Posted: 2/2002

ADCos Could Crack Open Local Phone Market Once and for All

By
Kim Sunderland

A
solution to monopoly in the local exchange marketplace, in which the industry moves one dominant firm to many competing firms, isn’t a pipe dream.

However, the hope for large-numbers competition among network-based carriers under the nation’s current and foreseeable market conditions is sheer fantasy, according to a new public policy paper.

The untapped option that finally could break open the local telephone market is a new group of firms known as alternative distribution companies (ADCos). They are the topic of a newly released study by the Phoenix Center for Advanced Legal and Economic Public Policy Studies, a think tank in Washington, D.C.

ADCos are essentially carriers’ carriers that plan to generate revenue by creating new high-speed alternative local telecommunication loops rather than by leasing lines from the incumbent local phone companies. The study submits ADCos as a viable solution to the proverbial “last-mile” problem, in which telecom customers still don’t have a choice when it comes to picking their basic local phone or Internet access providers. It’s a bottleneck stifling Internet-related innovation and economic growth, sources say, particularly regarding broadband.

If ADCos can get enough financial support to give the local monopolies a real fight, consumers might see the long-promised broadband revolution, says Phoenix Center President Lawrence J. Spiwak. “It is now six years [this month] since the passage of the landmark Telecommunications Act of 1996, but instead of flourishing competition, the competitive local carrier sector is in a financial meltdown.”

The entry of a wholesale-only “carriers’ carrier” for local access is required if local competition is ever to take hold and succeed argues Spiwak, along with Phoenix Center Adjunct Fellows and economists T. Randolph Beard and George S. Ford, in the paper, “Why ADCo? Why Now? An Economic Exploration into the Future of Industry Structure for the ‘Last Mile’ in Local Telecommunications Markets.”

Several ADCos already operate in the United States, most notably Silver Spring, Md.-based CityNet Telecommunications Inc. which uses state-of-the-art robots to crawl through city sewers to lay fiber-optic lines. The lines are connected directly to homes and businesses minus torn-up streets or reliance on the local phone companies.

CityNet Telecommunications completed work on a last-mile fiber network running through the public sewers last October in Albuquerque, N.M. The network links 21 high-rise buildings in the city, which is emerging as a high-tech hub in the West. The ring is connected to a carrier hotel in downtown Albuquerque. CityNet, which also leases fiber to other service providers, expects to link six additional buildings, including a Qwest Communications International Inc. central office. That will give more than a thousand business tenants access to a fiber-optic network.

Fortunately, CityNet Telecommunications and other ADCos don’t require new laws or regulations, saving the companies years of potential bureaucratic or court-related hassles. ADCos instead rely on what some experts contend should have been part of the Telecom Act when it was signed into law: Basic economics.

It’s Elementary, Dear Watson!

For years policy debate in the telecom industry has focused on whether the Telecom Act has opened up the local phone markets. Some argue the it has failed by not lowering entry barriers for competitive carriers. Spiwak goes further by saying all the various stakeholders in the process — policymakers, the capital markets and new entrants — have suffered from three fundamental misconceptions about the basic economics of the industry:

Spiwak says, “Sorry to say, but the reality proves quite different.”

To begin, entry into the telecommunications industry is an extremely expensive endeavor, requiring firms to sink huge amounts of capital and time to make a business work, he says.

On one hand, there are network costs. According to data from the Federal Communications Commission (FCC) and U.S. Security and Exchange Commission (SEC), network costs run about $1,750 per home passed, $2,500 per marketable home, or about $6,500 per customer. So, to construct an advanced broadband network for every household in the United States, the minimum plant investment would be about $300 billion, says the Phoenix Center study.

Entry costs also include non-plant costs, such as regulatory approval, advertising and customer service and retention, the study says.

It also reports non-plant costs often far exceed network costs — on average, $2 is spent on non-plant costs for every $1 spent on telecommunications plant.

Second, the economic data show, unlike the long-distance market, the local market will be able to sustain only a few access networks, Spiwak says. Companies, because of the huge sunk costs, must achieve scale economies quickly to meet debt load and operating expenses, Spiwak explains.

In order to make its investment in a new network pay off, an entrant would have to — virtually immediately — achieve a 35 percent to 40 percent penetration rate, Spiwak says. No new local competitive carrier has yet to make that happen.

Finally, Spiwak says incumbents try to evade compliance with the unbundling

provisions of the Telecom Act because no rational firm — especially a firm with huge sunk costs and a monopoly in a high margin business — would help rivals erode its monopoly position willingly.

“Until this inherent conflict of wholesale supplier/retail competitor is resolved, then the shenanigans will simply continue,” he says.

Alternative Thinking

New ADCos could change this situation by doing one thing and doing it well: Wiring homes and businesses with fat pipes rather than spending big bucks on marketing several other services.

As a last-mile solution, ADCos could help restore economic growth in the technology and telecom sectors, particularly for companies developing new broadband-related products.

Moreover, as a neutral platform, ADCos can deploy whatever technology they like to provide whatever products and services they may choose.

ADCos would have only other telecom carriers — such as CLECs — as their customers, and so they wouldn’t be inclined to sabotage the businesses that generate revenue, a tactic that competitive carriers complain is used by the incumbents.

Instead, ADCos would continue building out their networks to reach greater economies of scale, according to the study. The report adds ADCos in the long run would become a bigger rival to the incumbents.

Finally, if supply for local access becomes elastic, the incumbent may find it more profitable to divest voluntarily. AT&T Corp. did this when it broke off Lucent Technologies Inc.

Spiwak says if there is to be any hope of having the market perform efficiently, the presence of an ADCo is required. “While the economics dictate that the number of networks may be few, an ADCo permits the number of competitors to be many, the raison d’Ítre of market restructuring, which is a far better option then the road back to monopoly we are now upon,” Spiwak says.

Point, Counterpoint

Running counter to the idea of ADCos is the increasingly hot political potato regarding facilities-based carriers.

In Washington, a consensus is growing for the concept of carriers having their own facilities to compete effectively in the local market. FCC Chairman Michael K. Powell and many of the other commissioners, for instance, support this strategy as being the most beneficial for increasing competition and spurring broadband deployment.

“The best way to provide value to the customer is to own and operate your own network,” agrees Robert A. Saunders, senior analyst with The Eastern Management Group Inc. in Bedminster, N.J.

Network-based entrants eventually will consolidate the new networks built by their less successful peers and become “new ILECs” of the future, Saunders says, adding that today’s market is too crowded and overly aggressive, almost suicidal.

He cites In Tampa, Fla. as an example, pointing out that 35 competitive carriers are pursuing some 10,000 business customers. In such an environment, not all can survive.

“Once consolidation has rationalized the market, the need for carrier’s carriers will be significantly reduced,” Saunders says.

“Investors are weary of funding new entrants when it’s obvious there are too many out there now,” he says. “To spawn a whole new batch of wholesale competitors all trying to get the same capital to do the same thing is a mistake.”

Saunders says technology must lead the way with development of cheaper, more reliable platforms for delivery to spur residential level competition. He cites satellite, fixed wireless and cable as other ways to beat the last-mile problem.

Companies such as Allegiance Telecom Inc. have proven the smart build model works, while companies such as Time Warner Telecom Inc. have shown a company can build facilities and not bankrupt itself, he says.

“As networks are cobbled together in the wake of CLEC burnouts, a few successful carriers will outshine the Bells when it comes to customer service and product options,” Saunders says.

The Telecom Act is an acceptable model for increasing telephony competition and regulators should continue to enforce its tenets without putting the industry into a situation where too many resellers can once again engage in price slashing that ultimately benefits no one,he adds.

“Through greater levels of facilities-based competition using competitor owned and operated networks, we can bring so much more value to the U.S. communications network and getting companies spending with equipment vendors once again,” he says.