Mr. Chairman, thank you for the honor of testifying before your Subcommittee on the very important topic of consolidation in the telecommunications sector and what it means for the 1996 Telecom Act.
The views expressed here are my own and do not necessarily represent the views of Legg Mason Wood Walker, Inc. I request that my full written testimony be printed in its entirety in the hearing record.
Before I comment on the subject at hand it is important to provide a little background on the Legg Mason Precursor Group in order to understand my unique perspective. I am not a traditional Wall Street sell-side analyst who analyzes companies or recommends the purchase of stocks. I am a policy analyst for the investment community who tracks regulatory, technological, and competitive developments in the communications sector for large institutional investors, including many of the largest mutual funds, pension funds, banks, and insurance companies in the United States.
My institutional investor clients read my newsletter and consult with me because, unlike most of Wall Street, I do not focus my efforts on what will happen in the next quarter, but focus on trying to anticipate broadly what will happen in the next 3-18 months. The Legg Mason Precursor GroupSM attempts to anticipate investment relevant change which others do not see, fully appreciate nor yet understand. To the extent possible, my clients expect my best unbiased assessment of “what is and what will be” rather than the common “what should be” analysis of company advocates and those involved in the political or regulatory process.
With that in mind, I offer the following insights and observations on consolidation in the telecommunications sector, the pending SBC-Ameritech merger, and an assessment of how current conditions measure up to the goals of the 1996 Telecom Act, in hopes that they will be useful to the Subcommittee.
I. Telecom Consolidation And The SBC-Ameritech Merger
Clearly everyone is trying to understand why there has been more consolidation in the telecom sector than competition after passage of the 1996 Telecom Act. Without a dog in this fight, I will try and give you as objective and unvarnished an assessment as I can of what “is” really going on in the sector -- not what the various sides believe “should” be happening.
Very simply, what is happening is a massive clash of financial reality with flawed public policy and unrealistic expectations. SBC and Ameritech are pursuing one of the only financially rational paths that public policy has left available to them in order to forward the interests of their shareholders.
A. Capital Goes Where It Is Welcome: In a free society, money goes where it is welcome, not where regulators tell it to go. Regulators can attract capital to certain market locations through special financial or competitive incentives. However, regulators generally have a difficult time trying to force companies to do things that are irrational or financially detrimental to their interests.
Why is SBC merging with Ameritech? Why did SBC merge with PacTel, and Bell Atlantic with Nynex? Why will there likely be even more local telephone mergers? It is simply what is best for their shareholders.
In the most hostile regulatory environment the local telcos have ever faced, where they have been targeted by government as the companies that are supposed to “lose,” and the FCC describes itself the “champions of new entrants,” size and scale are the best defense of shareholder wealth. In a word, bigger boats are harder to sink.
While massive consolidation may not be the public policy result many would prefer nor had expected, it is clearly the most financially rational path a local telco can pursue under the current circumstances. Consider the following:
1. Most Attractive Available Investment Options: The only places the regulatory environment encourages the Bells to invest for shareholder growth are local to local mergers or investment overseas. Local to local mergers are one of the few areas where regulators have not been able to find clear legal authority to intercede. The local telephony business is their expertise. And overseas investment is encouraged as a matter of trade agreements that the U.S. Government has recently forwarded. Why do the Bells invest so much overseas? The trade agreements simply offer more protection of Bell shareholder wealth than do current United States regulatory policies.
2. The Market Facilitates and Rewards Scale: Long-term, facilities-based telecom is financially a scale business--regardless of regulator’s preferences. It requires a massive capital base to play at a global level. Consolidation in the telecom sector is nowhere near over. Expect more telco mergers and acquisitions. Long term expect the local and long distance industries to try and reintegrate. That is the normal state of affairs around the world, only here is it the Justice Department’s worst nightmare. Financial rationality will continue to fuel consolidation.
The roaring stock market also facilitates consolidation. Historically high stock values make these transactions easier. And if SBC-PacTel and Bell Atlantic-NYNEX’s example is any indication, the market rewards and values increasing size and scale in the local phone business.
3. Long Distance And Internet/Data Transport Investment Blocked: The Bells are the only five companies on the planet, which for regulatory reasons, cannot use their networks for long distance or Internet/data transport. All other 1,300 American local telcos can. All other American and foreign telecom companies can.
The United States is the only country in the world with a distinct long distance industry. The current American market structure is not typical; it is a very special case where the Bells local-long distance boundaries (LATAs) are not based on any current economic, technical or operational rationale. Fifty million Americans and every other nation’s telecom consumers have local telcos that are allowed to offer long distance service.
So far the regulatory “price” for the Bells to gain entry into long distance--facilitating their own market share loss for the benefit of their local competitors--has proven higher than a Bell is either able or willing to meet.
4. Current Regulation Discourages Investment In Local Plant and Bandwidth:
FCC and most state regulators believe that the only way to stimulate local competition is to force the Bells to resell or re-brand their local plant at enough of a discount that guarantees a profit for competitors. Is it financially rational for a Bell to invest in upgrading its local plant to get more bandwidth for its consumers if regulatory policy prevents the Bell from recovering its initial investment? Stimulating resale competition clearly is more prized by regulators than investment in bandwidth for consumers.
5. Telecom Act Effectively Blocked Rational Telco Investment In Cable: With the best of intentions, Congress attempted to encourage telco entry into the cable business through the Open Video System (OVS) provisions of the Telecom Act. However, the financial reality is that the OVS provision strongly discourages Bell investment in cable. The OVS provision requires that a telco building an integrated voice-video network has to reserve two-thirds of the channel capacity for competitors. From a Bell shareholder perspective, why would the company want to invest in building a network three times larger than it could ever use or take advantage of?
B. Not a Re-Assembly of Ma Bell: The number of Baby Bells was an arbitrary decision. Both the Justice Department and Judge Harold Greene left it up to AT&T to determine how many “Baby Bells” to create. One or 50 would have been allowed. AT&T chose seven. The breakup of AT&T was about splitting up the alleged anti-competitive leverage AT&T’s long distance and equipment business enjoyed from also controlling the local “bottleneck” exchange.
Bell-Bell mergers have little to do with the original antitrust problem prompting the breakup of AT&T. They are merely monopoly neighbors expanding their overall market footprint to gain further efficiencies and purchasing power. Under current antitrust law, that is not an antitrust violation because no competition is harmed. Hence, the Justice Department approved both the SBC-PacTel merger and the Bell Atlantic-NYNEX merger without conditions. In the end, I believe the government will not block the SBC-Ameritech merger, although I also believe this merger may “push the envelope” of the Justice Department’s tolerance that it will be subjected to much criticism, debate, and delay.
C. Consumer Impact: Essentially two of the best run local telephone companies will become one of the best run phone companies in the nation. SBC and Ameritech customers will enjoy a stronger more stable local phone company able to meet the increasing challenges of the marketplace. For probably 80-90 percent of their customers, SBC and Ameritech will be their facilities based local carrier for at least 5-10 years, it is in those consumer’s interests to have a strong phone company; because there will be no viable competitive alternative available to them.
II. 1996 Telecom Act – “The Law of Unintended Consequences”
For those trying to make sense out of what the 1996 Telecommunications Act has produced in practice versus expectations, it is helpful to review the official legislative purpose of this landmark legislation.
“An Act to promote competition and reduce regulation in order to secure lower prices and higher quality services for American telecommunications consumers and encourage the rapid deployment of new telecommunication technologies.”
As an observer and analyst for investors it appears to me that for the most part, the Telecom Act has deteriorated primarily into a grand regulatory/political/legal struggle over Bell entry into long distance. It appears from the outside that federal regulators have become fixated on their interpretation of the goal to “promote competition,” almost to the total exclusion of the second, third and fourth goals of the Telecom Act: “reduce regulation,” “lower prices and higher quality services for … consumers,” and “encourage the rapid deployment of new … technologies.”
This apparent federal regulatory fixation on opening up only the Bell monopolies to local competition and not the other 1,300 local telephone companies exists because Section 271 gives regulators much more authority to try and control the Bells than the other local telcos. The Telecom Act as written created a state-centric regulatory oversight model for opening up local phone markets. Sections 251 on interconnection and Section 252 on procedures for negotiation, arbitration and approval of agreements, give primary regulatory authority to the states. And so far the Eighth Circuit Court of Appeals has validated this state-centric interpretation of the Act and ruled that the FCC has very little legal oversight authority over local competition anywhere in the country. I expect that the Supreme Court will uphold the lower court’s state-centric view sometime next year.
In response to the FCC’s August 1997 “road map” decision in denying Ameritech’s Michigan application for long distance entry, the Eighth Circuit Court of Appeals issued a rare writ of mandamus to prevent the FCC from using its Section 271 Bell entry into long distance authority to subvert the court’s local competition ruling. The FCC has appealed this ruling to the Supreme Court and apparently many states reviewing Bell entry applications are ignoring the Eighth Circuit Court’s ruling. In particular, the recent New York Public Service Commission’s tentative approval of Bell Atlantic’s 271 application completely ignores the Eighth Circuit Court of Appeals October 14, 1997 ruling that telcos could not be forced to recombine un-bundled network elements.
A. “An act to promote competition…” All the current bluster and rhetoric about the prospects for local competition belie the reality that we are in the midst of a much grander experiment than most appreciate. Either we were wrong for the last several decades that the high capital cost of a local phone network made it a natural economic monopoly where the lowest average cost could be achieved by a regulated single provider or we are wrong now. Conditions from 1995 to 1996 simply haven’t changed as fundamentally as assumed by the Act.
Technology advancements were alleged to have changed monopoly economics. Local competition policy began to emerge during the cable-telco merger period when there was great hype and promise that the cable architecture would provide an alternative communications “pipe” into the home. As the basis for a rewrite of monopoly economics, the cable architecture has been an abysmal failure in providing a “competitive” alternative to the local phone company. Today only about one-twentieth of one percent of Americans get telephone service from their cable company and only about two-tenths of one percent of Americans get data or Internet service from their cable company. It will be a long, long wait before tens of millions of American consumers will enjoy a competitive telephony alternative from cable.
Adding to the belief that new technologies had changed long standing monopoly economics was the hype and promise behind PCS wireless technologies. While wireless growth has been spectacular in terms of the numbers of users and minutes of use, its reliability in reaching 911 emergency service is nowhere near that of a wireline phone. Wireless is simply not yet an economically viable direct substitute for most residential local phone service. And it will likely be several more years before the reliability of mobile wireless even approaches that of wireline in the consumer market.
If Congress overestimated the advancement of technology, (which I believe it did) and if Congress underestimated the economic efficiencies of a regulated natural monopoly, (which I believe it did) the nation in aggregate will be paying more overall for local phone service in the future, not less as expected.
Trying to promote competition in a natural monopoly is like trying to grow crops in a desert. You can do it if you are willing to massively subsidize the unnatural amount of water needed. Regulators can grow local competition in chosen locations, like they are in the business markets, if they are willing to massively subsidize the new entrant’s profits.
B. “…and reduce regulation…” Overall, the last two years have not been a reduction of regulation but a major increase in regulation. The FCC’s August 1996 interconnection order was several hundred pages long. The standard 271 application now entails several thousand pages. The new operational support requirements are highly specific and regulatory. And the new forward looking costing methodology the FCC calls TELRIC is actually a movement back towards micro-managed rate of return regulation. However, in defense of regulators, the Congress’ reduction in regulation goal is not entirely realistic if it also wants to overcome monopoly economics.
C.“…in order to secure lower prices and higher quality services for American Telecommunications consumers…” The supreme irony of the Telecom Act is that most all Americans already get near perfectly reliable local phone service for roughly 50 percent below cost. For most Americans, local phone service is already “as good as it gets.” Thus if moving toward competition ends these multi-billion dollar subsidies, it would mean that the average American consumer’s bill would increase by about $10-15 a month! While that is not going to happen for political reasons, the current way regulators are implementing the Act is leading us in the direction of the average American local phone customer paying more for local phone service. How could that be?
First, in order to jump start competition, regulators have strongly encouraged business competition in the belief that the benefits of business competition eventually would trickle down to consumers. What is really happening is political reallocation of who receives subsidies under the guise of competition. For obviously smart political reasons, regulators artificially have kept business line rates roughly twice as high as residential rates even though they are less costly on average because of geographic density and economies of scale for the express purpose of keeping residential rates low. However, for not so obviously smart political reasons, regulators are now doing everything they can to help competitors siphon off the subsidies they originally designed to keep residential rates low. Most all of the success of local competition to date results from the simple fact that regulators have set and are keeping monopoly business rates excessively high while allowing new entrants to implicitly “cream skim” subsidies without “explicitly” contributing to universal service.
Second, there are a lot of new regulatory costs to consumers bills being added to the overall system. While regulators would like to assume that their additional regulatory requirements do not add to consumers bills, it all eventually gets passed on to the consumer one way or another. Who is going to pay for number portability? For the billions of dollars in sophisticated operational support systems to aid competitors? For new discounts for schools, libraries and rural health care facilities?
From a consumer perspective, don’t expect them to cheer passage of the Telecom Act. Ask consumers who have had new regulatory fees added to their bills as a result of implementing the Telecom Act. Ask consumers who have suffered from “slamming” -- unwittingly having their long distance carrier switched. Ask consumers who have suffered from “cramming” -- unwittingly having charges or services slipped onto their bill. Ask consumers if they care to listen to another long distance or Bell ad about who the real “good” or “bad” guys are. Ask consumers if they appreciate paying 40 percent more for pay phones that require odd change, don’t make change, or make it a hassle to reach your long distance carrier.
D. “…and encourage the rapid deployment of new telecommunications technologies.” The cold reality is that deployment of new technologies for tens of millions of Americans would cost tens of billions of dollars. The local phone infrastructure costs roughly $300 billion dollars. To put that huge number in perspective, that is more than twice the total annual revenues of the entire local and long distance industries combined. Rapid deployment of new technologies is simply at odds with Federal goals of promoting competition and maintaining universal service.
With respect to infrastructure, current regulatory policies are financially irrational and destined to result in an underwhelming and disappointing amount of large investment in new technologies. Regulators are powerfully discouraging technology deployment by incumbents – the only market players with facilities currently in place and with the financial capability to tackle the task of providing more bandwidth to tens of millions of American consumers.
By forcing deep resale discounts of incumbent’s networks not based on actual costs but on the forward-looking costs regulators want them to be, regulators powerfully discourage deployment of new technologies by everyone concerned. Why should a competitor invest capital if they can lease the incumbents network without risk at a lower cost than even the competitor could build it for? Why should an incumbent invest to upgrade its plant if it will be forced to resell it less than it costs to provide it? That is the functional equivalent of the government adopting a “reverse patent” policy – that those who create the value are not allowed to enjoy the profits of their value-creation.
In conclusion, all is not well on the telecom regulatory front or with the Telecom Act itself. While many may not like it, consolidation is the most financially rational response to a very messy situation. And a quick review of the stated goals of the Telecom Act indicate it has been a law of unintended consequences.