CLECs: Back from the dead?

David Hadley and Sean Dohertyexplain why some competitive local exchange carriers may stage a Lazarus-like revival after two years of carnage in the telecommunications business.

4 min read
Telecommunications companies are at the center of the continuing technology meltdown that began in 2000. Nowhere is the carnage worse than in the competitive local exchange carrier, or CLEC, sector.

Remember the CLECs? They were the fancy new phone companies that were going to take on the Bell incumbents. New technology, lower prices, better service, and local, long distance and data all on one bill--the Bells didn't stand a chance. The future of telecommunications services for businesses belonged to Allegiance, Time Warner Telecom, WinStar, XO and their CLEC brethren.

Not only was the future with the CLECs, so were the regulators. The Telecommunications Act of 1996 meant to help the CLECs gain ground on the incumbents by permitting them to resell the incumbents' networks. Resale would eliminate the need to build out their networks first and enable faster customer growth. This would permit them to sign up customers first (albeit at low profit margins) and transition their customers over to their own network upon completion.

But something happened on the way to the future--most of the CLECs have failed or are fighting for their lives.

What's more, the regulators have seemingly turned against them, too, with the FCC now expected to reduce the incumbents' obligation to share their networks with the upstarts. This debacle raises two questions: Why did the CLECs fail? And do they have a future? Contrary to what many in the industry say, access to the Bells' network was not the central issue--the CLECs failed for the most traditional of business reasons.

In tier one U.S. markets, there simply were not enough business customers to justify the overinvestment in network assets, back-office systems, sales and marketing. Overinvestment led to overcapacity, which led to an extreme price war resulting in far too many customer "freebies" such as equipment.

Something happened on the way to the future--most of the CLECs have failed or are fighting for their lives.
Second point: With minor exceptions, CLECs were offering non-differentiated services using similar technologies. The principal CLEC pitch was "local, long distance and data on one bill, better service than the Bell, and we're cheaper." This pitch, of course, could not differentiate one CLEC from another.

Lastly, it was easy for CLECs to point the finger and blame the Bells for their failures but the truth was that the low gross margins on resale also meant that the CLECs lost money with every resale customer added. Also, it was resale that enabled CLECs to grow aggressively before they had developed robust back-office systems to handle such growth.

Now the industry is nearing a turning point and better times lie ahead for the remaining CLECs. This does not mean it is a good time to start a CLEC--the market value of these assets remains below the cost to build them from scratch. However, several factors will enable adequately funded CLECs to create returns for their investors in the future.

Voice and data opportunities continue to grow
The original CLECs--MFS, Brooks Fiber Properties--built profitable businesses almost ten years ago supplying long-distance voice services. Today's CLECs can capture the entire telecom dollar of their clients--local, long distance, data and enhanced services.

Excess competition disappearing
As usual, the market is cleaning up its own problems. The wave of bankruptcies and liquidations among the CLECs is eliminating the excess competition that precluded profitable growth. Relatively few of these companies are likely to emerge from bankruptcy--liquidations and asset sales are the rule, not the exception. The survivors will therefore have a chance to market against the Bells, not primarily against each other.

Customer acquisition economics shifting
As a result of declining competition, providers are once again able to sign up qualified customers on fair economic terms. No longer do providers offer businesses free installation, free customer premise equipment and free service for a month, so a major form of discounting has already been eliminated. Service prices are also firming up.

Providers pursuing disciplined network strategy
The essential truth that attracted capital to the CLEC business is still true today: Providing telecom services to customers via a network that you control is a high-margin business. The surviving CLECs are either very focused on limiting their customer growth to locations where they can serve their customers on their networks, or are much more disciplined in employing resale to generate high-margin revenue. The days of unfocused growth for CLECs are over.

Declining costs
CLECs enjoy declining costs throughout their business. Long-distance carriage and call-termination costs have declined dramatically because of the collapse of both the long-haul fiber companies and regulatory moves to push call-termination costs down. Costs across the board--hardware, back-office, network management and personnel--have declined dramatically.

Focus on ROI, not growth
At the height of the boom, CLECs were aggressively racing to "plant their flags" in

Now the industry is nearing a turning point and better times lie ahead for the remaining CLECs.
as many markets as they could, to demonstrate their growth potential (and to scare away competition, although that never seemed to work). Today's CLECs must ensure that their incremental investments all have positive marginal economics, and that they are engaged only in markets and in products and services that are profitable today.

Ten years ago, the early CLECs were in a high-return business of cherry-picking the incumbents' attractive business customers. Competition and overcapacity from too many new CLECs caused most of these companies to stray from the original business proposition and begin offering services to smaller companies at ever-lower margins. This was a key ingredient in the recipe for failure.

Now, as the excess competition fueled by the late 1990's capital boom disappears, CLECs can return to their profitable roots of cherry-picking the incumbents, and can provide both voice and data services this time around. But don't focus on market share growth--focus on profitability. CLECs can survive and thrive in the changing regulatory climate only if they stick to signing up "on network" customers on fair economic terms and aggressively take advantage of the opportunity to reduce their costs.