Subject: [NEXTEL-1] Legg Mason On -The Current State of Competition in the Communications Marketplac

From: "marcel_rf1" <[email-masked]>
Date: Fri, 27 Feb 2004 16:01:42 -0000

The Current State of Competition in the Communications Marketplace
Subcommittee on Telecommunications and the Internet
February 4, 2004
1:15 PM
2322 Rayburn House Office Building  

============================================================
Mr. Michael J. Balhoff 
Managing Director Telecommunications Group
Legg Mason Inc.
100 Light Street
Baltimore, MD, 21203 

Chairman Upton, Ranking Member Markey, members of the subcommittee, 
good afternoon and thank you for the opportunity to address you 
concerning the state of telecommunications competition and the growth 
in intermodal communications services. Let me state at the outset 
that my testimony today represents my opinion and does not 
necessarily reflect the views of Legg Mason or the other 
telecommunications analysts at our firm.

Curriculum vitae I am Michael J. Balhoff of 1213 Shady Creek Road, 
Marriottsville, Maryland 21104. I head the Telecommunications Equity 
Research Group at Legg Mason, a Baltimore-based full-service 
investment firm. I cover equities in the incumbent local exchange 
carrier industry, including the regional Bell companies and rural 
telephone carriers. My specific practice is most widely recognized 
for a focused coverage of rural telephone companies. We consult 
regularly with corporate managements and policymakers, and we provide 
investment advice to a wide range of institutional investors across 
North America and Europe, as well as private equity investors in the 
United States.

Focus of Testimony on State of Competition in Domestic 
Telecommunications I am honored to present to the Subcommittee on 
Telecommunications and the Internet about the developments related to 
competition in the communications industry. My understanding is that 
you wish to better discern 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.

I believe that the insight you have previously articulated in your 
invitation to me is correct - that advances in technology have 
spurred significant intermodal competition and that the intensity of 
competition is likely more widespread than many observers realize. I 
will state in my testimony that . . .

§ I believe competitive activity is significant in the business 
community; § Investors believe, in my opinion, 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; § I believe that competition, however, is 
occurring in intermodal form in the residential market through 
wireless, high-speed data services, and cable telephony; § My 
conviction is that 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; and § The current risk is that we eventually could be 
returning 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 because: (1) the expense of the investment in 
high-speed network is too high to generate a satisfactory return, (2) 
there is too much uncertainty or fear about rules requiring them to 
share their investment with competitors, or (3) the time required in 
the investment will be too extended.

In support of my views, I will briefly summarize publicly available 
data on: (1) ILEC (incumbent local exchange carrier) and CLEC 
(competitive local exchange carrier) voice marketshare for business 
and residential, (2) wireless service as a substitute for the local 
exchange service, (3) broadband market growth and the unique factors 
affecting the competitive landscape of cable-modem services and 
digital subscriber line services, and (4) cable companies' progress 
in capturing voice telephony market share based on circuit-switched 
and voice over Internet Protocol (VoIP) technologies.

Local Exchange Carrier Market Share One of the key goals of the 
Telecom Act of 1996 was the introduction of competition in the urban 
local exchange market. Most of the statistics from the FCC and the 
investment community verify that this goal has, in part, been 
achieved and that a significant number of customers are served by 
alternative local exchange service providers over the traditional 
telephony network, notably in the business marketplace. The FCC, the 
state regulators, and the courts have accomplished much of this task 
by setting myriad rules and clarifications for leasing the 
incumbent's network elements, incenting significant new investment by 
competitors, sifting through controversies related to arcane subjects 
such as collocations, hot-cuts, cost models and the long-distance 
Section 271 process. We have far more insight today into the 
legalities and technologies of communications than those policymakers 
had in the mid-to-late 1990s, but the end result is that they made 
possible real competitive growth. Illustrating the general trend 
toward competition, the most recent FCC data suggest that total CLEC 
market share has increased to 15% in June 2003 from 4% in December 
1999. Table 1 summarizes the data, with the statistics representing 
that the incumbent carriers' share of the total lines has slipped in 
the same three-and-a-half-year period to 85% from 96%.

Table 1: FCC Market Share Data

I believe that the competitive data are clear that the business 
market share shift has been dramatic. 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.

My view of the residential market is different, and I believe that 
the FCC data lead to more suspect conclusions. The residential market 
share shift occurred later than did the business shift, apparently 
for several reasons. First, residential rates have been maintained at 
relatively low levels and were even subsidized in some regions as 
part of public policy since the early part of the last century. 
Second, the costs associated with providing residential services are 
high, meaning that the profit spread is likely modest at best, which 
is why we have seen little investment on the part of copper-based 
competitors. Third, the usage volumes and mix of services are 
generally unattractive for residential competitors, especially 
compared with services provided to businesses. And, fourth, the 
investment necessary to provide ancillary services - video, high-
speed data, etc. - is prohibitive unless the communications provider 
can offer, and have a high probability of retaining, a much fuller 
array of services. More simply stated, the residential market is not 
naturally as attractive for a telephony-only competitor, and the 
market may not, in fact, be able to sustain multiple asset-based 
telephony-only competitors.

Predictably, some federal and state regulators have been unwilling to 
accept the tenet that competition is not as well-suited to the 
residences of the American public. Recognizing that the task they 
faced was complex and the goals worthy, regulators therefore chose to 
intervene, using a model that was similar to the one employed in the 
successful breakup of the long-distance monopoly market in the 1980s. 
Based on that model, state and federal regulators have required the 
incumbent to lease its network at deep discounts, which were far more 
complex in their formulation than the long-distance intervention in 
the 1980s. Sometimes the rates were set at very low levels and at 
other times they were fixed somewhat higher to incent competitive 
investment. In general, the TELRIC (total element long-run 
incremental cost) pricing model - using marginal costs analyses - 
assumed that, when the competitors were able to gain enough scale, 
they would build a newer, more modern stand-alone network. The goal 
was, like that of the simpler long-distance industry in the 1980s, 
the nurturing of real businesses, characterized by real assets and 
profit margins in the form of a sustainable business model.

Unfortunately, there appears to be virtually no such investment 
occurring on the part of copper-based competitors in the residential 
market because the premise was flawed. The miscalculation arose 
because investment costs and risk are very high in the residential 
local exchange business, especially compared with the relatively less 
expensive assets required to serve the 1980s' long-distance market, 
and the profit margins on LEC businesses are thinner and are probably 
not sufficient to sustain the higher levels of investment. 
Accordingly, today we have more "competitors" offering residential 
local exchange services based on regulatory approaches that, however 
well-intentioned, have not spurred viable long-term enterprises. In 
fairness, there were some competitors that tried to invest, but some 
have admitted that they were disadvantaged by a system in which 
TELRIC competitors had a more attractive short-term business 
proposition with virtually no capital costs and lesser competitive 
risk. In sum, we committed to a system in which there is 
disintermediation of the investment of the LEC shareholders into at 
least the some of the competitors without achieving the concomitant 
public policy goal of longer-term competitive activity. Worse, we may 
have a system that is draining cash flows from viable competitors - 
the LECs - precisely at the moment when they need to invest in order 
to withstand the next stages of formidable intermodal competitive 
activity from attractive wireless and cable-based services.

My view, then, is that we have been through a period of illusory 
business propositions that have burst badly, and we may have new 
illusions, including the less-than-convincing policy that the 
telephony-only POTS-like model can be competitive for residential 
customers. More directly stated, in the residential market, I believe 
that the only major facilities-based competitors in the U.S. are the 
wireless carriers and the cable operators, whose plant already exists 
or is in need of some relatively modest upgrade. Thus, the statistics 
tabulated about residential competition are, in the minds of 
investors, not representative of the underlying reality.

I believe that competition is, in fact, occurring, but it is through 
a fundamental intermodal shift, transpiring with the advent of new 
technologies and marketing.

Wireless as a Substitute for Wireline Service Clearly, wireless is an 
important source of competition. In fact, 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. 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.

Let us take a brief look at some statistics related to wireless. I 
note that, while it is clear that there is substitution whereby 
wireless-only customers may be 8% of the total consumer market today, 
it is admittedly difficult to calculate precise figures. To provide 
some insight into the data, however, we can examine recent reports of 
the Bell companies. Each of the carriers supplies information in 
formats different from the others, and the data are often different 
from the information supplied by that very carrier in the previous 
quarter, making analysis a bit tricky. In the most recent quarter 
reported last week, for example, SBC supplied interesting statistics 
to illustrate the company's improving performance in terms of line 
loss in certain of its service regions. In Table 2, the data are 
totaled and analyzed in a way different from SBC's presentation to 
investors, highlighting that the company was not doing quite as well 
as the initial investor slides depicted. While the company was 
posting lesser line losses in sequential quarters in terms of primary 
lines and second (also called "additional") lines, further analysis 
revealed that the net losses are actually growing in a way that 
cannot be explained solely by regulatory-imposed discounting rules. 
Using the company's data on residential lines - primary and 
additional - and subtracting them from the gains in wholesale lines, 
which are unbundled connections leased to competitors, the summation 
suggests that the total of retail and wholesale residential lines is 
contracting more rapidly in the last two quarters of 2003. I note 
that the wholesale data used in this analysis includes both 
residential and business lines, but I believe that the residential 
wholesale lines are growing at least as fast as the business lines, 
and that the conclusion is still the same. In the case of BellSouth, 
the company reports simply that it lost 7.3% of its retail lines year-
over-year and that the net loss of retail lines, offset by wholesale 
gains, was 3.1%. BellSouth's absolute losses in residential lines - 
combined retail less wholesale - in the fourth quarter were 134,000, 
slightly worse than the 130,000 lost in the third quarter. Verizon 
does not supply the data necessary to perform a similar calculation. 
What is the explanation flowing from these statistics? Substitution 
continues unabated.

Looking carefully at the analysis, however, reveals something more 
about wireless. 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. It appears to me that the higher losses are due to an 
acceleration in the movement toward wireless services and away from 
wireline telephony.

Table 2: SBC Quarterly Residential Line Loss

Legg Mason has published in the past that we estimate 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.

Table 3 provides wireless customer additions by carrier for each 
quarter since the beginning of 2002. The key messages are that the 
last three quarters have been marked by solid sequential growth in 
additions, that the strong wireless carriers have tended to gain 
share, and all this is occurring at a time when the RBOCs are 
reporting sharp year-over-year retail residential declines. The 
comparisons are startling - SBC reported 8.0% retail residential 
losses in the final quarter of 2003 compared with 2002, while 
BellSouth disclosed 7.3% contraction (cited earlier), and Verizon 
announced only the combined wholesale and retail slippage of 3.7%, 
meaning that the retail loss was likely more severe. With the 
introduction of wireless local number portability in late November 
2003 - permitting a wireline customer to port its number to a 
wireless carrier - it seems that the regulators have moved closer to 
stating that they view wireless as a substitute for wireline access 
that was once judged to be an imposing bottleneck.

Table 3: Quarterly wireless subscriber additions

Source: Company data; Legg Mason Wood Walker, Inc. Figures from 
Verizon, AT&T Wireless and T-Mobile for 4Q03 are actual.

Broadband Market Growth The growth in broadband services - primarily 
based on cable modems and DSL - continues to accelerate for 
residential and business customers. Table 4 details DSL data from the 
three-largest telephone companies, highlighting the quarterly 
increases in total lines served by the carriers and the increases in 
net additions each period. The increases have been gradual, but they 
are increases nonetheless, again over and against the RBOC line 
losses. 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.

Table 4: RBOC Quarterly DSL Totals and Net Adds

The cable operators have also reported high-speed data growth, with 
the absolute number of additions generally rising. Figure 1 
illustrates the subscriber quarterly additions, based on the 
companies that Legg Mason follows and our estimates of the other 
carriers. Notably, the 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.

Figure 1: High-speed data subscribers quarterly additions

Source: Company data; Legg Mason Wood Walker, Inc.

An alternative view is based on Legg Mason's estimates of the high-
speed market share as illustrated in Figure 2. The graphic conveys 
the commanding market leadership of cable operators in this expanding 
communications segment. At the same time, we estimate that cable 
share has slipped to approximately 57% in the final quarter of 2003 
from about 68% in the first quarter of 2003, with the major reason 
being the gradual pressure from RBOCs - much lower rates, better 
bundling, and more widespread availability - that appear to be 
focused on retaining high-speed share lest the Bells be disadvantaged 
when the cable operators begin offering VoIP services in 2004 and 
beyond. Additionally, the independent local exchange carriers have 
gained share, particularly in markets that are not as well served by 
cable operators.

Figure 2: High-speed market share: cable modems and DSL

Source: Company data; Legg Mason Wood Walker, Inc.

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. 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.

Cable Operators' Voice Share At present, competition from cable 
operators is relatively limited, as Cox and Comcast have some circuit-
switched customers, but few other cable operators have invested in 
cable telephony. 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.

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. Among the cable operators, 
Cablevision and Time Warner Cable are being watched most carefully, 
as they are offering widespread service earlier than their peers.

The power and speed of the rapidly approaching weather system was 
driven home last week (January 28) when Time Warner reported on its 
test market in Portland, Maine. The service was begun in May 2003, a 
mere nine months ago, 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 reported it was beginning to offer VoIP in 
Kansas City, Kansas, and Raleigh, North Carolina, and expected, by 
the end of the first quarter, to have service in a total of six of 
the company's 31 systems across the country, and, by the end of 2004, 
to have 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. Notably, the FCC 
reports that residential plus small business penetration of CLECs is 
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.

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. Further, the pricing for services will almost 
certainly, in my view, be more attractive than rates possible using 
legacy telephony, because of the underlying economics of Internet-
based technologies.

Another sign that the intermodal forces are significant is apparent 
in reviewing the RBOC responses. The storm is so fearful that the 
RBOCs are vigorously preparing for its onset by slashing pricing for 
their DSL services, sharpening their marketing on bundled services, 
pressuring equipment vendors to develop high-speed electronics in 
volumes at dramatically lower prices (deployment has yet to occur 
except in tests), and at least generically announcing VoIP products 
for businesses and residential customers.

Future-Oriented Policy Issues As I summarized at the outset, I 
believe 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. 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.

I do not propose that there are simple answers to these questions, 
but I have written and believe firmly that competition is unfolding 
in an intermodal world and that the RBOCs may not be able to reshape 
their services rapidly enough. It is clear to me that the RBOCs are 
conflicted about whether their investment expenditures are too high 
to justify widespread deployments. They are uncertain about whether 
alternative investments such as fiber-to-the-curb make more economic 
sense, but there is too great a risk in a world in which the rules 
promise that competitors will not dilute that investment if, and only 
if, the investment is all the way to the premise. And the RBOCs 
appear to me to be wrestling with the reality that the rebuild will 
be time-consuming, raising the possible evaluation of an alternative 
financial model in which the RBOCs admit that their securities are 
inevitably declining annuities, which is to say that they cede the 
emerging services to better-prepared asset-based competitors as they 
more responsibly return cash to their shareholders. If that happens, 
then I believe that the new communications marketplace could be 
served by alternative services that may be monopoly-like because the 
investment required to compete is so great.

Conclusion To summarize my testimony, I note that there are key 
points for this Subcommittee's reflection.

§ My simple observation as an analyst is that competition has 
generally worked where there are fundamental financial realities to 
support businesses. § In the enterprise and small business
markets, 
competitive growth is significant, with competitive penetration over 
30%. § Over and against that, in the residential market, I see a 
short-term competitive model that is understandably policy-oriented, 
but I believe that "competition" in the wireline copper-based 
telephony market will dissipate when the artificialities are removed 
within the next several years. § At the same time, it appears to
me 
that the tenet in sponsoring this Subcommittee's discussion is 
correct - that competition is unfolding through intermodal services, 
including wireless, broadband communications such as email, and, most 
importantly, through the very obvious and formidable threat of VoIP. 
§ If investors have a concern, I believe it is that they are
fearful 
that some policymakers misunderstand the nature of how competition 
unfolds, and that the natural competitors in the various marketplaces 
are constrained because cash flows and returns on capital 
commitments, in the case of the RBOCs, are uncertain precisely at a 
time when investment is necessary to cope with intermodal competitive 
threats.

Thank you for the opportunity to present my views.

Important Disclosures and Certifications

I, Michael J. Balhoff, CFA, certify that the views expressed in this 
research report accurately reflect my personal views about the 
subject securities or issuers; and I, Michael J. Balhoff, CFA, 
certify that no part of my compensation was, is, or will be directly 
or indirectly related to the specific recommendation or views 
contained in this research report.

The information contained herein has been prepared from sources 
believed reliable but is not guaranteed by us and is not a complete 
summary or statement of all available data, nor is it considered an 
offer to buy or sell any securities referred to herein. No 
investments or services mentioned are available in the European 
Economic Area to private customers or to anyone in Canada other than 
a Designated Institution.

Opinions expressed are subject to change without notice and do not 
take into account the particular investment objectives, financial 
situation or needs of individual investors. Employees of Legg Mason 
Wood Walker, Inc. or its affiliates may, at times, release written or 
oral commentary, technical analysis or trading strategies that differ 
from the opinions expressed within.

Legg Mason Wood Walker, Inc. is a multidisciplined financial services 
firm that regularly seeks investment banking assignments and 
compensation from issuers for services including, but not limited to, 
acting as an underwriter in an offering or financial advisor in a 
merger or acquisition, or serving as a placement agent for private 
transactions.

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