RESELLER CHANNEL: MARGIN MAKERS VS. MARGIN BREAKERS

Posted: 06/2002

MARGIN MAKERS VS.
MARGIN BREAKERS
A Rational Approach to Target Marketing
Under UNE-P

By Carey Roesel and Craig Neeld

THE UNBUNDLED NETWORK elements platform (UNE-P) has been characterized as resale with twice the margin. If this is true, does it ever make sense to pursue pure resale? Are the strategies any different between resale and UNE-P?

The wholesale rates available under resale hardly could be more different than the UNE rates comprising the UNE-P. Resale rates are based on the ILEC’s retail rate minus avoided costs (the costs avoided by the ILEC when a service is sold on a wholesale rather than retail basis). Generally speaking, resellers face a consistent 17 percent to 21 percent gross margin regardless of the customer type, feature penetration, usage pattern or location. UNE-P rates, on the other hand, are derived from ILEC incremental costs. And since ILEC costs and rates are so poorly correlated, it is essential that a UNE-P CLEC understand where the cost/price gaps are greatest to identify the most promising profit opportunities.

Comparing an ILEC’s UNE rates (i.e., costs) and retail service rates exposes areas of the local exchange market that are most ripe for competition. UNE rates offer an unusual opportunity for a CLEC to dissect what drives ILEC profits and to develop a marketing strategy that allows it to separate the margin makers from the margin breakers. A facilities-based CLEC can target in this manner as well, but to the UNE-P CLEC, the results are much more meaningful. Under UNE-P, the relevant ILEC costs — as identified by the UNE-P rates — become the CLEC’s costs. This is certainly not true for a facilities-based CLEC, where the difference between the ILEC and CLEC cost structures often renders seemingly desirable ILEC markets unreachable.

There are four primary market factors that drive margins for the UNE-P CLEC.

Customer Type. Many CLECs simply have avoided the residential market. This has been justified by the low return on the dollar and a high churn rate among the residential competitors. Remember, UNEs are blind to the designation of a customer as either residential or commercial, so low relative residential retail rates simply translate into low relative margins.

A key factor for the UNE-P CLEC, however, is that UNE-P is restricted by the FCC’s exception to the unbundled local switching requirement. ILECs are not required to make local switching available in density zone 1 in the nation’s top 50 MSAs for customers with four or more lines. This generally excludes residential customers from the exception, as the FCC intended. Consequently, markets that yield the highest margins based on the remaining three characteristics may be available only to CLECs willing to take on residential service.

Features. There is perhaps no better example of a high-margin, service anywhere than an ILEC calling feature. On the cost side, calling features are essentially free to the UNE-P CLEC. While volume discounts and bundling are common in the retail market, calling feature revenue can contribute so much to margin that losers become winners — particularly in the residential market.

Network Usage. UNE usage rates, inasmuch as they identify true incremental network costs, signal local exchange calling services are typically underpriced, while functionally similar switched access services are overpriced.

This means that usage within a designated local calling area often generates no revenue, but it does generate UNE usage costs — and these costs can be substantial and unpredictable. In West Virginia, for example, UNE usage costs easily can make up half of the total per-line UNE-P costs. Under such circumstances, a UNE-P CLEC can experience wide variations in actual margins based on customer usage patterns.

On the upside it means that UNE-P CLECs experience positive, and often substantial, margins on long-distance usage. The interstate and intrastate switched-access revenue generated by long-distance usage is a revenue source that is completely unavailable to resellers. Although switched-access rates are falling, and likely will converge with UNE usage rates over time, these charges continue to contribute to reasonable UNE-P CLEC margins.

Location. Location is where things get tricky. It is critical to the success of a UNE-P CLEC to know where to serve — down to the NPA-NXX level. UNEs, particularly loops, are zone-sensitive. This is because the FCC directed the state regulators to establish different rates for UNEs in at least three defined geographic areas within the state to reflect underlying cost differences. Because of these cost differences, dense metropolitan areas offer lower-cost UNEs than rural areas. Retail rates are often zone-sensitive as well, but the retail rate zone-sensitivity (i.e., “rate groups”) usually is related inversely to underlying costs. Rate groups were developed in the past by state regulators in an attempt to align regulated local exchange rates with a perceived “value of service.” The more lines within a customer’s local calling area, the higher the price. Many states have abandoned or consolidated rate groups, while some still have 10 or more. The key, then, for the UNE-P CLEC is to know where the UNE zone and rate group combinations are most favorable.

Anything short of an NPA-NXX-level evaluation will fail to capture the true potential, or in some cases the risk, of a market. Again, UNE-P is restricted by the FCC’s exception to the unbundled local switching requirement. The subtlety lies in the fact that the exception is allowed only in ILEC switches that are designated as density zone 1. (Density zones, in contrast to UNE zones, were established under the FCC’s direction to allow ILECs to charge geographically de-averaged rates for switched transport services provided to IXCs.) A CLEC should not assume that every rate center or NXX in a top 50 MSA is off limits because the local switching UNE is not available. For example, Boca Raton, Fla., is a top 50 MSA. It is also an attractive market for a CLEC, because it is a UNE Zone 1 (i.e., lowest cost) and Rate Group 10 (highest retail price). However, BellSouth Corp. is not required and may not be willing to sell unbundled local switching to the CLEC that places a UNE-P order for four lines or more in this market.

Instead of abandoning such a market, a CLEC may choose to focus on areas within the market that are not part of the FCC’s exception area. For example, Delray Beach, Fla., is in UNE Zone 1, Rate Group 8. This is part of the Boca Raton market, yet it is not in the exception area. By locating the desirable areas outside of the FCC’s exception area, CLECs strategically can enter attractive markets that may have been considered off-limits.

For another example, take a look at Florida’s east coast again, but go north of West Palm Beach to the rapidly growing area known as the Treasure Coast. Most rate centers in this area easily can produce favorable margins for the UNE-P CLEC. However, the Sebastian rate center could prove costly. Five of the six NXXs in this rate center are UNE Zone 2, Rate Group 6, which produces estimated gross margins in excess of 30 percent. Yet one NXX is a UNE Zone 3, rate Group 6, which likely would produce a negative gross margin. Such details are not readily apparent in overly broad market assessments.

Continuing with Florida examples, many have heard of Daytona Beach and perhaps know it as “The World’s Most Famous Beach.” New Smyrna Beach sits to the south of Daytona and is part of the greater Daytona Beach market. However, under the precise zone and rate group classifications, Daytona Beach is a UNE Zone 1, Rate Group 6, while New Smyrna is a UNE Zone 2, Rate Group 4. New Smyrna’s zone and rate group classification results in an estimated gross margin, absent any calling features, that is less than half that of Daytona (see chart
below ).

Click Here for Chart

To further illustrate, let’s shift up to Verizon Communications Inc. territory in the Commonwealth of Virginia. Here we find a diverse state that is home to industry related to our federal government as well as the tiny towns of the Appalachian Mountains. The differences become apparent when comparing a potential customer in UNE Zone 3, Rate Group 2, to another in UNE Zone 3, Rate Group 8. In Florida, virtually any UNE Zone 3 customer is a margin risk. Not so in Virginia. Certainly the customer in the UNE Zone 3, Rate Group 2 is an unlikely target, but not all UNE Zone 3s produce the same results. A customer in UNE Zone 3, Rate Group 8 reasonably could yield a gross margin exceeding 40 percent.

Different cost and retail rate structures have a profound influence on how to compete in the UNE-P market, and it is important to avoid drawing general conclusions until the numbers have been examined carefully.

Returning to our original questions: Can UNE-P generate margins that are double those under resale? Yes, but the odds for success drop considerably if the CLEC neglects to differentiate markets based on readily apparent differences in profit potential.

Does it ever make sense to pursue pure resale? Yes, but a CLEC must recognize the variety of market characteristics that make UNE-P more or less favorable than resale. Sweeping market generalizations will not identify accurately which customers are served more profitably via resale than UNE-P.

Are the strategies any different between resale and UNE-P? Absolutely. The similarities between resale and UNE-P often are overstated. Like resale, UNE-P provides the opportunity for relatively quick, broad-based entry into the local exchange market — but that’s where the similarity ends.

Carey Roesel and Craig Neeld are consultants with Technologies Management Inc., a telecommunications carriers’ consulting firm specializing in state and federal regulatory matters, since 1986. TMI offers publications, business tools and consulting on regulatory issues, regulatory compliance and competitive developments in the telecommunications industry, including a
UNE-P market analysis tool.