Chapter 2

A BRIEF HISTORY OF THE TELECOM INDUSTRY

In 1915, the first transcontinental phone call was made from New York to San Francisco. Now, the globe is interconnected via various traditional, wireless, and Internet-based technologies. Innovation has been constant—sometimes faster, sometimes slower. And by understanding the past and how we arrived at the present, investors can have a better idea of where Telecom may be going.

This chapter briefly documents the early development of the Telecommunications sector in the United States and the regulation that transformed it.

THE EARLY YEARS

The history of telecommunications is ancient. And while we could begin with smoke signals, they didn’t present much of an investment opportunity. For our purposes, we’ll start with the telephone—the birth of the Telecom sector as we know it.

Alexander Graham Bell—Father of the Modern Telephone

Alexander Graham Bell is recognized with inventing the first practical telephone. (Less well known is that he had a deaf mother and wife and was a third-generation elocutionist who taught Helen Keller.) But it was a race to the finish line. Elisha Gray (an assistant to Thomas Edison) and Bell filed similar patents on the same day in 1876. Bell ultimately received the patent, though he was accused of stealing the telephone from Gray, and numerous lawsuits ensued. The accusations still fly to this day, but no matter—Bell subsequently created the Bell Telephone Company in 1877, which evolved into the American Telephone & Telegraph Company (AT&T) in 1885.

Initially, people were so familiar with and enamored by the telegraph, few realized the incredible impact the phone would have on global business and society. In fact, Western Union passed on buying Bell’s patents for a measly $100,000 (approximately $5 million in 2010 dollars)1 because it considered the phone a passing novelty.2 Even so, telephones didn’t pose a real risk for Western Union and the telegraph for about 20 years.

It wasn’t until 1893 that the Bell patents expired, which resulted in greater competition that was beneficial to consumers but bad for AT&T. During its 17 years of patent protection (1876–1893), AT&T was able to earn a 46 percent return on investments.3 But the patent expiration led to increased competition, and by 1906, the company was earning only 8 percent on investments.4

The story for consumers was the opposite. In 1893, there were only 270,0005 phones in the US and the average number of daily calls per 1,000 Americans was 37.6 However, in 1900—seven years after the Bell patents expired—the number of phones jumped to six million,7 and the average number of daily calls skyrocketed to 391 per 1,000 Americans.8

Despite the clear benefits of competition for consumers—more phones and more calls—the US government eventually passed legislation to protect AT&T from competition at the urging and persistence of telephone industrialist Theodore Vail.

One Policy, One System, Universal Service

In 1907, Theodore Vail was appointed president of AT&T and publicly pushed his vision of a single telephone system through an advertising campaign and slogan, “One Policy, One System, Universal Service.” At that time, the US government wanted more competition and was agitated when Vail began buying independent competitors and purchased telegraph giant Western Union, which gave AT&T a monopolistic position in both telegraph and telephones. In response, the government negotiated the Kingsbury Commitment with AT&T in 1913, in which AT&T agreed to divest Western Union, to provide long-distance services to independent local phone companies, and to refrain from acquisitions.

However, there was a loophole. Under the Commitment, AT&T was allowed to swap telephones with competitors. The result was AT&T and other operators swapped phones to create their own geographic monopolies and avoid price competition—contrary to the goal of the Commitment. The Commitment did reduce AT&T’s ability to put competitors out of business—but it also deterred competitors from focusing outside their regional monopolies and attempting to build a competitive long-distance network. Legislators had designed the Commitment to be pro-competitive, but there were unintended consequences aplenty, and it had the opposite effect (which typically happens when it comes to major regulation or legislation).

Instead of feeling threatened by AT&T’s monopolistic regional actions and the lack of competition in long-distance service, many legislators and regulators began to view a telephone monopoly as “natural”—likely due to Theodore Vail’s public relations efforts. They thought (rightly or wrongly) competition resulted in duplication of investment and was therefore economically inefficient. Ultimately, for Vail and AT&T, it was more advantageous to be a heavily regulated monopoly than face the high and uncertain risks posed by competition.

While heavy government regulation and intervention are typically significant headwinds for most businesses, AT&T fared just fine. Even during World War I, when AT&T was nationalized for a year for security reasons, prices weren’t capped and it was even allowed to initiate a 20 percent hike in long-distance rates—a hike that remained in place for years after its re-privatization. Moreover, it’s estimated AT&T retained approximately $42 million (84 percent) of the estimated $50 million ($723 million in 2010 dollars9) in rate increases approved by the government during nationalization. If that wasn’t enough, the government then paid AT&T $13 million ($188 million in 2010 dollars10) to cover any losses the company may have incurred during nationalization, even though none were evident.11

The Communications Act of 1934 and Telecom Stability

After its re-privatization in 1919, AT&T operated as a monopoly with little regulatory interruption until the New Deal, when President Franklin D. Roosevelt sought to consolidate the regulation of all communications into one agency. By signing the Communications Act of 1934, Roosevelt created the Federal Communications Commission (FCC), which replaced the Federal Radio Commission and the Interstate Commerce Commission. The FCC was given power to impose service requirements at regulated rates in the Telecommunications sector and to control licensing and radio spectrum allocations—which effectively allowed it to regulate who entered the market. But while the Communications Act was part of the historically significant New Deal, it changed little for AT&T and instead nurtured a stable regulatory environment that secured AT&T’s monopoly for decades.

The greater part of the twentieth century was relatively uneventful for the Telecom sector because AT&T dominated—it had approximately 90 percent of market share in long distance and local access lines. AT&T maximized its dominance and monopolistic powers by relying on its own Western Electric and Bell Laboratories subsidiaries. Almost all the equipment AT&T used was produced by Western Electric, and all its applied and theoretical research was conducted by its powerful Bell Laboratories, which has produced seven Nobel Prize winners and major inventions like the transistor.

Although regulators ostensibly aimed to protect citizens from monopolies, they also had incentive to protect AT&T because American businesses and society were dependent on its services. Nevertheless, antitrust lawsuits periodically flared up, and in 1949, the US Department of Justice (DOJ) claimed the Bell Operating Companies practiced illegal exclusion by buying production and premise equipment only from Western Electric. The DOJ sought a Western Electric divestment, but AT&T settled in 1956—retaining ownership of Western Electric and avoiding its breakup by agreeing not to enter the nascent computer market.

With little competition and no change to AT&T’s businesses, its performance was much like other regulated utilities, such as gas and electric companies. Until significant legislation in 1996, Telecom overall performed similarly to the Utilities sector. As illustrated in Figure 2.1, between 1962 and 1996, Telecom outperformed the Utilities sector by a paltry 6.5 percent—mere pennies over that time period—with a high correlation of 0.69.

Figure 2.1 Telecom Versus Utilities Performance—Before Act of 1996

Source: Global Financial Data, Inc.; total returns for S&P Telecommunications and S&P 500 Composite, 02/28/62 to 02/29/96.

RECENT HISTORY

It wasn’t until the latter part of the twentieth century that Telecom regulation, and subsequently the competitive landscape, changed significantly. As a result, Telecom’s and Utilities’ relative performance deviated too. In stark contrast to Figure 2.1, Figure 2.2 shows between 1996 and 2009, Utilities outperformed the Telecom sector by 40 percent, and the correlation between the two sectors dropped to 0.26. The dramatic difference was driven by a string of events that began with an antitrust suit in 1974.

Figure 2.2 Telecom Versus Utilities Performance—After Act of 1996

Source: Global Financial Data, Inc.; total returns for S&P Telecommunications and S&P 500 Composite, 02/29/96 to 10/31/09.

Ma Bell Has Septuplets

In 1974, the gig was up—both the DOJ and MCI (see the MCI Communications Corp. feature further on for more about MCI) filed antitrust suits against AT&T. AT&T dominated the local telephone network, which is needed to complete a long distance call, and it could favor its own long distance services over MCI’s. The government alleged AT&T restricted competition in the Telecommunications market and therefore sought divestment of AT&T’s long distance services and of its Western Electric unit—again. AT&T fought the case for years, but settled with the Federal District Court for the District of Columbia in 1982.

In 1984, the federal court-approved Modification of Final Judgment (MFJ) required AT&T (Ma Bell) to break up into eight pieces—seven Baby Bells and one AT&T. AT&T was the remaining long distance provider, plus Bell Labs research and its equipment businesses. The seven Baby Bells, or Regional Bell Operating Companies (RBOCs), were formed as a spin-off from AT&T’s pre-existing 22 Bell operating companies. Each RBOC was effectively a regulated mini-monopoly that provided local services and was prohibited from providing long distance services.

By creating a division between AT&T’s long distance and local networks, regulators succeeded in encouraging long distance competition, and consumers benefited. Between 1984 and 2000, AT&T’s long distance market share dropped from 90 percent to under 40 percent, and the cost of making a long distance call dropped 70 percent!13 After decades of little opposition and a stable regulatory environment, the Telecom sector (at least the long distance market) began to look more like a competitive market and less like a heavily regulated utility.

The Telecommunications Act of 1996

The 1984 breakup of Ma Bell was intended to increase competition in the equipment and long distance markets, and later, the Telecommunications Act of 1996 sought to further increase competition—but at the local level.

At the local level, carriers had been clamoring for ways to grow their businesses and had been petitioning Congress to be allowed into the long distance market. In 1996, their wishes came true—but with a catch: Local carriers were allowed to enter long distance only after they offered wholesale network access and network interconnection opportunities to new competitors.

ILECs and CLECs

The law detailed pricing formulas for both wholesale network access and interconnection services. Wholesale network prices charged by the Incumbent Local Exchange Carrier (ILEC) on the Competitive Local Exchange Carrier (CLEC) were set by the FCC at the federal level at cost plus a “reasonable profit.” Those prices were then used by Public Utility Commissions at the state level to set local rates. The interconnection fees were based on a “reciprocal compensation” that assumed the average customer’s calls would result in minimal net payments between carriers.

However, the regulated pricing wasn’t as successful at promoting local competition because the Ma Bell breakup affected long distance services. As with a lot of regulation, it didn’t have the impact initially sought. For many ILECs, the benefit of gaining access to the long distance market was less valuable than maintaining their regional monopolies, so they simply delayed opening their networks to competitors.

The Universal Service Fund

Universal service was initially promoted by Theodore Vail and the government as a rationale for AT&T’s monopoly—they argued it would create a consistent technology that would make national network connections feasible. Over time, “universal” came to mean quality and reasonably priced services for all citizens.

As a result, the Telecommunications Act of 1996 created the Universal Service Fund (USF) to subsidize the costs of providing telecommunication services to largely rural and low-income populations. The significance for the Telecom sector is that some Telecom firms (aka telcos) receive subsidies to provide services, while the majority pay a percentage of their revenues to finance the USF. However, because contribution rates depend on how much money the USF believes it needs, the amounts can vary and the impact on telcos is difficult to predict.

Dot-coms and Seven Becomes Three

Despite some ILECs’ unwillingness to open their networks to competitors, local and long distance competition increased in the late 1990s as investors started pouring money into the Telecom sector. CLECs and just about anything Telecom became hot investments because of recently lowered barriers to entry and because these companies were laying fiber optic cables—the backbone for the Internet economy. It was a brand-new world: Telecom was no longer a boring utility—it was finally sexy!

But it wouldn’t last—although Telecom capital expenditures (building and upgrading networks) have always been cyclical, the dot-com bubble represented a boom-and-bust cycle the historically regulated sector had never before experienced.

High-flying companies like WorldCom and Global Crossing had both loaded up on debt to fund their spending—and collapsed. Even a giant like AT&T lost more than 50 percent of its market value.

The Great Consolidation

Even before the Tech bust caused many Telecom firms to disappear, the Telecom sector began consolidating in the mid-1990s due to fierce competition. Telecom firms have consolidated through mergers and acquisitions, as shown in Figure 2.3. While deregulation sought to increase competition by lowering barriers to entry and increasing the number of entrants, the reality has been companies must consolidate to compete—just three of the original seven Baby Bells are left.

Figure 2.3 Sector Consolidation: Mid 1990s–2007

Chapter Recap

The past provides context for analyzing the present and attempting to predict the future. The sector transformed from an idea many considered a passing novelty to one of the world’s most important services. Despite the significant changes throughout the sector’s history, there are trends that may lend some insight into the sector’s future:

• For much of the last century, high costs to provide telecommunication services resulted in significant sector regulation and protectionism.
• However, as new technologies have driven telecommunication costs down, regulation has decreased and competition has increased, resulting in lower prices and more services for consumers.
• As a heavily regulated sector, Telecom behaved like the Utilities sector prior to the mid-1990s. But since then, deregulation, competition, and the Internet bubble (and burst) have caused Telecom’s performance to be more volatile and sensitive to the ups and downs of the economic cycle.