Sector Spotlight: Long Distance Phone Biz Becomes a Major Disconnect

AT&T and Worldcom are looking for ways to enhance their struggling consumer long distance arena.
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AT&T

(T) - Get Report

and

Worldcom

(WCOM)

look like they're rotting at the core, which is made up of their consumer long distance businesses.

Such is the plight of lowly long distance these days as the established phone companies suddenly find themselves struggling to make long distance more than a drag on their stocks. The solutions may be radical and ultimately transform the industry.

"There will be a profound structural change to the long distance industry in six months," says Brian Adamik, a telecom analyst with the

Yankee Group

.

While no longer a growth business, long distance remains a mass-market service that Adamik says may be appealing to companies outside the phone industry, such as

AOL

(AOL)

and

Cablevision

(CVC)

, among others. The reason: Long distance could work better when offered to customers in combination with other services such as Internet access, TV programming or even financial services. AT&T already is trying a similar approach by buying and building a cable franchise, but it just may take too long to satisfy shareholders.

Dumping Long Distance?

That's one reason why AT&T Chairman and CEO Michael Armstrong has been huddling with bankers and consultants to explore different options for the company's consumer long distance business, says a banker familiar with the discussions. Those options include another tracking stock or an outright sale of the toll-call business.

AT&T shares have plummeted 34% since May 2 when the company said long-distance revenue was falling faster than anticipated and

warned analysts that earnings growth for the year would be 5% lower than it originally forecast. The stock now trades at 32, a low not seen since 1997, before Armstrong came in to remake the company.

Long Distance Woes
With the long-distance market suffering, the big three providers have watched their stocks tumble this year.

"Consumer long distance is an albatross around their neck right now, and Armstrong has been taking an enormous amount of heat lately," says the banker, who asked not to be identified. AT&T declined to comment.

Given the disappointment of the tracking stock for

AT&T Wireless Group

(AWE)

, observers say it's unlikely the market will warm to an

IPO of a no-growth business unit. So selling is the more attractive option.

AT&T isn't alone. Worldcom, according to a report in the

Wall Street Journal

, also was mulling an exit from consumer long distance as its merger with

Sprint

(FON)

began to fall apart last week. Worldcom wouldn't comment, but insiders say the company is weighing its options and may want to serve only business customers.

But what's so wrong with long distance business anyway? In a word: margins.

Here's the Process

The cost of handling calls is edging closer to zero. That can work in your favor if you control the entire route that a call travels. But if you don't own the route, a significant percentage of each calling dollar must be shared with companies that let you use their network, and that's where the big players get hit.

Nearly all U.S. long distance calls begin and end on the network of a regional or

Baby Bell

. In the middle of calls are the long-haul network service providers, including

Level 3

(LVLT)

,

Qwest

(Q)

and

Williams

(WCG) - Get Report

. There are plenty of them competing for business, which keeps prices low. But there are few Bells, giving them pricing power.

So a long distance company like AT&T, Worldcom or Sprint has to pay Bells at both ends of a call. The Bells, which like any other provider can get a cheap wholesale long distances rates have, only have to pay the Bell on the other end of the call. The Bells have another advantage -- they already have plenty of local customers, presumably making it easier to sell them long distance, which also eats into the long distance business at the likes of AT&T and Worldcom.

For instance,

Bell Atlantic

, now called

Verizon

(VZ) - Get Report

, has signed on 800,000 long distance customers in New York in just six months, says

CIBC World Markets

analyst Stephen Kamman. That's already 2% of the U.S. market and 6% of the New York market, says Kamman. (CIBC has done no underwriting for these companies.)

Attempting to Bypass the Bells

AT&T has spent more than $100 billion to be the nation's largest cable company, so it can bypass the Bells. AT&T is reengineering its cable systems so it can deliver a bundle of services such as phone, Internet and TV, and ultimately keep a full share of its customer's dollar. But that'll take time, and shareholders have grown weary of the plan.

All this raises the question of whether nontraditional players might be able to use long distance more effectively.

AT&T's long distance business, for instance, is veritable cash machine with enormous reach. Consumer long distance brought in $22 billion in revenue last year. It also has 60 million customers, which a company like AOL might value, says Yankee's Adamik.

"AOL is a major provider of services to consumers today," says Adamik. "They want to have a broader appeal than just to techno-geeks, they want to appeal to the mass market. And you're not going to find a better mass market than AT&T's." AOL didn't return calls seeking comment.

Cable companies such as Cablevision could also be attracted to long distance as they look to add phone service to their video offerings, says Adamik. The idea being, the broader range of services you can sell a customer, the better you can own that customer. Cablevision declined to comment.

So maybe it'll take a change of address for investors to fall back in love with long distance.