Posted: 04/2000

Chasing Rainbows
Prepaid Local Profit Potential Unrealized
By Josh Martin

The prepaid local phone
service industry is
on the verge of passing
the $1 billion revenue mark.
But providers are
unlikely to break
out champagne;
they will be too busy
competing for market share,
chasing as-yet largely
elusive profits.

Sometime later this year, the prepaid local phone service industry will pass the $1 billion revenue mark. But industry executives unlikely will break out champagne; they will be too busy competing for market share, chasing as-yet largely elusive profits.

Like other high-tech industries, annual growth rates are measured in healthy double digits. Presently more than 1 million customers use prepaid local service; industry analysts expect that number to grow to almost 4 million by the end of 2002, which they predict will generate almost $4 billion in revenues.

That growth is offset by the rapid increase in the number of players. The industry, which did not exist five years ago, is marked by intense competition, among the 400-odd prepaid vendors, RBOCs, incumbent LECs (ILECs), CLECs and other telecom service providers.

The industry’s growth has been so noticeable, it now warrants its own acronym: ALEC for Alternative Local Exchange Carrier. However, the average number of prepaid customers per company remains low.

“No one prepaid company has captured more than 100,000 customers,” says Dominick
Marchitto, president of Annox Inc. ( www.annox.com),
a prepaid vendor active in 12 states.

In fact, the industry average is less than 20,000 customers per provider, according to Annox. Numbers could shrink even further–prompting the specter of an industry shakeout–as other companies enter the field, lured by potential profits from millions of unserviced end users.

“This is the fastest growing segment of the local service market,” says Steve
Trotman, vice president of industry relations at the Telecom-munications Resellers Association
(TRA, www.tra.org). “The folks who enter this market are some of the smartest entrepreneurs in
the business.”

Prepaid service companies are licensed by state public utility commissions (PUC), in a process that can take as little as a month or as much as a year to complete. Many states allow phone companies to “piggyback” certification processes, so a company simultaneously can apply to offer prepaid local, as well as long distance, wireless and other telecom services.

Trotman says 60 of TRA’s 230 members that offer local dial-tone service also provide it on a prepaid basis. That number is expected to grow.

“It allows them to sell local dial tone above normal [postpaid] rates, increasing profit margins,” he says. “Traditionally, the biggest revenue source for the prepaid telecom market was the long-distance calling card. Now it’s shifting, with equal shares coming from prepaid long distance, wireless and local dial tone.”

However, the prepaid service industry will not come overnight.

“Growth has been slower than we had hoped or expected,” says Derek M.
Gietzen, president and CEO of Genesis Com-munications Inter-national (www.gencom.net).
“The hype far exceeded the reality. But the market has continued to grow.”

Gietzen points out that companies in this sector need to target their market, find a vehicle to attract customers, offer convenient payment sites or mechanisms and be prepared to provide additional services.

Genesis began as a CLEC, which offered local and long-distance services targeted to the California and Texas Hispanic markets. According to Gietzen, the company today has 95,000 customers, 10,000 of them use its CLEC services, 80,000 use long-distance services and 5,000 have prepaid service.

Although the prepaid segment did not grow as fast as anticipated, Genesis sees great potential.

“We’re in this for the long haul,” says Gietzen. “It’s a market segment with slow, steady growth.”

And it is a market with potentially huge profits. Industry executives say gross profit margins for prepaid local service vendors now range between 20 percent and 30 percent.

The greater profit potential could be offset by higher risks, however.

For example, Chad Hazam, president of Metro Teleconnect Companies, points out that while a conventional postpaid local service vendor might collect as much as 97 percent of billings, prepaid companies might collect only 70 percent, because of the unique characteristics of the prepaid end users.

ALECs face uphill battles with RBOCs and CLECs, on everything from access to customers to rate structures.

“The primary difficulty is the impediments thrown up by RBOCs,” says Annox’s Marchitto. “They say they can provide service cheaper, but they don’t provide it.”

Prepaid companies repeatedly have charged that RBOCs obstruct their access to the market, even though the Telecommunications Act of 1996 permits their entrance into it.

RBOCs say they are doing nothing to obstruct anyones access, arguing they adhere to the letter of the law.

“The rules of the road are now fairly well established,” says Larry Sarjeant, vice president for legal and regulatory affairs at the U.S. Telephone Association, the trade association representing RBOCs and other large phone companies.

Sarjeant points out that prepaid vendors pay the same tariff rates as other businesses, which are different from those rates paid by individuals.

On the customer access issue, Sarjeant argues the Telecom Act obligates carriers to protect customer information. At the same time, he sees no conflict if carriers use their internal customer database should they choose to market their own prepaid services.

“Any entity that does business in America has the right to do business with its own customers,” Sarjeant says. “Prepaid vendors and the RBOCs agree on one thing: These issues will be argued before the FCC
(www.fcc.org), as well as in front of state PUCs for years to come.”

Marketing Models

In this crowded environment, new marketing techniques and customer bases are being sought.

In its brief U.S. history, prepaid local service did not exist prior to the Telecom Act. Most prepaid customers have been drawn from two client groups: immigrants and “credit-challenged” individuals.

In Europe, where prepaid local service has been around since 1974, typical end users are more upscale (including students and young professionals), aided by the use of prepaid service cards in public pay phones.

Industry experts estimate the potential size for the U.S. prepaid market could range anywhere from 6 million to 25 million users. Using FCC and National ALEC Assoc-iation/Prepaid Communications Association (NALA/PCA, www.

thepca.org) figures, the total market probably exceeds 12 million (see graphic on this page), of which less than 10 percent is now served.

Unique conditions must exist, however, to sell prepaid service. Marketing campaigns often must be multilingual and multicultural.

But the biggest challenge simply is to reach potential customers in the first place.

“Potential customers have to go to great lengths to get this service,” Gietzen says. “They can’t just pick up the phone, because they don’t have one.”

Customer groups that are identified as potential pot-of-gold targets are senior citizens; immigrant and ethnic groups such as Chinese, South Asians, Caribbean Islanders and Hispanics; students; long-term medical care patients and their families; and people with auxiliary lines or vacation homes.

“Customers are overwhelmingly residential,” says Ron
Contrado, president of prepaid vendor Homisco (www.homisco.com),
and a TRA board member. “Businesses will figure out a way to pay the deposit for [conventional] dial-tone service.”

Prepaid local service remains more expensive than conventional local dial-tone phone service. Typical unlimited local service from a CLEC or RBOC will run $15 to $30 per month; prepaid vendors charge between $30 and $60, with the industry average now under $40 per month.

In addition, prepaid users must pay one-time, sign-on or connect fees, which can range anywhere from $25 to $100. This has given prepaid vendors the reputation of being “phone sharks.”

Yet, the actual profit margins often remain low, if any at all.

This is because prepaid continues to have low collection rates, high marketing costs and fees associated with legal and regulatory disputes. Above all, ALEC executives point out that local exchange carriers generally offer only low discounts off their rates, typically ranging between 15 percent and 19 percent.

New Services

While prepaid costs may be capped, the services are not. As the market gets more competitive, prepaid companies are making greater efforts to retain existing customers.

Industry studies show a typical prepaid customer currently only uses the service for only about a year.

Prepaid vendors increasingly are looking at strategic alliances and how they can bundle services to maintain their current customers and increase their market share.

Some companies, like Genesis, were CLECs before entering the prepaid field. Others, like Metro Telecon-nect, plan to offer new service menus, which may include everything from basic 411 information to call forwarding, Internet access and long-distance options.

The TRA and NALA/PCA believe the prepaid industry’s future depends on its evolution.

“Prepaid vendors got a bad image early on, of being unscrupulous businessmen,” notes Gietzen. “The TRA is working on standards and practices guidelines for the prepaid local industry to improve that image.”

Such standards are expected to be announced by the end of the year. These guidelines likely will include provisions that provide for clear customer contracts, itemized billing and the like.

With such self-imposed, industry guidelines, the relationship should become better among prepaid vendors and state regulators, who have often been among the industry’s harshest critics.

At the same time, individual ALECs and industry associations say the acrimonious relationship with RBOCs likely will continue.

“There is no indication they will adhere to regulatory and legislative mandates,” says Trotman.

The issues between these two groups center on access and billing: access to phone lines, access to potential customers, and billing procedures RBOCs use with ALECs.

Some within the prepaid industry have accused RBOCs of using delaying tactics and charging higher connection fees to discourage ALECs. For example, they say many RBOCs charge ALECs special “computer use” fees, even though computerized sales are less costly to transact.

At the same time, the ALECs claim the RBOCs often refuse to provide names of disconnected customers, which typically are the credit-challenged segment that forms the core of the prepaid business.

It is clear that as the number of prepaid clusters increases, at an annual rate of 100 percent or more–these issues likely are to become more important, as the value of the prepaid market grows.

Josh Martin is a freelance writer based in New York. He can be reached at
[email protected]

Prepaid Lifeline Service Forges Lasting Connections
BY JOSH MARTIN

For some customers, prepaid local service literally may be a matter of life and death.

“When people are ill, staying in touch with family and friends helps them recover quicker,” says Susan
Lawley, president of Lasting Connections (www.lastingconnections.org),
a Fairfield, N.J., charity that provides local and international prepaid service so families with extended medical crises can maintain phone service.

“The phone bill is an expense most people don’t think about in a medical emergency,” Lawley explains. “But often, a family’s phone bills can quadruple during such a crisis.”

Lasting Connections, founded in 1992, provides grants up to $500 per family based on financial need, communication needs and severity of the medical crisis. “We are the only charity targeting the telecommunications arena,” says
Lawley.

Funded largely by grants from Nortel Networks Corp. (www.nortelnetworks.com),
Lucent Technologies Inc. (www.lucent.com) and MCI WorldCom Inc.
(www.wcom.com), Lasting Connections has contributed more than 4,000 calling cards and $150,000 in phone service assistance to more than 500 families in the United States.

“There will be a growing use of this application,” says Lawley. “Prepaid phone service in a medical emergency isn’t a luxury. It is a necessity.”