Calling Home: Telephone Services Look Attractive Again

Competitive local exchange carriers finally realize that growth is good in this plain-vanilla area.
Author:
Publish date:

While far from healthy, the teleconomy has once again begun to show signs of life.

A few weeks ago, I

wrote about the dearth of activity in telecommunications immediately after Sept. 11: Nearly all pending deals had been put on hold or scratched entirely, and most business dealings -- even vendors just calling customers -- seemed to disappear.

That's no longer the case. As was becoming a trend before the terrorist strikes, most telecom activity is no longer about uppity things like optical or selling Gigabit Ethernet to corporations. Indeed, it seems that plain old telephone services (POTS) have become sexy again.

Case in point: Sources say that

Consolidated Edison

(ED) - Get Report

, practically the only U.S. utility with a relatively prosperous telecom division, is shopping around for a wholesaler to service somewhere around 300,000 POTS lines.

ConEd Telecom has been focusing mostly on non-POTS areas of telecom, like using its rights-of-way to lay new fiber for metro and

last-mile connectivity. But what's important here is that ConEd now apparently sees the importance of POTS.

Hearing About Voice

Many remaining competitive local exchange carriers, or CLECs, have finally come around to what the incumbent local exchange carriers, or ILECs, have always understood: POTS (essentially a simple dial tone and ability to make a phone call) still has good growth in it, and you can make a good buck selling it. Many CLECs anticipated a huge jump in data and Internet services and were hoping to differentiate themselves from the traditionally voice-centric ILECs with cheaper, higher-speed and more quickly deployed data and Internet services. But it turns out that, depending on whose numbers you're using and how they're being counted, voice stills pulls 80% of the revenue for ILECs and the telecom industry in general -- even in today's wired world. If you consider wireless as voice traffic, too, then this number can be even higher.

The Class 5 switch provides POTS (along with quite a few other things like voicemail, caller ID, etc.), and its economics still work, as basic voice services continue to grow. According to a recent Lehman Brothers report, voice services grew 10% annually for the past three years, and voice services are expected to grow at a 7% clip through 2005.

New technologies and ways of providing voice services continue to evolve, and the Class 5 and Digital Loop Carrier (DLC) methods of providing POTS are still nicely profitable (with high gross margins) and have good demand. The DLC method allows you to extend the local loop of the Class 5 switch. It is fed by either fiber (SONET, OC-3 or OC-12) or, more typically, copper DS-1s or DS-3s. The DLC is often the actual interface between the Class 5 switch and the end user. In either case, the Class 5 switch still processes the call (i.e., determines where to route the call, based on the digits the caller has dialed).

About Those Vendors

POTS' pseudo-re-emergence (pseudo because it never really went away) is another positive data point for traditional vendors, specifically

Nortel

(NT)

and

Lucent

(LU)

, which dominate the Class 5 world.

So how much will Nortel and Lucent benefit from this trend? Will it be notable in their bottom lines anytime soon?

Easy questions, tough answers. Here's why: With all the hype over the past few years about optical and sexier technologies, both Nortel and Lucent downplayed this part of their businesses, but it's still the cash cow that makes their businesses sustainable and gives them the dollars to invest in the newer technologies.

It's the Class 5 business that will help sustain Nortel and Lucent through this downturn. When things start to pick up again, the key for both is to have a clear evolution path for the incumbents and other survivors on how to evolve their imbedded Class 5 base to next-generation technology. The key for the ILECs and all carriers will be a combination of reducing operating expenses while creating new revenue-generating services.

Internet and data traffic continue to grow at a much faster clip than the aforementioned 7% growth rate of voice services. There's little doubt that Internet and data will soon account for more overall traffic than voice, too. But gross traffic doesn't translate into money. Indeed, it's the monetization (or lack thereof) of Internet traffic that's spelled the downfall for many a telco.

POTS is as alive and well as ever, and it's encouraging that many of the once data-centric CLECs finally recognize this simple fact -- one that the ILECs never forgot.

Cody Willard is president of TelEconomics Consulting, a financial and technology consulting firm. He is also founder of

TelEconomics.com, a Web site devoted to news and analysis of telecommunications stocks. Previously, he was senior analyst for a venture development company, and before that was a partner at the Lanyi Research division of CIBC World Markets. At time of publication, Willard had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Willard appreciates your feedback and invites you to send it to

clwillard@teleconomist.com.