By Cody Willard
From RealMoney.com
01/08/2003

In its first review of the Telecom Act of 1996 under Michael Powell's chairmanship, the Federal Communications Commission will make far-reaching changes to the telecom services landscape in the next few months.

Let's back up a bit. Under the guise of enabling competition, the Telecom Act forced the incumbent local exchange carriers, such as Verizon (VZ) and BellSouth (BLS), to open up their networks to competitors. In return, the ILECs would be granted permission to enter the long-distance business. To make a long story short, the Telecom Act has resulted in disaster, as competitive local exchange carriers and the telecom industry in general got drastically overbuilt and subsequently collapsed.

I suppose we should be thankful that the FCC is stepping in now, considering how much destruction this legislation has wrought on our economy. However, I doubt that any of the commission's changes, while certainly significant, will reverse the general industry trends or drastically change a sensible investment approach to the telecom world.

Competitive Shift

The "big change" that's got everyone buzzing is that the FCC is no longer going to force the ILECs to allow competitors to grow their business using the ILECs' switches. If the competitors want to offer local services, they'll have to buy their own switches to route telephone calls for their customers rather than simply leasing a port and the ILECs' switch.

For many carriers, such as Allegiance (ALGX) and AT&T (T), that built their own networks with switches (mainly of the Class 5 variety) bought from the likes of Nortel (NT) and Lucent (LU), nothing much will change. At this point, the ILECs will still have to allow competitors to use their local loop connection, that physical copper connection between you and the telephone central office where the switches are housed. Therefore, much of the competitive landscape will remain the same, though most carriers will have some holes in their networks, as they don't have switches everywhere they're offering services.

The FCC is also likely to rule that Internet broadband connections like DSL will now be considered "information services," not "communication services." That will level the playing field between the ILECs, which have thus far had to allow competitors to resell their DSL, and the cable companies, which don't have to share their cable broadband networks.

The Trouble With Spending

According to the ILECs and many market pundits, these changes would conceivably spur corporate spending. Because ILECs would no longer have to allow competitors to piggyback, they could start investing in new switches and technologies. Sure, they'll be more aggressive in buying new technologies and equipment that enables DSL, but the bad news is twofold.

First, we've already seen SBC (SBC) and Verizon get more aggressive about spending on these technologies, and it just isn't going to have a meaningful enough impact on capital expenditures, as least not for most equipment vendors. Let's be very clear: We'll never see spending at the levels we saw in 1999 and 2000, when anyone who wanted to start a telco instantly had billions to spend on equipment. Much of the increased spending is already happening, and last year, that emerging trend prompted me to forecast stabilizing gross capex in late 2002.

Second, the beneficiaries of this trend will be select. The regional Bell operating companies simply won't be buying equipment from startups or unproven vendors. I think the biggest winners could be Advanced Fibre (AFCI), Alcatel (ALA) and Tellabs (TLAB), which are all pretty well entrenched with the ILECs and offer appealing new technology products.

I don't expect Lucent and Nortel, which are the most well-entrenched and are likely finally seeing some stabilization of demand from their customers, to see much pickup in Class 5 demand, as an absolutely terrible glut of those switches already exists. Further, the RBOCs will still actually lose lines to CLECs and wireless, as CLECs will still be selling services and consumers will still substitute their phone lines with their wireless phones.

The upshot is that the ILECs and the cable companies will still be the only ones to thrive. The FCC rulings aren't really news; the popular press has simply picked up the story. I've told readers many times that these FCC changes were coming, in fact, since as far back as last March.

I like Advanced Fibre (and have recommended it to my newsletter subscribers at lower levels partly for these reasons) and Tellabs because of their clean balance sheets and good customer bases. I'm tempted to buy at least Advanced Fibre to get some exposure to this trend, even if it is mainly a function of Wall Street and media hype.