Annus horribilis? However you say it, CLECs have had a bad year

By Mark H. Reddig, editor, CLEC.com

When England's Queen Elizabeth, while making a speech to Parliament, wanted to describe the worst year of her life, she used the term annus horribilis ?Latin for "horrible year."

Although they haven't had any royal couples divorce, CLECs may well take some cues from Her Majesty when describing their own recent tough times.

In the past 12 months, the competitive firms have had their own annus horribilis. More than a dozen competitive-telecom firms, CLECs and others, have filed for Chapter 11, been delisted from the Nasdaq or even closed down completely and had their assets auctioned to the highest bidders during that time.

Blame has been flying everywhere, from the downturn in the market, to RBOC intransigence, lax regulatory enforcement of competitive rules, operational problems at the CLECs themselves, and on and on.

Experts may ?and do ?disagree on the reason for the current trend, but one thing is clear: The competitive, local-telecom industry, only a few years old, is undergoing a major transition that will have a profound effect on its future.

ASK NOT FOR WHOM THE BELL TOLLS ?

The first signs of a problem in the CLEC sector came nearly a year ago.

In May 2000, Vancouver, Wash.-based CLEC GST Telecommunications announced it had filed for Chapter 11 bankruptcy protection and had written a letter of intent to sell substantially all of its assets to fellow CLEC Time Warner Telecom.

It was August before another CLEC joined GST. Late that month, New Orleans-based CLEC firm American Metrocomm Corp. filed for Chapter 11 bankruptcy protection. That filing included a number of AMC subsidiaries.

By the end of 2000, the pace of bankruptcies in the CLEC segment took off. More than a dozen CLEC firms have filed for bankruptcy protection since November:

In November, ICG Communications Inc., an Englewood, Colo.-based CLEC.

In December, Waltham, Mass.-based CLEC Digital Broadband Communications.

In December, NETtle> integrated-communications provider.

In January, San Francisco-based data CLEC NorthPoint Communications.

In February, Missouri-based CLEC Omniplex Communications Group.

In March, Herndon, Va.-based CLEC firm e.spire Communications Inc., a provider of local, long-distance and DSL services.

In March, Austin, Texas-based data CLEC ConnectSouth Communications.

In March, Bellevue Wash.-based Advanced Radio Telecom.

In April, Reston, Va.-based Pathnet Telecommunications Inc., a local-services networking firm that offered connectivity to other carriers.

In April, Mobile, Ala.-based Actel Integrated Communications Inc., an integrated-communications provider that offered services in several southern states.

In April, New York City-based fixed-wireless CLEC WinStar Communications Inc.

In April, Louisville, Colo.-based data CLEC @Link Networks.

In April, Roswell, Ga.-based CLEC Telscape International Inc., a firm that specialized in services for the Hispanic community.

In May, Westbury, N.Y.-based CLEC North American Telecommunications Corp., also known as Natelco.?

In May, Vienna, Va.-based fixed-wireless CLEC Teligent Inc.

The problems have been especially pronounced in some segments of the CLEC industry.

The DSL sector has received particularly bad press, despite that several of its chief players ?most notably Santa Clara, Calif.-based Covad Communications Group Inc. and Englewood, Colo.-based Rhythms NetConnections Inc. ?continue to avoid Chapter 11, even after having been delisted from the Nasdaq.

Several of the bankruptcy filings have been among smaller players in that segment. For example, Herndon, Va.-based CLEC e.spire Communications Inc., a provider of local, long-distance and DSL services, filed for Chapter 11 protection with the U.S. Bankruptcy Court for the District of Delaware in March. And Louisville, Colo.-based @Link Networks announced in a letter to its customers in April that it had filed for Chapter 11 bankruptcy protection.

But the big hit came in January, when San Francisco-based data CLEC NorthPoint Communications filed a petition for Chapter 11 protection with the U.S. Bankruptcy Court for the Northern District of California in San Francisco. The company said at that time that it intended to sell its business and assets, and was seeking approval of open bid procedures from the U.S. Bankruptcy Court.

But DSL has not been alone among CLEC segments in taking a big PR hit. Fixed wireless, another relatively new technology in the market, has seen several major players hit the skids.

For example, Bellevue Wash.-based Advanced Radio Telecom quietly filed its petition for Chapter 11 bankruptcy protection in March. The day before it filed, the Nasdaq stock market halted trading in its stock.

In April, New York City-based fixed wireless CLEC WinStar Communications Inc. voluntarily filed for protection under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court for the District of Delaware. The same day it announced the filing, WinStar filed a lawsuit against Murray Hill, N.J.-based Lucent Technologies Inc., alleging breach of the telecom-equipment suppliers obligations under its agreement with WinStar.

And in May, Vienna, Va.-based fixed-wireless CLEC Teligent Inc., an early entrant in competitive telecommunications, filed for Chapter 11 bankruptcy protection. The firm said at the time that it planned to reorganize its capital structure under Chapter 11 protection. Earlier that month, the provider laid off about 800 workers and the Nasdaq stock market halted trading in its stock.?

BUSINESS PLAN? WHAT BUSINESS PLAN?

A number of experts point to flawed business plans when discussing recent CLEC failures. The basic premise of some competitive firms was based on questionable assumptions, they say, or the plans were constructed with virtually no information about the markets they hoped to serve.

Several of those failed approaches stand out, said Craig Clausen, senior vice president and COO of Chicago-based CLEC research firm New Paradigm Resources Group.

Many CLECs, he said, took a "Field of Dreams" approach to the market, believing that if they built networks, customers would simply show up.

Another was what he called the "MCI Mentality." When the long-distance market was opened up, MCI quickly gained 10 percent to 15 percent of the market, he said, to a great extent from "people who were pissed off at AT&T and just wanted to exercise their freedom of choice." Some CLEC executives thought that the same process would occur when local markets opened up, and that consumers would simply abandon the RBOCs en masse out of anger ?something consumers clearly did not do.

Yet another was the "Bright and Shiny" system, Clausen said, where CLECs said, "Let's make sure we touch the biggest bright and shiny buildings in each city, and we'll be fine, we'll gather enough customers."

Those early CLECs would run fiber in Chicago, for example, to the Sears Towers and the Amoco Building without doing any serious market assessment to determine whether a need or desire existed for their services in those facilities.

"Well," Clausen said, "that didn't work out."

But the most serious philosophical problems were in-house, going down to the level of how the companies were assembled and operated.

Some firms, he said, "had people in the executive suite who were not particularly focused on building a company."

"At times, with certain CLECs, that was an issue, not having people who were interested in building a company, but rather building an asset that could be flipped," he said.

Those managers concentrated not on creating a system that would sustain the business in the long run, but in creating a set of assets and a customer base that could be brought together quickly, valued and sold to the benefit of stockholders and investors.

The philosophy seemed to be, "You know you're going to be out the door in 12 to 24 months when you've flipped the company to somebody else and let them worry about it," Clausen said.

"There's a difference there," he added. "Building a company takes a longer-term perspective. Cobbling together an Access database solution to manage your inventory is a little short run."

Many of those managers were inspired, Clausen said, by such events as the WorldCom acquisition of MFS Communications.

"Suddenly it was, whoa! Look what these guys go for ?billions of dollars," he said. "All we have to do is be there, too ?and someone with big dollars will come in a gobble us up, too."

Another difficulty plaguing the CLEC sector was that too many of the competitive firms were targeting the same lucrative business customers. While that technique could work for one competitor, experts noted, it could hardly work when a large number all target the same niche market.

Kenneth Brown, director of technology programs at the Arlington, Va.-based Alexis de Tocqueville Institution, in a white paper titled "Understanding the CLEC Crisis," cited figures from the 1992 U.S. Census indicating that of the 5.5 million businesses in the United States, 668 are businesses with more than 10,000 employees.

"However, despite the relatively small scope of this market, many startup CLECs chose large-business customers as their target market, assuming that they would be able to generate significant revenue with the least amount of sales activity," Brown said in the paper.

Brown said those CLECs underestimated the complexities involved in providing service to those firms, as well as competition from other CLECs and the lengths the RBOCs would go to keep their hold on the large-business customers.

"Effective market selection must consider the accessibility and defensibility of the customer base, as well as the operational requirements that need to be met in order to serve that customer base," Brown wrote. "When competing against an established company that holds a majority of the market, it is wise to select a customer segment that is both accessible and defensible."

Or, in simpler terms, customers should be easy to get and easy to keep.

"Failing to see the acquisition of customers as one of the key challenges of the business proved detrimental for many companies," Brown said in the white paper. "Companies overestimated their ability to acquire the needed volume of customers at a reasonable cost."

John Malone, president and CEO of The Eastern Management Group, a management-consulting firm based in Bedminster, N.J., said that in some markets ?he cited major cities in Florida ?too many CLECs were operating in the same geographic area, targeting the same customer base.

Malone pointed to industry data that indicated an average of 15 CLECs operated in each Tier I market in the state.

"In the largest cities with a population of 3 million or more, if each CLEC puts in its own switch and needs 6,000 business customers to be profitable, this accounts for about 75 percent of the market," Malone said in a release. "In cities of about 2 million that still have an average of 15 CLECs, the number of required business customers exceeds the actual number of customers available.

"This does not even take in to account the presence of the incumbent," Malone said. "In other words, not every company can or will succeed with this level of competition for business customers.''

ROLL OUT THE BARREL

But how crowded the market is, or what the competition is, are only part of the picture. How a firm rolls out its service can also have a big effect on whether it succeeds or fails, Roderick Beck, telecom analyst with New York investment bank Brill Capital, said.

Firms such as Dallas-based Allegiance Telecom sequentially rolled out service, he said, first opening in one market, then another, then another. But some providers, including some of the large DSL firms, opened in a large number of markets simultaneously, which means they developed massive capital expenditures with no revenue.

The advantage of the sequential model, Beck said, is that it allows older markets to mature ?and become profitable ?before new markets come on line. In the all-at-once model, during a large part of the company's timeline, none of its markets are profitable.

And that means that in bad times, the sequential model can offer a company a shelter from the market storm, Beck said. If, as they have recently, the markets turn against a firm, it can withdraw from more costly and less profitable new markets and concentrate on its older, more profitable regions. Meanwhile, the firms that took the all-at-once approach, in some cases having no profitable markets, have nowhere to hide.

"A sequential rollout gives you a lot better chance of navigating the financial waters," Beck said. "A lot of companies failed because they developed a land-grab mentality."

That also helps a firm when it has to go back to investors for more cash to fund its business plan or for further expansion.

"It's very nice to go to investors the way Time Warner Telecom can and say 'I have a 70-percent EBITDA margin'," Beck said. "What is SBC's EBITDA margin? Thirty percent.

"If you show that to investors, particularly in rough times like now, that makes raising money a whole lot easier," Beck said.

SMOOTH OPERATORS

Not all the troubles in the CLEC segment have their roots in the outside world. For some competitive firms, internal, operational issues are at the root of the current difficulties.

Two key operational issues have particularly haunted the troubled CLECs, NPRG's Clausen said. The first is the ability ?or inability ?to provision service.

"If you can't provision lines, you can't access revenues from those customers," he said. "That was something the CLECs underestimated tremendously."

A significant number of firms entered the CLEC space expecting local competition would be similar to entry into long-distance competition, a "fairly simple" affair, he said.

"[Early CLECs thought] this will be simple, we'll put in a class 5 switch, we'll plug it into the ILEC's network, and we'll all be fat, dumb and happy," Clausen said.

However, it turned out to be much more difficult than they expected.

For one thing, it was much harder to turn up a class 5 switch than it was to hook into the long-distance market. Other firms, such as WinStar, had difficulties because of the nature of their technology.

Another barrier was interconnection.

"Interconnection issues took a long time to iron out," Clausen said. "And to a certain extent, they're still not ironed out. There's still delays in getting an ILEC's lines cut over to your network."

Yet another provisioning challenge was turning up service for individual customers. Many CLEC customers still see significant lag times ?and many, he said, are not willing to wait.

The other operational barrier that faced CLECs was the lack of available, complete OSS packages early in the segment's history.

"There was no package generally available for these guys to use to do everything from customer care to inventories to billing," Clausen said. "That proved to be a tremendous problem."

A smattering of vendors were producing individual pieces of the OSS puzzle, but few fully integrated packages were produced at that time, and many of those were not designed with a small startups like CLECs in mind.

Some CLECs were so desperate to bring order to their systems they even developed "home-grown" systems, Clausen said, even using modified Access databases to run their systems ?a bad idea for a firm that wants to deploy thousands of lines per day in a heavy growth phase.

One firm, e.spire, even went for a long period without billing up to 20 percent of its customers because of back-office-system problems.

"That does reflect the importance of having a solid well-integrated operational support system," Clausen said.

Within the OSS, one area of particular importance is electronic bonding. Allegiance is a good example of why those systems are so vital, Clausen said. The Dallas-based firm, one of the most successful CLECs, is perhaps the best in the field at bonding.

"Without electronic bonding, without a true interface ?it led to a whole host of problems," Clausen said. "You couldn't bill customers, you couldn't take care of them, you couldn't manage your inventory, you didn't know what the hell you had, basically."

But even for firms that conquer such operational challenges, other barriers remain. And among those are the ever-present incumbent carriers.

EVERY TIME A BELL RINGS

A considerable amount of hue and cry has erupted from CLECs that are in trouble that their difficulties are due, in part or in whole, to roadblocks thrown up by the RBOCs and a lack of help from regulatory agencies.

"To their peril, new CLECs did not anticipate that competing ILECs would be relentlessly aggressive in an effort to keep their market share and local customers," the Tocquiville Institution's Brown said in his white paper.

RBOCs, Brown said, had little incentive to improve their service to the CLECs, since delays in serving CLEC customers only benefited the RBOC by making it more attractive to customers.

"When service issues first began to occur, the CLECs, failing to comprehend the RBOCs?lack of incentive for improving service, attempted to work problems out with the incumbents," Brown said. "When this method failed, startup companies discovered that they had tremendously underestimated the influence the incumbent providers held over the legal and regulatory environment in the telecommunications industry. When an RBOC did not adequately fulfill its obligation, there was no true method of recourse."

Initially, NPRG's Clausen said, part of the problem with RBOCs was due to "genuine confusion." The incumbents had never had to hook into a competitive network before; they had 100 years of government-protected monopoly behind them, with the only interconnections being to firms that covered separate, nearby geographical regions, or to long-distance networks.

Now, suddenly, they had a whole series of competitors, often covering the same geographical ground, and wanting access to the most delicate places in the RBOCs' network ?the central office.

"Of course, they got understandably queasy about that," Clausen said. "'You want to come into our brain room and you want to muck around?' So they threw up barriers. It was almost a reactive mode."

Then the thinking moved, Clausen believes, to a higher, executive, strategic level, where the firms decided they could not allow competitors in.

That strategic thinking came back to the operational level, where suddenly, CLEC technicians coming into an RBOC central office could face restrictions that ran from the sensible to the ridiculous ?for example, Clausen said, a CLEC technician working in a central office might be told he couldn't use the RBOC bathroom, or that he had to use separate parking. Or the RBOC might argue about whether CLEC equipment had to be caged, or uncaged.

"There was some genuine confusion," Clausen said. But some firms said to themselves, "Gee, maybe this genuine confusion can work to our advantage, so let's perpetuate it a little further."

But while problems with the RBOCs were "certainly a factor" for CLECs, "does it explain these CEOs out of their responsibilities? No," Ryon Acey, vice president at Richmond, Va.-based securities firm BB&T Capital Markets, said. "Flat out, there were some very poor decisions made on the part of management, and nothing they can say can change that."

If RBOCs, the FCC and the PUCs were the primary factors in CLEC failures, Acey said, then why are some competitive carriers doing so well? That brings us to our next target, the financial markets.

BLAME IT ON WALL STREET-OR NOT

The troubled financial markets have been another frequent target of finger-pointing. The CLEC crisis, after all, has coincided with the decline of the tech-heavy Nasdaq index.

But while the financial markets certainly have not made things comfortable for CLECs, Acey rejected the idea that some firms would not have gone under if the good times had continued to roll.

"It was just a matter of time," he said. "I don think it took a market to fall apart for investors to figure that out. They would have figured that out sooner or later."

Instead, Acey points to internal financial concerns as a more important source of the failed CLECs' woes.

He sees three principal problems in common at CLECs that have fallen into bankruptcy, he said:

First, the firms did not have "the appropriate capital structure," meaning they were too highly leveraged;

Second, the firms were depending on revenue that was not "end-user focused," meaning their business had no direct connection to the actual user of the telecom services.

Third, the firms didn fully fund their business plans.

"The name of the game has always been pre-fund your business plan," he said. "And I think we all forgot that."

Acey pointed to MFS Communications, now part of WorldCom. In the mid-1980s, several firms had better business plans than MFS, he said, but MFS survived because it was fully funded from the beginning.

And because of that, "They didn need cash when the markets weren willing to give," he said. "They were pre-funded."

Some newer firms went into the market, brought in some venture capital, but didn fully fund their business plans, expecting that the market would provide more when needed. The key error those firms made, he said, was to plan their growth based on that expectation.

That led to a number of firms with partially constructed networks and no cash to finish the buildout because the capital markets shut down, Acey said. "That left a lot of stranded assets."

On the revenue side, Acey said some carriers, rather than focusing on long-term end-user-focused revenue streams, targeted revenue streams that were much easier to provision and to generate revenue from in the short term.

"The poster child for that is ICG," Acey said. hey went after managed modem lines like gangbusters, and discovered that that a tough business to scale. They aggressively went after that business at the expense of proper provisioning and scaling that business in a manageable fashion.

hey fell on their face,?Acey added. hen the network began to fall apart, their customers defected.?

Another example, Acey said, is Teligent, which had scaling difficulties due to the nature of its technology.

n pursuing point-to-point so aggressively, they discovered that it was a tough service to provision,?Acey said.

The firm had trouble with such things as antenna installation on rooftops and the expense of truck rolls early in its business plan.

DSL carriers, such as NorthPoint, Rhythms and Covad, have had difficulties because of the wholesale nature of their business plans, Acey said.

For one thing, the DSL providers were, in a sense, wholesale providers of a service they had to purchase wholesale from the RBOCs. In addition, the firms were not directly connected to their customers.

hey depend on other carriers for the foundation of their business plan,?Acey said. hat a dangerous thing to do.?

The reliance on a single technology was also a factor, he said.

ou are, by definition, a one-trick pony,?he said. ou only sell one service, and when you do that, you can only compete on price.?

The separation from the end-user, combined with the single-technology track led to other problems, Acey said, such as a lack of customer loyalty and a lack of diversification in services.

A multiple-technology provider, since it offers more than one service, has a better ability to retain that customer if it can compete in terms of price on one of those services. That model also offers financial advantages.

he capability to improve margin increase,?Acey said. our networking costs and your SG&A costs can both be amortized over a larger base of revenues per customer.?

And when a company is supplying directly to the end-user, the BB&T analyst said, it lowers their exposure if a single customer leaves. If a single Internet user leaves an ISP that supplies DSL, that perhaps $40 to $50 a month in lost revenue, out of perhaps hundreds of thousands of users that pay the same fee. If a single customer of a wholesale provider leaves, that provider can lose a large portion of its income in a single action.

Among the DSL providers, Covad has been particularly aggressive in bringing end-users of its non-paying ISP customers directly onto its network, connecting itself with more end-users more directly. But Acey indicated that the effort would not likely be enough to turn the firm around, in part because the effort comes so late.

TO CASH FLOW OR NOT TO CASH FLOW ?THAT IS THE QUESTION

Another financial factor pointed to by several analysts as a problem is the industry's reliance on EBITDA as an indicator of success.

NPRG's Clausen stressed that the success of any company should be determined by profitability or actual cash-flow positive, "not this nonsense of EBITDA positive, or worse, adjusted-EBITDA positive."

The figure has little basis as an indicator of a firm's ability to continue as a going concern, he indicated.

"If you approach this from a personal perspective, if you think about what EBITDA is, earnings before interest, taxes, depreciation and amortization, it's not cash-flow positive, it's not what you have in your pocket at the end of the day," Clausen said. "You're still running negative cash flow.

"Imagine if you couldn't cover the interest portion of your mortgage," he said. "I'm EBITDA positive; I bring home enough money to pay for the food and the gasoline and to clothe the kids, but gee, I can't make my interest payment, I can't make my tax payment. Well, you're filing for bankruptcy."

The CLEC industry, he said, has been somewhat crafty in moving investors' attention to the EBITDA figure, by convincing them that the CLEC segment is somehow different from other industries, and that they EBITDA figure accurately reflects success.

"If EBITDA moving toward EBITDA positive didn't work, then we'll just add adjusted, and adjusted can mean anything," he said.

The basis for the adherence to EBITDA was the whole belief in the "new economy," that the new entrants were in a sense different, just as the new economy was different, and that called for a different financial measurement.

Now, in the wake of the segment's problems, more industry officials and experts are calling for a focus on cash flow.

"Becoming EBITDA positive is an important step," Clausen said, "but let's not lose sight of the fact that it's not the end."

BUT WHAT ABOUT THE GUYS WHO ARE DOING WELL?

A great deal of newsprint ?or the virtual equivalent ?has been consumed discussing "the demise of the CLEC sector" or "what went wrong with the CLECs" and so on.

And while stock prices in the sector have shown massive drops since last year ?some down to as little as 10 percent of their peak price ?other numbers don't seem to reflect an industry on the outs.

The CLEC.com directory currently lists 244 active, facilities-based CLECs in the United States and Canada. A year ago, before the crisis entered its heavy phase, the listing had fewer than 200 entries.

Fewer than a dozen and a half facilities-based CLECs have declared Chapter 11 in the past 12 months, less than 8 percent of the firms in the industry.

So why has the series of failures generated so much press? In part because some of the firms that have failed generated so much press as the sector was on the rise ?the publicly traded CLECs.

"That's what people don't understand," Brill Capital's Beck said. "The CLECs that get attention are the ones that are publicly traded. So they look at that and say this industry's going to hell."

Acey agreed.

"The bankruptcies we've seen so far, they represent the highly visible segment of the market and the majority of the competitive space," he said. "There are some fairly sizable private companies out there that we haven't heard from. But for the most part, the publicly traded carriers represent the vast majority of the competitive-telecom space, at least at the local loop."

Many of the other carriers, Acey said, are smaller, privately held regional carriers that he believes will never likely become a significant force in the market. But many of those smaller firms will continue to function, Acey said, especially as telecom becomes more of a packet-based market, which requires less investment than traditional class 5 equipment and enables smaller firms to gain some market share.

In addition, Beck said that a large number of CLECs were "in the pipeline," and that the industry is actually expanding, not contracting. Many of the new entrants he sees are in new segments, including Ethernet carriers such as Yipes. Those carriers are pulling in hundreds of millions of dollars in new investments, Beck said.

However, Acey said some of the smaller CLECs and specialty firms would not likely survive in the long term, and their passing, because of their small size and small market share, is not likely to be noticed as much as the current series of big-headline firms.

SURVIVORS

Several firms are frequently mentioned when industry experts talk about survivors.

Allegiance, invariably, leads the list. But others that crop up include Time Warner Telecom, McLeodUSA and XO Communications.

Few find fault with Allegiance. But there are others in the top bracket that garner some concern. Acey said that among those firms frequently mentioned as survivors, XO is the one that is perhaps the shakiest.

"I think they've got some real issues to get beyond," Acey said.

"XO operationally is a good company; the problem is their balance sheet is out of whack," Brill Capital's Beck said. "They're a company that if they had money, they would go like gangbusters, and rightfully so."

XO has a very experienced leadership, and the firm has diversified into new technologies, such as LMDS, NPRG's Clausen said. But the firm is weighted down by debt. It has to make hundreds of millions of dollars in interest payments each year on that debt.

"If they can restructure that, handle that, they'll be in a good position," Clausen said.

Time Warner is another strong contender to survive and thrive, Acey said, but the firm also has some sore spots. It still depends, he said, on income from other carriers for a considerable portion of its revenue, especially in the area of special access for interexchange carriers.

However, Acey said, the firm does have a good management team, the company is fully funded and ?unlike most in the sector ?has profits.

McLeodUSA also has a strong management and funding picture, he said.

The same principals that apply to firms that have fallen apply to those who are successful, Acey said.

f you look at Allegiance, theye got a very attractive balance sheet, it not too highly leveraged, theye got a revenue base that end-user focused and theye pre-funded their business plan,?he said. hose are the three keys to survival. And the key to success is actually putting up good numbers and execution.? THERE'S SMART, AND THEN THERE'S SMART

Clausen said that the CLECs that are surviving, and even doing well, include the so-called "smart-build" CLECs, especially niche players that focus on particular market segments.

He cited the ever-present Allegiance, focused on small and mid-sized businesses; Chicago-based Focal, which centered on the Internet market; and Fairport, N.Y.-based PaeTec Communications, which Clausen called "an exceptionally well-run company." PaeTec focuses on the hotel and hospital industries.

The smart-build philosophy, he said, helps the CLECs develop a strong customer base and contributes to controlling capital expenditures.

But industry observers are not in complete agreement on the viability of the smart-build model.

Beck said that he sees the smart-build model as a source of trouble and as the CLEC sector with the most bankruptcy trouble.

"There's a big chunk of bankruptcies where the carrier's are going down because there's so much skepticism about the model," Brill's Beck said.

"In principal, the model works really well, but virtually everyone has been having problems with it," Beck said.

Beck said that principal especially applies among the large DSL providers, which, although they are primarily wholesalers, he still places in the smart-build category, since they rely on the ILECs' loops for last-mile access.

He points to Rhythms, Covad and NorthPoint ?all firms that have seen their share of financial difficulties ?but also to DSL and VoDSL providers such as Mpower, which he said have the additional challenge of executing a difficult technological model.

Beck sees end-to-end network business models ?especially those that use fiber to the premises ?as the most likely to survive in the long term.

"The stock prices of all these companies are down, but the bottom line is that the fiber guys will survive," Beck said, "if they can get adequate funding."

However, he does see some smart-build firms surviving. And the key to success is partly internal, involving both the voice network and OSS. Beck, like other analysts, points to the Allegiance model.

"That model doesn't seem to work very well unless you have a very good back office, like Allegiance, for example," Beck said.

Successful electronic bonding is a big part of the back-office formula, he said. Mpower, he pointed out, announced it had completed bonding with Ameritech and Pacific Bell in September 2000, while the firm has been public for nearly three years.

In addition, Beck said that Allegiance has concentrated on traditional T1 services rather than basing all of its services for businesses on DSL technologies.

"Allegiance probably has a higher cost structure on paper than a DSL provider, because the T1 equipment it puts in a Bell central office is more expensive and consumes more power and takes more space," he said. "The bottom line is it's a 25-year-old mature technology. It's much more reliable, it's built to handle voice, it doesn't go down as frequently and the Bells will generally service T1s more expeditiously than they will DSL circuit, and that includes their competitors."

T1s also eliminate distance limitations, as long as repeaters are used, Beck said, which means it can reach a larger number of customers than DSL can from a single collocation.

"If you can get a much bigger addressable market per colo, then your economics look better," he said. "And if you don't have the reliability stigma of DSL, then you're much more likely to get a customer to say yes."

One of the trends Beck ?and other analysts ?sees ahead for those firms like Allegiance that are expected to survive is an industry consolidation, with the emergence of "super CLECs," carriers made up of the networks of several smaller carriers, or local and regional carriers moving to a national scale.

Jun 1, 2001

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