1 BERNSTEIN RESEARCH Fiber: Revolutionizing the Bells Telecom Networks A Joint Bernstein Research-Telcordia Technologies Study With competition poised to re-intensify in their core wireline businesses, the Bells are facing a degree of earnings stagnation over the next five years never before experienced in their 20-year histories; short of adopting a harvest strategy, the only other reasonable approach appears to be a revolution in network design and business management We believe that fiber-to-the-premise (or FTTP, for short) can lead to this kind of transformation; it is often dismissed by those that contend such an investment can t be justified by the revenue opportunities from the new services it supports missing the point that FTTP s true opportunity lies in the ability to dramatically reduce the RBOCs costs If started in 2005, an FTTP network connecting more than 30 million customers would cost the three largest Bells about $45 billion to build, but would deliver $9-$10 billion in incremental EBITDA by 2008 and would pay back the initial investment in six or seven years; even though an aggressive FTTP build is likely the right strategic move for the Bells, investors are likely to punish them for it, due to its negative near-term impact on free cash flow Among the RBOCs, Verizon is the most likely to pursue a fiber build of the degree envisioned; SBC and BellSouth are more likely to opt for an intermediate, fiber-to-the-neighborhood strategy, attempting to leverage existing partnerships to deliver bundled consumer services, while not directly addressing the approaching earnings challenge MAY 2004 SEE THE LAST TWO PAGES OF THIS REPORT FOR ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES
2 Background and Acknowledgements Motivations As it was becoming increasingly apparent that the RBOCs earnings growth over the next two years would be more dependent on cost-cutting than a recovery in the top line, we undertook an analysis to better understand the nature of the cost structures of the Regional Bells. To do this, we enlisted help from Telcordia Technologies, formerly Bell Communications Research or Bellcore. Prior to its sale to SAIC in 1997, Bellcore was the shared research and development resource of the Regional Bells, in much the same way that Bell Labs was for AT&T. However, unlike Bell Labs, Bellcore continued to provide financial analysis support for the Bells, analyzing service costs and providing activity-based cost analysis. The research took an important turn as we dug deeper into the cost structures of the Bells. Rather than evolving into a study about which RBOC has delivered best-in-class cost management versus its peers and the financial opportunity available if the laggards could catch up, the study became a what-if analysis to quantify the opportunity for the Bells if they transformed their operating expense-heavy cost structures through a broad deployment of FTTP. In the collaborative work summarized in this report, we worked with members of one of Telcordia s strategy and business analysis teams to dissect the RBOCs reported cost data. As part of this effort, we leveraged Bernstein s and Telcordia s proprietary financial models as well as company-reported SEC/GAAP financials and FCC (ARMIS) data adjusted to normalize for differences in reporting standards. Acknowledgements Numerous individuals in both organizations contributed to this study and its distillation into this report. On the Bernstein side, we would like to acknowledge the support of Josh Harrington, Jeff Beard and Lauren Pastrich for helping shepherd the analysis and report through its many iterations. On the Telcordia side, we would like to thank Hank Broer, Gene Luciani and Steve Buczek for their help in analyzing the FCC ARMIS cost data and the different FTTP and FTTN scenarios. Telcordia Technologies is not a broker-dealer or investment advisor, and neither it nor its employees are associated persons of, or are otherwise affiliated with, Sanford C. Bernstein & Co., LLC or Sanford C. Bernstein Limited. Telcordia is providing this report for informational purposes, and not for use by any recipient whose principal use of this report is or will be for the purpose of making investment decisions in the securities of companies addressed directly or indirectly in this report. The report is a research and information tool that may reflect one or a limited number of perspectives that may not represent all or prevailing opinions; it is not meant as a specific guide to action; and it should not be relied on as a sole basis for decisionmaking. Telcordia has not analyzed, or otherwise opined upon, the securities of any company mentioned in the report or provided information reasonably sufficient upon which to make an investment decision. All forecasts of potential revenues, earnings and share losses, as well as the conclusions and supporting analyses, are solely the responsibility of Jeff Halpern and Bernstein. All information in this report is provided on an as is basis, and Telcordia expressly disclaims all warranties, express or implied, statutory or otherwise, including without limitation, any implied warranties of merchantability or fitness for a particular purpose, and warranties as to noninfringement, accuracy, completeness or adequacy of information. No communication of Telcordia or any of its employees, licensors or third-party information providers shall create any warranty. The report speaks as of the date of its preparation and publication, and Telcordia does not undertake to advise the reader of any change in the information or views contained therein.
3 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 1 Portfolio Manager s Summary The Regional Bell Operating Companies (RBOCs) are stuck between a rock and a hard place. On one side, they are faced with an intensifying competitive landscape for their wireline business a business that drives 65% of their current revenues and over 80% of their combined free cash flow. On the other side, they currently generate sufficient cash flow to fully fund a major network upgrade to their highest-value customers that would significantly improve their cost and service competitiveness. However, undertaking such a project with its less-than-certain returns would result in significant investor backlash. So what are Bell managers to do? Without an upgrade, the RBOCs are destined to be zero- to low-single-digit EPS growth companies for the next decade or longer. With it, their current multiples will certainly compress, at least in the near term. Fiber-to-the-premise (FTTP) is an option that we believe has been prematurely abandoned by both investors and company managements. The most common argument holds FTTP as unjustifiable due to the limited revenue opportunities it supports (generally believed to be only faster broadband connections and entertainment video). This mindset, in our opinion, misses the point that the majority of the financial justification for a broad and aggressive RBOC FTTP overbuild lies in its ability to upend and streamline the Bells management of their networks and business processes. We have dissected the cost structures and drivers of Verizon, SBC and BellSouth, and have concluded that deployment of an FTTP network connecting half of the Bells residential customers and 80% of small business customers in the 20 most populous states would enable cost-cuts amounting to $5.5 billion annually by 2008 and support cash flow associated with incremental revenues of an additional $4 billion. All told, a net investment of $45 billion in FTTP by the three Bells over the next four years would yield incremental EBITDA of $9-$10 billion, suggesting a payback of the investment by Financially justifiable as it may be, such an investment will not be popular with Bell investors. The RBOCs have a checkered history of delivering returns on large infrastructure projects. And while we readily admit numerous risks exist to the Bells achieving the forecast gains from the proposed FTTP build, we believe the upside is worth the risk. Among the Bells, Verizon appears furthest ahead in its commitment to a fiber future. SBC and BellSouth are expected to limit FTTP deployment to new developments (the greenfield approach) while holding out hope for a silver bullet perhaps from Washington and testing the waters on interim solutions like fiber-to-the-neighborhood. Regardless of current commitment, we believe the Bells are, at best, dead money for investors for the foreseeable future and rate all three market-perform. Bernstein: Jeff Halpern, Senior Research Analyst Telcordia: George Garceau, Managing Director Sammy Thomas, Senior Director May 20, 2004
4 2 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS
5 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 3 Table of Contents Significant Research Conclusions 11 The State of U.S. Telecom 19 A Dour Outlook for RBOC Earnings 35 Defining the RBOCs Wireline Cost-Management Problem 44 Evolution, Revolution or Something in Between? 53 Capital Requirements of an FTTP Network 59 Stimulating Revenue Growth: The Opportunity from FTTP 67 Savings, Savings and More Savings 75 Potential Constraints to Doing the Right Thing 85 Half-Way Strategies: Alternatives to FTTP Deployment 88 Can the Bells Afford to Do FTTP? Can They Afford Not to? 96
6 4 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS
7 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 5 Index of Exhibits 1 Financial Overview 10 2 RBOC Operating Income Drivers: E 12 3 Five-Year Average Market-Cap Weighted Relative Price-to-Forward Earnings of the Regional Bells 13 4 RBOC Expense Structure (2003) 13 5 RBOC Operating Expense Reduction Needed to Achieve 5% Average Annual EPS Growth 13 6 RBOCs Headcount Reductions: Cash Costs per RBOC Line in Service (Excl. Pension and OPEB Expenses) 15 8 Composition of Potential Incremental EBITDA from an FTTP Build 16 9 Cumulative FTTP Project Cash Flow: 2004E-08E Total U.S. Telecom Services: Revenue Growth Wireline vs. Wireless Industry Growth Total U.S. Telecom Services: Retail Revenues Telecom Industry Growth vs. Nominal GDP Growth ( ) Telecom Spending as Proportion of Household Spending Consumer Wireline Services as a Percentage of Total Telecom Industry (2003) Total Domestic Telecom Services: Revenue Growth Incremental Lines Lost to UNE-P/Resale Competitors (Net) Sequential Change in UNE-P/Resale Access Lines in Service (Net) Share of Consumer Losses to UNE vs. Cable Telephony and Other Facilities-Based Strategies Enterprise Business Market: Projected Growth RBOC Balance Sheet Comparison: Total Wireline Capital Spending: Level and vs. Sales Capital Spending-to-Revenue by RBOC Wireline Return on Investment Capital by RBOC Mix of Industry Revenues: Mix of Industry Revenues: Mix of Industry Revenues: 2008E Front-End Cyclical Exposure Business Line Competitive Mix 29
8 6 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 30 Consumer Line Competitive Mix Business Access Line Growth vs. Nominal GDP ( E) Long Distance Voice Revenues: Consumer and Enterprise Long Distance Wireline Retail Voice Price and Volume Trend Retail Long Distance Voice Volume Substitution Local Data Revenue Forecast Business-Dedicated Local Data Forecast Corporate Data and IP Forecast Wireless Revenue Growth vs. Penetration Wireless Industry Revenue Mix Shift Voice and Data ARPU Total Mobile Subscribers RBOC vs. Utility Index: Consensus Earnings Growth Expectation RBOC vs. Utility Implied Earnings Multiples: One-, Two- and Three-Year Forward P/Es Drivers of RBOC Top-Line Growth Wireline Revenue as a Percentage of Total Revenue Wireline Voice Revenues Share of Total Telecom Services by RBOC RBOC Cost Structure (2003) Wireline Expense as a Percentage of Total Expense Current Level of Employees as a Percentage of Year-End RBOC Wireline Cash Expenses (Excl. Pension, OPEB and Options) RBOCs Wireline Cash Expense per Access Line (Excl. Pension and OPEB) RBOCs Total Reported Access Lines in Service: E Drivers of RBOC Operating Profit Growth Verizon: Drivers of Long-Term Earnings SBC: Drivers of Long-Term Earnings BellSouth: Drivers of Long-Term Earnings RBOC Operating Expense Reduction Needed to Achieve 5% Average Annual EPS Growth Wireline Cash Expense as a Percentage of Total RBOC Operating Expenses Wireline Cash Expense as a Percentage of Total RBOC Operating Expenses Excl. Pension, OPEB, Options and Depreciation Three Major Categories of Wireline Cash Expense (2003) RBOC Cash Expense Detailed by Category (2003) 45
9 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 7 63 FCC ARMIS-Reported Expenses as a Percentage of GAAP Wireline Expenses Reported Total Access Lines Reported Access Line Growth Wireline Cash Expense by RBOC Growth in RBOC Wireline Cash Expenses by Category ( ) Adjusted Per-Line Wireline Cash Expense by RBOC Business Management Expenses: Verizon Business Management Expenses: SBC Business Management Expenses: BellSouth Customer Service Expense by RBOC Network Operations Cost Trends by RBOC Detailed Operations Expenses: Verizon Detailed Operations Expenses: SBC Detailed Operations Expenses: BellSouth RBOC Productivity Improvements: Employees and Access Lines per Employee RBOC Consumer Access Line Mix RBOC Operating Cost Breakdown RBOC Cash Expenses by Category Wireline Cash Expense per Line (Excl. Pension and OPEB) RBOC Wireline Cost Drivers Twenty States to Deploy FTTP in an Aggressive Scenario Residential and Small Business Customers Connected to FTTP: 2005E-08E Voice Lines Converted from Copper Network to FTTP Network FTTP Configuration Major FTTP Network Elements and Vendors Cost to Deploy FTTP: Average per Connected Customer and Total (2005E-08E) Distribution of Housing Units Across the 20 States Deploying FTTP Connected Customers in an Aggressive FTTP Rollout Scenario Additional Revenue Generated by Aggressive FTTP Rollout EBITDA Associated With New Revenues in an Aggressive FTTP Rollout FTTP Incremental Revenue by Source: 2008E FTTP Incremental EBITDA by Source: 2008E RBOC Penetration of Video Market With Aggressive FTTP Deployment 70
10 8 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 96 FTTP Video: Revenue, Expense and EBITDA 2008E FTTP Video: Revenue and EBITDA by RBOC 2008E Incremental FTTP High-Speed Data Revenue and EBITDA by RBOC: 2008E Incremental FTTP Retained Voice Revenue and EBITDA by RBOC: 2008E RBOC Staff Reductions: RBOC Staff Reductions as Percentage of the Levels at Beginning of Verizon: Operating Expense Excluding Pension, OPEB and D&A ( ) SBC: Operating Expense Excluding Pension, OPEB and D&A ( ) BellSouth: Operating Expense Excluding Pension, OPEB and D&A ( ) Simplified Residential Wireline Copper Network Schematic RBOC Wireline Field Operations Expense by Function FTTP Network Schematic Potential FTTP Expense Savings by Function vs. Legacy Copper Network Infrastructure FTTP Savings Function-Level Details Verizon New York: Annual Operating Expense per Line Current Network vs. With FTTP SBC Texas: Annual Operating Expense per Line Current Network vs. With FTTP BellSouth Florida: Annual Operating Expense per Line Current Network vs. With FTTP BellSouth: Operating Expense Savings by State in FTTP Deployment Scenario SBC: Operating Expense Savings by State in FTTP Deployment Scenario Verizon: Operating Expense Savings by State in FTTP Deployment Scenario FTTP vs. FTTN Architectures and Associated Hardware Costs Voice, Video and High-Speed Data Penetration Assumptions for a Hypothetical FTTN vs. FTTP Deployment in a 10-Million-Household Market Incremental Income Effects: FTTN Incremental Income Effects: FTTP Simulated EBITDA: FTTP 2008E Simulated EBITDA: FTTN 2008E Drivers of RBOC Operating Profit Growth: E 96
11 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS FTTP Build: Cumulative Cash Flow Breakeven Analysis RBOC Free-Cash-Flow Forecasts: Current vs. With FTTP RBOCs Five-Year Earnings Outlook: Current Forecast vs. With FTTP Verizon s Five-Year Earnings Outlook: Impact of FTTP SBC s Five-Year Earnings Outlook: Impact of FTTP BellSouth s Five-Year Earnings Outlook: Impact of FTTP Aggregate RBOC ROIC Outlook: Current Forecast vs. With FTTP ( E) Verizon s ROIC Outlook: Current Forecast vs. With FTTP ( E) SBC s ROIC Outlook: Current Forecast vs. With FTTP ( E) BellSouth s ROIC Outlook: Current Forecast vs. With FTTP ( E) 99
12 10 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS Exhibit 1 Financial Overview Qwest SBC Verizon BellSouth AT&T Price (May 19, 2004) $3.75 $24.41 $36.09 $25.12 $ Week Range $3-$5 $21-$28 $31-$41 $23-$31 $16-$23 YTD Relative Performance (11.1)% (4.3)% 5.0% (9.1)% (14.4)% Stock Rating O M M M M Revenue ($ million) 2003 $14,288 $50,069 $67,752 $26,364 $34, E 14,276 50,863 70,231 27,032 31, E 14,517 63,676 72,248 35,162 29, E 14,492 65,184 73,722 35,965 28, E 14,280 66,787 75,519 36,778 26, E 14,065 68,763 78,004 37,915 25,662 Five-Year CAGR ( E) (0.3)% 6.6% 2.9% 7.5% (5.8)% EBITDA ($ million) 2003 $3,749 $16,902 $27,430 $11,328 $8,831 Margin 26.2% 33.8% 40.5% 43.0% 25.6% 2004E $3,969 $17,028 $27,121 $10,942 $6,780 Margin 27.8% 33.5% 38.6% 40.5% 21.4% 2005E $4,674 $19,983 $27,189 $12,726 $6,054 Margin 32.2% 31.4% 37.6% 36.2% 20.5% 2006E $4,779 $21,226 $27,375 $13,586 $5,279 Margin 33.0% 32.6% 37.1% 37.8% 18.7% 2007E $4,642 $21,979 $27,511 $14,121 $4,558 Margin 32.5% 32.9% 36.4% 38.4% 17.0% 2008E $4,389 $22,260 $27,121 $14,404 $3,960 Margin 31.2% 32.4% 34.8% 38.0% 15.4% Five-Year CAGR ( E) (14.8) EPS ($) $(0.38) $1.55 $2.62 $1.95 $ E (0.45) E Consensus (0.49) E (0.03) E Consensus (0.23) E E E E Pct Change 18.4% (9.0)% (9.9)% (0.5)% (53.4)% Market Capitalization ($ million) $6,690 $80,846 $99,969 $46,070 $13, E Net Debt ($ million) 15,353 7,427 40,687 5,847 10,056 EV ($ million) 22,043 88, ,657 51,917 23, E EV/EBITDA 5.6x 5.2x 5.2x 4.7x 3.5x 2005E EV/EBITDA E P/E nm E P/FE nm BellSouth s 2003 EPS excludes Latin America. Source: Corporate reports and Bernstein estimates and analysis.
13 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 11 Significant Research Conclusions Wireline to the Rescue? (Not Wireless?) Most investors assume that a revival in the U.S. telecom industry s prospects are tied to only wireless services, because that segment promises the most upside in revenues. But the wireline side of the business, which generates most of the cash, also offers a way to invigorate the business. Specifically, we believe that the development of a new, fiber-based access network, replacing the copper wires, provides an opportunity for a revolutionary shift in the RBOCs business and operating models. Serving customers over a fiber-to-the-premise (FTTP) access network would enable the RBOCs to offer new services, thereby retaining existing subscribers, which would drive over $6.0 billion in incremental revenues and basis points of incremental growth by And it would facilitate the migration to an operating system requiring a significantly smaller labor force, leading to operating expense savings of over $5 billion. Admittedly, the costs of developing such a network are daunting. Achieving targeted cost reductions would require converting approximately 33 million residence and small business customers (50 million existing voice lines) from an access network based on copper wire to one based on FTTP by the end of At the same time, significant changes in operations processes have to be instituted. And the window of opportunity is small. A longer time period for the transition or a smaller deployment would not generate sufficient operations savings or market share in video and broadband access to support any reasonable earnings growth. We estimate the net capital expense of the FTTP deployment that we envision would be in the $40-$45 billion range, after factoring in the capital savings realized from not investing in the maintenance or evolutionary development of the legacy copper plant. Given the costs, a conversion to FTTP is currently an unpopular viewpoint with telecom managements and investors. However, we believe it is inevitable that the RBOCs will acknowledge the benefits of the conversion, and migrate towards this way of thinking given the numerous pressures facing their core businesses over the next half decade. And this could cause the market to rethink their earnings forecasts and valuations for the RBOCs. What If the RBOCs Don t Make a Revolutionary Change? Before we analyze the costs and benefits of FTTP, we need to put its upside in context of the status quo. Against the background of the overall telecom services industry forecast to grow only 2-3% annually (assuming price rationalization and consolidation do not materialize), we expect the RBOCs to essentially hold share. Thus, despite a strengthening economy, the RBOCs will grow revenues at only 2-3% annually over the next five years, after having posted mid- to high-single-digit top-line growth during the previous boom cycle. The main drag on the RBOCs top-line growth will come from a shrinking retail share of local consumer access lines, compounded by a slower wholesale recovery per retail line lost with Voice-Over-Internet-Protocol (VoIP) from competitive local exchange carriers (CLECs) and cable operators supplanting wholesale (UNE-P) as the platform of choice (see Exhibit 2). The threat from cable MSOs should not be taken lightly, as they are about to possess the ability to efficiently roll out competitive voice services.
14 12 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS And while some of this trend will be offset by continued growth in wireless, the relative size and cash-flow-generating capabilities of the local consumer access and wholesale units imply the RBOCs are doomed to flat to low-single-digit earnings growth, at best, for the foreseeable future. Exhibit 2 RBOC Operating Income Drivers: E $35 $9.0 $0.3 $32.4 $30 $29.6 $(0.4) $(0.1) $ Billion $25 $20 $(6.1) $ Operating Income Wireline Wireless International Directory Other 2008E Operating Income Source: Bernstein estimates and analysis. What Would Make the RBOCs More Interesting Investments? As companies whose stocks have historically traded at 77% relative forward earnings multiples to the S&P 500, the Bells will need to deliver earnings growth substantially better than the paltry revenue growth we expect, if they are ever to command multiples nearer to market parity than that seen over the past two to three years (see Exhibit 3). While the scaling of nascent businesses and the reduction in financing costs through debt reduction will help to offset the anticipated declines in core wireline revenues, transforming the historically high-cost local access networks will be of paramount importance to achieving earnings growth and making the Bells more nimble competitors. Wireline costs account for between 45% and 60% of the total expenses of the RBOCs including their proportionate wireless property ownerships, depreciation and nonoperating expenses like interest (see Exhibit 4). Looking at the hurdles facing the RBOCs over the next several years, we see continued local share loss to competitors; subscale (but improving) margins in DSL, enterprise and long distance; and higher depreciation expense as a result of network upgrades. Against our existing long-term revenue forecast, in order to put the magnitude of the challenge in context, the RBOCs must cumulatively wipe off $4.2 billion of total wireline operating expense from their income statements to deliver just 5% annual EPS and dividend growth (see Exhibit 5). And that view assumes that all excess equity free cash flow is plowed into debt reduction, driving financing costs down.
15 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 13 Exhibit 3 Five-Year Average Market-Cap Weighted Relative Price-to-Forward Earnings of the Regional Bells Exhibit 4 RBOC Expense Structure (2003) 1.00x 0.92x 0.84x 0.76x 0.68x 0.60x 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 43% 16% 3% 15% 4% 0% 18% 3% 5% 10% 0.52x May 1999 Nov 1999 May 2000 Nov 2000 May 2001 Nov 2001 May 2002 Nov 2002 May 2003 Nov 2003 Current Revenue Wireline OpEx Wireless OpEx Other OpEx Wireline D&A Wireless D&A Other D&A Operating Profit Non-Op. and Other Taxes Net Income Source: FactSet and Bernstein analysis. Source: Bernstein/Telcordia analysis. Exhibit 5 RBOC Operating Expense Reduction Needed to Achieve 5% Average Annual EPS Growth $1.8 Billion $0.7 Billion $1.7 Billion $6.2 Billion $6.4 Billion $4.2 Billion Verizon SBC BellSouth Baseline Net Income Expense Reduction Source: Bernstein analysis. An Evolutionary Approach to Cost-Cutting Just Won t Cut It Zero top-line growth and lower earnings expectations drove the Bells to shed 10% of their workforce during 2001, 10% during 2002 and 7% in 2003, eliminating a total of 164,000 employees over the past three years (see Exhibit 6). Nonetheless and not to belittle the impact such cuts have on the employees affected these reductions should be viewed in the context of the RBOCs needing to evolve into leaner, more competitive companies.
16 14 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS Exhibit 6 RBOCs Headcount Reductions: Thousands Verizon SBC BellSouth Source: Corporate reports. The cuts at SBC and Verizon, while certainly taken from some of the least-efficient businesses, reflect merger integration synergies from the combination of Bell Atlantic, Nynex and GTE into Verizon, and Southwestern Bell, PacTel, Nevada Bell, Ameritech and SNET into SBC as much as true operational improvements. Thus, even though the first round was painful, the analyses presented in this report show that it barely scratched the surface of what is necessary to insure the long-term attractiveness of the Bells to investors. Despite having cut 25% of their wireline labor force over the past three years, the RBOCs as a group have demonstrated remarkably poor ability to actually cut costs. Underlying this dichotomy are the facts that unit labor costs are increasing (due to labor agreements), while the workload did not decrease substantially and overtime made up for shortfalls in labor requirements. While access lines in service have been declining since 2000, cash costs per line (retail and wholesale) have been increasing over that time period, even when the extraordinary pension-related charges and other accruals are excluded (see Exhibit 7). Clearly, the old model for costcutting isn t working. Revolution vs. Evolution The RBOCs have two key options in attacking their core cost structures. One is evolutionary: attempt to manage as many cost pools as possible according to best-in-class metrics (in the service industry, not just telecom). The second is revolutionary: reengineer the underlying processes through an aggressive deployment of fiber deeper into the network. We believe the answer lies somewhere between the two options: overbuild approximately 50% of their existing network in the major metropolitan areas of the top 20 states with an FTTP solution, while evolving the cost structure towards best-in-class metrics in the remaining markets.
17 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 15 Exhibit 7 Cash Costs per RBOC Line in Service (Excl. Pension and OPEB Expenses) $360 $350 $340 $330 $320 $310 $ Source: Bernstein/Telcordia analysis. Even though the FTTP part of the answer might be considered heretical (particularly when advocated by a Wall Street sell-side analyst), we believe that the deployment of new, fiber-based access networks could revolutionize the RBOCs operating models and invigorate earnings growth. Serving customers over an FTTP access network would not only enable new services thereby facilitating the retention of existing subscribers and development of new revenue streams but also (and, as important) would facilitate labor force reductions and process reengineering that are unthinkable with the current copper and circuit-switched technologies at the core of the Bells networks today. Defining and Quantifying an FTTP Strategy Maximizing the financial benefits of an FTTP build would require migration of half of the Bells customers in five to seven years, a significantly faster deployment than the usual glacial approach to network upgrades. A longer time period for the transition would not generate sufficient operating savings to offset the Bells market share losses, while a smaller deployment would lack the scale to positively impact longer-term earnings growth. An FTTP build that would cover one-half of the RBOCs current consumer lines and 80% of small business access lines in the metropolitan and dense suburban areas of the top 20 states would cost $45-$50 billion but would generate nearly $10 billion in incremental annual EBITDA by the end of the five- to seven-year deployment period. Driving more than onehalf of the financial case are the achievable cost savings with such an aggressive, market-by-market deployment encompassing not only the building of an FTTP network, but also the retirement of elements of the old copper network.
18 16 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS Our analysis shows that such a scenario would enable the Bells where FTTP is deployed to cut some operational costs by 100% (for example, the central office installation), others by as much as 90% (facility assignment), and others by 30-70% (customer service and central office network care). High-speed data market share, video, and retention of otherwise lost voice subscribers would support the remainder of an FTTP business case (see Exhibit 8). Exhibit 8 Composition of Potential Incremental EBITDA from an FTTP Build Total Is About $9.5 Billion Video 13% OpEx Savings 57% High-Speed Data 20% Retained Voice 10% Source: Bernstein/Telcordia analysis. Killing the Balance Sheet Is Not a Necessary Evil of FTTP Exhibit 9 As important as the fact that such a revolutionary network upgrade can deliver a strong positive return on investment is the fact that the Bells can likely pay for it out of current free cash flow rather than through additional balance sheet leverage. The proposed FTTP build is expected to deliver cash-on-cash breakeven in as few as five years and full payback in seven years (assuming an 8% weighted-average cost of capital), which is much faster than the large infrastructure projects of the past. Driving the positive project economics is a combination of $7.2 billion in cumulative incremental revenue less programming and other direct costs, total cumulative operating expense savings of $10.7 billion, and cumulative reductions in copper investment totaling $2.7 billion. We estimate that the cumulative FTTP project cash flow in 2008 would be $27.1 billion (see Exhibit 9). Not to be overlooked is the fact that despite the magnitude of the proposed undertaking, we have intentionally staged the deployment to ensure that the Bells can continue to pay dividends (at current levels) and service their existing debt. Said differently, we have sized each year s deployment to optimize the cash flow expected from the legacy business without jeopardizing equity and debt holder payments. Cumulative FTTP Project Cash Flow: 2004E-08E ($ billion) FTTP Capital Investment $47.6 Reduced Copper Investment (2.7) Operations Expense Savings (10.7) Incremental Operating Profit (7.2) Cumulative Project Cash Flow $27.1 Source: Bernstein/Telcordia analysis.
19 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS 17 Life Is Never Simple: Constraints on a Full FTTP Rollout Unfortunately, there are four factors likely to impede or discourage the RBOCs from delivering the cost cuts we foresee from FTTP. The first and potentially most significant constraint is the Bells often contentious relationships with their highly unionized labor force. The second encompasses the ongoing regulatory disincentives to investment, which encourages competition through mitigated capital investment rather than RBOC investment through mitigated competitive access to new facilities. The third constraint is the asymmetric treatment of taxation, which puts the RBOCs at a disadvantage compared to cable and wireless. The final constraint is the management challenge of imposing revolutionary business changes on embedded processes. Interim Solutions Fall Far Short of Needed Benefits FTTP is not the only option the Bells have for attacking the cost structure issues or lack of a consumer video offering. Addressing the second deficiency first, they have already forged agreements (Verizon and BellSouth) or partnerships (SBC) with the direct broadcast satellite (DBS) providers that enable satellite offerings to be part of the Bells bundles. On the cost side, all of the Bells have turned to customer resource management (CRM) as a source of potential business transformation, focusing on e-enabling customers. However, both of these solutions fall far short of the potential financial impact possible from FTTP. Another option that is emerging is fiber-to-the-neighborhood (FTTN). We analyzed the economics of FTTN and came away disappointed. Assuming an FTTN deployment were to be undertaken for the same geographies identified as most important for FTTP and followed a deployment plan as aggressive as the one outlined, we estimate FTTN would require 5% of the capital outlined for FTTP (or $1.5 billion), would deliver 8% of the revenue benefits, but none of the cost savings. The FTTN strategy succeeds in conserving capital and cash flow, but it does not deliver material benefit to topline or earnings growth, in contrast to the FTTP strategy. Risks Risks to our estimates of the financial implications of a full-scale FTTP build come from our assumptions of the upside available from process reengineering, expense reductions and additional revenue from new services (such as video). If the companies were unable to fully realize these benefits potentially due to their own decision for a slower or smaller deployment than we have outlined, or due to the constraints identified above or consumer adoption of video services from the RBOCs proves to be less than expected, then the financial justification for FTTP could be called into question, and payback periods for the capital investment may be unreasonable. Our current forecast for the companies in our coverage includes a slow rollout of fiber, consistent with current RBOC strategy, rather than the revolutionary, full-scale, rapid deployment outlined in this report. Investment Conclusion Even though first-half 2004 has turned out to be a period of improving wireline fundamentals for the RBOCs (particularly SBC), we remain cautious about the group for the medium term. We are concerned about the 9-12 month sentimental/headline risk and the month financial impact on the RBOCs consumer voice market share from accelerating availability of cable telephony and other VoIP platforms. Longer term, we are much gloomier than the consensus about the magnitude of the likely line losses, and believe that the evidence of such losses will cause the Street s expectations to
20 18 FIBER: REVOLUTIONIZING THE BELLS TELECOM NETWORKS fall once again. We rate Verizon, SBC and BellSouth market-perform, with cash-flow-based target prices of $38 for Verizon, $28 for SBC and $31 for Bell- South. Looking longer term, we believe the case for an aggressive FTTP buildout by the Bells is sound from both the strategic and financial perspectives, but we also believe it will be met, at least initially, by investor derision. Verizon has already announced a $1 billion capital program around its version of FTTP, running fiber to one million homes in a Dallas, Texas suburb. As this study highlights, we would be supportive of a broader deployment across a defined geographic area by Verizon or any other RBOC assuming it engendered the cost-cutting intent outlined above. Thus, reinforcing our cautious view is the belief that the Bells are damned if they do, damned if they don t relative to fiber. Without FTTP, they will be disadvantaged in their response to cable s onslaught on both product and cost bases. With FTTP, they must spend tens of billions in capital to deploy against a still uncertain outcome. Neither option will be popular with investors accustomed to the Bells recent capital discipline and hope for improving returns on invested capital. Nonetheless, we believe FTTP is not only the right tactic for the Bells, but also a strategically and financially justifiable one.
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