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Veteran Observer of Communication Wars Sizes up the Industry's Evolving Competit

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Battle of the Nets:
July 18,2003
By Dow Jones Newswire
An Interview with Blair Levin

He has been on the frontlines of major changes in telecommunication policies since his days as chief of staff to former Federal Communications Commission Chairman Reed Hundt in 1993-97. Levin now provides counsel to Legg Mason Wood Walker clients on regulatory developments of importance to media and telecom investors. As managing director of Legg Mason's Telecommunications Equity Research Group, he most recently distinguished himself by making a smart, contrarian call on a closely watched regulatory decision that established new rules for the telecom network platform. The decision had a major negative impact on the Baby Bells. For his insights into some of the latest issues in telecom and media, please read on.

-- Sandra Ward

Barron's: What is the biggest issue in telecom, media and cable right now?

Levin: All three certainly intersect with each other, but in the telecom world, the biggest and most important issue is the migration of revenues from the traditional low-competition, high-margin, monopoly wired phone networks to the high-competition, low-margin, wireless and data networks. That shift -- from wire line to wireless and data -- has been ongoing and it is dramatic and important. Those elements are cannibalizing the traditional wire-line networks. That shift is going to get worse with Voice Over Internet Protocol on the horizon. You see small signs of it now with companies like Net-to-Phone and Vonage and others. In the future, cable will be doing more Voip and other companies, such as Microsoft and Apple, will be doing things with it. You have a negative trend for telecom companies that is going to become more negative.

Another critical point: We don't see any new revenue sources that are going to make up for the deterioration in wire line.

Q: How far off is the threat from VoIP?

A: Some would argue it's here today in the sense there are companies like Vonage offering it. Vonage has only 35,000 cus tomers. Cablevision will be providing a Vonage-like service starting this summer. Vonage does not have some kind of proprietary technology that prevents other people from doing what they do. But we're finally getting certain competition for voice services that could really undercut the Baby Bell revenue stream.

The big moment will be when Comcast decides to do it. I don't think that's this year. I don't think it's next year. It's probably a 2005 event, but there are a number of different factors that could speed up the process or slow it down. AOL could do it, but they have to do their spinoff first and they have a lot of more pressing priorities to get through. Charter and Adelphia have a lot of financial issues to sift through before they could start doing it or not.

Q: So cable companies will dominate VoIP?

A: Yes, and the entrepreneurial companies like Vonage are probably going to have to align with cable. One of the most interesting trends in telecom is the coming battle between the edge providers versus the network providers. As broadband penetration grows, there will be the ability to separate the transmission of service from the applications of voice, video and data. Now we deliver voice services over a network, and the voice service we commonly talk on is vertically integrated and is owned by the phone company that owns the wires to your phone. Cable companies, on the other hand, bundle programs over their own pipe. However, the broadband world offers the possibility of separating the services from the transmission, using pure edge providers.

Q: Explain what an edge provider does.

A: Edge providers don't own the network but simply are at the edge of the network offering the service. Vonage utilizes your broadband connection through a Cisco box, which connects to your phone and allows you to make phone calls over the Internet. Vonage didn't ask the cable company's permission to be able to make that phone call. They benefit from the phone network, but as a business proposition they are not part of the phone network. It is the separation of transmission and service. Similarly in video, a cable channel in the past would have to ask the cable company's permission to ride over the cable pipe. HBO, for instance, had to strike a deal with Comcast. But that is not going to be the case necessarily with broadband. Interestingly, ABC is now offering an on-demand video service, but instead of doing a traditional channel where they pay a bunch of startup fees to the cable guys, ABC is simply offering video over broadband on a subscriber basis for something like $4.95 a month. Instead of following the HBO model and charging $10 a month and then giving the cable guys X and keeping Y, ABC will get 100% of that $4.95 and ride over somebody else's wire.

Q: Who wins this battle?

A: The Bells and the cable guys probably win because of the power of bundled services and customer relationships. But the edge providers will bring enough pressure so that those bundles will have to be very sophisticated in terms of the way they are marketed and the way they are put together and the way they are priced.

Q: What about pricing? Who's going to make money providing all these services.

A: It is going to be much harder than it was back in the 'Seventies, 'Eighties and 'Nineties. Competition has been introduced to every sector, every part of the telecommunication and media sector, and there is no high ground and no safe territory. There aren't any easy businesses now, but I am not totally pessimistic. Voice, video and data services are essential services. People love the service; people need the service. They are going to be willing to pay money for the service. But the way people are going to make money is going to be different than it was in the past.

Q: How do the Bells compete with VoIP?

A: One school suggests some form of bundling so the Bells own the customers sufficiently and are not at risk of losing revenues. Another school of thought holds that by investing in much bigger broadband pipes, the Bells will overbuild the cable industry and provide more functions and better performance in the same way the cable industry overbuilt the satellite industry in the 'Nineties. I favor the bundling school, but the Bells are making noises about their significant investments in new broadband, and that is important to watch.

Q: What about consolidation?

A: There is a lot of desire for wireless consolidation. There is a desire for integration of the long-distance providers with the local Bell companies. All the Bells at the right price would love to have the enterprise operations of AT& T. There is even occasional talk of further ILEC [incumbent local exchange carrier] integration, whether it be some of the non-Bells like Alltel buying more properties or whether it be another Bell merger. Everyone is waiting for the other guy to make the first move.

Q: And when will someone move?

A: The question is: What could force people to make a move? Possibly the implementation of local-number portability where you can carry your wireless phone number to another carrier, which will occur in late November. That could trigger a battle between the wireless companies that forces certain wireless companies to either get out or consolidate.

Arguably, the wireless guys should have consolidated before portability went into effect. Having no national wireless technical standard makes consolidation more difficult. And the number of potential deals is really limited; out of six wireless players, we could see consolidation to four. The social issues become so much more difficult as well as the pricing issues.

Another event that could spark more consolidation is the emergence of WorldCom, now called MCI, from bankruptcy.

Q: Do you think that will be an easy process?

A: As everyone else's confidence has grown, mine has actually shrunk a bit. I still think they are going to emerge. But bankruptcy is kind of like a baseball game in which you have to watch the first inning and you have to watch the ninth inning. Most of what happens in the middle isn't that indicative of the outcome. If people couldn't kill it early on, the real effort will come late in the game. More and more folks are doing their best to try to either keep them in bankruptcy longer, have the company be liquidated or hurt them as they come out of bankruptcy. In terms of its impact on consolidation, from an antitrust perspective, the optimal moment for a Bell to buy MCI's enterprise operation is when it emerges from bankruptcy. The enterprise operation, its Internet backbone service for large businesses, is the crown jewel. It's an area that AT&T and MCI dominate, but the Bell companies are now able to get into that business since completing their applications for long-distance service. Verizon Communications is best positioned to serve that market, because their footprint includes more Fortune 500 companies. But Verizon almost certainly can't buy AT&T for antitrust reasons. So the question is: How does Verizon get into that business? Do they try to buy MCI, which they tried to do before the WorldCom fraud was revealed. How do they react if Bell South were to buy AT&T or were to try to buy MCI? How does SBC Communications react? From an antitrust perspective, the longer WorldCom is out there and the more the Bell companies grow their enterprise business, the harder it will be to let a deal go through. If the Bells want to buy, the best moment is in the three-to-six-month period when MCI emerges from bankruptcy.

Q: Are the Bells in any mood to spend money on acquisitions, and will their stock prices allow it?

A: This is actually a fairly good economic climate and much improved from where it was a year ago. Their stock prices are certainly better than they were a while ago. The Bells are also all interested in adding a video piece to their bundles. Do they strike up marketing agreements with a satellite company? Or do they contemplate buying a satellite company, as SBC considered? Or do they invest in big broadband networks capable of delivering video? These are really important decisions and they are going to be made in the next couple of years. But none of this alleviates the fundamental problem that Voice Over Internet poses. In other words, consolidation is not necessarily the answer to the fundamental problem.

Q: Earlier you mentioned Apple and Microsoft in discussing Voice Over Internet. What roles are they playing?

A: Apple just came out with a prototype called iChat, which is essentially a voice version of instant messaging. Microsoft, as part of Project Longhorn, which is the next version of the operating system, is understood to be putting in Voip applications. The cost of a voice communication would be the same as a cost of an e-mail, which is to say the marginal cost is zero. It threatens to put enormous pricing pressure on what can be charged for voice communication. What was really hilarious to policy wonks like myself was when SBC filed a pleading that argued for restrictive constraints on Microsoft so that Microsoft wouldn't end up dominating the voice business. It is unusual for a company with arguably a 90%-plus market share to argue that a company with zero market share is in danger of beginning a monopoly. But if you look out 10-20 years, the argument is not without merit.

Q: So does Microsoft get into the phone business?

A: No. There are certainly lots of deals between Microsoft, and MSN has deals with a variety of Bell companies and is an investor in cable companies. Microsoft is everywhere, so you see a lot of convergence. But Microsoft has made it clear they think bundling Internet services with transmission is yesterday's game. They made the decision not to compete with the cable guys and the Bell guys on selling broadband transmission. Instead, they aspire to be the best edge provider of Internet services.

Q: Let's move on to media and the relaxation of media-ownership rules.

A: People talk about the change in the media-ownership rules leading to media concentration or consolidation. Certainly, it is going to lead to some. But to me, the more important issue is: How do you rationalize the footprint? How do you create the most efficient delivery of services, whether you are delivering content or you are delivering advertisements? Under the old rules, where in most markets you were limited to owning one television station, it might have made sense to be in 30 cities with 30 television stations. But under the new rules, it doesn't necessarily mean you go to 60 stations, although you might want to do that. Instead, you might trade 15 of your stations so you can achieve duopolies in 15 cities. There is tremendous synergy if you own two TV stations in one market. It is a proven way of decreasing costs, leading to higher margins.

Q: Who is best positioned to take advantage of the new ownership rules?

A: There are a number of different companies, but certainly Tribune Co. and Gannett, companies that currently own newspapers and TV properties, have been arguing for a long time they could improve their product and delivery and also their economics by eliminating the newspaper-broadcast ownership ban. They should be clear winners. Fox Entertainment and Viacom, on the other hand, could lose out if the national television ownership cap is rolled back to the earlier level, which prevented the networks from owning television stations that broadcast into more than 35% of the nation's homes, because the two companies exceed that cap and would be forced to sell stations. Other networks hoping to extend their footprints might also not have that opportunity, given efforts by Congress to roll back some of the changes approved by the FCC.

Q: How serious is the threat by Congress to review the change and maybe roll it back?

A: The threat to roll back the national media ownership cap to 35% from the recently approved 45% is very serious, and that is significantly more at risk than changes, say, to the newspaper-broadcast ownership ban. There will be a very significant effort to roll back all the rule changes, but in the end the FCC rule changes on newspaper-broadcast ownership and duopolies will likely stand.

Q: What makes you so sure?

A: In Washington, it's never good to be too sure of anything, but based on our contacts on the Hill and among lobbyists and the companies, it's clear that the issue that is drawing the most concern is the network-ownership cap.

Q: So what kind of a time frame are we talking about for any economic impact from the new ownership rules?

A: We are going to go into the fall still not certain about how Congress will act on these things. That is clearly going to slow down some deals. Everybody who was anticipating doing some deals will put it off because you don't want to do a deal that could affect the vote. But we aren't going to see big deals coming out of this, at least not in the first wave of these rules. We are going to see a lot of trades and swaps. The other big deal that is going on that is every bit as significant in terms of industry structure but is getting less attention than the media ownership rule change is the DirecTV-News Corp. deal. It is the first integration of a broadcast network with a multichannel video- distribution platform. Rupert Murdoch will find the synergies there, and when he does Viacom will say, hmmm, if he can find them, so can we. They will be looking at Echostar or they will be looking at a cable company. Similarly you could see NBC and ABC wondering whether they, too, will have to merge their operations with a multichannel platform.

Q: Thanks, Blair.

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