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Choices, Competition, Cutbacks

Vonage In Print News

February 9, 2004

By Shawn Young

More than three years after the Internet and telecommunications investment bubble burst and the economy soured, the nation's phone companies remain besieged.

Businesses still aren't splurging on hiring or technology, which means there's less demand for office phone lines or expanded corporate telecom systems. Consumers are taking advantage of an unprecedented array of affordable choices, ranging from calling over the Internet to using a long-distance carrier for local service. And many investors, whose money disappeared with the bubble, are gone for good.

The major telecom companies are struggling to adjust. They're looking for efficiencies and laying off workers. They're pursuing a handful of promising growth areas, such as using Internet technology to transmit phone calls and expanding cellphone services. The regional Bells are pushing their long-distance business, while long-distance companies are hawking local service. And everybody is waiting for the next round of mergers to give a boost to the industry and perhaps curb competition.

Here are the 10 trends that have the industry buzzing.

1. New Technologies, New Choices

Consumers and businesses increasingly are finding cheaper substitutes for conventional phone service.

Long-distance carriers like AT&T Corp. and the four regional Bell companies are losing business to cellphones, the Internet, cable phone services, e-mail and online chat.

Not only are the leading phone companies fighting one another, they're confronted with rivals that weren't even in the equation a few years ago. Cable-television companies increasingly are offering high-speed Internet and phone service over cable lines. Cable Internet service is more popular than the phone-company version so far, and cable companies have signed up about 2.7 million local phone customers. At the same time, phone services that use Internet technology are poised to explode in availability and popularity.

It is all taking a toll on the traditional phone carriers. AT&T's revenue fell 13% in the fourth quarter, and its consumer revenue plunged nearly 19% as local phone companies expanded into long distance and more consumers made long-distance calls on their cellphones. About 5% of consumers have gotten rid of traditional phones and use only cellphones. The Bells have done exceedingly well in long distance, often racking up market share of as much as 30% in a year. But long-distance service is less profitable than local, and Goldman Sachs analyst Frank Governali estimates the Bells need to gain four or five long-distance customers to make up for each local customer they lose.

The three largest Bells -- Verizon Communications Inc., SBC Communications Inc. and BellSouth Corp. -- have lost plenty of local customers. The Bells lost 2.6 million retail lines in the third quarter alone as long-distance carriers lured away local customers and more people passed up second phone lines or fax lines in favor of cellphones or high-speed Internet connections that don't tie up the phone.

2. Competition Goes Local

Nearly eight years after the Telecommunications Act of 1996 ended the regional Bells' monopolies on most local phone service, millions of consumers finally have a choice of local phone companies.

For many people, that has meant lower prices and the reassurance of knowing they can take their business elsewhere if they're unhappy. AT&T, MCI and a bevy of smaller companies offer local service in most cities and are heavily promoting package deals that include local, long-distance and high-speed Internet service, often at big discounts to the prices charged when such services are bought individually. The local service usually includes perks like call waiting or voice mail thrown in as freebies.

The Bells aren't giving up without a fight. They're now offering extensive packages with plenty of add-ons that take advantage of their greater ability to offer high-speed DSL lines and wireless. Package plans are an area of growth for telecom carriers and an important tool for holding onto customers, but the price cuts involved are squeezing profit margins.

The newfound local competition is mostly based on the Bells' renting phone lines and other aspects of their networks to other carriers at wholesale rates set by regulators. The arrangement is the outcome of years of bruising regulatory battling.

3. Bad Numbers

It turned out that some of the spectacular, conventional-wisdom-defying growth in the late 1990s was achieved the old-fashioned way -- by lying, cheating and fudging.
The industry has the dubious distinction of having spawned one of the biggest accounting frauds ever, the $11 billion accounting fraud at WorldCom Inc., now known as MCI, which also spawned the biggest Chapter 11 bankruptcy-court filing in history. Global Crossing Ltd. also went into bankruptcy protection amid an accounting scandal, and past accounting practices at Qwest Communications International Inc. remain under investigation. Even Sprint Corp., known for conservative accounting, suffered a management and corporate-governance crisis that cost its top two executives their jobs after they participated in personal tax shelters that have since been questioned by the Internal Revenue Service.

The entire industry's reputation has suffered, and companies are now facing the consequences: new corporate-governance regulations, wary investors and increased activism among shareholders. Many companies have had to overhaul fast-and-loose internal cultures. They're also struggling to revive the morale of employees whose savings and faith in management have been gutted at the same time that salaries and bonuses shrank and layoffs multiplied workloads.

4. An Urge to Merge

A bout of deal making would invigorate the industry, reshuffle company strategies and help tame some of the industry's self-destructive tendencies, many investors say. But for all the talk, not much has happened so far. Sellers haven't been able to command the prices they'd like, while buyers are fearful of overpaying, inflating their debt, scaring their shareholders and getting slapped down by regulators.

That may all be about to change as multiple suitors court AT&T Wireless Services Inc., which has put itself up for sale. With six major national players, wireless is the industry segment most overdue for consolidation and least likely to face regulatory resistance to deals. Still, wireless deals are complicated by technological differences among carriers and by corporate structures. Sprint PCS is a tracking stock of Sprint Corp., while the two largest players, Verizon Wireless and Cingular, are joint ventures. Cingular is owned by SBC and BellSouth; Verizon Wireless is owned by Verizon and Britain's Vodafone Group PLC. That split ownership makes it more cumbersome to strike deals.

Among conventional wireline companies, long-distance carriers AT&T, Sprint and MCI are seen as the most likely targets, and the local Bells as the most likely acquirers. The long-distance carriers' relationships with big businesses are a coveted asset -- if regulators and shareholders play along.

AT&T came close to a merger agreement with BellSouth in October, but BellSouth balked, according to people familiar with the matter. It was concerned, these people say, about shareholder reaction, price and resistance from its wireless partner, SBC. And negative reactions from investors helped derail talks between SBC and satellite broadcaster DirecTV last year.

5. Lower Prices, Higher Bills

Lower prices are enticing many consumers to spend more.
A proliferation of alternatives and new technologies is forcing phone companies to keep competing on price. The big long-distance carriers have for years used price as a key weapon in the battle for elite contracts with government and big businesses, but now even smaller companies and high-end consumers are getting price breaks.

For consumers, the picture is mixed. Prices have generally dropped over the years, but the popularity of new amenities like caller ID, cellphones, second phone lines and Internet hookups means that many people are spending more than ever.

Average household spending for local, long-distance and wireless service jumped to $83 a month in late 2002 from $58 in 1995, despite generally lower prices, according to the Federal Communications Commission. Long-distance rates have dropped dramatically, from an average of 32 cents a minute for state-to-state calls in 1984, when the government broke up the old AT&T monopoly, to seven cents in 2002, the FCC says.

The big phone companies are focusing their competitive efforts on serving businesses. Analysts have long feared that MCI's re-emergence from bankruptcy protection this year would spark another bout of price cutting, but rivals aren't waiting. AT&T, the nation's largest business carrier, cut deals on contracts with business customers in the fourth quarter and has declared it's not willing to lose on price.

6. Cut, Cut, Cut

Reducing expenses is the industry mantra as the top companies try to weather the downturn and position themselves for a revival of demand.

Virtually every company in the industry has had to cut jobs because of falling orders. The top players also have to trim down to fend off threats from small but nimble rivals as well as companies that are emerging from bankruptcy protection with their staffs cut to the bone and most of their debts wiped out.

More than 160,000 jobs have been eliminated at the Bells and the top three long-distance companies since 2000, when payrolls peaked at 878,000. Tens of thousands more workers are likely to lose their jobs in the next year or two.

Big phone companies like MCI and AT&T are also scrambling to simplify and automate their operations. The explosive growth and the merger boom of the late 1990s left many companies not only overstaffed, but also swamped with overlapping systems for functions such as order processing and billing.

The danger of cost cutting, of course, is that it can go too far, destroying employee morale, damaging the quality of service and leaving companies ill-prepared to seize opportunities.

7. You've Got Your Number

New regulations that let many people keep their phone numbers when they switch wireless services could shake up the industry.

Starting in November, people in most cities who wanted to switch wireless services could do it without having to notify everyone in their lives that they had a new phone number. Perhaps more radical for the industry, customers can now switch their home number to a wireless phone, making it easier for many people to go entirely wireless.

The new wireless rules so far haven't unleashed a flood of pent-up demand, as some analysts had predicted. But their more-subtle effects, such as sharpening competition between a carrier's landline and wireless units, could be important.

The Bells, which own the nation's two largest wireless carriers and have enthusiastically embraced wireless, are clearly in an awkward position: How do they promote their wireless arms without completely undermining their more-profitable wireline operations?

8. The Online Advantage

Placing phone calls over the Internet or over privately managed networks that use Internet technology is all the rage. It's called VOIP, short for voice over Internet protocol, and it lets a wide range of companies offer phone service without having to rent or re-create complex phone networks.

Upstarts such as Vonage Holdings Corp. and Skyper Ltd. have helped push the whole thing into the mainstream and have an influence far exceeding their tiny size. Cable companies are jumping in to compete with phone companies, and phone companies are using Voip to compete with one another.

Every major phone carrier is jumping in, with retail or wholesale projects under way at AT&T, MCI, Sprint, Verizon, SBC, Qwest and BellSouth. Time Warner Cable, a unit of Time Warner Inc., in December said it expects to be able to offer Voip service to about 18 million households by the end of this year, and other cable companies are also pushing to offer the service.

Internet protocol technology treats a phone call like any other type of data, breaking it into digital bits and sending the fragments as efficiently as possible amid the flow of other data. At the end of their journey, the bits are reassembled into a voice. This is much cheaper and more efficient than traditional phone-circuit technology, which holds open a dedicated connection throughout a call.

Internet protocol technology has been around in one form or another for years, and companies like AT&T and MCI already make extensive use of it inside their networks and with corporate clients.

Investors are piling in, too. Vonage, of Edison, N.J., and Net2Phone Inc. of Newark, N.J., raised a total of $100 million in November despite regulatory debate about what regulations, if any, should apply to such services.

9. The Hot Spots

So-called Wi-Fi hot spots -- where people can pull an Internet connection out of thin air -- are cropping up by the thousands, but it's not clear who's going to make money from them.

Consumers and companies have been using wireless technology to let multiple computers share the same link to the Internet for several years, but now the technology is moving into public spaces like parks, airports and coffee shops. The technology is called Wi-Fi, short for wireless fidelity.

At first, Wi-Fi was primarily the domain of home networkers and hobbyists, but the big money is arriving. T-Mobile, a unit of Deutsche Telekom AG, has set up thousands of Wi-Fi hot spots in Starbucks coffee shops, Borders book stores and airports. Wireless carriers such as AT&T Wireless and Verizon Wireless have established roaming agreements with Wayport Inc., which has been setting up connections in hundreds of hotels and airports nationwide.

SBC has begun the rollout of 2,000 hot spots it plans to have operating by the end of this year. Disparate hot-spot operators have started agreeing to give each other's customers access, which is essential if hot spots are to become a consumer mainstay.

Still, commercial Wi-Fi use is in its infancy, and it isn't clear whether charging people for Wi-Fi connections will turn out to be a lucrative, large-scale business. A hodgepodge of different carriers and sometimes complex procedures for making connections currently limit Wi-Fi's appeal.

10. The Broad View

High-speed Internet connections have become common, but phone companies still trail cable companies in a market that's crucial to their future.

Nearly 19% of U.S. households -- about 21 million homes -- now have high-speed Internet connections. Nearly all get it either from their cable company over a cable modem or from their local Bell company in the form of digital subscriber line, or DSL, service. As rival companies and new technologies eat away at the Bells' traditional phone business, they can't afford to lose the race to sign up the rest of the nation for broadband.

The phone companies invented DSL long before the Internet was a household word. But they were slow in rolling it out.

Providing broadband was technically and strategically easier for cable companies, and they established a lead that phone companies still haven't closed. At the end of last year's third quarter, cable had about 62% of the broadband market, according to UBS Securities analyst John Hodulik.

The phone companies are fighting back and are successfully capturing an increasing share of new broadband customers. Their weapons include lower prices and package offers that combine local and long-distance phone service with cellphone plans and DSL, all at a discount to a la carte prices.

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†AK and HI residents pay $29.95 shipping. ††Limited time offer. Valid for residents of the United States (&DC), 18 years or older, who open new accounts. Offer good while supplies last and only on new account activations. One kit per account/household. Offer cannot be combined with any other discounts, promotions or plans and is not applicable to past purchases. Good while supplies last. Allow up to 2 weeks for shipping. Other restrictions may apply.

1Unlimited calling and other services for all residential plans are based on normal residential, personal, non-commercial use. A combination of factors is used to determine abnormal use, including but not limited to: the number of unique numbers called, calls forwarded, minutes used and other factors. Subject to our Reasonable Use Policy and Terms of Service.

2Shipping and activation fees waived with 1-year agreement. An Early Termination Fee (with periodic pro-rated reductions) applies if service is terminated before the end of the first 12 months. Additional restrictions may apply. See Terms of Service for details.

HIGH SPEED INTERNET REQUIRED. †VALID FOR NEW LINES ONLY. RATES EXCLUDE INTERNET SERVICE, SURCHARGES, FEES AND TAXES. DEVICE MAY BE REFURBISHED. If you subscribe to plans with monthly minutes allotments, all call minutes placed from both from your home and registered ExtensionsTM phones will count toward your monthly minutes allotment. ExtensionsTM calls made from mobiles use airtime and may incur surcharges, depending on your mobile plan. Alarms, TTY and other systems may not be compatible. Vonage 911 service operates differently than traditional 911. See for details.

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