In 2008, businesses procured inter-city telecommunications services from an already highly concentrated, but in some cases very competitive, industry. We don't expect major changes to the telecom industry structure in 2009. Change in the party controlling the White House and the U.S. Justice Department may, however, preclude further significant industry consolidation in 2009.Sprint seems preoccupied with the wireless side of its business and Qwest just can't seem to break into the top tier of wireline carriers. That leaves AT&T and Verizon with not quite a duopoly, but something that sometimes feels pretty close. Let's hope that Sprint can right itself, Qwest becomes a more effective competitor, and/or one or more of the next tier (Level 3, XO, etc) breaks out. All of this has implications for telecom deals.
Although duopolies generally treat their customers badly, some customers secured very favorable telecom deals with significant price reductions in 2008. We expect that smart customers will also be able to negotiate good deals in 2009. It seems counterintuitive that 'dominant' carriers would offer aggressive rates and terms when they face limited competition. We think the reasons AT&T and Verizon do so are (1) they are losing a core wireline business, residential telephone service, and (2) they want to keep and win businesses customers to 'upsell' them management services and applications that telecom companies believe they can provide as effectively as--or more effectively than -- other IT suppliers.
Consider the business environment that carriers are facing. Consumers are replacing the traditional twisted pair with cable telephony and wireless service. In the second quarter of 2008, AT&T's wireline revenues dropped by 2.2% compared to the second quarter of 2007. For the same reporting period, Verizon's wireline revenues fell by 1.8%. AT&T and Verizon have been able to offset poor wireline performance with strong gains from their wireless businesses, resulting in overall revenue gains. Comcast (the largest cable television company), on the other hand, enjoyed two to three times the rate of revenue growth in the second quarter as AT&T and Verizon. Even if demand for wireless data service grows, as it will, the carriers as public companies need new revenue sources because cable competition and wireless competition will continue.
The carriers' behavior in 2008 suggests that the need to retain and grow enterprise customer business is stronger than the duopolistic dynamic. We suspect that the same will be true for 2009. Retaining and winning new enterprise customer business is important given the serious erosion of the residential customer base, and is even more important because enterprise customers are seen as an important source of new high-margin business. These customers are the target market for applications that ride on the carriers' transport services -- data security, remote hosting, managed services, data mining, and the like.
This doesn''t mean that the carriers will give enterprise customers whatever they want--far from it. Unless an incumbent carrier believes that there is a reasonable chance that it may lose at least a significant share of a customer's business, the carrier will not propose leading edge prices or terms. That's not evil--it's just the free market in operation. There is no need for a carrier to erode its margins if it isn't worried about losing the business. In addition to offering mediocre prices, carriers facing a customer that they believe is locked in invariably seek to "claw-back" some contractual provisions to which they previously agreed. In 2008, customers who did not manage their telecom procurements well, and who as a consequence had little leverage, may have improved their pricing a bit, but they almost certainly fell behind the market.
Business customers who used a genuinely competitive procurement process, and who were knowledgeable about contracting for telecom services, or who hired knowledgeable professionals, realized significant savings in 2008. We expect these customers to continue to do well in 2009. We estimate that on average customers who "buy smart" and act to obtain and exploit leverage obtain interstate rates that are 20% lower than those obtained by their less savvy, more trusting peers.
Carriers, particularly AT&T and Verizon, want the business of both classes of customers, but don't need to make as many concessions to hold the business of those who don't maximize their leverage. The carriers will compete vigorously for the business of sophisticated customers because if they lose the transport business, a bad outcome in and of itself, they also won't sell these customers the applications that are important to the carriers' future business plans.
Whether there will be enough competition in the telecom market to force flow-through of the continuing cost savings that are inherent in the declining cost structure of the telecom industry is an open question. At some point market shares may stabilize, and if the industry is duopolistic at that point, price and other concessions will be very hard to win, even for customers who manage their procurements well. The market was not at that point in 2008, and we don't think that it will be in 2009. The need to grow revenues and position themselves for the changing business environment are giving the carriers reason to compete for business if they are forced to so. If customers opt not to hold the carriers' feet to fire, so to speak, they will pay too much for network services at a time when every business is trying to save money.
Even customers who have used the leverage that comes from being highly valued customers must be aware of carrier strategies that will rob them of leverage in the future. For example, do not make a financial commitment that you may not meet. A commitment shortfall will lead to a contract extension at rates materially above market rates. Along those same lines, avoid service sub-minimums and circuit-specific minimum retention periods. These sub-commitments can give back to the carrier leverage that you used effectively during the procurement process.
Less obvious, but still troubling, is the possibility that customer demand will become "sticky" as customers subscribe to carrier-provided applications that are (a) integral to customer operations and (b) integrated with carrier transport services. Sticky demand makes it harder for a customer to maintain appropriate leverage in the carrier relationship. We understand that the decision to integrate applications with transport is a cost/benefit decision, and suggest that it behooves users to consider the loss of leverage as a cost.
In 2008, the FCC continued to refuse to 'regulate' even where the evidence challenged the view that the telecom environment is fully and effectively competitive. Rather than promote competition, FCC decisions in 2008 were neither pro-competition nor consumer-friendly. Instead, they will make it more difficult, if not impossible, to detect price gouging and anti-competitive cross-subsidization. Unless the agency reconsiders its decisions, AT&T, Qwest and Verizon will not be required to allocate their costs between regulated and unregulated service, between interstate and intrastate services and among interstate access service rate elements. As a consequence, it will be virtually impossible to know the carriers' returns and whether their prices are excessive. Even though smart, tough business customers won significant rate concessions in 2008, enterprise customers--like the rest of us--are paying too much for telecom services because access services are overpriced. Proving this will be very hard now that the carrier-friendly FCC has allowed the carriers to bury the bodies, so to speak. Enterprise users can only hope that FCC decision making will improve in 2009.
