Playing with Fire

Posted: 07/1998

Playing with Fire
Local Service Resale Hurts, But Does It Burn?

By Ken Branson

In the classic film "Lawrence of Arabia," Peter O’Toole, playing the romantic
desert hero, sticks his hand in a candle’s flame and leaves it there for several seconds
without so much as a grimace. A companion does the same for an instant, then recoils.

"Ow! It ‘urts, Mr. Lawrence!" the companion says. "What’s the secret,
sir?"

"The secret," O’Toole/Lawrence replies, "is not minding that it
hurts."

And so it is, according to analysts and resellers, with local service resale. The
business of buying other people’s local telecommunications services at a discount and
selling them to someone else under one’s own brand is many things, they say, but it is
not, by itself, a path to riches.

"Anybody who has (local) resale as their strategy doesn’t have a business
plan," says Sheldon Ohringer, president of ICG Communications Inc. ICG, which buys
services for resale selectively, plans to offer its capacity wholesale later this year.

The hurt, resellers say, comes from the discounts offered to them by incumbent local
exchange carriers (ILECs), which range from 17 percent to 25 percent. These discounts are
from gross margin, and so the reseller must pay all its considerable expenses from that
discount.

Steve Troutman, director of resale for the Telecommunications Resellers Association
(TRA), says the discounts should be "30 [percent] to 40 percent, minimum."

And there is other pain to be borne, according to Ernie Kelly, president of TRA. The
services included in the wholesale package should include such features as
call-forwarding, call-waiting, caller ID and, above all, voice mail.

"We think the discounts are inadequate for dial tone," Kelly says. "But
we’re concerned about other things that affect residential retail that are addressable.
Voice mail, for instance, is not being resold across the country, and where it is being
resold by the ILECs, it’s not being resold at a discount. We think that is a very large
inhibitor to local residential competition. It’s tough to win over a residential customer
if you’re a reseller today, but even tougher if you can’t offer the incumbent’s voice mail
product. It leads to us losing customers we would otherwise get."

Nonetheless, there appear to be reasons for not minding that it hurts.

There is the possibility that someone will at least lower the flame by raising the
discount rate, according to Andrew Isar, president of Harbor Consulting Inc. "I think
the industry is betting on the fact that, as time goes on, and market pressure and
regulatory decisions favor competitive entry, the discounts will increase, the problems
interfacing with incumbents will decrease, and the competitive alternative to the
incumbents’ networks will arise–all of which will mean that the margins will improve
dramatically and resale will be a viable business in and of itself," Isar says.

Another reason for entering local service resale is to solidify one’s customer base and
entice new customers by leveraging a new service. Boston-based Metracom Corp. is an
example.

"We started out as a switchless long distance reseller, and we continue to be
switchless," says Kevin Estes, vice president of Metracom. "And we saw the great
opportunity of being one stop for our customers in the local market. Local service and
long distance, combined, is a very powerful marketing tool; we want to be one of the
first."

Metracom is a privately held company, and Estes would not say whether the company is
profitable. But Metracom is in the process of being acquired by UniDial Communications
Inc., another privately held long distance company based in Louisville, Ky. Susan
Gosselin, manager of corporate communications at UniDial, says it was Metracom’s
experience in local resale, and her own company’s wish to enter that market, that first
attracted UniDial to Metracom.

Estes concedes that local service resale is no way to make a living, and will not
speculate about future revenues any more than he will discuss current ones. But he says
there are "soft benefits" to local service resale for a company with an
established base of customers, such as his.

"There are strategic benefits besides the battle between revenue and cost,"
he says. "Increased collections, increased customer retention. By increased
collections, I mean, if you are a single provider of services, your customers are going to
be more likely to pay their bills than if you were just a long distance reseller, because
you are providing them with a more valuable service–dial tone."

Bill Capraro Jr., president and chief executive officer of CIMCO Communications Inc.,
Oak Brook Terrace, Ill., has his arm in the flame, but is smiling. "Losing money? Of
course we are," Capraro says. "There are many reasons for that, and margins are
one. But fortunately, we have a very stable, large, existing customer base, so we are able
to add local telephone service with relatively low expenses."

Of course, Capraro, unlike Lawrence, doesn’t really enjoy pain. But he believes there
is a point to his suffering. "As the business grows, Ameritech [Corp.] (from whom
Cimco buys wholesale) will have to decide whether they want to make us a legitimate offer
to keep our business, or allow competitors to take that business away from them. It’s just
like it was, say, 12 years ago in long distance. AT&T [Corp.] had the opportunity to
embrace the reseller community and didn’t do it. Now, they’re on the outside, looking
in."

TRA paints an unflattering picture of ILECs in general and regional Bell operating
companies (RBOCs) in particular. TRA’s view is that ILECs have been forced to provide
wholesale access to unbundled elements. They do not do it with a song in their hearts.
Kelly, TRA president, thinks state regulators should force higher discount rates, or
include in those discounts "vertical features," such as voice mail, on which the
margins are higher. He also would like the Federal Communications Commission (FCC) to
bring access charges down faster.

RBOC spokespeople respond that they don’t set the tariffs and, consequently, don’t set
the rates. They are for local competition, they say–and yes, they spend a lot of time
making sure they comply with the law and regulatory orders.

"We view the resale business as a good business opportunity for the company,"
says Joe Chandler, a spokesman for BellSouth Corp. "We have organized ourselves so we
can provide our new CLEC (competitive local exchange carrier) customers with what they
need to operate in the local market. We have about 83 CLECs in our nine-state region, of
which 51 are pure resellers. Those 51 resellers have taken from us 342,000 access lines.
Our approach is, hey, we support local competition. We support that part of the
Telecommunications Act [of 1996]. We believe the entire market should be open,
including long distance, and we’re still waiting on that. We see this as a viable business
for the corporation and we’ve set up organizations specifically to serve that
market."

Chandler adds that the discount rates are based on the retail rate for local phone
service, "and in every state where we operate, the retail rate is well below what it
costs to provide that service."

Peter Karoczkai, Bell Atlantic Corp.’s vice president of marketing and product
management for telecom industry services, also points out that the discounts are based on
tariffs filed by his company, argued over in hearings and approved–or not–by state
regulators.

"Bell Atlantic has led the nation in opening its network to competition, long
before the Telecommunications Act was passed," Karoczkai says. "The act and the
FCC order are the law of the land, and we are very busy making sure that we are
implementing all of its provisions, and fully ensuring that we’re meeting all our
obligations under the act and the FCC orders, the various state orders, and the hundreds
of interconnection agreements we have signed. How much would we have done on our own? I
simply don’t know, and it isn’t much good to speculate. However, Bell Atlantic has done
probably the most in the country in terms of the other RBOCs, and if you ask our customers
to compare us to the others, they would probably tell you the same."

And, indeed, UniDial’s Gosselin says that Bell Atlantic’s reputation for being
relatively cooperative with resellers helped convince UniDial to make its bid for
Metracom.

But the ILEC’s inability or unwillingness to bring its discount rates up, and its
relative slowness to respond, is starting to attract competitors much like blood in the
water attracts sharks. Right now, they’re just circling, but the circle is narrowing.

"There is money to be made," says Dale Thompson, director of wholesale
marketing for local service product development at WorldCom Inc. WorldCom announced a
local wholesale offering in May.

Thompson says his company will aim its wholesale service at carriers with large numbers
of business customers. WorldCom will beta test the service later this year and plans to
make it generally available in 54 cities on Jan. 1, 1999. According to Thompson, WorldCom
will offer discounts of 30 percent to 35 percent. He says that state regulators don’t set
rates; they approve tariffs filed by phone companies.

"We file our tariffs, count our costs, and we play in the same marketplace as the
ILECs," Thompson says. "We don’t have as large a staff to play with in certain
arenas…They have additional expenses that they have decided to incur, and that we have
decided to avoid."

WorldCom will not be alone.

WinStar Communications Inc., based in New York City, touts its "wireless
fiber" approach as the solution to the "last-mile problem." Frank Jepson,
senior vice president for capital market relations, says WinStar provides local service to
businesses in 24 markets, and expects to be in 30 markets by the end of this year. By the
end of 1999, Jepson expects to be in the 40 largest markets in the United States. The
company’s approach, of course, is based on its acquisition of licenses in the 38 gigahertz
(GHz) spectrum.

"This allows us to deliver to buildings service that is equivalent to optical
fiber but that relies on radio links, optical microwave technology, if you will,"
Jepson says. "So we create line of site links between customer buildings and hub
sites that we build in our cities."

Jepson acts as a wholesaler in those markets where it makes sense to do so, and one of
those markets is the Chicago region, where CIMCO’s Capraro uses WinStar for redundancy.

Capraro explains that CIMCO offers to resell a customer Ameritech’s local service, and
then offers WinStar’s at a considerably lower rate–say 5 percent to 10 percent less–as a
"backup, in case you should lose Ameritech service coming into your building through
the basement, you still have WinStar on the roof."

ICG’s wholesale offerings will have a distinct flavor. Ohringer says his company has a
distinct footprint in Ohio, California, Colorado and parts of the Southeast. It expects to
wholesale its local services to other CLECs with different footprints.

"For example," he says, "I might want to (enter the market in) Miami,
but I have no facilities there. So I might buy capacity from a CLEC that does; and it
might buy capacity from me in Denver. I’d rather give my money to another CLEC, and I
think other CLECs would rather give their money to me, than to an RBOC."

Teleport Communications Group Inc. (TCG), based in Staten Island, N. Y., wholesales its
local services to other companies. Wholesaling is a small but significant tactic for the
company as it seeks to keep TCG’s name before resellers and agents, according to Roger
Cawley, vice president of public affairs. He points out that TCG doesn’t advertise much,
and is not as well known as it would like outside the Fortune 500 companies on whom it
built its reputation.

Relatively large, aggressive companies such as WinStar and ICG also use resale as a
tactic, a sort of stalking horse, as they build their networks out into new territory.

WinStar’s Jepson explains that his company does not wait until a city’s skyline is
studded with its dishes and anchored with its hubs before it seeks customers. It seeks
customers while its facilities are being built, and puts them on the local ILEC network
until those facilities are ready.

ICG’s Ohringer says his company will do what it has to do to get a new customer and
hang onto him.

"Take a bank with 80 lines in its headquarters building," Ohringer says.
"But they’ve got 10 branches, and two lines in each branch. Let’s say we can put the
headquarters on-net right away, but can’t do that for the branches. But the bank says,
‘Look, we want those branches as part of the deal.’ We’ll put them on the ILEC network
until we can get them on-net."

Local service resale, then, appears to be a two-edged sword–useful to certain
companies in certain circumstances, but dangerous for others. A solid customer base, a
good business plan, and a clear idea of where to go next seem to be advisable. Fun, it’s
not. Peter O’Toole, ordered into the desert in "Lawrence of Arabia," tells
Claude Rains, "Oh, good! This is going to be fun!" Rains looks at him
quizzically and says, "It is well known, Lawrence, that you have a funny sense of
fun."