Bells Face the Music on Pricing Rules

The FCC's final verdict on reseller discounts could short-circuit a sectorwide rally.
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The Baby Bells seek to gain back lost ground this week when regulators issue final telecom pricing rules, though some investors aren't holding their breath.

The big local phone companies endured a sharp selloff in February when the Federal Communications Commission issued a largely negative preliminary decision. Wall Street's discontent centered on what's known as mandatory discounting on voice lines. That's a practice that forces

Verizon

(VZ) - Get Report

,

SBC

(SBC)

,

BellSouth

(BLS)

and

Qwest

(Q)

to offer discounts to phone-service rivals.

Now, the FCC is expected to issue final comments, ending months of market speculation over the direction of give-and-take at the bitterly divided agency. Baby Bell shareholders are crossing their fingers for a softening in the language of the agency's Feb. 20 preliminary order.

Still, most observers doubt the new ruling will ease the Bells' pain, what with their core businesses still reeling. And barring a complete rewrite, the agency's latest remarks are expected to trigger a whole new round of lawsuits and appeals from the industry.

Competition

Observers expect that this week's order will formalize the decision to hand wholesale pricing jurisdiction to the states, with a stipulation to phase out mandatory discounts altogether in three years. The discounts were designed to promote local phone competition, by forcing the Bells to rent their networks to rivals who, in turn, resell the service. But the Bells say the resale prices mean red ink to them.

The rules date back to the Telecom Act of 1996, a nebulous body of guidelines intended to foster phone industry competition. Going into the FCC's triennial review of local competition laws issued in February, many observers had expected to see some of the wholesale pricing laws rolled back, to the benefit of the regional Bells. But in a 3-to-2 vote, the agency let the rules stand and handed off the matter to the states.

Having lost hundreds of thousands of customers already to resellers like

AT&T

(T) - Get Report

and

MCI

, the Bells have vowed to fight back -- both in the marketplace and in the courthouse. Recent flat-rate and

bundled service packages have helped the Bells stem the loss of customers.

Wall Street viewed the original order as a

hard blow to the Bells, sending their shares on a sharp three-week decline. But some analysts later predicted that the final version of the FCC order would soften some of the impact. The Bell stocks are all now above their February levels.

Rewind

Few expect any

significant changes to the order, which has some investors betting that the final version will amount to a replay of the disappointment of the original. With no obvious relief from the discounting rules, these investors suspect that an unchanged order will dash some of the recent Bell-side optimism.

With massive debts, no revenue growth and a shrinking core local phone business, the Bells don't exactly offer much right now to entice investors. Even the new growth areas -- think of the cash-burning digital subscriber line, or DSL, business -- only compound the problem, in some regards.

The FCC order won't change the picture much for the Bells, says money manager Craig Nedbalski of Victory Capital Management.

"Clearly the economy hasn't helped, business spending has not picked up and there's been no new demand for services," says Nedbalski, who owns SBC and Verizon. "But I am encouraged by the strong DSL rollout."

That's the angle some investors are playing on the FCC ruling. The one positive from the Feb. 20 guidance was that the agency left the Bells alone when it came to data lines.

Nedbalski says the Bells' DSL technology, which falls under that part of the ruling, is loaded with untapped potential that is as yet underappreciated. Now that the FCC has dropped the requirement that the Bells share the lines with competitors, they are free to capitalize.

"Now it's just a matter of hitting critical mass," says Nedbalski. "Before the FCC review, there was no incentive because they had to build it and then sell it below cost to competitors."

So the Bells might well be hoping that investors focus on that DSL opportunity when the final order comes out -- and not on the continuing customer exodus from the local phone business.