Thrown for a Loop

By Daniel Eisenberg

For Will Harpest, a third-grade teacher who lives in Lisle, Ill., the ad campaign was the last straw. A longtime customer of one of the big phone companies known as Baby Bells, Harpest, 54, had grown weary of having to deal with separate phone bills for local and long-distance calls. But, like most Americans, he couldn't do much about it until recently. Sure, he could change long-distance carriers and chase the lowest rates as often as he pleased, but he was still a virtual captive of SBC Ameritech, the sole owner of the prized last mile of copper wire into his home.

Then Harpest saw a couple of SBC ads telling customers that switching to the new local services offered by the likes of AT&T was as foolish as poking a fork into a toaster or sticking your tongue to a metal pole in freezing weather. Far from amused, Harpest thought the ad could "give kids bad ideas." But it gave him a good idea. He called AT&T, already his long-distance provider, to sign up for its local service, seeking only the convenience of a single bill. He was surprised to learn the switch would also save him about $10 a month. "I was impressed," he says, "that someone would offer to get me a lower cost without my even inquiring about it."

Harpest is just one of the small but growing number of consumers who are firing their local phone companies. Six long years after the Telecommunications Act was supposed to help break the Baby Bells' hammerlock on local phone service, competition in the residential market is finally starting to heat up--and the Bells' once dependable growth is cooling down. Thanks to newly aggressive state regulators who are forcing BellSouth, SBC Communications, Verizon and the much smaller Qwest to lease their networks to competitors at lower prices, rivals like AT&T and MCI are for the first time snapping up some of the most lucrative customers. "Now we have a real fight," says former Federal Communications Commission (FCC) chairman Reed Hundt, a key architect of the 1996 landmark legislation.

That may well be, but the Bells complain that it's not a fair fight. The way they see it, by requiring the Bells to lease access to their networks at a price that doesn't cover the cost of running and maintaining them, the states are essentially forcing the Bells to subsidize the competition. But given how vigorously the Bells have protected their turf and helped push up local rates over the years, few outsiders are shedding tears for what many view as a bunch of crybabies. As often happens in this combative, litigious industry, both sides are waging the battle as furiously in the regulatory arena as in the marketplace, sparking debate about the very nature of competition. Scott Cleland, CEO of the Precursor Group, an independent investment-research firm in Washington, thinks the Bells have a legitimate beef. "Do we want a marketplace of forced reallocation of wealth," he asks, "where shareholders pay consumers?" Certainly investors don't. The Bell stocks are widely held, and some Americans end up saving less on their phone bill than they are losing in their mutual funds and 401(k)s.

Over the past 12 months, AT&T has lured about 2 million new local customers. By the end of this year, MCI should have 3 million; in just the past six months, 1 million customers have signed up for its new Neighborhood Plan, a bundle of local and long-distance service that allows unlimited U.S. calls for $50 to $60 a month. From December 1999 to the end of 2001, the number of Bell lines leased by rivals quadrupled, to about 8 million. That's one of the few bright spots for the otherwise floundering long-distance giants, which have been able to grab nearly 10% of the market in certain states, such as Michigan and New York. It's no wonder that Wall Street has dragged down the stocks of the three major Bells as much as 30% over the past 12 months or that, with revenues and earnings flat or dropping, BellSouth, SBC and Verizon have been handing out thousands of pink slips. "The Bells have started to bleed. This is what everyone was waiting for," says Jeffrey Kagan, an independent telecom analyst in Atlanta, referring to the original intent of the Telecommunications Act. "Now the question for regulators is, When do you give them a Band-Aid?"

Some of the Bells' wounds may not be easily healed. More and more Americans, especially the young and single, are relying on wireless phones as their primary mode of communication; 3% to 5% of Americans have no landlines into their homes. Wireless calls account for fully 30% of all personal calling minutes and are expected to reach 50% by 2006, according to the Yankee Group, a tech consultancy based in Boston. Verizon owns the nation's largest wireless carrier, and SBC and BellSouth jointly own its closest competitor, Cingular. But the fiercely competitive, low-margin wireless business is no substitute for the steady profits the Bells long reaped from local service.

A small but growing number of consumers are taking a bigger leap, buying their phone service from a cable company like Cox Communications, which has grabbed a 25% market share in Orange County, Calif., and Omaha, Neb., or the new Comcast, which recently merged with AT&T Broadband. And as more households upgrade to high-speed Internet access (2 out of 3 choose a cable modem over a DSL phone connection), the Bells are losing a valuable source of revenue: the second phone line that customers use for dial-up Internet service.

For the first time since the Great Depression, the number of residential phone lines in the U.S. declined last year, about 1%, a trend that is expected to continue for the foreseeable future. Says BellSouth ceo Duane Ackerman: "We have enough on our plate without having to deal with contrived competition."

To rid themselves of it, Ackerman and his colleagues Ivan Seidenberg at Verizon and Edward Whitacre at SBC are pressing FCC chairman Michael Powell to modify the competitive rules during the agency's "triennial review" early next year. If they don't get relief, the Bell chiefs warn, the last relatively healthy sector of the ailing telecom industry will soon be facing financial ruin, and America's communications infrastructure will follow it into disrepair.

"It makes no economic sense for the competitors to invest capital at these prices," says Randall Stephenson, chief financial officer of SBC Communications. "We still maintain the network and provision it, and the cost structure doesn't change. From a financial perspective, the model is unsustainable." As long as they are subsidizing their rivals, the Bells insist, there's no reason for them to upgrade their networks, which puts a further drain on the depressed equipment sector, including companies like Lucent Technologies and Nortel Networks.

The Bells' crying and moaning might elicit more sympathy if, over the past six years of deregulation, they had delivered on their promises to compete against one another for local service. During that period, they have incurred repeated fines by federal and state regulators for not opening their networks. "They were so busy trying to prevent real competition that they let a monster develop," says Royce Holland, CEO of Dallas-based Allegiance Telecom, which has $517 million in annual sales and is one of the few surviving small, competitive local exchange carriers that have built a solid business selling telecom bundles to small and midsize businesses. As for the Bells' poor-mouthing, Holland quips, "If anybody thinks they'll invest more money in their networks if they get their monopoly back, I've got some swampland in Texas to sell."

Many in the know, including staff members at the FCC, share Holland's incredulity about the Bells' dire warnings. Earlier this year, the Bells' critics point out, the U.S. Supreme Court ruled that the resale pricing methods used by regulators are appropriate, guaranteeing the Bells their costs plus a reasonable rate of return. If the rules are such a great deal for the resellers, "why aren't the Bells competing in each other's territory?" asks AT&T president Betsy Bernard. To be sure, both sides in this argument have valid claims. While it's probably true that the Bells aren't heading for bankruptcy, it's also clear that regulators are assessing the Bells' costs on the assumption of super-efficient communications networks that in most cases don't yet exist.

"This is not science. It's a policy goal," says Eli Noam, director of the Columbia Institute for Tele-Information in New York City. "It's pretty clear that, given the head start of the Bells, it's difficult for someone to come in without a little regulatory weighting of the scales. But you don't want to prolong it. It puts regulators in the driver's seat."

AT&T and MCI claim that they don't want to remain under the government's wing forever. They insist they will eventually build their own local facilities and networks in densely populated major metro areas (except for the last mile to the home, which no one expects will ever be replicated). But in a business with massive fixed costs and economies of scale--in which the current local networks were built with government subsidies and a guaranteed rate of return--the newcomers say they can't make the necessary investments until they have built up a critical mass of customers. Wayne Huyard, chief operating officer of MCI, which is part of WorldCom, currently enmeshed in bankruptcy proceedings, says the Bells' claims are "absolutely a scare tactic. We don't want to ride a competitor's networks any longer than necessary. But they realize that forcing a premature migration to our own networks will kill competition. It's classic monopolistic maneuvering."

The irony, not lost on observers from Wall Street to Washington, is that if the Bells' rivals stay in the business long enough and persuade wary capital markets to finance their separate networks, the Bells' distress could grow worse. Instead of getting paid a nominal amount by rivals who piggyback on their networks, the Bells would be getting almost nothing from customers they lose. Lawrence Babbio, president of Verizon, insists, "I'd rather take that risk [than see the situation persist]. It's a trade I'd make any day of the week." But Babbio knows it's not likely that he will get the chance anytime soon. Even if Powell can give the Bells some of what they so desperately want--and many believe the FCC chairman will try to do so--the access requirements will probably be gradually phased out over a few years.

In the meantime, the Bells are doing their best to fight back in the marketplace. By leasing long-distance networks in much the same way their rivals do for local service, they will soon be able to offer long distance throughout much of the nation, a good sign, given that they have already grabbed a 30% share in certain states, such as New York and Texas. Because long distance on its own is no longer such an attractive business, the Bells are busy rolling out bundles of local, long-distance, Internet-access and wireless service--often all on one bill--to try to stem the tide of defections. Even though the Bells can't offer multinational companies much in the way of international calling, all of them--led by Verizon--are making a concerted push for U.S. Big Business customers, a sector still dominated by AT&T, MCI and Sprint.

Echoing most telecom-industry analysts, Powell has made clear that he thinks that the industry may well need another round of consolidation to get back on sound footing--whether that means SBC and BellSouth or Verizon and Qwest joining forces, the Bells snapping up their newfound competitors at AT&T and MCI, or some of the six major wireless carriers finding strength in numbers. But, as Gene Kimmelman, co-director of the Washington office of Consumers Union, points out, "If Powell goes too hard too fast, he could end up with egg all over his face, with a more monopolistic market that cries out for new regulations." And surely the last thing he wants is to leave people like Will Harpest with fewer real choices and no one to call for help. --With reporting by Perry Bacon Jr./Washington and Noah Isackson/Chicago

With reporting by Perry Bacon Jr./Washington and Noah Isackson/Chicago