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Chairman Upton, Ranking Member Markey, members of the subcommittee, good
afternoon and thank you for the opportunity to address you concerning the state
of telecommunications competition and the growth in intermodal communications
services. Let me state at the outset that my testimony today represents my
opinion and does not necessarily reflect the views of Legg Mason or the other
telecommunications analysts at our firm.
Curriculum vitae I am Michael J. Balhoff of 1213 Shady Creek Road,
Marriottsville, Maryland 21104. I head the Telecommunications Equity Research
Group at Legg Mason, a Baltimore-based full-service investment firm. I cover
equities in the incumbent local exchange carrier industry, including the
regional Bell companies and rural telephone carriers. My specific practice is
most widely recognized for a focused coverage of rural telephone companies. We
consult regularly with corporate managements and policymakers, and we provide
investment advice to a wide range of institutional investors across North
America and Europe, as well as private equity investors in the United States.
Focus of Testimony on State of Competition in Domestic Telecommunications I
am honored to present to the Subcommittee on Telecommunications and the Internet
about the developments related to competition in the communications industry. My
understanding is that you wish to better discern how much the voice and data
markets in the United States have evolved over the last several years and how
much they are likely to continue to change in the foreseeable future.
I believe that the insight you have previously articulated in your invitation
to me is correct - that advances in technology have spurred significant
intermodal competition and that the intensity of competition is likely more
widespread than many observers realize. I will state in my testimony that . . .
§ I believe competitive activity is significant in the business community;
§ Investors believe, in my opinion, that the current deep discounting in the
residential market has created competitive statistics that are higher than most
investors are willing to believe, and fund managers are generally unwilling to
commit long-term capital to a system that they perceive as often based on
regulatory arbitrage; § I believe that competition, however, is occurring in
intermodal form in the residential market through wireless, high-speed data
services, and cable telephony; § My conviction is that investors expect that
the voice services provided by cable operators based on Internet Protocol will
have a transforming effect on the telecommunications market within a few brief
years; and § The current risk is that we eventually could be returning to a
monopoly system owned by the cable operators if the local exchange carriers (LECs)
are unable or unwilling to invest in the longer-term network because: (1) the
expense of the investment in high-speed network is too high to generate a
satisfactory return, (2) there is too much uncertainty or fear about rules
requiring them to share their investment with competitors, or (3) the time
required in the investment will be too extended.
In support of my views, I will briefly summarize publicly available data on:
(1) ILEC (incumbent local exchange carrier) and CLEC (competitive local exchange
carrier) voice marketshare for business and residential, (2) wireless service as
a substitute for the local exchange service, (3) broadband market growth and the
unique factors affecting the competitive landscape of cable-modem services and
digital subscriber line services, and (4) cable companies' progress in capturing
voice telephony market share based on circuit-switched and voice over Internet
Protocol (VoIP) technologies.
Local Exchange Carrier Market Share One of the key goals of the Telecom Act
of 1996 was the introduction of competition in the urban local exchange market.
Most of the statistics from the FCC and the investment community verify that
this goal has, in part, been achieved and that a significant number of customers
are served by alternative local exchange service providers over the traditional
telephony network, notably in the business marketplace. The FCC, the state
regulators, and the courts have accomplished much of this task by setting myriad
rules and clarifications for leasing the incumbent's network elements, incenting
significant new investment by competitors, sifting through controversies related
to arcane subjects such as collocations, hot-cuts, cost models and the
long-distance Section 271 process. We have far more insight today into the
legalities and technologies of communications than those policymakers had in the
mid-to-late 1990s, but the end result is that they made possible real
competitive growth. Illustrating the general trend toward competition, the most
recent FCC data suggest that total CLEC market share has increased to 15% in
June 2003 from 4% in December 1999. Table 1 summarizes the data, with the
statistics representing that the incumbent carriers' share of the total lines
has slipped in the same three-and-a-half-year period to 85% from 96%.
Table 1: FCC Market Share Data
I believe that the competitive data are clear that the business market share
shift has been dramatic. The FCC surveys state that CLECs penetrated, on
average, 23% of the reported U.S. business lines by mid-2003. In certain denser
business centers, the penetration of business lines appears to be above 40%. In
short, my view is that, in the wake of the Act, competitors have entered a
financially attractive market to target those customers that could generate
reasonable profits in high-density regions. The result is that businesses now
have a variety of asset-based competitors from which to choose.
My view of the residential market is different, and I believe that the FCC
data lead to more suspect conclusions. The residential market share shift
occurred later than did the business shift, apparently for several reasons.
First, residential rates have been maintained at relatively low levels and were
even subsidized in some regions as part of public policy since the early part of
the last century. Second, the costs associated with providing residential
services are high, meaning that the profit spread is likely modest at best,
which is why we have seen little investment on the part of copper-based
competitors. Third, the usage volumes and mix of services are generally
unattractive for residential competitors, especially compared with services
provided to businesses. And, fourth, the investment necessary to provide
ancillary services - video, high-speed data, etc. - is prohibitive unless the
communications provider can offer, and have a high probability of retaining, a
much fuller array of services. More simply stated, the residential market is not
naturally as attractive for a telephony-only competitor, and the market may not,
in fact, be able to sustain multiple asset-based telephony-only competitors.
Predictably, some federal and state regulators have been unwilling to accept
the tenet that competition is not as well-suited to the residences of the
American public. Recognizing that the task they faced was complex and the goals
worthy, regulators therefore chose to intervene, using a model that was similar
to the one employed in the successful breakup of the long-distance monopoly
market in the 1980s. Based on that model, state and federal regulators have
required the incumbent to lease its network at deep discounts, which were far
more complex in their formulation than the long-distance intervention in the
1980s. Sometimes the rates were set at very low levels and at other times they
were fixed somewhat higher to incent competitive investment. In general, the
TELRIC (total element long-run incremental cost) pricing model - using marginal
costs analyses - assumed that, when the competitors were able to gain enough
scale, they would build a newer, more modern stand-alone network. The goal was,
like that of the simpler long-distance industry in the 1980s, the nurturing of
real businesses, characterized by real assets and profit margins in the form of
a sustainable business model.
Unfortunately, there appears to be virtually no such investment occurring on
the part of copper-based competitors in the residential market because the
premise was flawed. The miscalculation arose because investment costs and risk
are very high in the residential local exchange business, especially compared
with the relatively less expensive assets required to serve the 1980s'
long-distance market, and the profit margins on LEC businesses are thinner and
are probably not sufficient to sustain the higher levels of investment.
Accordingly, today we have more "competitors" offering residential
local exchange services based on regulatory approaches that, however
well-intentioned, have not spurred viable long-term enterprises. In fairness,
there were some competitors that tried to invest, but some have admitted that
they were disadvantaged by a system in which TELRIC competitors had a more
attractive short-term business proposition with virtually no capital costs and
lesser competitive risk. In sum, we committed to a system in which there is
disintermediation of the investment of the LEC shareholders into at least the
some of the competitors without achieving the concomitant public policy goal of
longer-term competitive activity. Worse, we may have a system that is draining
cash flows from viable competitors - the LECs - precisely at the moment when
they need to invest in order to withstand the next stages of formidable
intermodal competitive activity from attractive wireless and cable-based
services.
My view, then, is that we have been through a period of illusory business
propositions that have burst badly, and we may have new illusions, including the
less-than-convincing policy that the telephony-only POTS-like model can be
competitive for residential customers. More directly stated, in the residential
market, I believe that the only major facilities-based competitors in the U.S.
are the wireless carriers and the cable operators, whose plant already exists or
is in need of some relatively modest upgrade. Thus, the statistics tabulated
about residential competition are, in the minds of investors, not representative
of the underlying reality.
I believe that competition is, in fact, occurring, but it is through a
fundamental intermodal shift, transpiring with the advent of new technologies
and marketing.
Wireless as a Substitute for Wireline Service Clearly, wireless is an
important source of competition. In fact, investors and analysts ask about
wireless substitution on virtually every investor communications-related
conference call. As analysts, we track the falling numbers of LEC access lines
that can be fully explained only by reality of competitive choice, including
wireless. We analyze the innovative types of services that appear increasingly
attractive because they offer new features, including mobility, text messaging,
image generation, etc. My observation is that policymakers, understandably, work
within legacy constructs - including statutes and case law - that define
wireless and other intermodal services as different from traditional telephony,
and some policymakers have been slow to embrace intermodal services as
competitors. At the same time, I believe firmly that those newer carriers, based
on proven alternative technologies, are formidable competitors precisely because
their products are different from copper-wired services.
Let us take a brief look at some statistics related to wireless. I note that,
while it is clear that there is substitution whereby wireless-only customers may
be 8% of the total consumer market today, it is admittedly difficult to
calculate precise figures. To provide some insight into the data, however, we
can examine recent reports of the Bell companies. Each of the carriers supplies
information in formats different from the others, and the data are often
different from the information supplied by that very carrier in the previous
quarter, making analysis a bit tricky. In the most recent quarter reported last
week, for example, SBC supplied interesting statistics to illustrate the
company's improving performance in terms of line loss in certain of its service
regions. In Table 2, the data are totaled and analyzed in a way different from
SBC's presentation to investors, highlighting that the company was not doing
quite as well as the initial investor slides depicted. While the company was
posting lesser line losses in sequential quarters in terms of primary lines and
second (also called "additional") lines, further analysis revealed
that the net losses are actually growing in a way that cannot be explained
solely by regulatory-imposed discounting rules. Using the company's data on
residential lines - primary and additional - and subtracting them from the gains
in wholesale lines, which are unbundled connections leased to competitors, the
summation suggests that the total of retail and wholesale residential lines is
contracting more rapidly in the last two quarters of 2003. I note that the
wholesale data used in this analysis includes both residential and business
lines, but I believe that the residential wholesale lines are growing at least
as fast as the business lines, and that the conclusion is still the same. In the
case of BellSouth, the company reports simply that it lost 7.3% of its retail
lines year-over-year and that the net loss of retail lines, offset by wholesale
gains, was 3.1%. BellSouth's absolute losses in residential lines - combined
retail less wholesale - in the fourth quarter were 134,000, slightly worse than
the 130,000 lost in the third quarter. Verizon does not supply the data
necessary to perform a similar calculation. What is the explanation flowing from
these statistics? Substitution continues unabated.
Looking carefully at the analysis, however, reveals something more about
wireless. First, the total residential loss can be explained, in part, by the
shifting to cable modems or DSL, but data substitution is generally a
second-line phenomenon, and the second-line loss is slowing and is well below
the total loss. It does not seem that the loss is due to a more severe economic
downturn, as the economy appears to be improving, nor does the loss appear to be
due to the shift to cable telephony, as those forces are still relatively
nascent. It appears to me that the higher losses are due to an acceleration in
the movement toward wireless services and away from wireline telephony.
Table 2: SBC Quarterly Residential Line Loss
Legg Mason has published in the past that we estimate that roughly one half
the residential line loss is the result of consumers' cutting off slow
circuit-switched second lines to migrate to high-speed data substitutes, and
that approximately 25% of the share shift was due to consumers' substituting
into wireless services. The data now suggest that the trend toward wireless is
accelerating, as cellular price plans and convenience have occasioned the growth
of wireless to approximately 157 million subscribers at the end of the fourth
quarter compared with approximately 185 million wired telephone lines, by Legg
Mason estimates.
Table 3 provides wireless customer additions by carrier for each quarter
since the beginning of 2002. The key messages are that the last three quarters
have been marked by solid sequential growth in additions, that the strong
wireless carriers have tended to gain share, and all this is occurring at a time
when the RBOCs are reporting sharp year-over-year retail residential declines.
The comparisons are startling - SBC reported 8.0% retail residential losses in
the final quarter of 2003 compared with 2002, while BellSouth disclosed 7.3%
contraction (cited earlier), and Verizon announced only the combined wholesale
and retail slippage of 3.7%, meaning that the retail loss was likely more
severe. With the introduction of wireless local number portability in late
November 2003 - permitting a wireline customer to port its number to a wireless
carrier - it seems that the regulators have moved closer to stating that they
view wireless as a substitute for wireline access that was once judged to be an
imposing bottleneck.
Table 3: Quarterly wireless subscriber additions
Source: Company data; Legg Mason Wood Walker, Inc. Figures from Verizon,
AT&T Wireless and T-Mobile for 4Q03 are actual.
Broadband Market Growth The growth in broadband services - primarily based on
cable modems and DSL - continues to accelerate for residential and business
customers. Table 4 details DSL data from the three-largest telephone companies,
highlighting the quarterly increases in total lines served by the carriers and
the increases in net additions each period. The increases have been gradual, but
they are increases nonetheless, again over and against the RBOC line losses. In
terms of the numbers of customers subscribing to DSL each quarter, the
three-largest Bells report 706,000 new lines added in the fourth quarter of 2003
- announced in the last week - following 661,000 in the preceding period and
508,000 in the three months before that.
Table 4: RBOC Quarterly DSL Totals and Net Adds
The cable operators have also reported high-speed data growth, with the
absolute number of additions generally rising. Figure 1 illustrates the
subscriber quarterly additions, based on the companies that Legg Mason follows
and our estimates of the other carriers. Notably, the cable operators continue
to attract more subscribers in absolute terms each quarter compared with the DSL
additions by the Bell companies and the additions by all LECs.
Figure 1: High-speed data subscribers quarterly additions
Source: Company data; Legg Mason Wood Walker, Inc.
An alternative view is based on Legg Mason's estimates of the high-speed
market share as illustrated in Figure 2. The graphic conveys the commanding
market leadership of cable operators in this expanding communications segment.
At the same time, we estimate that cable share has slipped to approximately 57%
in the final quarter of 2003 from about 68% in the first quarter of 2003, with
the major reason being the gradual pressure from RBOCs - much lower rates,
better bundling, and more widespread availability - that appear to be focused on
retaining high-speed share lest the Bells be disadvantaged when the cable
operators begin offering VoIP services in 2004 and beyond. Additionally, the
independent local exchange carriers have gained share, particularly in markets
that are not as well served by cable operators.
Figure 2: High-speed market share: cable modems and DSL
Source: Company data; Legg Mason Wood Walker, Inc.
In our consultations with investors and regulators over recent months, I have
suggested that the expanding battle over high-speed data is the thunder in the
distance before the most formidable storm of intermodal competition is upon us.
My view is that the Bells recognize that the true residential competition is
about to break out and competitive activity, ironically, has nothing to do with
what the deep discounts or other temporary constructs that regulators have
employed in attempting to change what has for so long been an intractable
residential marketplace.
Cable Operators' Voice Share At present, competition from cable operators is
relatively limited, as Cox and Comcast have some circuit-switched customers, but
few other cable operators have invested in cable telephony. The most recent FCC
competitive statistics, as of the end of June 2003, contend that there were
approximately 3.0 million cable telephony lines in the United States, accounting
for about 11% of CLEC lines and 2% of the total domestic switched access lines.
I believe the statistics are interesting, but do not merit much study because
the true intermodal cable product is already making its entrance in the form of
voice over Internet Protocol.
My view that most telephony investors are profoundly concerned about VoIP
competition is evidenced by the fixation on the competitive share shift
generated by tiny providers such as Vonage, Net2Phone, Skype and Pulver.com.
Investors follow every signal from the cable operators that are market-testing
VoIP and those that have begun to roll out the Internet-based service. Among the
cable operators, Cablevision and Time Warner Cable are being watched most
carefully, as they are offering widespread service earlier than their peers.
The power and speed of the rapidly approaching weather system was driven home
last week (January 28) when Time Warner reported on its test market in Portland,
Maine. The service was begun in May 2003, a mere nine months ago, and management
reports that it has captured more than 10,000 VoIP customers, which is about 23%
penetration of the high-speed customer base, 9% of the company's video customers
in the region, and, by Legg Mason's estimate, 5% of the homes passed in
Portland. The company also reported it was beginning to offer VoIP in Kansas
City, Kansas, and Raleigh, North Carolina, and expected, by the end of the first
quarter, to have service in a total of six of the company's 31 systems across
the country, and, by the end of 2004, to have service in virtually its entire
cable footprint.
If we compare Time Warner's penetration rate to the FCC competition
statistics cited at the outset, I suggest that Time Warner could be near 5%
residential penetration within its first year of service, adjusting for the fact
that the company's homes-passed are fewer than the residential telephony lines
in the region. Notably, the FCC reports that residential plus small business
penetration of CLECs is 12% as of June 2003, based significantly on the
discounted rates the regulators set. It appears that, within two years, we could
see the residential competitive statistics bypassed by VoIP services in a
marketplace that is fundamentally driven by technology changes, and a result
accomplished far more effectively than might have been expected through
regulatory incentives.
I believe that the introduction of VoIP services will move residential
competition to a place that legislators and regulators could not have expected
realistically under the copper-based telephony model. In this new intermodal
competitive landscape, consumers will be able to choose from asset-based
competitors whose services are differentiated from, and more convenient than,
circuit-switched telephony. Further, the pricing for services will almost
certainly, in my view, be more attractive than rates possible using legacy
telephony, because of the underlying economics of Internet-based technologies.
Another sign that the intermodal forces are significant is apparent in
reviewing the RBOC responses. The storm is so fearful that the RBOCs are
vigorously preparing for its onset by slashing pricing for their DSL services,
sharpening their marketing on bundled services, pressuring equipment vendors to
develop high-speed electronics in volumes at dramatically lower prices
(deployment has yet to occur except in tests), and at least generically
announcing VoIP products for businesses and residential customers.
Future-Oriented Policy Issues As I summarized at the outset, I believe that
the emerging intermodal forces raise serious policy questions. Regulators and
legislators will increasingly have to consider whether the incentives and
constraints that they are employing are dismantling the correct bottleneck
monopoly in light of the rapidly changing technologies. In fact, I believe that
many of the more thoughtful policymakers recognize that backward-looking schemes
are seriously limiting RBOC investment and that the limitations could have
unintended consequences in causing the LECs to slow their commitments to the
forward-looking wireline markets in which fiber and optical electronics are key.
I do not propose that there are simple answers to these questions, but I have
written and believe firmly that competition is unfolding in an intermodal world
and that the RBOCs may not be able to reshape their services rapidly enough. It
is clear to me that the RBOCs are conflicted about whether their investment
expenditures are too high to justify widespread deployments. They are uncertain
about whether alternative investments such as fiber-to-the-curb make more
economic sense, but there is too great a risk in a world in which the rules
promise that competitors will not dilute that investment if, and only if, the
investment is all the way to the premise. And the RBOCs appear to me to be
wrestling with the reality that the rebuild will be time-consuming, raising the
possible evaluation of an alternative financial model in which the RBOCs admit
that their securities are inevitably declining annuities, which is to say that
they cede the emerging services to better-prepared asset-based competitors as
they more responsibly return cash to their shareholders. If that happens, then I
believe that the new communications marketplace could be served by alternative
services that may be monopoly-like because the investment required to compete is
so great.
Conclusion To summarize my testimony, I note that there are key points for
this Subcommittee's reflection.
§ My simple observation as an analyst is that competition has generally
worked where there are fundamental financial realities to support businesses. §
In the enterprise and small business markets, competitive growth is significant,
with competitive penetration over 30%. § Over and against that, in the
residential market, I see a short-term competitive model that is understandably
policy-oriented, but I believe that "competition" in the wireline
copper-based telephony market will dissipate when the artificialities are
removed within the next several years. § At the same time, it appears to me
that the tenet in sponsoring this Subcommittee's discussion is correct - that
competition is unfolding through intermodal services, including wireless,
broadband communications such as email, and, most importantly, through the very
obvious and formidable threat of VoIP. § If investors have a concern, I believe
it is that they are fearful that some policymakers misunderstand the nature of
how competition unfolds, and that the natural competitors in the various
marketplaces are constrained because cash flows and returns on capital
commitments, in the case of the RBOCs, are uncertain precisely at a time when
investment is necessary to cope with intermodal competitive threats.
Thank you for the opportunity to present my views.
Important Disclosures and Certifications
I, Michael J. Balhoff, CFA, certify that the views expressed in this research
report accurately reflect my personal views about the subject securities or
issuers; and I, Michael J. Balhoff, CFA, certify that no part of my compensation
was, is, or will be directly or indirectly related to the specific
recommendation or views contained in this research report.
The information contained herein has been prepared from sources believed
reliable but is not guaranteed by us and is not a complete summary or statement
of all available data, nor is it considered an offer to buy or sell any
securities referred to herein. No investments or services mentioned are
available in the European Economic Area to private customers or to anyone in
Canada other than a Designated Institution.
Opinions expressed are subject to change without notice and do not take into
account the particular investment objectives, financial situation or needs of
individual investors. Employees of Legg Mason Wood Walker, Inc. or its
affiliates may, at times, release written or oral commentary, technical analysis
or trading strategies that differ from the opinions expressed within.
Legg Mason Wood Walker, Inc. is a multidisciplined financial services firm
that regularly seeks investment banking assignments and compensation from
issuers for services including, but not limited to, acting as an underwriter in
an offering or financial advisor in a merger or acquisition, or serving as a
placement agent for private transactions.
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