Is Local Resale a Sinking Ship?

Posted: 05/1999

Is Local Resale a Sinking Ship?
Voyagers Prefer Facilities; Hope Floats in UNE-P
By Ken Branson

It looked like a plan in 1996 when Congress passed the Telecommunications Act: The
incumbent local exchange carriers (ILECs) had networks, but couldn’t sell beer on a
troopship; competitive companies–brand-new–had no networks, but they knew how to sell.
The Telecom Act, the Magna Carta of competition, said the ILECs had to open their
networks. Therefore, why shouldn’t the savvy marketers buy ILEC lines at a discount and
resell them?

USN Communications Inc., Chicago, was one of the earliest practitioners and most vocal
advocates of resale, striking early resale agreements with Ameritech Corp., Chicago, and
the former NYNEX Corp. (now part of Philadelphia-based Bell Atlantic Corp.). "The
Company believes that its business strategy affords it more flexibility to take advantage
of regulatory and industry dynamics than its facilities-based competitors," reads
USN’s initial public offering (IPO) registration statement, filed with the U.S. Securities
and Exchange Commission on Oct. 21, 1997.

As expected, the company cited the availability of unbundled network elements (UNEs)
that it could purchase economically from the regional Bell operating companies (RBOCs) and
rebundle into an alternative local service option. "The company expects to exploit
this opportunity by rebundling network elements, thus expanding its products offering and
improving its strategic position. In addition, the increased construction by
facilities-based CLECs (competitive local exchange carriers) has improved the value of the
company’s services by creating alternative resale partners other than the RBOCs."

But instead of becoming local resale’s most heralded pioneer, it has become its
most-pitied poster child. The company went public in February 1998 at $16 per share, rose
to $23, and then plummeted through the summer and fall. It began 1999 below $1, was
eventually suspended from trading on the NASDAQ National Exchange, and filed for
protection from its creditors under Chapter 11 of the Bankruptcy Act on Feb. 18. CoreComm
Inc., New York, has announced its intention to buy most of the company’s assets, pending
approval of the Bankruptcy Court in Wilmington, Del.

Leaving aside for now whatever unique corporate pathology might have been at work at
USN, the failure begs the question: Is there any hope for local resale as a strategy?

Man Overboard

Analysts and industry executives say it’s extremely difficult for a competitive carrier
to make money in local resale. Their view is illustrated by recent moves by McLeodUSA
Inc., Cedar Rapids, Iowa, and e.spire Communications Inc., Annapolis Junction, Md., who
have begun to pull back from resale to concentrate on building out their own networks.

In fact, some companies, such as the Telecom Alliance Inc., Wallingford, Conn., are
building a business around offering products designed to make the transition from resale
to facilities easier for competitive carriers.

But many companies, such as Tyson’s Corner, Va.-based Net2000 Communica-tions Inc., are
using resale as a market-entry tactic, and the managers of some companies, such as
Frontier Corp., Rochester, N.Y., believe their particular markets or strategies permit
them–or even require them–to squeeze value out of local resale. And still others, such
as Access One Communications Inc., Fort Lauderdale, believe the UNE platforms (UNE-P), now
offered by BellSouth Corp., Atlanta, may vindicate the original resale vision.

Steve Trotman, director of industry relations at the Telecommunications Resellers
Association (TRA), takes the dark view. "Right now, frankly, we don’t see it (local
resale) as a sustainable business plan," Trotman says. "Margin is the biggest
hurdle, and even if we could get decent margins, the ILECs have not viewed [local resale]
as a good distribution channel, but as competition. And then there are fees and poor
service from the ILECs."

Margin is the difference between the discounted price an ILEC charges a
reseller–ranging from 15 percent to 26 percent, Trotman says–and what the reseller
charges the end customer. According to Trotman margins vary from 15 percent to 21 percent,
differing from state to state. "And out of that has to come all your overhead, sales
commissions and everything else," Trotman explains. "And that doesn’t include
any upfront charges, which really start to whittle away at your margin."

For Charlie Thomas, president and CEO of Net2000 Communications Inc., local resale is a
thing done out of necessity, and soon never to be done again. "We definitely use
local resale as a market-entry tactic," Thomas says. "The fact of the matter is,
it’s impossible to make money on local resale. USN was an example of that."

But for the next year or so, Thomas and his colleagues will be reselling a lot of
lines. They began as agents for Bell Atlantic, and are making the transition to an
"integrated communications provider." By the end of next year, they expect to
offer switched service in Baltimore; Boston; Long Island, N.Y.; New York; and Virginia
Beach/Norfolk, Va. Net2000’s first switch, a DMS 500 from Nortel Networks, Richardson,
Texas, has just been installed in Washington, and the company is preparing to cut
customers over to it. They aren’t waiting for the switches to be installed in the other
target cities; rather, they are reselling Bell Atlantic’s service in those cities. Market
necessity has driven them to it, but Thomas watches sales success in his target cities
with decidedly mixed emotions.

"The good news is, we win lots of new customers," he says. "But the bad
news is, every time we bring in a dollar on a resale, two or three dollars go out the door
to cover that dollar."

Once the switches are installed in this first round of cities, Thomas says, that’s it
for local resale. His sentiment is widely shared among his peers, most of whom appear to
think that local resale, while it might be a quick way to get into business, is an even
quicker way to get out of it. Even USN, after its stock fell dramatically in the second
quarter of 1998, announced that it eventually would become a facilities-based carrier. At
press time, however, USN had not announced the deployment of any switches. Also, at press
time, USN officials had not responded to requests from PHONE+ for interviews.

However, CoreComm president and CEO J. Barclay Knapp told PHONE+ that CoreComm, which
intends to buy USN, will combine resale with a network strategy as it tries to expand from
its original base in Ohio to cover the rest of the Midwest and Northeast. On the same day
CoreComm announced its intention to buy USN, it announced the intended purchase of
MegsINet Inc., a Chicago-based Internet service provider (ISP) and CLEC with its own
network. Knapp says CoreComm wants USN for its customer base and MegsINet for its network.

Facilities or Bust

Some competitive carriers remain committed to a facilities-based strategy, based on
their understanding that to control the switch is to control the customer, and to control
the customer is essential. For example, Jeff Blackey and his colleagues at US LEC Corp.,
Charlotte, N.C., would no more commit their futures to local resale than they would hold
hands and take a collective dive off Charlotte’s Bank of America building. Even as a
market-entry tactic, local resale is just asking for trouble, says Blackey, US LEC’s vice
president of marketing.

"By doing local resale, we would be putting our customers, who have faith in us,
in the hands of someone else," Blackey says. "By using our own facilities, we
can control quality of service (QoS), the accuracy of billing and the provisioning
process."

US LEC doesn’t offer service in a city unless its switch is already there. And it
doesn’t put a switch in place until its marketing people have decided that a particular
city is a good place for US LEC to do business. US LEC targets medium to large businesses
and institutions in prosperous southern cities. "It has to be a city where we can get
transmission facilities from a number of providers," Blackey says. "It can’t be
a sole-source place. We look for cities that are growing, or large enough to support the
competition that’s there and that’s going to be there. We’re very big on looking at
markets adjacent to where we operate; you won’t see us jumping all over the place."

Having decided on a city, US LEC consults with Lucent Technologies Inc., Murray Hill,
N.J., its main switch supplier, on the exact configuration of the switch intended for that
city. US LEC staffers then select a site for the switch. The company hires a local sales
manager, who hires salespeople. The salespeople go after customers about three months
before the switch is turned up.

NewSouth Communications Inc., Greenville, S.C., follows the same path. This is not
surprising, since NewSouth’s CEO, Michael LaFrance, and US LEC’s CEO, Richard Aab, are
both veterans of the former ACC Corp., a competitive long distance carrier founded by Aab
and bought by AT&T Corp. last year.

"We (former ACCers) think it’s important to make money in business," LaFrance
says, his tongue practically sticking through his cheek. "Lots of people in this
business think you can lose money forever as long as your stock price goes up. Not
us."

Aside from the margin problem, LaFrance sees local resale as a long series of
catastrophes waiting to happen. "We don’t want to be dependent on Bell (BellSouth,
the local ILEC) for anything, if we can help it," LaFrance says. "No matter how
hard they try, they still screw it up."

LaFrance says companies that practice resale often lose their customers to "infant
mortality"–a customer’s departure due to problems arising during cutover from the
ILEC’s switch to the competitor’s switch. "We’ve never lost a customer for any
reason," he says.

Seaworthy

Frontier however, still pursues resale as a tactic. Ninety-seven percent of the
customers of Frontier’s CLEC operations are on resold lines, according to Bill Hammond,
vice president-product management for Frontier. The company is aggressively building its
own facilities, but even a year from now, Hammond estimates that 80 percent to 85 percent
of his customers will be resale customers.

Frontier’s situation is different in many ways. For instance, Hammond points out that,
at Frontier, "CLEC" is a product, not a separate company, or even a separate
line of business. "We look at resale differently, for a couple of reasons,"
Hammond says. "First, we’ve always looked at resale as a way to complement our
product set and offer an integrated package–long distance, local and Internet service–to
our customers. It reduces the attrition on our long distance business by about 50 percent,
and it’s a big plus for our salespeople, who are finding it difficult to get a foot in the
door just talking about long distance. Now they can lead by saying we offer local service
in 70 percent of the United States [as defined by access lines, and not counting the 34
markets where Frontier is an ILEC]. That’s a bigger footprint than Ameritech. In fact,
it’s a bigger footprint than most RBOCs."

The margins are just as thin for Frontier as they are for everybody else, but Hammond
says Frontier’s costs are thinner as well. "Resale makes sense for us because we are
a LEC in 34 markets," Hammond says. "So we have unique resources in terms of
people. They’ve been in the local business for years, so when we have to communicate with
other LECs about repairs, changes of service, moves and so on, they know how to do that.
And we also have a billing system as a long distance provider. So we’ve found it easier to
get into local service quicker."

Hammond declines to name a target figure for the percentage of customers Frontier will
have on-net in, say, five years. Frontier provides local service for 200,000 access lines
right now, and many of them belong to customers with 12 lines or fewer. For those with
more lines, or for those who "are heavy users of long distance," Frontier may
find it more attractive to put them on its own facilities. "We will only do
facilities when we can access a customer with a T1 line," Hammond says.

Bill Tucker, principal in the telecom consulting firm Competitive Communications Group
LLC, Bethesda, Md., agrees that resale still may make sense for Frontier, or for a smaller
carrier serving a market or market segment with few competitors. "I guess if you do
everything right, and you’re in a market or market segment without a lot of competition,
you can push that price point near the Bell price and eke out some single-digit
margins," Tucker says. "But it’s not for the faint of heart. It doesn’t take
much to turn a 3 percent margin into a negative 20 percent margin."

A Life Raft?

The ILECs themselves always have been somewhat conflicted about resale. It keeps
traffic on their networks, but it also costs them retail customers. BellSouth management
apparently has decided that traffic on the network is more important for the long-term
health of the company than retail market share in the short term, because the company has
recently made UNE-P available to its competitors. Under UNE-P in BellSouth’s territory, a
reseller has access to the entire BellSouth network, with discounts as deep as 40 percent.

As far as Tucker is concerned, the news is not that BellSouth has taken this
initiative, but that it has taken so long for an ILEC to do it. "What they (ILECs)
have done by insisting on these 20 percent discounts is protect market share in the short
term, but force everybody to go out and buy switches and build competitive networks,"
Tucker says.

BellSouth had struck two deals as of press time–Access One Communi-cations and Access
Integrated Networks Inc., Macon, Ga.–and intends to negotiate more. The BellSouth offer
is this: A competitor can have access to the entire BellSouth network, and all the
vertical services that are available only a la carte under standard resale agreements, in
return for putting 70 percent to 90 percent of its circuits on that network. Jim Brinkley,
senior director of interconnection services marketing at BellSouth, says BellSouth will
take care of all the "professional services" involved in running the network and
handling the CLEC’s traffic on it. A CLEC can choose to sign for three, five or seven
years; it can put 70 percent, 80 percent or 90 percent of its circuits on BellSouth’s
network. The longer the contract and the more circuits on BellSouth’s network, the lower
the cost to the CLEC, according to Brinkley.

"Our rationale is simple," Brinkley says. "We want to keep people on our
network. We were seeing a lot of network buildout in our area–something like 180
operational competitive networks. That’s a lot of investment going into the area. We
wanted to make an offer that was competitive with CLECs’ cost to build. That will keep
them on our network. True, it puts them in competition with our retail networks, but
that’s been looked into, and it was decided that this was the best thing to do for
BellSouth."

Not surprisingly, some competitors are skeptical about the motives behind the sudden
willingness of BellSouth to negotiate these agreements at deeper discounts.

Shay Houser, CEO of State Communications in Greenville, S.C., is migrating his company
from a resale to a facilities-based strategy, and he is deeply suspicious of the BellSouth
offering. Since he who owns the switch owns the customer, in Houser’s view, any company
accepting BellSouth’s offer will get better margins for now, but leaves its long-term
future in the hands of its fiercest competitor. "Seven years!" Houser exclaims.
"Seven years is a long, long time in this business."

Brinkley concedes that BellSouth wants CLECs to buy UNE-P rather than build their own
networks, but asserts that BellSouth’s motive is the entirely innocent, if
self-interested, one of making money. BellSouth has dedicated 1,800 people to operations
of UNE-P, and 300 salespeople to market the program. Brinkley won’t say how much money
BellSouth expects to make, but insists that it does intend to make money on UNE-P.

The agreement between Access One and BellSouth calls for Access One to use BellSouth’s
network for five years, and for 70 percent of its circuits to be on that network. Ken
Baritz, Access One’s chairman and CEO, says the company will have at least one switch–in
its Orlando office–but will pursue UNE-P and resale as a strategy for the immediate
future.

"We were the first to sign UNE-P with BellSouth, and we basically feel we
developed the terms along with BellSouth," Baritz says.

Baritz commends BellSouth for being "proactive" in adapting a UNE-P offering.
And he believes that UNE-P, while different from the standard resale contract offered by
BellSouth, vindicates the vision that he and other entrepreneurs had at the beginning.
"Our vision, from day one, was that, although the landscape was heavily against
us–margins, quality of service, and so on–we believed that would dramatically change,
based on our reading of the Telecommunications Act," he says.

To build one’s own network is risky, Baritz thinks. Who knows what tomorrow’s facility
of choice will be? And how about the necessity of raising all that money to buy switches,
routers and cross-connects? And how about all the time and money devoted to acquiring or
leasing real estate? All those worries, Baritz happily points out, belong to BellSouth.

Tucker says it’s too early to say for sure whether the UNE-P offering is a deal with
the devil or a viable long-term strategy for competitors. "Both answers are
correct," he says. "It really is a strategic question to be answered at the
highest levels of a CLEC. What do you want to be when you grow up? What do you want to
look like in, say, five years? If you are willing to do resale, why not do UNE-P?"

The difference between Access One’s view of resale and the opinions at NewSouth or US
LEC may have something to do with the market each company competes in. US LEC and NewSouth
are business-oriented CLECs. Access One aims at small-business customers and residential
customers; so does State Communications. Both companies offer local, long distance and
Internet access service, bundled, to their customers. Both spend as little as possible on
sales and advertising. They have studied USN’s case closely, and believe they know what
went wrong–and right.

"Every nickel they saved by not going to facilities went to growing a
nonperforming sales force," Baritz says. "They went from 0 to 500 (sales staff),
and spent $20 million on that sales force. Think of the human resources costs! Think of
the real estate costs!"

Houser adds, "We’re growing at about 30,000 access lines a month, which is pretty
close to where USN was last year. But we’ve got 130 employees today. When USN was growing
like that, they had 1,600!"

Still, Baritz says, it was USN that "built the model" for resale by signing
"long-term, volume contracts" with their ILECs. "Frankly, that was the seed
of what we did with UNE-P," Baritz says.

Ken Branson is the business and finance editor for PHONE+ magazine.