Subject: [NEXTEL-1] Lawmakers Examine Competition in Communications Marketplace

From: Marcelrf <[email-masked]>
Date: Wed, 18 Feb 2004 13:15:47 -0500

Lawmakers Examine Competition in Communications Marketplace

Feb 16, 2004

Technology Advances Spur Intermodal
Competition, Analysts Say

Advances in technology are spurring a rapid evolution of voice and data
markets in the United States and dramatically heating up competition in
the sector, industry experts told a House subcommittee earlier this
month. These changes taken in tandem may strengthen the hand of the
e-business marketplace because market forces will boost functionality
and make robust functionality more affordable, particularly to the
all-important small to medium enterprise (SME) sector.
The hearing before the House Energy and Commerce Committee's
subcommittee on telecommunications and the Internet came on the heels of
last month's Supreme Court decision to block antitrust lawsuits against
telecom companies for alleged violations of the Telecommunications Act
of 1996. Many observers believe that the High Court's unanimous decision
will lead to full implementation of the Act.

The House panel called the industry experts up to Capitol Hill to be
briefed on how much the voice and data markets in the United States have
evolved over the last several years and how much they are likely to
continue to change in the foreseeable future.

Michael J. Balhoff, managing director, telecommunications group of Legg
Mason Inc. in Baltimore told the panel that advances in technology have
spurred significant intermodal competition and that the intensity of
competition is likely more widespread than many observers realize. He
pointed out that the current deep discounting in the residential market
has created competitive statistics that are higher than most investors
are willing to believe, and fund managers are generally unwilling to
commit long-term capital to a system that they perceive as often based
on regulatory arbitrage.

However, Balhoff pointed out, competition is occurring in intermodal
form in the residential market through wireless, high-speed data
services, and cable telephony and he believes investors expect that the
voice services provided by cable operators based on Internet Protocol
will have a transforming effect on the telecommunications market within
a few brief years. There is a risk is that the industry could return to
a monopoly system owned by the cable operators if the local exchange
carriers (LECs) are unable or unwilling to invest in the longer-term
network. Three factors could cause this: the expense of the investment
in high-speed network is too high to generate a satisfactory return,
there is too much uncertainty or fear about rules requiring them to
share their investment with competitors, the time required in the
investment will be too extended.

"I believe that the competitive data are clear that the business market
share shift has been dramatic," Balhoff said, citing FCC survey data.
"The FCC surveys state that CLECs penetrated, on average, 23% of the
reported U.S. business lines by mid-2003. In certain denser business
centers, the penetration of business lines appears to be above 40%. In
short, my view is that, in the wake of the Act, competitors have entered
a financially attractive market to target those customers that could
generate reasonable profits in high- density regions. The result is that
businesses now have a variety of asset-based competitors from which to
choose."

The Wireless Alternative

These days, wireless also is an important source of competition and
investors and analysts ask about wireless substitution on virtually
every investor communications-related conference call. "As analysts, we
track the falling numbers of LEC access lines that can be fully
explained only by reality of competitive choice, including wireless,"
Balhoff said. "We analyze the innovative types of services that appear
increasingly attractive because they offer new features, including
mobility, text messaging, image generation, etc. My observation is that
policymakers, understandably, work within legacy constructs - including
statutes and case law - that define wireless and other intermodal
services as different from traditional telephony, and some policymakers
have been slow to embrace intermodal services as competitors. At the
same time, I believe firmly that those newer carriers, based on proven
alternative technologies, are formidable competitors precisely because
their products are different from copper-wired services."

Looking carefully at the analysis, however, reveals something more about
wireless, Balhoff reasoned. First, the total residential loss can be
explained, in part, by the shifting to cable modems or DSL, but data
substitution is generally a second-line phenomenon, and the second-line
loss is slowing and is well below the total loss.  "It does not seem
that the loss is due to a more severe economic downturn, as the economy
appears to be improving, nor does the loss appear to be due to the shift
to cable telephony, as those forces are still relatively nascent," he
said. "It appears to me that the higher losses are due to an
acceleration in the movement toward wireless services and away from
wireline telephony."

Legg Mason estimates that roughly one half the residential line loss is
the result of consumers' cutting off slow circuit-switched second lines
to migrate to high-speed data substitutes, and that approximately 25% of
the share shift was due to consumers' substituting into wireless
services. The data now suggest that the trend toward wireless is
accelerating, as cellular price plans and convenience have occasioned
the growth of wireless to approximately 157 million subscribers at the
end of the fourth quarter compared with approximately 185 million wired
telephone lines, by Legg Mason estimates.

Broadband services also are growing at a healthy pace in both business
and residential markets - a growth primarily based on cable modems and
DSL. DSL data from the three- largest telephone companies show quarterly
increases in total lines served by the carriers. "The increases have
been gradual, but they are increases nonetheless, again over and against
the RBOC line losses," Balhoff said. "In terms of the numbers of
customers subscribing to DSL each quarter, the three-largest Bells
report 706,000 new lines added in the fourth quarter of 2003 - announced
in the last week - following 661,000 in the preceding period and 508,000
in the three months before that."

Meanwhile, cable operators have also reported high-speed data growth,
with the absolute number of additions generally rising. Research
indicates that cable operators continue to attract more subscribers in
absolute terms each quarter compared with the DSL additions by the Bell
companies and the additions by all LECs.

Legg Mason estimates that cable operators' market share in this
communications segment has slipped to approximately 57% in the final
quarter of 2003 from about 68% in the first quarter of 2003. The major
reason for this is the gradual pressure from RBOCs - much lower rates,
better bundling, and more widespread availability - that appears to be
focused on retaining high-speed share so the Bells will not be
disadvantaged when the cable operators begin offering voice over
Internet protocol (VoIP) services in 2004. Independent local exchange
carriers also have gained share, particularly in markets that are not as
well served by cable operators.

High-speed Data, VOIP Are Battlefields

Balhoff believes that the most significant competitive battle on the
horizon will be waged over high-speed data - the lifeblood of B2B or B2C
e-commerce operations.  "In our consultations with investors and
regulators over recent months, I have suggested that the expanding
battle over high-speed data is the thunder in the distance before the
most formidable storm of intermodal competition is upon us," he said.
"My view is that the Bells recognize that the true residential
competition is about to break out and competitive activity, ironically,
has nothing to do with what the deep discounts or other temporary
constructs that regulators have employed in attempting to change what
has for so long been an intractable residential marketplace."

VoIP is significant as well. While cable operators today are offering
relatively limited competition in delivering voice, those numbers are
likely to grow rapidly.  "The most recent FCC competitive statistics, as
of the end of June 2003, contend that there were approximately 3.0
million cable telephony lines in the United States, accounting for about
11% of CLEC lines and 2% of the total domestic switched access lines. I
believe the statistics are interesting, but do not merit much study
because the true intermodal cable product is already making its entrance
in the form of voice over Internet Protocol," Balhoff said. "My view
that most telephony investors are profoundly concerned about VoIP
competition is evidenced by the fixation on the competitive share shift
generated by tiny providers such as Vonage, Net2Phone, Skype and
Pulver.com. Investors follow every signal from the cable operators that
are market-testing VoIP and those that have begun to roll out the
Internet-based service."

This new competitive line in the sand is illustrated by Time Warner's
report last month on its test market in Portland, Maine. The service was
begun in May 2003 and management reports that it has captured more than
10,000 VoIP customers, which is about 23% penetration of the high-speed
customer base, 9% of the company's video customers in the region, and,
by Legg Mason's estimate, 5% of the homes passed in Portland. The
company also is beginning to offer VoIP in Kansas City, Kansas, and
Raleigh, North Carolina. By year's end, the company expects to be
offering the service in virtually its entire cable footprint.
"If we compare Time Warner's penetration rate to the FCC competition
statistics cited at the outset, I suggest that Time Warner could be near
5% residential penetration within its first year of service, adjusting
for the fact that the company's homes-passed are fewer than the
residential telephony lines in the region," Balhoff said. The FCC
reports that residential plus small business penetration of CLECs was
12% as of June 2003, based significantly on the discounted rates the
regulators set.
"It appears that, within two years, we could see the residential
competitive statistics bypassed by VoIP services in a marketplace that
is fundamentally driven by technology changes, and a result accomplished
far more effectively than might have been expected through regulatory
incentives," he pointed out. "I believe that the introduction of VoIP
services will move residential competition to a place that legislators
and regulators could not have expected realistically under the
copper-based telephony model. In this new intermodal competitive
landscape, consumers will be able to choose from asset-based competitors
whose services are differentiated from, and more convenient than,
circuit-switched telephony." The analyst also believes the pricing for
services will be more attractive than rates possible using legacy
telephony, because of the underlying economics of Internet-based
technologies.

Looking to the future, Balhoff believes that the emerging intermodal
forces raise serious policy questions. "Regulators and legislators will
increasingly have to consider whether the incentives and constraints
that they are employing are dismantling the correct bottleneck monopoly
in light of the rapidly changing technologies," he said. "In fact, I
believe that many of the more thoughtful policymakers recognize that
backward-looking schemes are seriously limiting RBOC investment and that
the limitations could have unintended consequences in causing the LECs
to slow their commitments to the forward-looking wireline markets in
which fiber and optical electronics are key."

Convergence of Services Is Reshaping
Market, Louthan Believes

The convergence of services, providers, and service offerings are all
blurring the lines between local voice, long distance voice, wireless,
data, and video services, Frank Louthan vice president equity research,
Raymond James Financial, Inc. told the House panel.

"We see technological barriers becoming weaker and competition for these
services increasing," he said. "As the RBOCs integrate their offerings
with satellite providers through joint ventures, the cable operators
roll out telephony services, wireless data becomes a larger mass-market
offering, and other new technologies complicate matters further, we
believe the regulatory community should be aware of the impact these
trends will have on the industry participants, investors, and
consumers."
Although local voice services were historically dominated by the local
Bell monopolies, these services are now experiencing a higher degree of
competition from a number of sources. IXCs and CLECs are attacking the
mass market largely as UNE providers, although this source of
competition has higher concentrations in states with lower UNE rates.
Cable operators are increasingly rolling out switched voice services,
although their mass roll-out has been somewhat limited thus far as they
wait for VoIP to become more of a reality. Other factors impacting local
telephone companies include a decline in second lines as consumers
abandon them for a broadband connection or wireless phone, and the
replacement of primary lines by wireless phones as that technology
becomes a more ubiquitous service.

While the Telecom Act of 1996 created a large influx of competitors
using different sets of assets to somehow capture revenue from either
voice or fast-growing Internet services, the end result has been greater
competition at all levels. There also has been an erosion of the health
of the industry as these competitors all seek to cover their high fixed
costs with lower and lower contributions from incremental sales.

"The real issue, in my opinion, gets down to the general economics of
the business, which I believe to be largely fixed, thus making it
difficult for multiple network providers in the same market to generate
a positive return," Louthan said.  "The high fixed costs can create high
incremental margins and significant profitability over time, although
this should not be mistaken for an open invitation for many competitors
to enter the market, as those profits erode quickly in the face of
multiple providers. Eroding profits, in turn, provide disincentives to
investors, which I view as a negative scenario in a capital-intensive
industry such as telecommunications."

The industry is now in a state of flux that discourages spending on new
assets, since the recent large investments in capital have not earned
returns. This has, he believes, discouraged innovation from telecom
equipment providers due to pressure on pricing, revenue, and cash flow.
Meanwhile regulation has done its part in discouraging investment where
it can be deployed most effectively, namely the "last mile."

"I believe there is more competition than necessary in the telecom
industry at the present time," Louthan said. "The investment community
is largely uncomfortable with spending on new facilities due to
continued erosion of industry fundamentals and a general lack of comfort
with the regulatory environment. With some level of competition, I
believe incumbent providers and new entrants are kept on their toes,
innovation ensues, and pricing is likely to remain at a lower level than
under a monopoly-regulated regime. However, the current state of the
industry is not healthy, as carriers are seeing their returns decline
and investors are growing less likely to participate in an industry that
is perceived to be irrational."

With respect to the broadband revolution, Louthan believes that cable
operators have done an excellent job of deploying the capability, and in
so doing have demonstrated how market forces can be the best driver of
companies bringing new and innovative services to the marketplace.

"I believe this is largely due to the certainty of the investment for
the MSOs, as they may have been reluctant to roll out a mass broadband
offering had they been required to resell it under regulatory driven
rates in a similar manner to the RBOCs," he said. "Meanwhile, the RBOCs
have lagged cable providers in deploying broadband and simply gaining
customers, in part due to issues with their plant, but also out of
concerns over stifling regulation, be it either allowing competitors to
use their facilities or simply paying more attention to their battles
over voice regulation. Considering the amount of choice customers have
in broadband, not to mention the nascent wireless data offerings that
are further changing the game for broadband and data access, regulation
of this market would simply stifle rather than promote competition over
the long run, in my opinion."
The most significant technological driver for change is VoIP, he said.
"Once again the cable provider, with plant already deployed and an
embedded customer base to market the service towards, appears to have an
advantage. The cable operators have the financial resources, economic
justification, and expertise to pull-off mass-market offerings that
should spur competition and new services."

Louthan also sees the lines that separate technologies and competitors
blurring in the eyes of customers, but regulation typically has not
considered this broader market for telecom services. "I do not believe
residential or business customers suffer from a lack of choice in
telecommunications services, which is a development that will be
proliferated by the quickening pace of technological innovation in the
coming years," he said. "The total impact of all mediums of telecom
competition and consumers' indifference between them should be strongly
considered in the continuation and modification of telecom regulation."

Telecombweb-

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