rubik's cube and you'll get the picture. In the new
environment, the barriers between silos become semi-permeable. More
important, business organizations themselves are structured in new ways.
A single carrier that wants to offer bundled services finds itself cutting
across old lines. For a non-facilities-based carrier, that means acquiring
sales and distribution assets across silos.
"We are your one-stop shop" is the desired sales platform. There's no
need to own all the component parts of the business, which are
outsourced. What is required is access to the full range of services that
constitute the "bundle" offered to customers.
For a facilities-based carrier, more money and muscle are needed, since
local network assets must be married to long distance infrastructure and
packet networks. "Ma Bell" has to be put back together, and stitched to
the world of packet networks as well.
This wide-open atmosphere means providers have extreme latitude to
innovate--not simply by customer, service and geography, but by
organizational structure. A carrier can excel in a switching, routing, sales,
distribution or transport layer, for example, without "owning" all the
component pieces of a full delivery system.
"We do long haul," "We do Internet," or "We do Internet protocol (IP),"
are some variants. "We do local," or "We do DSL," are some examples
of niche business platforms. "We do Iowa," or "We are a nationwide
local services provider," are others.
The inevitable business platform includes both retail and wholesale
functions. "Don't build your own network, use ours," is the position
occupied by this kind of carrier. This is especially true for facilities-based
long haul carriers, backbone ISPs or incumbent LECs (ILECs). So
data-centric CLECs represent the latest differentiation of new-breed
carriers. "We are nationwide DSL wholesalers," is the niche.
The DSL Niche
We should expect that most investment bankers will continue to shower
their attention and money on "voice-centric" CLECs, however. For
despite the Internet's explosive growth, most of the $220 billion carrier
business is voice-driven.
Today, a CLEC's financial worth and gross revenue opportunities are
driven by switched voice services. And money talks.
There's also some disagreement about the near-term ability of all-packet
networks to provide the full range of voice-related services, however
advantageous they are for data networking. As a result, most of the
big-money investment banks have left the pioneering to venture
capitalists, since DSL-centric firms are still seen as a niche without the
upside offered by switched voice--a $220 billion business (including
wireless services) in 1998, according to Richard Klugman, Goldman
Sachs analyst. Voice may be slower growing, but it still represents the
big, established market with proven customer demand, well-defined
pricing models and customer expectations. DSL still must prove itself.
Tomorrow, data will play a bigger role. But data is still a smaller market,
and opportunities for huge mega-mergers continue to revolve on
voice-related revenues and customers. But that's not the point.
Data-centric CLECs aren't waiting for tomorrow because they smell a
niche today. Using DSL technology, this new breed of CLEC avoids the
switched voice market. Instead, these new data-centric carriers are
essentially partners with ISPs who want to provide their customers
affordable and fast Internet connections.
Omaha-based Level 3 Communications Company Inc. is pursuing a
slightly different strategy, seeking to deliver all services over an IP
network, but including all the traditional voice functions and features. ICG
Communications Inc., Intermedia Communications Inc. and Convergent
Communications Inc. offer other variants on the "data-centric" strategy.
All three CLECs offer a "triple-threat" long distance, local and Internet
access bundle. Intermedia arguably emphasizes its nationwide frame relay
network. ICG, by virtue of its acquisition of Netcom, a major ISP, may
have a stronger play in that area. Convergent emphasizes premises
network integration, because one way to grab a niche is to look outside
the silo. In Convergent's case, it's the $104.1 billion computer services
market.
Price is key to the data-centric CLEC strategy. Santa Clara, Calif.-based
Covad sells its "TeleSpeed" symmetrical 1.1 megabits-per-second
(mbps) service for $195 a month, far below the cost of a T1 (1.5mbps
dedicated) circuit, which can range from $800 to $1,000 a month.
If 5 million U.S. PCs are connected to DSL circuits, each paying $150 a
month, the market is worth $9 billion a year. If 10 million PCs are
connected, the market may be worth $18 billion. Of course, that assumes
prices won't decline as DSL becomes a mass-market phenomena. At
$50 a month, 25 million DSL circuits yield carrier revenue of about $15
billion.
But some of the RBOCs, including US WEST Communications Inc. and
BellSouth Corp., are starting to deploy mass-market DSL services of
their own, so Covad and the other data-centric CLECs have to move
fast. Meanwhile, high-speed cable modem services are starting to
appear, as well.
But none of that seems to bother CLEC executives. Covad will get
"single-digit into double-digit penetration over the next five years," says
McMinn.
Noting the penetration for direct satellite broadcast provider DirecTV,
which garnered a 2 percent penetration in two years, making it the "most
successful consumer electronics innovation ever," McMinn says Covad
"absolutely" can maintain a business at single-digit take rates.
There's going to be an adoption curve for DSL, and if Covad does its
job right, Says McMinn, the curve will look like the adoption curve of
other generations of modems--of 9.6 kilobits per second (kbps), of
14.4kbps and of 28.8kbps, and now DSL. At some point Covad will be
shipping 25 million DSL modems a year, just like the modem
manufacturers are shipping 25 million analog modems this year, he says.
Covad has inked partnerships with about 20 San Francisco Bay Area
ISPs and plans to be operating in the San Francisco, Seattle, Los
Angeles, Boston, New York and Washington markets by about March
1999. E.M. Warburg Pincus, Crosspoint Ventures and Intel Corp. were
early investors. And Covad recently raised $152 million in a private
placement of debt and equity.
NorthPoint, backed by Accel Partners, Benchmark Capital and
Greylock Management, likewise offer ISPs business-class data services
on a wholesale basis. The company offers connections at 160kbps,
416kbps, 784kbps or 1.04mbps. An end-user connection of 160kbps
costs $99 wholesale from NorthPoint; a 416kbps service costs $135; a
784kbps service costs $165; and 1.04mbps service costs $199.
The vast middle market of small- to medium-sized businesses and branch
offices is the target customer segment. And the market is growing fast.
The Stamford, Conn.-based Gartner Group estimates that more than a
million U.S. small businesses invest in Internet connectivity every year.
And most will be receptive to high-speed connections. Verona,
N.J.-based researcher TeleChoice Inc. predicts that data service
revenues will grow from $20 billion in 1995 to more than $40 billion by
the year 2000 as a result.
Level 3's DSL access unit, formerly XCOM Technologies Inc., uses a
similar model, but dips into the retail segment of the business as well.
XCOM gets 65 percent of its revenue from ISPs and 35 percent from
corporate customers. First-round financing came from Battery Ventures
and Matrix Partners.
What's notable here is that initial funding has come not from the
more-traditional Wall Street investment banking concerns, but from the
ranks of venture capitalists. And their attention still is riveted on voice
opportunities. Because that's where the money is.
Voice Still Rules
For all of today's leading CLEC companies, voice revenues have the
most significant impact on the ability to raise investment capital. Indeed,
most of the industry's revenue growth since 1995 has been based on
voice services, anchored by local revenues and local access line growth.
That's not to deny that data access already has assumed vast tactical
significance. Indeed, the whole idea behind integrated access devices is
the ability to put additional revenue-generating services over a T1
connection initially installed to support key system or private branch
exchange (PBX) voice traffic.
"CLECs with facilities are shifting to data services to leverage those
assets," W. Todd Scott, Furman Selz analyst, points out.
Seen in that light, data services already are a crucial driver of incremental
revenue, especially when a partially filled voice pipe can carry Internet
access or private data network traffic as well. But the long-term carrot is
the sheer opportunity for web-based traffic.
Bell Atlantic Corp. executives, for example, believe the data and Internet
services market in its region could reach $85 billion by the year 2003,
notes James Henry, Bear, Stearns & Co. Inc. telecom analyst. Sprint
Communication Co.'s Integrated On-demand Network (ION) project,
and a recent $100 million investment by Japanese carrier NTT in
Denver-based ISP Verio Inc. are other examples of the growing
importance of data services as a growth driver.
As a practical matter, though, data services will not drive U.S. CLEC
share values or ability to raise additional capital in 1998. Indeed, the
catalysts for the balance of 1998 are strictly related to access-line and
revenue growth. And the simple fact is that those metrics hinge on
voice-related services, not data.
"We believe that the primary driver of the CLECs over the long term will
continue to be their strong fundamental performance on all levels," says
Henry. "Revenue growth is the initial benchmark on which investors
should focus as they look at the CLECs."
And that means local dial tone sales will be the primary growth driver. At
the moment, long distance, enhanced data, and Internet services are
secondary--though important--factors. And just as surely, earnings
before interest, taxes, depreciation and amortization (EBITDA) is the
revenue-related item of primary importance to investors today, says
Henry.
The emergence of data-centric CLECs is but the latest development in
both CLEC strategy and industry reshaping. In chasing a distinctly new
niche, such carriers also are attracting investment from non-traditional
venture capitalist sources. And that speaks volumes about the continued
restructuring of a once-stodgy industry.
Gary Kim is strategic research director at Convergent
Communications and editor-at-large of X-CHANGE. He can be
reached at (303) 749-3061.
Copyright c 1998 by Virgo Publishing, Inc.
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