Editor’s note: Russ McGuire is the online director of Business Reform Magazine. Each issue of Business Reform features practical advice on operating successfully in business while glorifying God.

The telecom industry appears to be emerging from its three-and-a-half year slump. In the next few weeks, we will likely see two major companies emerge from bankruptcy, MCI (formerly Worldcom) and Global Crossing. However, there are still significant barriers that are keeping the industry from achieving consistent financial performance and growth.

In short, for the telecom industry to truly return to financial health, three conditions must be met:

  • Healthy competition must displace irrational competition.
  • Focused market strategies must replace illogical market segmentation.
  • Broadband deployments must generate healthy revenue growth.

For the past five years, the industry has been dominated by irrational competition. The Telecom Act of 1996, paired with the explosion of Internet demand, launched a thousand startups into every nook and cranny of telecom-dom. In every segment of the industry, dozens or hundreds of companies were funded, each under the assumption that, if they could just get 5% of the market, all of the investors would be rich. Unfortunately, there weren’t nearly enough 5% slices to go around. As startups became desperate, prices plummeted (meaning that 5% needed to become 10%), and buyers gained all the power.

Typically, such a destructive environment quickly gets worked out. Such a situation is rationalized through consolidation. Most bit players disappear while the most promising ones are acquired by larger players or merge to form sustainable businesses. Unfortunately, that hasn’t happened in telecom. At least not yet. So far, enough capital has been available for failing companies to gain new investment to buy their way through Chapter 11 bankruptcy (as Global Crossing is doing). But, there hasn’t been enough consolidated capital to fund a major roll-up of the industry.

The net result is that there are still too many competitors who have not yet achieved a sustainable level of market share. To achieve economies of scale, it is likely that an asset intensive carrier must achieve 10-20% share in the markets they serve, and until the existing players reach that level, they will continue to operate in irrational ways.

There may be some hope that the MCI and Global Crossing bankruptcies could be first steps towards healthy consolidation. There are two critical pre-requisites before an industry roll-up is likely to happen. First, the unwise capital needs to be eliminated. Second, new, wise capital needs to be available.

The bankruptcy process is eliminating unwise capital. Both lenders and investors (myself included) foolishly bought into the telecom vision of the late 1990s and we put our money into companies at valuations that, in hindsight, were simply ridiculous. Most bankruptcy proceedings are wiping out the investors and significantly devaluing the debt. Eliminating this cost of over-valued capital is critical before anyone will look at buying any of these foolishly funded telecom companies.

Once the companies are cleaned up, there needs to be a new source of capital to fund buying the companies. Both MCI and Global Crossing have very impressive sets of assets. With debt and existing shareholder equity eliminated, and with the broader capital markets improving, I wouldn’t be surprised to see the funds emerge to acquire these two companies and spark an industry-wide roll-up.

Such a move could also help address the second critical issue in the telecom industry.

Ma Bell was broken up by anti-trust regulators in 1984. The company was split into AT&T, which primarily offered long distance service, and seven regional Bell operating companies (NYNEX, Bell Atlantic, BellSouth, Southwestern Bell, Ameritech, USWest, and Pacific Bell) who primarily offered local telephone service. This move opened the doors for new companies to compete with AT&T for long distance. Sprint and MCI joined AT&T in the top tier of the new long distance industry. Worldcom later bought their way into the club by acquiring MCI.

Unfortunately, all of these companies defined themselves by the service they provided – long distance service – and perhaps as meaningfully, by the service they didn’t provide – local telephone service. Such a definition is illogical, inefficient, and poorly serves the customer.

One of the major outcomes of the Telecom Act of 1996 has been the state-by-state regulatory approval allowing the regional Bell companies to offer long distance service. The incremental cost to the Bells of offering long distance on top of their existing local infrastructure is miniscule. However, even without competing on price, the Bell companies have been able to take significant market share at the low end of the market. Customers, especially consumers, appreciate the kind of cost-effective bundles that the Bells have begun to offer.

This has forced AT&T and MCI to put increasing emphasis on serving the business customers that require the more sophisticated and data-centric solutions that are a challenge for the Bells. To lock-in these customers, these long-distance players have needed to effectively solve the local service piece.

Consolidation will undoubtedly dramatically reshape the industry. I seriously doubt that, when the dust settles, we will still have separate local and long distance industry segments.

The third and final component required for an attractive industry is revenue growth. Demand, as measured in units consumed, continues to grow aggressively in most segments of the industry. However, this demand growth has been more than offset by price declines, resulting in flat, or even falling revenues. This trend must change or the industry won’t be worthy of investment.

People generally aren’t going to increase their talking. Thanks to cellphones and voicemail, we have already seen the ramp in demand growth driven by voice traffic. Even if voice became totally free, it’s unlikely that we’d find many more minutes in the day to be talking on our telephones.

Therefore, telecom growth will be driven by data, and the greatest opportunities for revenue growth will come from continued migration to broadband connections and the emergence of value added services over those broadband connections. The long-promised high-margin services offered on top of commodity bandwidth have still not arrived. And until they do, telecom will continue to be only marginally attractive to investors.

Are we likely to see consolidation in the industry in the next 12 months, resulting in a smaller number of stable competitors? I tend to think the time is right. The next few months will probably set the stage.

Will that industry restructuring replace illogical market segmentation with market strategies truly focused on customer needs? I hope so. I believe that the artificial segmentation between local and long distance will be removed, but how effective the resulting strategies are will be determined by who is left standing.

Can the industry finally figure out what a value-added service is and how to deliver it in a way that creates value for customers and profits for the provider? That’s the longest shot of all.

But, if the industry fails to achieve these three critical steps, investors are likely to continue to look elsewhere for attractive returns.

Russ McGuire is Online Director for Business Reform. Prior to joining Business
Reform, Mr. McGuire spent over twenty years in technology industries, performing various roles from writing mission critical software for the nuclear power and defense industries to developing core business strategies in the telecom industry. Mr. McGuire is currently focused on helping businesspeople apply God’s eternal truths to their real-world business challenges through
Business Reform’s online services. He can be reached at [email protected].

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