IN THE YEARS SINCE

the telecom bust, competitive carriers have struggled to pull themselves together, refining their business plans and appeasing creditors. The survivors, who number in the tens down from hundreds, are now engaged in different pursuit one for scale, reach and density. While this is a sure sign of a maturing industry, the natural course of consolidation among CLECs has been accelerated in response to megamergers among giant phone companies, giving rise to a new class of CLECs that might be called Super Tier 2 carriers.

The rise of the Super Tier 2 player was predicted earlier this year by Gartner analyst Jay E. Pultz. With greater economies of scale, such Super Tier 2 companies could better compete against the behemoths of AT&T [Inc.] and Verizon [Communications Inc.] and likely make a nice profit selling at prices significantly lower than their bigger competitors, he wrote in his blog.

The defining characteristic of these companies appears to be a revenue stream hovering around $1 billion. XO Communications Inc., with 2005 revenue of $1.43 billion, has been alone in this category until recent matchups among its competitors. In particular, the merger of PAETEC Communications Inc. and US LEC, which was announced in August, will create a $1.3 billion company.

Others are not far behind. If Time Warner Telecom Inc. is successful in its July bid to buy Xspedius Communications LLC, it will have created a company with combined revenue approaching $1 billion (Time Warner Telecoms 2005 revenue was $708 million alone). One Communications, a privately held company, which came together earlier this year through the combination of Conversent Communications, Choice One Communications and CTC Communications, claims annual revenue of $800 million.

Just behind this super CLEC group, another tier of regional companies is settling near the half-a-billion-dollar mark an attractive merger or acquisition point. On the West Coast, for example, Telepacific Communications is now a $400 million company following its August acquisition of rival Mpower Communications Corp. And, on the East Coast, Broadview Networks Inc., the product of the January 2005 merger with Bridgecom, announced plans to acquire ATX Communications in late June, forming a $400 million company when it closes, executives said.

SIZE MATTERS

Acknowledging the changing face of the telecom industry following the megamergers, PAETEC Communications in June bought back the majority of the company from institutional investors. That move freed the carrier to do other types of transactions, says PAETEC Chairman and CEO Arunas Chesonis. US LEC came up after the recapitalization and it was a great opportunity to create a much larger company with the scale you need to compete with the bigger companies.

PAETEC has networks throughout the United States, but linking up with US LEC gives it additional concentration in Chicago, on the Eastern seaboard and along the West Coast. PAETEC also was able to make good on its foiled plans to go public since US LEC is publicly held (see related story).

PAETEC is not alone in identifying the need to gear up for an intensifying fight with the Bells.

We know weve not collectively, as an industry, been as effective as we all think we should be in taking business away from local telephone companies, says Ray Allieri, president of business services for One Communications. You need scale to be able to do that.

While US LEC will bring additional onnet markets to the new PAETEC, the CTC/Choice One/Conversent merger created density for One Communications. By adding colos, the company has reduced the distance between its PoPs and its customers, reducing the cost of delivering services. A provider such as One Communications, which is concentrated in a specific area, offers significant market presence and market power to control quality of service, delivery and cost of service, says Allieri.

Indeed, while the telecom industry affords opportunities to smaller niche players, success in the local telephony business largely depends on scale and density. Operating leverage does matter, says Michael Robinson, CEO of Broadview Networks. As the price point per unit whether its per minute or per T1 or per line comes down, being able to drive costs down with it [enables] you to maintain a level of profitability and, I think, investment.

To invest in new technologies [and] new sales forces to open up new markets, you need to have a certain mass.

Time Warner Telecom is using its mass to acquire an additional 800 fiber-connected buildings from Xspedius, says Michael Rouleau, senior vice president of business development and strategy for Time Warner Telecom. When the deal closes, the CLEC will have more than 7,000 fiber-fed buildings serving additional cities its enterprise customers want to connect to. Xspedius on-net buildings extend into different cities, adding Fort Worth to Time Warner Telecoms presence in Dallas, as one example.

Rouleau says the megamergers present an opportunity for Time Warner Telecom to serve enterprise customers that want a choice other than the incumbent facilities. Its important for them to have somebody who is not just reselling the incumbent infrastructure, but rather can build their own fiber network, he says. They want somebody who is in a position to build out a network for them and has the scalability to do it.

The urge to merge is unlikely to end soon though some predict a digesting period as companies integrate their operations. We continue to believe that consolidation is a very logical type of activity in this type of market, says Raul Martynek, president and CEO of InfoHighway Communications Corp., a $110 million company based in New York. We are looking at additional opportunities. InfoHighway in 2005 paired up with Eureka Networks. That transaction brought InfoHighway out of its reliance on dying UNE-P regulations and set the stage for it to remain strong in the wireline business, says Martynek.

Eschelon Telecom Inc., a $220 million CLEC, also has announced its rollup strategy and has been gobbling up companies to reach a stated objective of acquiring $100 million in CLEC revenue over a two-to-three-year period. With the acquisition of Oregon Telecom Inc. and pending purchases of Mountain Telecommunications Inc. and OneEighty Communications Inc., the company has acquired approximately $50 million in revenue. Were getting closer to our goal, said Eschelon President and CEO Richard A. Smith in a press statement.

Broadviews Robinson says his company also is open. In the near term, our focus is more density and more growth where we are likely to be an acquirer either organically or non-organically like we have with the Bridgecom deal or with ATX, he said.

Even PAETECs Chesonis says there could be more deals for the company after it merges with US LEC. We are both growing combined in that 12-to-15 percent range, so we dont have to acquire other companies to continue to grow, but I think both companies have made acquisitions in the past and will look to be sort of opportunistic, he says.

The rumor mill already includes Californiabased rival TelePacific as its next target.

But where will consolidation stop? In 24 months, there probably will be five-to-seven facilities-based CLECs, with revenue ranging from $1 billion-$3 billion annually, says Martynek, venturing a guess about the landscape. I like to remind people how many car companies are there in America? How many airlines? Not that many.

The market had too many small competitors, he contends, and combining a few, well-run players will be the best thing for customers, employees and agents.