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Marguerite Reardon

Ben Charny


Jim Hu

Staff Writer, CNET

Something had to give in the telecom industry.

For years, analysts and industry execs have warned it was only a matter of time before the glut of U.S. telephone operators caused a market collapse. There simply weren’t enough people, homes and offices to keep every existing phone company in business. Now SBC’s proposed $16 billion acquisition of AT&T is forcing its fellow Baby Bells to look harder at merger options.

“When you have a bunch of companies all trying to get into each others’ businesses, and increasing competition from new players, consolidation becomes a necessity,” said Brad Wilson, an analyst with Legg Mason. “But I think it’s happening a lot quicker than we had expected.”

The mergers began about six months ago in the wireless market. Top-tier cell phone operators AT&T Wireless and Cingular Wireless merged. Then in December, local, long distance and cell phone giant Sprint made a $31 billion bid for wireless operator Nextel Communications. Additionally, a number of failing rural cell phone operators have been devoured by second-tier wireless operators.

Last week, merger madness hit a fever pitch when local phone giant SBC announced it was buying AT&T for $16 billion. Now a game of musical chairs is underway as the three remaining Baby Bell local phone providers–Verizon Communications, Qwest Communications and BellSouth–scramble to find partners and position themselves in the changing telephony market.

“Right now there’s definitely a battle shaping up over MCI,” Wilson said. “After that, it’s hard to say what will happen.”

Word leaked out last week that Qwest offered to gobble up MCI, the No. 2 U.S. long-distance company, for $6.3 billion. But MCI seems to be holding out for a better offer. Verizon and Bellsouth could still make a play for the company, experts say. Verizon is reportedly already looking into an acquisition. All three local providers would get a boost from MCI’s enterprise customers.

Qwest could benefit from MCI’s small debt load and $5.6 billion in cash, which it could use to help pay down its own $17 billion debt load. But analysts say it’s the least attractive potential suitor. The company’s traditional phone business has been declining at a rate of roughly 4 percent a year. Its 14-state region is thinly populated, so it has far fewer broadband and long-distance customers than the other three Bell companies. It also doesn’t own its own wireless business.

Whoever ends up with MCI, one thing is certain–there will still be two Baby Bells left without nationwide partners. And then what? If struggling Qwest loses MCI to a better bid from Verizon, it might end up with fellow local carrier, Bellsouth, say some analysts. There’s also talk that Verizon might be eying Sprint to get its hands on the carrier’s wireless business.

And of course there’s always the prospect that nothing happens at all.

Your 21st century telco
In some ways, the idea of the regional Bell companies buying up long-distance players seems like a bad one. All three long-distance carriers–AT&T, MCI and Sprint–have seen revenue in their traditional voice business decline rapidly over the past few years. The very fact that these companies are up for sale is a result of a business model in decline.

But the mergers and acquisitions are creating a new type of phone company, and long distance is only a part. The traditional local and long-distance phone company sold only local phone services, and very little else. The new telecom provider will be a national company that packages voice, video, cell phones and broadband–wireless and wireline.

So why are all the Bells after long-distance partners? Though deregulation lets the Bells compete in most parts of the United States, they’re all still regional players. The lack of a global or nationwide network makes it difficult for the Bells to compete for the largest corporate customers, which have offices all over the globe.

Grabbing AT&T or MCI also would give a Bell buyer a new revenue base of corporate customers. In regions where the networks overlap, they can also save by consolidating functions. And they can eliminate fees that they had to pay to long-distance carriers to carry their traffic over their backbones.

Can you hear my bid now?
Though all the Bells have motivation to seek mergers, not all suitors are created equal.

Verizon and BellSouth are viewed as top picks for MCI, while Qwest is seen as the least desirable.

As in the case of the other Bells, Verizon has seen revenues and subscription for its traditional local telephone business decline. In 2004, Verizon lost 2.5 million wireline customers, finishing the year at 53 million. The company has offset these losses with growth in DSL and Verizon Wireless. It’s in these two businesses where Verizon plans to stake its future.

“Verizon is the only wireless player without an enterprise customer base.”

–Telecom analyst Brad Wilson

On the one hand, acquiring MCI seems like it wouldn’t fit into Verizon’s strategy to focus on its DSL and wireless businesses. Verizon has already taken a huge gamble by putting billions of dollars into building speedier fiber-optic lines into peoples’ homes to deliver TV programming, high-speed Internet access and voice calling over one line into homes. Buying MCI would seem to take the company in the opposite direction, toward its traditional voice business. But MCI’s enterprise customers could also help Verizon grow its wireless business.

“All the wireless carriers want to sell to corporate customers,” said Legg Mason’s Wilson. “Verizon is the only wireless player without an enterprise customer base.”

Plus, MCI is cheap. Qwest has bid about $6.3 billion for it, according to reports. What’s more, thanks to the company’s $11 billion bankruptcy last year, MCI is practically debt-free.

“We technical folks always talk about the quality of the network and the international reach,” said Frank Dzubeck, CEO of Communications Network Architects, a telecommunications consultancy in Washington, D.C. “But it’s really about the financials. The company has zero debt. That alone has potential acquirers drooling.”

Some analysts say they don’t think that Verizon really wants to buy MCI, but the merger between SBC and AT&T has forced the company’s hand.

“I think it would be a defensive move,” Wilson said. “They’d rather spend a few billion to keep it out of the hands of a competitor.”

Or spend the big bucks on Sprint
Verizon is also said to be eyeing Sprint. Unlike MCI, Sprint offers an extensive wireless network that could fit in nicely with Verizon’s wireless network.

Sprint, which has typically played third fiddle to AT&T and MCI in the long-distance market, will probably be the only long-distance provider to escape the market consolidation with any semblance of value for shareholders. Unlike the other two, Sprint has successfully transformed itself over the years into a top-tier wireless provider.

“I bristle whenever I hear we’re the nation’s No. 3 long-distance company,” Sprint Chief Executive Gary Forsee said recently. “We’re not.”

It’s more than that. Today, more than half of Sprint’s revenues come from sales of phones, voice minutes and wireless data plans. Those figures will only grow when its $31 billion deal for Nextel closes.

But Sprint’s very success invites regulatory trouble, since a combined Verizon Wireless and Sprint would have more than 50 percent of the cell phone market in some cities, including New York.

“There would be significant regulatory risk if they went after Sprint, much higher than what Sprint-Nextel faces,” said David Kaut, equity analyst at Legg Mason. “The government doesn’t like it when an already No. 1 guy merges with the No. 3 guy in the market.”

Plus, there’s the Nextel penalty. A deal with Verizon would almost certainly scuttle Sprint and Nextel’s $31 billion merger, announced in December. The breakup fee alone would cost about $1 billion, on top of the price tag for Sprint’s wireless and long distance IP networks–about $50 billion, analysts estimate.

Quiet…too quiet
BellSouth could also be a potential buyer for MCI. But so far, the company has stayed on the mergers and acquisitions sidelines.

“BellSouth’s just been too quiet,” an industry source said. “They must be freaking out because their three competitors are making moves.”

Some analysts have suggested that BellSouth and Qwest may get together if Verizon makes a play for MCI. But others say Qwest has nothing to offer BellSouth. And they think BellSouth would be better served teaming up with a wireless provider, such as Sprint. With AT&T’s network assets, SBC will now become a key competitor to BellSouth in certain regions, which could strain its partnership in Cingular. BellSouth owns a 40 percent stake in Cingular and SBC owns 60 percent.

But Sprint would likely be too expensive for BellSouth. And a combined Sprint/Nextel would have little use for BellSouth’s local access lines.

Starts with “c,” rhymes with able
Cable operators can’t be counted out of the merger picture, and Sprint may be their best focus.

The new full-service, nationwide carrier that’s emerging first took root with cable companies, which embraced a new technology for shifting phone calls off traditional local networks and onto the Internet. The new tech–voice over Internet Protocol (VoIP)–allows them to all but give away long distance and local calling in their service bundle in a major challenge to Verizon, Qwest, BellSouth and SBC.

“The circle will now be complete,” said A.T. Kearney Vice President Alex Lui. “God gave us mobility, ubiquity, bandwidth and Internet Protocol addressability, which has made long distance no longer a product, much less a company. It’s just another application on the IP network and a part of the new improved telco of the future.”

Sprint is considered by A.T. Kearney’s Andrew Cole as the No. 1 target for any cable company that wants integrate wireless more easily into their offering, then “go toe-to-toe with Bells.” But again, Sprint has become much stronger since it announced the merger of equals with Nextel.