GRADUATE SCHOOL OF BUSINESS STANFORD UNIVERSITY

CASE # SM-5B
DATE MAY 3, 2000

THE U.S. TELECOMMUNICATIONS INDUSTRY (B): 1996-1999 TEACHING NOTE

SUMMARY
This B case describes key developments in the telecom industry since the passage of the Telecommunications Act of 1996. This was a period of considerable merger activity in the industry, with increasingly intense competion, continued convergence between voice and data networks, and a number to technological innovations. In the wake of the Telecommunications Act, long-distance service providers were attempting to enter local markets, while local carriers sought to provide long distance and other services. In terms of the strategic dynamics framework, this case illustrates the impact of runaway change on industry players. It also shows how in the face of this runaway change, industry players have to realign their actions to suit the necessary changes in strategy that result.

THEMES
1. The impact of regulatory change. 2. The impact of technological change. 3. The opportunities and threats associated with convergence.

SUGGESTED ASSIGNMENT QUESTIONS

1. How has the Telecommunications Act of 1996 affected telecoms? 2. During the period of 1996-1999, what are the key developments that have reshaped the local service industry? Why did these happen? What are the implications? 3. During 1996-1999, what are the key developments that have reshaped the long distance industry segment? Why did these happen? What are the implications? 4. How has the Internet affected the telecom industry? What are the implications for providers of local or long distance services?

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5. By 2005, what is the telecom industry likely to look like?

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SUPPORTING ANALYSIS AND DISCUSSION QUESTIONS

1. How has the Telecommunications Act of 1996 affected telecoms?

Passage of the Telecommunications Act (on February 8, 1996) set up three major battlefronts within the industry. First, it opened the $108.3 billion (1998 revenues)1 market for local phone service to its first serious competition. AT&T, the nations largest telecommunications company, was now permitted to get back into the local phone business, which it had been forced to leave 12 years earlier. Second, the Act allowed the incumbent local exchange carriers (ILECs) to enter the long-distance business, both within and outside of their service region. They could offer in-region long-distance only after demonstrating that they had opened their local markets to competition, but they were free immediately to offer out-of-region long distance, without any precondition. Third, the Act shifted cable companies into a new strategic position. Cable companies have wires into customers homesthe coveted last mile. Though the idea of cable telephony had been around for years, cable operators had been prohibited from offering phone service. The Telecommunications Act gave new life to the prospect of cable-based telecommunications. However, instead of trying to compete in each others regions, the presumed outcome to the Telecommunications Act of 1996, RBOCs consolidated. The Act sparked a wave of mergers among the RBOCS. 2. During the period of 1996-1999, what are the key developments that have reshaped the local service industry? Why did these happen? What are the implications?

During the timeframe of this case, ILECs underwent consolidation. As of May 1998, the RBOCs consisted of: Ameritech (served the upper Midwestern United States, proposed for combining with SBC Communications) Bell Atlantic (served the northeastern United States; has taken over NYNEX) Bell South (served the southeastern United States) SBC Communications (formerly Southwestern Bell; served the southwestern United States; also owns Pacific Bell) US WEST Communications (served the western United States)2 Throughout the timeframe of the case, the RBOCs continued to control the physical assets of the last mile to customers. Meanwhile, CLECs offered fully switched services, primarily to business users, but managed only small penetration (approximately $1.7B).

1 2

Preliminary Statistics of Common Carriers, 1998 Edition, Federal Communications Commission, 5/99 www.whatis.com

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ILECs still controlled the physical access to customers. They spent $400 billion to convert to fiber. Cable operators were a threat to ILECs. Cable companies spent $20 billion to convert to highbandwidth networks. However, most cable companies had limited cash reserves and poor reputations with consumers for service. The CLECs had offered fully switched services, but primarily to business users. At the time of the case, they had managed only a small penetration. The ILECs stalled the implementation of deregulation in their markets by using the following tactics: Make interconnecting difficult Lobby state regulatory bodies to impede entry Block phone number portability

3.

During 1996-1999, what are the key developments that have reshaped the long distance industry segment? Why did these happen? What are the implications?

Industry Structure of Long-Distance Share of Market 55% 17% 10% 18%

AT&T MCI Sprint 800 others

This segment grew intensely competitive. AT&Ts pricing dropped 60% over a ten year period. AT&T, MCI and Sprint were building their own local networks, but it was an enormous job. AT&T managed to build 100 switches. ILECs controlled over 17,000 switches.

4.

How has the Internet affected the telecom industry? What are the implications for providers of local or long distance services?

Internet technology affects the telecom industry is two important ways: data traffic and Internet telephony. Data traffic included transmission of fax, text, graphics, video, audio and other nonvoice content. Data traffic drove the demand for broadband services. While the backbones of phone networks could handle the traffic demand associated with broadband, the twisted-pair copper wire that ran the last mile from the central office switch to the consumer could not, and became the source of bottleneck for many consumers.

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The problem of delivering broadband to homes and offices drove many important decisions for telecom companies. For example AT&Ts push into cable with its purchase of TCI and other assets, was partly motivated by the desire to provide broadband service to consumers. AT&T was seeking to offer a complete telecom solution to businesses and consumers: long-distance and local phone service, cable, high-speed Internet access and other advanced services (e.g. movies on demand ). A new type of provider emerged with Data CLECS, firms offering DSL service to small and midsized businesses and the home office consumer. These companies took advantage of the ILECs slow movement in this market and quickly established themselves in major metropolitan areas with key customers. While data traffic was exploding, telecoms had to consider the specter of Internet telephony. The use of the Internet for long-distance voice communications carries considerable economic appeal for consumers. Calls made over the Internet whether voice or data are not subject to the access fees that local phone companies charge for terminating standard long-distance calls. At the time of the case, long-distance companies paid out a third of their revenues in access fees. Thus avoiding those charges meant large cost savings. By 1996, the Internet clearly had positive and negative effects on wireline telecoms. 1996 and Beyond Internet Effect on Wireline Pros Cons

Inexpensive Lack of Security Independent Management Lack of Responsible Party Means of data transmission for individuals and Convergence of wireless telephony and Internet small businesses ILECs can offer access (how to price it?) Potential substitute for voice traffic ISPs and ADSL compete for data Cannibalize and commoditize

5. By 2005, what is the telecom industry likely to look like? A discussion of the immediate future of U.S. telecoms should include the following: Broadband and RBOCs. Broadband refers to technologies that provide multiple channels of data over a single communications medium, typically using some form of frequency or wave division multiplexing. Students could examine the implications of services such as DSL to the RBOCs portfolios.

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Proliferation of cellular technologies (CDMA, GSM, PCS, TDMA) 3. The proliferation of wireless standards in the U.S. has slowed the introduction of wireless applications in the nation. The following is a review of the salient features of each cellular technology. CDMA, after digitizing data, spreads it out over the entire bandwidth it has available. Multiple calls are overlaid over each other on the channel, with each assigned a unique sequence code. The digital wireless personal communication service (PCS) is expected to use CDMA widely in the United States. A group called PCS PrimeCo that includes NYNEX, Bell Atlantic, USWest and Airtouch Communications has announced plans for PCS systems that use CDMA. GSM (Global System for Mobile communication) is a digital mobile telephone system that is widely used in Europe and other parts of the world. GSM digitizes and compresses data, then sends it down a channel with two other streams of user data, each in its own time slot. It operates at either the 900 MHz or 1800 MHz frequency band. GSM is the de facto wireless telephone standard in Europe. GSM has over 120 million users worldwide and is available in 120 countries. Since many GSM network operators have roaming agreements with foreign operators, users can often continue to use their mobile phones when they travel to other countries. PCS (personal communications services) is a wireless phone service somewhat similar to cellular telephone service but emphasizing personal service and extended mobility. It's sometimes referred to as digital cellular (although cellular systems can also be digital). Like cellular, PCS is for mobile users and requires a number of antennas to blanket an area of coverage. As a user moves around, the user's phone signal is picked up by the nearest antenna and then forwarded to a base station that connects to the wired network. The "personal" in PCS distinguishes this service from cellular by emphasizing that, unlike cellular, which was designed for car phone use with transmitters emphasizing coverage of highways and roads, PCS is designed for greater user mobility. It generally requires more cell transmitters for coverage, but has the advantage of fewer blind spots. TDMA (time division multiple access) is a technology used in digital cellular telephone communication to divide each cellular channel into three time slots in order to increase the amount of data that can be carried. TDMA is used by Digital-American Mobile Phone Service (D-AMPS), Global System for Mobile communications (GSM), and Personal Digital Cellular (PDC). However, each of these systems implements TDMA in a somewhat different and incompatible way. Wireless Internet. This generally refers to handheld devices that can access the Internet. Such devices uses WML (Wireless Markup Language), formerly called HDML (Handheld Devices Markup Language), a language that allows the text portions of Web pages to be presented on cellular phones and personal digital assistants (PDAs) via wireless access. WML is part of the Wireless Application Protocol (WAP) that is being proposed by several vendors to standards bodies. The Wireless Application Protocol works on top of standard data link protocols, such as GSM, CDMA, and TDMA, and provides a complete set of network communication programs comparable to and supportive of the Internet set of protocols. WML is an open language offered royalty-free.

Details of the wireless technologies from www.whatis.com.

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LOOKING AHEAD
WorldCom dominated the news at the end of 1999. Reviewing the merger of WorldCom and MCI can prompt students to consider the implications of this kind of vertical integration. The action is allowed under the 1996 deregulation. The merger presented WorldCom the opportunity to offer customers an integrated service package. Services included: Long-distance Local (CLEC) access to capture business customers Internet data traffic An analysis of the merger will reveal that ILECs and wireless assets are missing from this vertical stack. Students can speculate about what other assets a vertically integrated portfolio might contain. Satellite Communications stalled somewhat by 1999. Iridium went bankrupt during 2000. Cable remained a threat to telecoms. Cable passes 91 million US households and penetrates 66% of them. However, the strength of the cable threat was mitigated by several factors. Cable offered high-bandwidth, but tree and branch structure is less secure and only 25% are equipped for video on demand. No technical component standards predominate. Cable modems are still expensive. The industry lacks organizational capabilities and possess a reputaiton for poor customer service. Customers associate cable with entertainment, not communication.

Globalization of the telecom industry proceeded during the timeframe of the case. European Union underwent full deregulation on January 1, 1998. Global alliances increased: AT&T and their World Partners MCI and BT Sprint France Telecom Deutsche Telecom However, Japans NTT resisted deregulation. Class Wrap-Up

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Three segments, Long-Distance, Local and Cable, in which telecoms currently compete are subject to low revenue growth due to: Competition in long-distance contains pricing, Saturation in the local market (few households left to wire except for secondary lines), Saturation and inability to raise prices in the cable market.

Thus a predatory scene is emerging. Looking for expansion or growth opportunities has induced telecoms to build infrastructure. However, it is important to question their Field of Dreams strategy (build it and customers will come). Wishful thinking does not equal strategy. Interactive TV was an example of wishful thinking over strategy. Unless a telecom company can bring a new service or a new way of delivering service better, it is not likely to be successful. They will have to compete by taking away each others share of market and margins.