Larissa Herda, CEO of tw telecom (Nasdaq: TWTC), is feeling confident about the success of the CLEC she runs. In Q2 2012, the service provider's revenue rose 1.6 percent sequentially to $364.5 million due to strong carrier Ethernet and VPN sales. Of course, the main concern that's on the mind of Herda and other competitive carrier executives these days are the rules governing the special access circuits they have to purchase from incumbent carriers like AT&T (NYSE: T) and Verizon (NYSE: VZ) to extend their services where they have not yet built out fiber.
At the same time, the service provider continues to expand its product portfolio with two new automation tools, including its One to Many service for its wholesale carrier customers and a new Dynamic Capacity tool that enables its retail customers to automatically increase their bandwidth allocation. Sean Buckley, Senior Editor of FierceTelecom, caught up with Herda to talk about how the company is finding success as a competitive carrier in a rapidly consolidating market segment.
FierceTelecom: During your keynote address at the recent COMPTEL Fall show, you talked about how the FCC should revise its rules around special access. Talk about what you think is needed to level the playing field?
Larissa Herda: We're basically looking for competitive policy that is basically fair and reasonable. During my keynote at COMPTEL, I talked about how AT&T in August came out with a filing where they're looking to get out of their wholesale obligations to sell wholesale services because the world is going to IP technology. The box on the end of the line is changing and so they're saying, "it's no longer TDM so therefore we don't have to provide it." We're saying it should be technology neutral, because it really doesn't matter that the FCC price and service quality rules where ILECs have market power regardless of the technology used. Their proposal is that they don't have to sell wholesale services.
We have been working on special access reform for a long time and we've been trying to again keep the incumbents from being able to raise their prices. If there's competition, we have never been able to raise our prices, and if there's competition then prices generally come down. There was one incumbent who tried to raise their prices last year in the same region, and fortunately the FCC got them to take that off the table with a little pressure from COMPTEL and the industry. I think it is amazing to us that they could even put it on the table. We want the FCC to use the market tests that they have that demonstrate if there's no competition for services then there need to be policies around service quality and price. If it's a monopoly service, there need to be some protections against them from degrading our service and hurting our businesses.
FT: Obviously, tw telecom has built a successful facilities-based business, but what is the impact of the wholesale changes AT&T is proposing?
LH: What's happening today is customers want you to be where they want you to be, not necessarily where you are. The vast majority of our revenue resides on our fiber network, but most of that revenue is also tied to circuits that are not on our network that we have to buy from someone else. Nobody has ubiquitous access—not even the biggest carriers in the world—so we're all compelled to buy cooperatively from one another. Everywhere where we provide service, there's usually another competitor that can provide the service, which is usually the incumbent.
Our behavior is very competitive: We offer customers reasonable contract terms and competitive pricing, and that's the nature of competition. That's not what we find when we deal with the incumbents. In fact, one of the biggest problems we run into with the incumbents is what we call the "heroin drip." The contract terms that they impose upon us, force us to buy from them and force us to buy more every year. And if you don't, you have these very, very steep penalties.
What happens is it prevents you from buying services from other carriers because you constantly have to meet this revenue expectation. It's a very anti-competitive type of a policy, and they don't allow us to move to new technology. They're trying to get us commit us to special access on ever higher and higher amounts, when special access is declining because everyone is moving to Ethernet, but they say that that's a completely different commitment you have to make. They won't allow us to make the transition from the old technology to the new technology.
For us, even though our core value proposition to a customer is very much centered on our fiber network, our customers have branch offices and we're not going to be able to build fiber into every office. So we have to buy services to those locations where you're never going to have competition. We have to be able to get those services at a reasonable price and reasonable service quality. We have 16,000 buildings connected to our network, but there are a lot of buildings out there that we're still not in yet.
FT: Can you talk about your own External-Network to Network Interconnection (E-NNI) partner strategy and the challenges of maintaining Quality of Service (QoS) with those arrangements?
LH: We buy services from competitive carriers when we can, but the problem is a lot of them don't have a lot of buildings. Our strategy first is if we can get Ethernet from another provider, we prefer to deploy that to a customer location. We have teams in our network operations center that have to stay on top of the service quality issues that we see every day with special access. There are chronic issues that crop up on the copper plant, for example. Our biggest cost in terms of maintenance is around buying circuits from incumbents. Now, if they could just meet the same service commitments they require of us we'd be very happy, but they won't.
FT: Are you seeing the FCC take any action on the special access front that could help competitors like tw telecom?
LH: You hit the nail on the head. We've been trying to get a number of things: have stable prices; have stable service quality; have contract terms that are fair and competitive and allow us to move technology and don't require us to constantly feed the dragon, so to speak, because we want to use a lot of different carriers if we choose. These are very simple things we're looking for.
We'd like to see wholesale Ethernet become more competitive. The incumbents managed to get forbearance on Ethernet regulation because the FCC did not make any decisions. After one year, it was automatic forbearance. There was no process; there was no evaluation; there was no determination of a competitive situation. Ethernet is special access, so special access is a monopoly in a lot of places and Ethernet is a monopoly as well. We'd like to see that reversed. We have situations where we buy Ethernet wholesale from an incumbent and find out that the customer is paying a retail price that's significantly less than what we're paying wholesale, and yet we're billing millions of dollars a year with these carriers while the customers are only billing $1,000 so there's a disconnect there. There needs to be some sort of reasonable competitive policy around wholesale Ethernet services.
FT: tw telecom arguably was one of the earliest providers to offer Ethernet services. How important is Ethernet in your portfolio and how has it evolved?
LH: Ethernet is core to our business. It is core to our revenue growth. It is driving innovative services like Dynamic Capacity. It is driving innovative services like our "One to Many" Ethernet access product, which we can sell to carriers, data centers and infrastructure providers.
Today, for a carrier to get Ethernet, they have to connect to each Ethernet provider in each market. Well, we have a product coming out this quarter that a carrier now only has to connect in one market in the United States and we'll take them to all 75 of our markets. We're constantly innovating around Ethernet, so it's a very important product for our growth. It is also an important product to enterprise customers for the flexibility, lower cost, and the ability to innovate. With our Dynamic Capacity product, customers can now go from 10 Mbps Ethernet and within 12 seconds they can triple their capacity themselves. Think about the implications of what that means for them and their ability to manage things in their network—things that are unexpected in their network.
FT: In developing Dynamic Capacity, what did you have to do in the back office to make that capability work?
LH: We spent years putting this product together. It was a vision that we set out a long time ago that when we acquired various companies we really integrated everything. We shut down systems and we moved customer data into single systems.
We have this "One" platform concept with one set of customer data, for instance. If you go to an incumbent, they have to go into different systems to find customer data because they're serving them in various parts of the country and they have four different ILECs they have owned. With us, they have one place to go to for their billing, service and maintenance information. We took that concept to the whole network, so we have one national network that's fully integrated so that when the customer goes into their portal and they say "I want to take that 10 Meg circuit and make it 30 Meg," what happens is the system goes in and checks the inventory in Ohio, New York, or wherever they have service and says, "Yes the capacity is there and here's what it will cost you and customer, do you want it?" If the answer is yes, the capacity is then opened up.
You have to have a thoroughly integrated platform to be able to do something like that. We took a few steps back after we made the Xspedius acquisition in 2006. We weren't able to deploy any new products for a year and a half because we were doing all of this in our systems and you couldn't be developing new products in old systems. We made some hard decisions at that time to thoroughly integrate the business because we knew we had to be something different; we couldn't just be the same old carrier to customers. We want a future when a customer buys from us they never have to process another order and everything is done automatically. They can provision services without service orders. All of the activities are not typical telco activity. It's an on-demand world and we're trying to create on-demand services on the network side, which is very unique.
FT: In Q2 2012, a key portion of growth was Ethernet, of course, and VPN. Do you see those elements as table stakes in your success in selling Ethernet and other access to large business clients?
LH: VPNs are all part of the growth portfolio. We have hit a point in the business where half of the revenue comes from data and IP services portfolio, and about half of those come from that strategic portfolio of Ethernet and MPLS-based VPN. A lot of the new product activity is focused on driving growth in those segments.
FT: Besides retail services, are you finding more wholesale opportunities, particularly for data center connectivity and Fiber to the Tower (FTTT)?
LH: We have over 350 third-party data centers that we are connected to with fiber and are connecting them up literally every week. We've been aggressively selling to that customer base. Imagine you're a data center and you have all these customers, and we are connected to all of these enterprise buildings. They can go to those customers and say "with tw telecom, you could increase your bandwidth instantaneously once you're connected," and that's a very powerful data center product.
Our One to Many product for carriers is the first innovation we have done with Ethernet for carriers. I think that's going to be huge because it's a huge cost savings. They don't have to spend the capital in every single market. All they have to do is connect up with us and we're not charging them for each connection. I know they have these Ethernet exchanges out there that make money on that, but we make money on selling the network.
A lot of those companies don't have the infrastructure between markets. Think about an international service provider that only has a couple of points of presence in the United States. This means that they don't have a backbone that gets them to Columbus, Ohio, for example. We see wholesale carrier services as a great opportunity. It represents about 20 percent of our revenue, but we view data centers as part of the enterprise space. As far as FTTT goes, we have chosen to do a number of those over the years where it makes sense financially and where we have a lot of fiber network, and as opportunities present themselves we'll continue to look at those.
FT: Can you talk about the ever-consolidating nature of the competitive telecom business, and do you plan on making more acquisitions yourself?
LH: We're very fortunate because we have organic growth. When you have organic growth, you have the choice to not make acquisitions unless you feel like it is strategically important to do it. When you don't have organic growth, you see companies making a lot of acquisitions.
When you look at the history of companies out there, you'd see some correlation. We made our last acquisition in 2006 and that really completed our national footprint for us. It has actually enabled us to be who we are today and enabled us to sell to as many customers as we have today.
Our business strategy is a local business strategy on a national level, so it's important to drive shareholder value by driving cash flow growth and our margin expansion. The way we do that is by building more density in the markets that we're in. We have so much market opportunity in those markets and even in the old ones where we have been present for a long time.
Putting more buildings on the network and more of the revenues on the fiber is what really drives the value of the business because it is the gift that keeps giving. It's not about being the biggest. It's about being the most profitable, being the company that delivers the best service, and delivers the best shareholder value. I know there have been companies in this industry that have a lot more revenues than us, but are worth a lot less.
We have always been, relative to others in our sector, highly valued by the market because we're so disciplined with our financials, we're focused on profitability, and we're focused on top line revenue growth with margin. Having revenues with margin is important because that's what builds shareholder value. We have some of the highest shareholder value with some of the highest EBITDA margins in the business, and that's how the market values this industry today. If you can show you can do that on an organic basis, the market values that. How we serve our customers, the whole customer experience we provide, the innovation we provide our customers, and the flexibility we show our customers are all important to our success.