Pay Phone Market Embraces Initiatives to Spark Rebirth

Posted: 05/2000

Pay Phone Market Embraces Initiatives to Spark Rebirth
An Endangered Species?
By John S. Bain

Some major events may be in the offing for the pay phone industry, which, if successful, would send a message to practitioners and investors not to write this business off just yet.

As expected, the industry’s potential may be tied directly to expanding pay phone services, such as Internet access. Still, even as this possibility could save a floundering industry, pay phone service providers (PSPs) continue to find themselves in protracted battles for compensation. Some independent pay phone operators simply will not make it and will eventually be squeezed out of the industry.

Simply put, the promise of better things to come through the Telecommunications Act of 1996 has not been realized because of court and regulatory delays, as well as the increased use of cellular and other services.

The recent disclosure that SBC Communications Inc.
(www.sbc.com) will give up its 12-state service area is powerful evidence that a financially strong industry leader has concluded the pay phone’s future has limited prospects.

Every publicly traded company associated with the pay phone industry is trading at or near all-time low prices in the midst of the greatest bull market in U.S. history, and two major publicly traded PSPs have gone bankrupt.

On the other hand, promising initiatives under way within the industry would telegraph what may be a rebirth. Companies are developing Internet access through so-called “Internet kiosks” at airports, hotels and other strategic locations.

And the same regulators and consumer advocates who wept openly when the local coin rate went to 35 cents per call, don’t seem to care that Internet access can cost 25 cents per minute (frequently with a four-minute minimum). Of course, it is doubtful Internet kiosks will replace a sizeable fraction of the roughly 2 million pay phones in service anytime soon.

The kiosks are only one way the industry is looking to recreate itself.

Elcotel Inc.
(www.elcotel.com) has introduced its “Grapevine” series of display-equipped pay phones, which are intended to generate vertical revenue through advertising sales.

The company has suggested that a market may develop in which advertising will enable route operators to offer free local (and, eventually, long-distance) calling in exchange for being exposed to advertising at pay phones.

Also, Davel Communications Group
(www.davelgroup.com), the leading publicly traded pay phone service provider, is experimenting with nontraditional pricing plans, including a 50 cent local coin rate and/or dime-a-minute pricing in selected markets.

Understanding the Past

To understand the search for new life in its industry, it is necessary to know why it sailed into dire straits.

Pay service has existed from the earliest days of the telephone. Even before long distance, pay phones generated additional revenue for the local telephone company and introduced telephone service to people who had not installed them at their homes or businesses.

As telephone penetration and the mobility of society increased throughout the 20th century, pay phones became a vital link in providing away-from-home access. As long-distance service improved and innovations such as Direct Distance Dialing and Calling Cards were introduced, pay phones became the choice communication device for travelers.

By the time the modern era arrived (which we date from the 1982 antitrust consent decree that broke up the old Bell System), anyone with an appropriate calling card or a bag of coins could make calls from pay phones anywhere in the country.

At the end of 1981, Bell Labs reported an estimated 1.6 million pay phones were in service within the Bell System. Those phones generated an estimated $3 billion in annual revenue, or $156 per phone per month.

At that time, the 2,000 other U.S. LECs controlled another 400,000 pay phones.

Before the split of the Bell System, all the gadgets attached to subscribers’ telephone lines–telephone sets, answering machines, modems, facsimiles, PBXs, etc.–were essentially a monopoly of the LEC in any given service area. But once the Bell breakup occurred, the FCC
(www.fcc.gov) also declared all the newly installed accoutrements were deregulated and were the choice of the customer.

This left pay phones in a conundrum. It was not clear who the subscriber to pay phone service was. The FCC tried to solve the problem by declaring that pay phones should stay in the regulated rate base. It reasoned that because the features and functions that enabled pay phones to operate originated in the LEC’s central office, they should be classified as “Central Office Equipment” and stay with the regulated portion of the business.

The notion came in handy when it came time to implement the terms of the antitrust consent decree that broke up the Bell System. With few exceptions, the BOCs kept their coin-operated pay phones, and AT&T Corp.
(www.att.com) ended up owning most coinless pay phones, supposedly because coin phones generated mostly local calls, whereas the coinless phones were used primarily for calling card and long-distance calling.

Rise of Independents

In June 1984, the FCC approved the operation of Independent Pay phone Providers (IPPs). However, because the LECs had no public tariff for provision of ordinary coin-line service, the service was not available to potential competitors. Instead, various LECs filed new tariffs to provide special rates for what they called Customer-Owned Coin-Operated Telephone (COCOT) service.

Given that pay phone service is not thought to provide big profits for LECs, it was not clear why the LECs did not establish tariffs immediately for coin-line service. If such tariffs had been established on profitable terms, it could have provided the LECs a graceful way to leave a business that brought only marginal profits at best.

Explanations could be that the LECs simply had a knee-jerk anticompetitive reaction; they did not have the systems and technology in place to enable them to provide coin-line service to IPPs; or they did not know what the cost of coin-line service was, since the software, switching, and other necessary functions were and are embedded in the overall network equipment infrastructure.

The reason also could have been that the LECs were attempting to cost justify a coin-line tariff that would have made it obvious that the basic local coin rate had been unprofitable and subsidized by other services for decades.

If so, such end-user pricing would have been revealed to be significantly below cost, and, therefore, blatantly anticompetitive.

In other words, LEC coin-line tariffs would have had to be high enough to make it obvious that if they charged their own phones such a rate, they would lose money. But that would have embarrassed telephone companies and regulators, who would have had to admit that some services lose money.

The COCOT lines are identical to ordinary residential or business access lines, providing dial tone, ringing current, and not much else. But for some strange coincidence, COCOT lines are tariffed at rates higher than equivalent facilities. This put independent PSPs at an economic disadvantage, particularly because the LECs did not recover the full cost of their own coin lines through the pay phones themselves.

Timeline: Historical Milestones In the Independent Pay Phone Industry

In addition, because the telephone companies retained control of the COCOT lines, it was the LECs that decided which IXC should be “presubscribed” to the long-distance calls made from each pay phone, and, of course, their choice was AT&T.

As a result, the early IPPs could not tap into revenues the higher priced toll calls generated from their equipment. They were limited to collecting only the coins deposited for basic-rate local and sent-paid toll calls.

A Glimmer of Economic Hope

In October 1988, IPP economics changed when Judge Harold Greene extended the presubscription requirement to include pay phones. Under his ruling, the location provider, not the local telephone company, had the power to choose the IXC to which the pay phone would be presubscribed.

For the first time, location owners, or the IPPs who contracted with them for the locations, could reach agreements with IXCs to retain a portion of the noncoin revenues their pay phones generated.

One might have thought this development would have created a rush to provide services. It didn’t. In fact, to this day, established telephone companies still do not offer certain services to independent pay phone providers.

Because the ruling did not encourage established phone companies to offer service to independents, the industry created its smart phone and developed the Alternate Operator Services (AOS) industry.

This caused confusion throughout the coin and noncoin telephone monopoly. Entrepreneurs of every stripe, including multiple location owners (such as gas station chains), vending machine route operators, multiple-level sales organizations and limited partnerships entered the business.

This Is Competition?

For nearly 200 years, U.S. citizens were sold on the notion that competition leads to lower prices, better service and increased consumer choice. In the telecommunications industry, this appears to be the case with deregulation.

But when IPPs decided to operate a pay phone route as a profitable business, the
public faced higher prices and, in many cases, lower levels of service.

Because pay phone management had been left to the telephone companies under the former monopoly structure, significant latitude existed for the new entrants. They could pick and choose, so they sought only the best pay phone locations, which threatened to leave LECs with all the unprofitable, carrier-of-last-resort business that nobody wanted.

The independents also could provide service under different terms and conditions. To make a profit, many began at higher prices, and none had the service capabilities of the established phone companies.

This led to critics labeling the IPPs an “abuse” of the industry.

Was the Abuse Label Fair?

Philosophically, the tendency is to view LECs and, to a lesser extent, the IXCs as obstructive, reactionary, anticompetitive forces, which tried to stop innovative, profit-driven entrepreneurs from operating the pay phone business more efficiently.

A closer look at the situation makes it clear the LECs and IXCs are not necessarily wrong.

Consider AT&T as an example. Why shouldn’t AT&T provide IPPs a cut of the revenues that customers pay on long-distance calls that are made from the independent pay phones?

A pay phone is a capital asset; the IPPs have an investment in it. The IPP should be entitled to earn a reasonable return. But from AT&T’s viewpoint, the company already pays LECs on each end of the call a proportion of its toll revenues in the form of “access charges.” Why should it pay another party another fee because the pay phone ownership changed?

The LECs would argue they will lose the coin revenues from the phones; the IPPs will engage in cream skimming–taking only the most profitable phones and leaving the LECs stuck with the losers. Also, the diversion of OSP calling to AOS companies robs LECs of their per-minute interexchange access charges, which are needed to offset the underpriced basic exchange rates.

IPPs, on the other hand, would complain they are not charities. They have significant capital invested in the instruments, and they are entitled to compensation when their phones are used.

Finally, consumer groups and regulators would question whether deregulation to encourage competition is supposed to decrease prices to the public.

How can they all be right? The answer is in how telephone pricing was established during the monopoly era. For decades, local coin calling rates were held to preposterously low levels as regulators turned to other services to absorb most of the inflationary cost increases of recent decades.

Chart: Davel Communications Stock Price Chart

In Texas, for example, the 25 cent rate went into effect in 1979. Assuming the price was “just and reasonable” when it was established, how could it be considered to be fair in today’s marketplace?

The public has been sold on the concept that “competition lowers prices” for so long that it is hard to accept, in the case of pay phone service, that a level playing field means prices must increase.

CICs and PICs

With the FCC’s “equal access” order came the establishment of “Carrier Identification” or “Primary Interexchange Carrier” codes (CIC or PIC). The five-digit codes took the familiar “10XXX” form. By dialing the codes from most normal residential or business lines, consumers can reach the dial tone of any of the IXCs that offer service in the area.

But when IPPs presubscribed to other IXCs in order to share in the toll revenues generated, IXCs struck back with a marketing campaign to inform the public how to reach them through the 10XXX codes.

This created a new problem for the IPPs–the loss of revenue from their most profitable calls. The smart phone appeared to come to the rescue, as the IPPs outsmarted the IXCs by programming the phones to block 10XXX access codes.

Long-distance carriers retaliated with the development of other access methodology, chief among them were the “800” access numbers, such as “800 CALL ATT.”

The only option the IPPs had was to block these codes as well. In some cases, they blocked all 800 calls, which caused such an uproar, it led to well-meaning but naive consumer advocates clamoring for industry reform under the guise of the “Billed Party Preference” (BPP).

Congressional Intervention

The complaints of poor service, high rates and other problems in the provision of pay phone service got Congress’ attention in 1990. It responded with the Telephone Operator Consumer Services Improvement Act.

Among other things, the legislation forbade IPPs and other service aggregators to block access to nonpresubscribed IXCs. It also required that rates had to be quoted upon request, and that pay phone locations and services must be posted.

The bill directed the FCC to determine whether IPPs should receive compensation for originating interstate calls to nonpresubscribed IXCs that traditionally had not paid for such calls.

The FCC concluded a system of per-call compensation for all calls made from pay phones, including 800 subscriber calls, should be implemented. However, it also pointed out that no mechanism existed to track dial-around calls, so it directed an interim compensation of $6 per phone per month to be paid to each pay phone by the IXCs as a group.

The low amount was justified by the FCC’s conclusion that compensation should be based on 800 access calls, and not 800 subscriber calls, even though all the other parties made money on them. Even so, $6 per month was better than nothing.

After the legislation was implemented, the IXCs aggressively promoted their dial-around access numbers. And, AT&T and Sprint Corp.
( www.sprint.com) struck deals with the IPPs, receiving FCC approval to implement 25 cent per-call compensation. This led to the FCC later issuing a proposal to change the rules and allow all IXCs to pay on a per-call basis.

In July 1992, the FCC reaffirmed its conclusion that, although IXCs were required to compensate IPPs for 800 access calls, the order did not apply to 800 subscriber numbers. The differentiation was based on the assertion that compensation was due only on “access code calls.”

The FCC decided that only 800 access calls deserved compensation, and set the interim amount (until a per-call system could be put into effect) at $6 per IPP phone per month.

The policy allowed callers to use pay phones to access subscriber 800 and other toll-free numbers without compensation of any sort. This led to what some PSPs called a “clear case of government confiscation of private property,” but none was willing to take the issue to court.

The IPP, however, joined with the American Public Communications Council (APCC) and the Florida Pay Telephone Association (FPTA) to challenge the FCC in the U.S. Court of Appeals for the District of Columbia.

The court found no reason to distinguish between subscriber and access 800 calls, and in May of 1995 remanded the case back to the FCC for consideration of compensation for 800 subscriber calls.

Saved by the Telecom Act

The FCC avoided addressing the issue because by then Congress had passedthe Telecommunications Act of 1996,
which preempted anything the FCC may have considered.

The act mandated numerous changes affecting the industry. Among them were measures that relax antitrust and other restrictions on the BOCs and other LECs, while opening up the local exchange business to competitive entry.

In the regulations written to implement the Telecom Act, Section 276 specifically addresses the pay phone industry. It was written uncommonly clear and direct. The language states “that all pay phone service providers are fairly compensated for each and every completed intrastate and interstate call” made from their pay phones.

The act requires the FCC to modify the calculation of the interstate access charge to “discontinue the intrastate and interstate carrier access charge pay phone service elements and payments … and all intrastate and interstate subsidies from basic exchange and exchange access revenues.”

What this means is LECs no longer can make a profit in their regulated business by installing and maintaining unprofitable pay phones.

The act also orders the FCC to consider a mechanism under which the BOCs could participate in InterLATA traffic and the location owner’s selection of the IXC serving the phone. This provision actually strengthens the BOCs’ competitive position, as they can bargain on behalf of the location owner for a cut of the IXC revenues.

But most importantly, Congress gave the FCC only nine months to provide the regulatory guidance the act contained.

Fairness or Obstruction

Section 276 touched off a sequence of administrative and judicial events that can be viewed as either a confirmation of the deliberative fairness, thoroughness, and openness of the judicial and regulatory review process, or as an idiotic example of the bungling, incompetent and obstructive policies of the courts and regulatory authorities.

It has been more than four years since the Telecom Act became law, yet issues relating to Section 276 remain unresolved.

One of the few actions stemming from the act is that the FCC nailed down deregulation of local coin calling rates. That resulted in the local coin rate increasing to 35 cents in most jurisdictions.

Basic issues relating to compensation for dial-around calls, however, remain unsolved, despite three FCC orders, numerous court appeals and a significant amount of pending litigation.

In January 1999, the FCC adopted its Third Report and Order on dial-around compensation. Attempting to overcome the federal court’s objections to the earlier pay phone orders, the FCC adopted a different methodology to support the per-call dial-around compensation rate.

Calling it a “bottom-up” approach, the FCC calculated an average “fully distributed cost” for each call made from a pay phone and concluded that PSPs are entitled to 24 cents for each dial-around call.

This order has been appealed by everyone involved. The court heard oral arguments in late January, but did not indicate when it would rule on the case.

Wireless’ Impact

For years, observers have suggested wireless services eventually would supplant pay phones. However, until the late 1990s, there was no evidence that this was happening.

Then, in November 1997, about the time the local coin rate was deregulated, pay phone operators noticed an abrupt decline in calling volumes.

Many believed it was the price hike. However, it was during this same time that major cellular and other wireless providers began to introduce bucket services. Part of these services are flat, monthly rate pricing plans that include a relatively large number of airtime minutes.

Having already paid for the airtime, the wireless subscriber’s marginal price for a local call becomes zero compared to the 35 cents the pay phones demand.

Other marketing initiatives such as 1-800-CALL ATT eroded the “0+” long-distance revenue base of the pay phone providers. Discount services, such as AT&T’s 1010-345 Lucky Dog access code, began to attract a following.

Prepaid calling cards have also gained in market strength, some of which use the packet-switched Internet for call completion (avoiding the originating access charge).

The result was a 17 percent average monthly decline of pay phone calls between 1996 and 1997, and it has continued to drop.

Grim Reaper or Rising Phoenix

Where does this leave the pay phone industry?

To be successful, operators have to be as inventive as Elcotel or Davel.

That would mean if SBC sells or otherwise disposes its 12-state, half a million pay phone business, the purchaser/operator will have a business that has the potential to generate half a billion dollars or more in annual revenue.

Numbers like that attract attention.

Major events, innovative concepts and ideas may be in the offing for the pay phone industry. Practitioners and investors are advised not to write it off just yet.

John S. Bain is a nationally recognized securities analyst with Hoak Breedlove Wesneski & Co., a Dallas-based investment bank. In addition to the public communications industry, he focuses on the ISP and CLEC industries, and the emerging market for Internet Telephony. He can be reached by e-mail at
[email protected]. A complete copy of his research report “Retrospective and Outlook for the Public Pay phone Industry” is available upon request.

A Penny for Your Thoughts … er, Advertising
By Stacy Lane Linkmeyer

Pay phone users, lend an ear–whether you want to or not.

The days of picking up the receiver, depositing coins and hearing a dial tone may soon be a thing of the past. In fact, in some states it already is.

When users pick up the receiver, many hear a recorded advertising rather than a standard dial tone.

Whether pay phone users and operators like it or not, the industry has changed forever. As a result of cell phones, dial arounds, mergers and consolidations, many pay phone owners looking to reinvigorate their business have been forced to wake up and face the advertising.

Intellicall Inc.
(www.intellicall.com) is one company that has created audible advertising as a way to help pay phones pay off. Using a proprietary downloadable speech file, independent pay phone providers
(IPPs) can issue a six- to eight-second advertisement with Intellicall’s technology.

The process is simple. Intellicall sells the pay phone operator a $500 license to use a speech file. An advertiser provides the file to the operator who downloads the message to the phone. Multiple messages can be changed on a regular basis, and the phone can track how many times the message is played.

“What this allows is the pay phone providers to get the revenue for advertising without having to go out and invest in replacing equipment,” says Intellicall president and CEO John McDonald Jr.

“It certainly is a good revenue generator with little expense.”

The technology is being tested at prime locations in New York City on pay phones owned and operated by Global Network Communications
(www.globalnetlink.com), and Intellicall expects to take the technology nationwide in the near future.

The software can be added to any of Intellicall’s estimated 45,000 ASTRATEL 2 pay phones. Otherwise, operators can upgrade other Intellicall phones to make them advertising-compatible for about $300, says Diana O’Connor, Intellicall’s manager of marketing communications and training.

After that investment, operators can expect a return of $10 to $15 per phone each month, depending on how active the phone is, she says.

“If you have 100 phones that do 100 calls a day and you get a penny for each one of those, that’s a chunk of change that adds up over time,” O’Connor says. “You can recoup your investment very quickly.”

Another company looking to change the pay phone environment is Elcotel Inc.
(www.elcotel.com), a Florida-based provider.

In addition to using audible advertising, Elcotel has hopes of turning the traditional pay phone into a multimedia marketing tool for targeting consumers on the go.

Elcotel released its Grapevine network terminal, which combines traditional pay phone capabilities with sponsor-paid content and advertising, e-commerce, e-mail and personalized services. It looks like a conventional pay telephone, but is equipped with a display screen on which advertisers can shoot messages to phone users. Advertising can be rotated up to six times per minute and tailored to the phone’s location.

When the phone is in a static state, it scrolls branding and promotion information. When a consumer is using the phone, advertising will be presented in numerous ways. In partnership with Elcotel, the pay phone service provider (PSP) can develop advertising similar to that of the web, such as banner or interstitial ads.

“Our approach is to try to provide new tools for the traveling public to keep them connected,” says Michael Nastanski, executive director of marketing at Elcotel. “In the context of providing those services, we’re looking toward advertisers, or to what we call sponsors, to underwrite the delivery of that information and those services. It’s not advertising for advertising’s sake, it’s to underwrite services for the traveling public.”

Nastanski says the Grapevine will add to the existing pay phone environment and fulfill a new need for connectivity in the marketplace.

The Grapevine isn’t designed for a street-corner location, he says. It is better suited for high-profile, indoor locations such as malls and convention centers.

Although popularity trials are taking place in Chicago, New York and other major U.S. cities, some companies already seem sold on the technology.

Canada Pay phone Corp.
(www.canadapayphone.com) recently entered a $125 million deal with Elcotel to install 45,000 terminals in hotels and resorts across Canada over the next five years. And Microsoft Corp.
(www.microsoft.com) featured the product in its booth at the March Embedded Systems Conference.

Grapevine is the first public Internet appliance to operate solely on Microsoft technology.

Although Nastanski would not talk price, he said the Grapevine terminal does cost more than other pay phones. For advertising, costs fall between traditional out-of-home media and Internet advertising on a cost per thousand impressions basis.