Phone Rivalry as Simple as McDonalds vs. Burger King, SBC Head Says
The future of local telephone competition in California lies in a complicated mash of arcana -- depreciation schedules, “fill factors” and interest rates -- filtered through federal regulations, state hearings and bitter rivalries.
But to Edward E. Whitacre Jr., it’s as simple as two all-beef patties, special sauce, lettuce, cheese, pickles, onions on a sesame-seed bun.
Comparing phone service to Big Macs is one way the chairman of SBC Communications Inc., the state’s dominant local phone company, hopes to persuade the California Public Utilities Commission to raise the prices that SBC is allowed to charge rivals such as AT&T; Corp. to rent the lines, switches and other gear required to provide a dial tone.
Those prices, which the PUC will set later this year, are at the center of a nasty fight between SBC and the companies trying to crack SBC’s near-monopoly on providing local phone service.
“We’re having to sell at below our costs, and that’s the unfair part,” Whitacre said in an interview with The Times. “It’s like McDonald’s cooking a hamburger and Burger King being able to buy it for a nickel and putting their name on it” -- and then reselling it for a fat profit.
SBC’s competitors counter that there’s no beef in Whitacre’s argument.
They say low, discounted rental rates are the only way for them to gain a foothold in the lucrative California market. Once they obtain enough market share, they can financially justify installing their own equipment.
Besides, AT&T; and others say, SBC makes money even when rates are discounted.
“Because of technology, the costs of providing service continue to go down -- not up,” said James L. Lewis, vice president for public policy at WorldCom Inc.’s MCI unit. “That’s the way it ought to be.”
Thanks to the impenetrably complicated economics of telephone networks, it’s nearly impossible for anyone -- even the phone companies themselves -- to figure out precisely what the fair rental rate is. Yet that doesn’t stop armies of lobbyists and consultants from trying to convince the PUC that they’ve got the answer.
“The lobbying is as intense as anything I’ve ever seen,” Commissioner Geoffrey F. Brown said. “It’s a very tough game. These company lobbyists are take-no-prisoners types: polite but persistent. There are real big bucks involved. If these guys don’t perform for their companies, they’re out on their ears.”
Commissioner Carl Wood agreed: “This is their livelihood, big time. According to some players, this is a life-or-death situation.”
The origins of the rate fight go back to the Telecommunications Act of 1996, which was designed to give consumers more choices and lower prices for local phone service. In exchange for renting their equipment to other phone companies at regulated rates, SBC and the other Baby Bells are allowed to offer long-distance service.
In California, the fight really heated up a year ago when the PUC set interim rates for SBC, ordering the San Antonio-based company to charge an average of $14.16 a month per line for the rental of its gear. SBC says that is far too low: It wants the PUC to set rates that average more than $30 a month.
Just what steps SBC may take to try to achieve that aim isn’t clear. Recently, when the company wanted Illinois to raise lease rates, it went straight to the state Legislature, short-circuiting a rate-setting hearing.
With lobbying help from its union, SBC got a bill introduced, passed and signed into law in four days. Starting next month, SBC will be allowed to charge rivals an average of $22 a month -- up from the current average of $12. AT&T; and others have sued to overturn the law.
SBC President William Daley told investors in New York last week that the company would follow a similar strategy in “a couple of other states” that have low rates. He didn’t identify the states, but California’s rates are among the lowest in the country.
Pricing Principle
To set rates, California and other states rely on a formula that focuses on what it would cost to build and operate a brand-new network -- one that, because of new technology, would be more efficient but less expensive than existing systems.
Because the pricing formula is based on forward-looking costs, the Bells aren’t supposed to include historical, or embedded, costs in their calculations. But that’s exactly what the Bells say they need to do to account for the billions of dollars they have spent on the nation’s phone infrastructure.
The U.S. Supreme Court upheld the forward-looking formula last year. Since then, more than two dozen states have lowered leasing prices to boost competition from AT&T; and other alternative local phone service providers, which claim about 5% of the country’s local phone market.
Joe Gillan, an economist working for a coalition of Bell rivals, said the focus on “forward-looking costs” isn’t unique to telecommunications.
“Homeowners insurance companies say they will give you the replacement cost of your home if it’s lost in a fire,” he explained. “The principle is no different in telephone pricing. We’re not going to figure out what you paid for the lines and the switches or how much they have deteriorated. We’ll pay you what it costs to replace it.”
The Bells say that shortchanges them. Because they own the infrastructure, they say, they alone shoulder the cost of keeping it up and running.
“It costs us millions of dollars a year,” said SBC spokesman Selim Bingol. “If the phone network goes down, do you think AT&T; is going to fix it?”
To bring Baby Bell Verizon Communications Inc.’s rates in line with SBC’s, the California PUC in March set the average rate for Verizon at $16.08 a month in the carrier’s densely populated Southern California markets. Verizon wanted $20.52 and has asked for a rehearing. The company’s permanent wholesale rates will be set next year.
Two key factors the PUC will weigh in setting permanent rates for both Verizon and SBC:
* Depreciation. Just as a 15-year mortgage carries a higher monthly payment than a 30-year mortgage, a Bell that takes less time to write off the cost of its capital investments can charge competitors more. Verizon, for instance, contends that it should be allowed to depreciate its digital switches in as few as 10 years because competition is forcing it to upgrade its equipment so fast. Rivals say the depreciation period should be 16 1/2 years.
Lines that connect homes and businesses to central switching stations, Verizon says, should be depreciated over 15 years. Competitors put the period at up to 30 years, pointing out that customers already have paid for those lines several times over. “It’s not Verizon’s network; it’s the public’s network,” said Carolyn A. Tyler, a WorldCom spokeswoman.
* Interest rates. They vary on almost a daily basis as the Bells finance improvements and as lenders reassess the risk of losing the money they lent to the companies. Verizon maintains that regulators should factor into their formula an interest rate of 12.5% to 13%. Competitors say it should be as low as 6%.
In deciding permanent rates, the PUC also will look again at overhead, which includes expenses on such things as office furnishings and legal advice. In the interim rate case, regulators said Verizon could tack on 22% to the lease price to cover overhead. Rivals said overhead should total no more than 8%.
The agency also will have to look at each market to see whether enough competition exists to continue requiring discount rates. The idea of the discounts is to give competitors a chance to build enough market share in a community to warrant installing their own gear. A typical phone switch costs up to $3 million and serves several hundred thousand people.
State regulators and Bell rivals insist that discounted rates are high enough for the Bells to make profits -- though admittedly not as much as they make selling services directly to consumers at retail prices.
“The Bells go to Wall Street and say they are making buckets of money, and then they go to Capitol Hill in Washington and tell lawmakers they are losing money hand over fist,” said Royce Holland, chairman of Allegiance Telecom Inc., a Dallas-based local phone company that filed a bankruptcy reorganization petition two weeks ago.
A study in February financed by Bell competitor Z-Tel Communications Inc., based in Tampa, Fla., estimated that SBC’s average profit margin is 19% on a complete package of network equipment leased to a competitor.
SBC says it doesn’t make any money on the package.
“If we were making a 19% profit, I think we’d be happy,” SBC spokesman John Britton said. “We’re losing money.”
Another study, by the technology research firm Yankee Group, which is backed by the Bells, found that they lose as much as $351 million a year in revenue from leasing their networks to rivals at government-mandated rates. That’s even after accounting for the additional revenue the Bells now receive by selling long-distance services.
Competing for Big Fry
Some critics wonder why the Bells don’t take advantage of the state-mandated leasing prices to invade one another’s territory. SBC and Verizon, for instance, have customers right across the street from each other in many parts of Southern California. Yet neither has moved to lease facilities that would enable them to compete for residential and small, neighborhood business phone lines.
SBC pledged four years ago to compete in 30 major markets outside its 13-state territory in order to win government approval to buy Ameritech Corp. But so far it has targeted only big-business customers in those markets.
Whitacre, SBC’s chairman, said small-business and residential customers wouldn’t provide enough revenue to justify the expense of building out SBC’s network in the 30 markets. And the company doesn’t want to lease equipment from another Baby Bell to reach them because it wants to control its own infrastructure.
“We believe the best way to compete in the long term is to compete over our own facilities, and we are moving in that direction,” he said.
The Bells and their allies say state-mandated leasing rates discourage the building or upgrading of networks. Their critics say the rates are essential to the very existence of competition.
“If the prices are set too high,” said Natalie L. Billingsley, senior analyst at the California PUC’s Office of Ratepayer Advocates, “it’ll discourage competitors from entering the market, and consumers won’t have any choice.”
