Making sense of the Tier 2 wireline service provider consolidation wave

Michael Kennedy, Network Strategy PartnersWhat do CenturyLink (NYSE: CTL), Fairpoint (OTC: FRCMQ.PK), Frontier (NYSE: FTR) and Windstream (Nasdaq: WIN) see that everyone else is missing? It seems to be common industry knowledge that voice and wireline services are dying out, yet these companies are picking up the spinouts of other service providers at a rapid rate. For example, Fairpoint, Frontier, and Windstream have acquired rural properties from Verizon over the last several years while CenturyLink which was formed through the merger of Century and the Sprint (NYSE: S) spinout, Embarq, is about to more than double in size through its merger with Qwest (NYSE: Q).

The business case for investing in wireline service providers is difficult. Subscriber lines in service are declining at between 5 percent and 10 percent annually and service revenues are holding even at best, even with boosts from new broadband and enterprise IP services. Wireline operators are falling behind cable operators' broadband service offerings. FCC figures show cable with a 53 percent market share compared to 37 percent for DSL and 5 percent for fiber.

In addition, the financial positions of many wireline operators are weak.  They carry too much debt and many lack the growth to cover future interest payments. They lack the resources to make needed investments in optical fiber and Ethernet technology required to rollout residential triple play and enterprise Carrier Ethernet services.

Tier 2 wireline consolidationNew business models are needed to resolve these issues. The formation of new second tier U.S. wireline service providers are part of that process. The thing that most clearly distinguishes these companies from the two giants, AT&T (NYSE: T) and Verizon (NYSE: VZ), is that they operate in smaller cities and rural areas, while the giants operate primarily in the big metro areas.  The second distinguishing characteristic is that they are mostly pure play wireline operators, whereas the wireline businesses of AT&T and Verizon are increasingly being subordinated to their wireless businesses. Finally, AT&T and Verizon serve the majority of large U.S. enterprise accounts and provide much of the U.S. (and world's) backbone Internet capacity. Other wireline service providers do little of this, though Qwest is an exception.

As compared to the large metro areas, rural areas and small cities are less dense, have less income diversity--fewer very rich or very poor people--fewer enterprise establishments, and less wireless coverage.  Competitive conditions are different as well.  There is less head-to-head competition and satellite TV is more dominant than in urban areas. The politics surrounding communications issues are markedly different than in urban areas. There is a unanimity among rural enterprises, service providers, and elected officials who work together to obtain state and federal support for networking programs and investments.

Tier 2 consolidationThe new business models are built around three critical success factors. The first is cost reduction.  There are many work processes and common costs in wireline communications. Centralization of work and the extensive use of remote management and monitoring yield big dividends. This presents the opportunity to reduce unit costs which is particularly important in the declining and low growth business segments. For example, Frontier Communications estimates it will save $500 million annually by year-end 2012 through consolidation of executive management, legal, information systems, finance, and accounting activities.

Residential broadbandThe second critical success factor is to deploy leading edge access infrastructure. This must necessarily feature fiber to the home or fiber to the curb--GPON or IP DSLAM. Critical upgrades will include deployment of 10 GE in the metro backbone and IP/Ethernet for triple play residential and Carrier Ethernet business services. Residential broadband requires very substantial upgrades to be competitive.  For example, the FCC estimates the actual average throughput--not the advertised maximum rate--for DSL is now 2.5 Mbps.  It estimates that within five years this average rate across all technologies will be 12 Mbps. This will be needed primarily to meet consumer expectations for video delivered over the Internet. The residential access network must also be capable of delivering multiple streams of proprietary video services, which within five years will likely include 3D TV.  3D TV currently requires bandwidth of 38 Mbps--the full capacity of a 6 MHz channel. Access infrastructure also must carry business services side-by-side with residential services. These include access to business establishments and increasingly, wholesale backhaul services used to connect wireless operators' base stations to their Radio Network Controllers. 100 Mbps Ethernet is fast becoming the fundamental access requirement as it replaces T1/E1 (1.5/2.0 Mbps) access services.

Unlike more urban markets, there is plenty of room for growth of high speed Internet services in rural areas. For example, the FCC has set a target of 85 percent penetration of high speed Internet service by year end 2013. Frontier reports that its newly acquired properties have high speed Internet penetration of only 64 percent.  This provides headroom for growth.

Tier 2 service provider bundlesCreation of service bundles is the final critical success factor.  Service bundles increase customer loyalty, reduce churn and support price premiums. It is surprising to me to learn that bundles that combine local telephone and long distance telephone service are nowhere near as common in rural areas as they are in urban areas. This provides some easy money and room for growth.

The newly combined second tier operators have an opportunity to create the new business models needed for the wireline market of the future. It is built around debt restructuring, reducing cost, and investment in new access technology. They must focus on the needs of rural areas and small cities which are uniquely different than those of the big urban centers served by AT&T and Verizon.

Michael Kennedy is a regular FierceTelecom columnist and is the co-founder and Managing Partner of Network Strategy Partners, LLC (NSP)-www.nspllc.com-which serves as management consultants to the networking industry. He can be reached at [email protected]

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