What’s Ahead for the CLECs?

There’s a question that keeps coming across my e-mail lately, especially from agents. It’s asked in various forms, but the long and short of what people are wanting to know is this: “How long do you expect the regional and national CLECs to keep their heads above water?”

I have no doubts that additional consolidation will occur. Sadly, the next round of consolidation will occur around marginal CLECs. So who are marginal CLECs?

Marginal CLECs will be those CLECs that are faced with pricing pressures as the result of not having an ability to differentiate services or hold a margin due to reliance on ILEC infrastructure. In addition, those ILEC-dependent CLECs carrying debt greater than three-times EBITDA, in my opinion, may be forced into the situation as credit markets remain elusive and expensive. For example, in Missouri, the ILEC has been relieved to raise prices to CLECs. In general, special access costs across the United States will increase as the ILECs no longer are obligated to provide volume or terms. The ability for ILECs to raise prices of wholesale pieces and parts via forbearance is not an issue of “if” but “when” — that’s reality. Most CLECs relying on Type 2 ILECs will not see costs decrease as prices decrease.

If the telecom meltdown of 2001 to 2003 is any indicator of how the current market conditions may force behavior, the squeeze could be on. It is important to note that the current downturn is not network-centric as in 2001 to 2003, but it is deeper, wider, more sinister and more global.

Some unsophisticated CLECs will make an attempt to survive by lowering prices believing that lower prices will stimulate growth and cash flows. I agree with this somewhat but only to the extent you have 100 percent control over your network operating costs and by increasing volume you get economies of scale for better margins. However, the more a CLEC relies on the ILEC for pieces and parts, the more likely the CLEC in a price-lowering market cannot achieve margin sustainability. The ILECs are not benevolent and will not lower their wholesale pieces and parts unless the law says to do so. We saw many companies go bankrupt in 2001 to 2003 by lowering prices as a single, unsophisticated strategy.

Given the credit crisis (and my theory that the current situation will weigh on telecom well into 2010), I believe we will start to see a realization by Wall Street, and those that have the capacity to lend, that top-line growth by itself is meaningless without margin/profit growth. If you look at recent M&A, it was driven and debt-funded around that testosterone-driven top-line growth. We are now watching many companies struggle with integration, and some may end up in Chapter 11 as a result. The other problem all CLECs face in the United States — none of us is “too big to fail” in terms of our federal government. So as much as the “big” CLECs like to beat their chest in superiority over smaller CLECs — we are all basically a gnat on a rhinoceros’ ass in the scheme of a $3 trillion global telecom economy.

If I were an agent of any sort, I would focus on carriers that have competitive sustainability. You can start by looking at who survived the 2001 to 2003 telecom implosion without going Chapter 11 or Chapter 22. These firms obviously have something going for them, and more than likely it is discipline, cost control and focus. Now, my bias under full disclosure is that I am a fiber bigot. Worse yet, I am a metro fiber bigot. From analyst reports, PE firms with lots of cash and lenders, there is a high interest in enabling established, healthy companies with a track record of organic growth that own local fiber-optic infrastructure well beyond the headlines of the global credit crisis. PE firms looking five to 10 years down the road now realize that real broadband is over fiber and that any and all known and unknown applications will initiate or terminate over a local fiber-optic network. Some analysts readily are reporting wireless having a place, but it will not come close to the fiber-optic infrastructure, which is close to the customer.

I believe agents need to reassess their models to serve and transition from a volume-driving activity to delivering growth margins to those companies that have great control over their network costs. I have spoken with agents for the type of business we have — all data/IP, 20-megabit or higher enterprise customers with a minimum of $5,000 MRR — and I have yet to have an agent show us a model that beats a direct sales force. Below 20 megabits is the traditional low-end game of lowest price, drive-by selling and a costly back-office/customer touch where margins are quickly eroding while basic bandwidth demand increases as copper becomes an insufficient medium. There is an abundance of price-discounting channels available within this lower segment.

My opinion is that the sales agent of the future is not an agent but a partner — an integral part of the organization. This type of partner is loyal and not waiting for the next best commission deal to come along. This partner understands how to sell into an existing price point to hold it or grow it ... not lower it.

Dave Rusin heads up American Fiber Systems, a leading metro fiber provider in 10 markets around the United States. Before he started AFS, Rusin was president of Frontier Communications, the country's first CLEC. He said that experience taught him that phone companies didn't have what it takes to provide exceptional network services. It also inspired him to start a company that would do things right. In addition to his blog for xchange, Rusin writes a blog called Telecom Straight Shooter.