CLEC Update: Large National, Regional Competitors Set to Exhibit Grace Under Pressure

| Sep 16, 2008 | Business Network Services - U.S. | Advisory Report

| Analyst: Brian Washburn

Issue

Incumbent local carriers rack up deregulation victories; cable competitors expand into small business services; roiling financial markets and a shaky economy put pressure on funding sources and potential business customers: The competitive local exchange carrier (CLEC) base is coming under renewed competitive pressure on multiple fronts. Competitors including tw telecom and PAETEC have recently described macroeconomic headwinds affecting their business; some CLECs have noted slowing business and/or have adjusted guidance for 2008. The telecom sector took its share of hard knocks alongside the 2001 dot-com bust; and while no service provider is immune to a harsh economic downturn, the offers and business models of CLECs should be resilient enough to withstand the brewing economic environment.

Current Perspective

Note: Portions of this Advisory Report draw from the Current Analysis Telebriefing titled “The CLEC Trajectory: From Regulation to Market Competition,” June 31, 2008. The Telebriefing expands on some of the background topics presented here.

The CLEC industry is just over 12 years old, and that brief time has been tumultuous. The sector debuted when the Telecommunications Act of 1996 was signed into law, which started the run-up of a telecom bubble tracking alongside the dot-com bubble. In 2001, large parts of the competitive carrier industry went bust together with the dot-com collapse. The survivors picked up the pieces in 2002-2004, and much of the industry has held its own since then, even as CLEC regulatory vehicles with the incumbent local carriers (ILECs) eroded. When the mergers took place that turned AT&T and Verizon into the largest carriers in the U.S., large CLECs followed suit in 2005-2007 with their own consolidation, gaining economies of scale that strengthened their balance sheet as well as their market reach.

As 2008 winds down, the stage appears set for a big industry-changing event, this one fueled by soft macroeconomic conditions and sparked by a bust in the financial industry. A few CLECs have issued public warnings about issues they see in the SMB base. tw telecom, for example, reported pressures based on souring economic conditions in some regions of the country, and anticipates increases in churn from its small business customer base. PAETEC also reported seeing an uptick in churn, and observed price pressures and a worsening macroeconomic environment. Despite both carriers describing overall growth in their business, investors pummeled these companies for their observations. It may still turn out these providers benefited from spotting and reacting early to changes on the ground, and demonstrated that they are closely in tune with the SMB sector.

CLECs today appear more resilient than they were five to seven years ago and able to survive if economic conditions continue to erode. Among the major independent retail CLECs are PAETEC, XO Communications and tw telecom on the national arena; One Communications and Broadview Networks in the northeast; Cavalier Telephone in the mid-Atlantic and mid-west; NuVox and Deltacom in the southeast; and Integra Telecom and TelePacific in the west. These CLECs are relatively healthy financially and have a solid base of business customers. Six of these “top 10” are privately held companies, and two of the public companies (XO and Deltacom) are held by a single majority investor. The CLECs that have publicly disclosed any sizable long-term debt have locked in long-term financing, carrying them to 2012 and beyond; the exception, XO Communications, fell into line at the end of July 2008 by funding made available through the CLEC's majority investor, Carl Icahn. In addition to the major retail players, two CLECs merit top status for their market size and strategic importance in the wholesale sector: Covad Communications for its broadband services (Covad was taken private in April 2008) and Level 3 Communications for its near-blanket nationwide coverage of voice access services.

The CLECs' successes come despite a headwind of deregulation. Between actions in the courts and by regulators, CLECs have suffered a series of setbacks that can be grouped into the following categories:

• ILECs have been granted permissions to expand into markets previously closed to them;
• Requirements on ILECs to unbundle some services, so CLECs could purchase them a la carte, were eliminated;
• Rate regulation for some services CLECs purchase from ILECs have been removed;
• While other sectors were being deregulated, voice over IP headed the other way, as regulators removed tools competitive carriers had been using to bypass ILECs and lower their costs; and
• ILECs no longer need to publish openly available information on many of their high-end services, and on certain cost and accounting data.

The deregulation push forced major CLECs to refocus mainly on markets where they have their own facilities (i.e., a colocation presence in ILEC central offices), and on delivering advanced, higher-margin services such as IP-based integrated voice/data services delivered over T1 access. CLECs as a whole are now more sophisticated in the value-added services they offer, such as managed network services; hosting, hosted messaging and managed applications services; connectivity to data centers; multi-location IP VPNs; and firewall and security services. Some carriers have even reached out to offer integrated wireless services (see “As Incumbents Broaden Their Wireless Bundles, CLECs Take a Stake in the Mobility Game,” March 14, 2008).

The CLEC industry needs this broader range of bundled services because in 2008, the business units of leading cable competitors have stepped into the multi-line voice/data integrated access business. Based on their listed pricing, cable industry players can offer a bundle of 10 voice lines with business broadband Internet ranging from 15 Mbps to 30 Mbps download speeds for between $345 and $610 per month. All other differences (including SLA guarantees) aside, competitive carrier samples using an integrated T1 service to combine ten voice lines and 1.5 Mbps dedicated Internet access ranges from $740 to $800 per month. CLECs are vulnerable to the same differentials when they must vie against cable providers for business broadband, where these providers can offer downstream speeds between 15 Mbps and 30 Mbps at costs of $30 to $150 per month – faster and cheaper than what CLECs can muster over copper today. Verizon's FiOS is cable's most capable speed/price point competition to date; Verizon is not required to make this access infrastructure available to CLECs.

For now, the ILECs seemed to have tested the limits of deregulation in their bids to achieve non-dominant status for some of their major metros. The FCC, which has defined Omaha, NE and Anchorage, AK as non-dominant markets, to date denied petitions by Verizon to add New York, Philadelphia, Pittsburgh and Virginia Beach; and petitions from Qwest to add Denver, Phoenix, Minneapolis/St. Paul and Seattle to this list. Achieving non-dominant status would free the ILEC to negotiate commercial access rates with CLECs in the market, which would likely erase incentives for CLECs to invest any further in facilities-based competition in those markets.

As of mid-September 2008, there is great economic uncertainty in the air. The ongoing financial fallout could have huge ramifications for public and private investors everywhere, including the telco industry. If enough businesses are forced to curb headcount or even dissolve, major telcos will see their customer base erode across the board, particularly in the SMB market. CLECs may find themselves in an all-out war for SMB customers between the ILECs and the cable providers. Making matters even more unpredictable is the uncertainty of an upcoming presidential election that can shake up the composition of the FCC and shift the federal government's balance everywhere from congressional committees to various agencies. Given the numerous other pressing issues the incoming administration will face, however, it seems unlikely that any large-scale swings in competitive telecom regulation will happen within the first 12 months of the new administration, regardless of its party affiliation.

Recommended Vendor Actions

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Recommended End User Actions

• SMBs and other business customers tend to be in contracts lasting a year or longer, with penalty clauses for early termination. SMBs experiencing cutbacks and budget troubles can always discuss the situation with their carrier(s) and see what alternatives might be available to reduce their costs, for example by signing a new contract with revised services and pricing that meet their changing needs.

• SMBs simply looking for the most bang for their buck – in terms of raw bandwidth and lowest cost – should evaluate their cable provider, ILEC and at least one CLEC or other competitive provider. For smaller businesses, the cable provider may have the most favorable package price, but the customer should expect the package not to have any service guarantees. In other words, the cable provider will try to prevent outages and fix them if they occur, but has no obligation to issue a credit even if an extended outage occurs.

• For businesses concerned about whether their carrier can weather a financial downturn, the large national and regional CLECs are relatively solid financially: They may be incurring net losses on paper, but tend to range from cash flow breakeven to modestly profitable. These organizations have been through tough times already, and over the last decade most have become fairly lean, strongly customer-focused organizations.

• Businesses that need a stable long-term carrier partner do need to take a look at their options, especially if they prefer a smaller CLEC or ISP. A large enough customer should be able to pressure a small service provider into opening its books enough to show its basic balance sheets. A high debt load relative to revenue, small amount of cash on hand, consistent negative cash flow and/or EBITDA losses are all obvious warning signs that the service provider is probably not a stable long-term partner.

• CLECs focus their business around services delivered through the ILECs' copper access loops, but these providers typically have a broader collection of assets. Businesses that require high-capacity services including optical transport, or that need connectivity to data centers and managed/hosted services, may find that their CLEC is actually a more broadly defined competitive carrier capable of supplying services to meet all their needs.

CLIENTS ONLY

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