CLEC: An Insider’s Look at the Rise and Fall of Competition in the Local Exchange Competition

Citation

Lehman, D. (2003), "CLEC: An Insider’s Look at the Rise and Fall of Competition in the Local Exchange Competition", info, Vol. 5 No. 1, pp. 79-81. https://doi.org/10.1108/info.2003.5.1.79.5

While there were some 300 competitive local exchange carriers (CLECs) with $87 billion in capitalization in the USA in 1999, these totals had dwindled to 200 firms with but $4 billion by 2002. CLEC investments are now valued at six cents on the dollar (Darby et al., 2002). So, it is timely to find this book by an industry insider, addressing the rise and fall of the CLEC industry in the USA. Readers looking for answers, however, will come away puzzled, at best. The book amply accounts for the difficulties faced, and mistakes made in the first six years after the Telecommunications Act of 1996 was passed. What the author does not explain, at least on the surface, is why investors threw so much money for so long at companies that did so many things wrong. Perhaps inadvertently, however, the book may provide insights – so first what the book does document and then what lies beneath the surface.

McDermott argues that CLECs made numerous strategic and operational mistakes. Fundamentally, they did not understand that the local exchange business was far more complex than the competitive access provider (CAP) market and inter‐exchange market (IXC) with which they were familiar. CLECs promised their investors that they would be EBITDA (earnings before income tax, depreciation, and amortization)‐positive within three years. Although they managed to build out their networks within this time frame, they failed to deliver an operational network with customers and support systems in place. Their business plans called for 15 percent market penetration by year three – a number that apparently appeared in numerous CLEC business plans covering the same cities. Under pressure from potential investors, CLECs overextended their business plans to too many cities. This forced them to decentralize operations with no support systems in place. The result was unauditable sales and billing practices. In fact, much service either never got billed, or the bill was never collected. McDermott even speculates that the CLECs’ three‐year goal could have been met, had the money billed been collected.

Resale of service was a major factor in the CLEC failure. CLECs failed to recognize that the profit margins were much smaller for resold services than for services sold using their own facilities. Salespeople offered excessive inducements to customers served via resale in order to meet revenue targets. Costs mushroomed as CLEC business plans were overextended geographically. The need for operational support systems was recognized too late and was inordinately expensive to provide, given that the CLECs had no systems in place and inadequate human capital to address the problems. In fact, many CLECs were keeping records by hand. Employee turnover was another constant problem. Training was inadequate and expertise was hard (and expensive) to come by. CLEC salespeople were totally unfamiliar with incumbent local exchange carrier (ILEC) services, so they did not know what they were selling nor how to request the ILEC services the customers required. Operations were decentralized with virtually no coordination across the multiple cities in which they operated. Billing was a disaster. DSL (digital subscriber line) service backfired when the ILEC facilities on which it depended were not forthcoming.

McDermott does not put all the blame on the CLECs and their investors. There is plenty of responsibility given to ILEC anti‐competitive practices, tactics of litigation, and regulatory ineffectiveness. The pressures from the investment community were unrealistic as well. In the end, the CLECs succeeded in building their networks on schedule but did not succeed in anything else.

The description of the local exchange business and its complexity are the book’s strengths. The book could serve as a primer on business basics – it describes the multiple systems that must be coordinated if a local exchange business is to be successful. What is missing is the explanation of how this could have happened. How could “very experienced investors” (p. 93) that asked questions that were “intelligent and pointed and required knowledgeable responses” have directed so much money to companies that were making so many fundamental mistakes? McDermott does not address this paradox.

The irony may be answered by looking beneath the surface of his text which lacks references or notes[1]. This could be excused as this is a narrative book rather than an academic treatise. But some of the material cries for substantiation. For example, on p. 201, McDermott states, without support, that “[C]ustomers would pay $79.00 per month for ADSL rather than $39.00 per month if they could just get it.” This contrasts sharply with published analyses of broadband deployment[2]. Is this the type of “analysis” that CLECs conducted when formulating their business plans?

McDermott repeatedly cites the CLEC industry as having $44 billion in revenue in the year 2000 (pp. 146, 174, 279, 305, 306). Strangely, on p. 161, however, the revenues are cited as just $4 billion. A typo? It turns out that neither figure is close to correct. The FCC reports total CLEC industry revenues in 2000 as $8.5 billion from local service ($13.2 billion from all services) (Federal Communications Commission, 2000). Are order of magnitude differences in actual revenues relevant when dealing with an industry whose founders “see a vision, something that is bigger than themselves that they can help create” (p. 269) and who “were experienced risk‐takers who viewed the opening of the local exchange business to competition as surpassing the opportunities that they had had in developing both the long‐distance and CAP businesses” (p. 270)? When no facts or evidence are required, is it surprising that so many mistakes are made?

McDermott faults the CLECs for investing too much in obsolete technology (voice switches). He is talking about disruptive technologies when (p. 74) he cites the work of Joseph Schumpeter:

Back in the 1970s Joseph Schumpter [sic] called this the creative destruction of technology. He was referring to the VHS format eliminating the more elegant Beta format for videocassette recorders, but it also applies to the problem that SONET/ATM will be faced with from IP technology.

In fact, of course, Schumpeter died in 1950, long before the Beta/VHS wars. The misspelling of the name may be viewed as a simple mistake, but I believe it signifies deeper issues. A simple Internet search for “Schumpter” reveals numerous references to the misspelled name. Many of these are simple misprints – as evidenced by the correct spelling elsewhere in the document[3]. Other references to “Schumpter” are not so innocent[4]. I am suggesting that McDermott’s error was not the result of ignorance of the facts – it reveals a deeper and more pernicious problem. The Internet, responsible for much of the dot.com frenzy and irrational exuberance of investors, is a particularly bad information medium.

The problems of the CLEC industry are not unrelated to this property of the Internet to facilitate the spread of inaccurate information. After all, it was inaccurate statements like “Internet traffic is doubling every three to four months” that contributed to the fall of Worldcom (see, for example, Sevcik (1999)). The euphoria about how the Internet would change everything may have helped sustain unrealistic expectations about CLEC prospects. In that sense McDermott’s failure to document or authenticate may be viewed as a continuation of these problems. In turn, this may help explain why so much money was thrown at firms that made so many fundamental business errors.

This leads me to the book’s conclusions, which suggest a rosy future for the CLECs now that they have learned their painful mistakes. Among these is the statement (p. 300) “If the CLEC can manage a data network, they could just as easily manage and maintain server farms for Web‐hosting and other applications. It’s not that they can’t, it’s that they haven’t.” This is but one of the factors that lead McDermott to proclaim “Once again, opportunity is beginning to beckon” (p. 324). Yet his book leaves me wondering if anything is really different now. The appeal is still based on belief, not evidence. In that sense the book CLEC is a lot like investing in a CLEC’s stock, but with far more limited downside risks. If the past failure of the CLEC industry is to be understood, then much research remains to be done to disentangle the various contributing factors to seemingly irrational investor behavior:

• •

  To what extent were investors truly irrational?

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  Did regulatory behavior contribute to the belief that CLECs were guaranteed success?

• •

  Did regulatory behavior contribute to the strategy selection of the CLECs (e.g. by affecting the relative prices of facilities‐based and resale‐based entry)?

• •

  Did the overall market collapse make it impossible to distinguish CLECs with “better” or “worse” business plans and operations?

Answers to these and related questions may have profound effects on investors and policy‐makers. While providing a first‐hand detailed description of industry behavior, the book may be more indicative of the problem than of the solution.

Notes

1. 1.

   It could also have been cut in half with editing. What one review (www.isp‐planet.com/cplanet/business/08August2002/clec_book.html) calls its “conversational style” actually reads as if it was dictated into a recorder and put on to paper without editing. Ideas are repeated numerous times and the 25 chapters often cover the same ground.

2. 2.

   For example, the US Department of Commerce (2002, p. 14) reports that “Many consumers fail to see the value proposition for investing in broadband, considering it a luxury they cannot afford or not yet worth the $45‐$55 per month investment”.

3. 3.

   For example, in a speech by Dr Joseph Bordogna, Deputy Director, Chief Operating Officer, National Science Foundation, in a Brookings Institution Seminar on Science and Technology Policy, 12 June 2000.

4. 4.

   For example, see “Creative destruction” at charlestonsc.hiringnetwork.com/common/article18.html, available at: www.ecommerce‐now.com/images/ecommerce‐now/Austrians.htm, or “Entrepreneurship, personality tests and small business,” by Dale Krueger, Missouri Western State College (found at a University of Central Arkansas site). Interestingly, the misspelling also appears in the “Draft Text for the FCC’s Strategic Plan, 2003‐2008” found on an Australian government site. The mistake was apparently subsequently corrected before being put on the FCC Web site.