Recently there have been some rumors about the possibility of AT&T and Verizon merging. While we think that both companies would probably like to see this happen, there is virtually no chance that the US government would permit it – at this time. Here’s why. 

Reestablishment of the Monopoly – A Brief History Of Telecommunications 

The biggest problem with the idea that AT&T might merge with Verizon Communications is that it would essentially reestablish the merged company as the dominant telecommunications company in the US. 

Allowing the two companies to merge would essentially “undo” the breakup of AT&T as a monopoly in 1982.

At the time, the breakup of AT&T was designed to create more competition in the long distance market.  This might be hard to believe today, but at the beginning of the 1980s, long distance service was the “crown jewel” of the telecommunications industry. 

Local service was, in fact, subsidized by long distance revenues, at rates set by regulators. 

The idea was that local service was something that everyone should be able to afford, and therefore regulators offset the cost of local service by overcharging for long distance, which was viewed as a luxury and primarily used by businesses. 

The breakup created the Regional Bell Operating Companies (RBOCs), which were initially limited to providing local services only. 

This left AT&T as a long distance only provider (as well as other business oriented private line services) and a computer vendor. 

AT&T completely failed in the computer business, although such an outcome was virtually impossible to see at the time, even though IBM had just introduced the PC. No one could have predicted how the PC would transform the telecommunications industry, although that is what happened, once the internet became possible just 12 years later. 

The Telecommunications Act Of 1996

The Telecommunications Act of 1996 was designed to encourage competition for local phone service to compete with the RBOCs. 

The Act required the RBOCs to provide access to their telecommunications network to anyone who wanted to offer services to local customers. 

The RBOCs were required to “lease” access to their existing systems at low, regulated rates. Competitors were also allowed to place their own equipment in the central offices of the RBOCs. 

The tradeoff provided to the RBOCs, almost as an incentive to open up their systems to competitors, was that they would be allowed to begin offering long distance service, once they had proven they had allowed competition for local phone service to emerge. 

The irony of this situation is that most of the competitive companies that actually began using the legislated access to the infrastructure is that most of those competitive companies never reached profitability – yet their existence was used by the RBOCs to show compliance –and therefore be allowed to provide long distance service. 

(We wrote about this ironic outcome of the Telecommunications Act of 1996 in a column entitled “The Unintended Outcome of the Telecom Act of 1996” from July 30, 2001.)

The Telecommunications Act of 1996 wound up being the technology equivalent of the Oklahoma Land Rush.  Venture capital flowed into new telecommunications companies at an astonishing rate – most of which would eventually be lost in the Internet Bubble Crash of 2000. 

Once the RBOCs gained the ability to provide long distance service, they became “single source” vendors of telecommunications services. 

The “single source” vendor concept has been the secret to the telecommunications industry, as the vendor that can provide all of today’s telecommunications services over a single network has an incredible advantage of efficiency and product integration. 

(We wrote about the “single source vendor” concept a long term competitive advantage in a column entitled “The RBOCs Will Inherit The Earth – Verizon” on May 18, 2002.) 

Both of predictions in the two articles mentioned above have proven to be true – and the trends on which those predictions were made are still true. 

There are only two significant RBOCs left – Verizon and AT&T (which began as SBC, an original RBOC that acquired its original parent company, AT&T).  The only other remaining RBOC, CenturyLink, began as a competitive company that eventually acquired Qwest, an original RBOC). 

If Verizon and AT&T were allowed to merge, a strong argument could be made that all of the legislative efforts to create competitive telecommunication services in the past 35 years were simply unsuccessful. 

The argument that Verizon and AT&T face significant competition from cable companies is an extremely weak one, in our view. 

The Diminishing Threat From Cable 

The cable companies are often cited as the primary competitors for Verizon and AT&T, especially since both now offer television services essentially the same as most cable companies. 

This argument was particularly strong during the 2000s, as the cable companies began to invest in improving their internet services. 

Certainly cable companies today offer competitive “triple-play” packages that include internet, line based voice, and television services over a single delivery system to the customer. 

However, while the cable companies were investing in improved bandwidth, they were still utilizing the existing cable networks, which had been first installed in the 1980s. There are no design features of the cable networks that allow for greatly enhanced services over the next 20 years, as the need to redesign the system in the 2000s only underscores. 

Verizon, on the other hand, was investing the FiOS fiber optic based system, which currently is using only 10% of its data delivery capacity. 

In addition, each FiOS customer has a direct line to the central office of the network, which means that each individual customer suffers no bandwidth loss when neighbors are also accessing the system. 

This is not true of the cable networks, which still operate on a “headend” design system. 

The headend system connects all of the users in a specific neighborhood to a single multiplexing box which then routes the data to the general internet (for internet service) or to the cable provider network (for television service). 

Although the headend system is completely digital and is continually being advanced, the system still suffers from the fact the a single resource must be shared by all of the users of the particular headend. This means that bandwidth is decreased when it is shared with other users. 

The biggest disadvantage suffered by the cable companies, however, is the fact that they have no cellular phone customers. 

The Cellular Phone Segment 

Although some cable companies have partnered with cellular providers, such as Spring, the partnership is a purely marketing relationship. 

There is no provision of cellular service over the cable companies’ existing cable networks. 

This is going to be a strong disadvantage when cellular services begin to integrated into the existing telecommunication services already offered by Verizon and AT&T. 

We have been predicting the arrival of this “quadruple-play” service for several years, although it does not seem to be on the near horizon. 

When it arrives, however, and the cellular service functionality begins to be fully integrated into the “triple-play” services, the cable companies will be unable to compete. 

At this point, there will be a slow and gradual erosion of the cable company base into the Verizon/AT&T customer base. 

The slow, but continual, migration of television and video services onto the internet – instead of delivery over a cable system – is yet another factor that is working against the cable companies. 

This point is underscored by the recent barrage of public relations pieces by the cable companies arguing that there is no need to start selling video services in an “a la carte” manner. 

An example of this is the recent furor over HBO Go, which HBO refuses to sell to anyone who is not already a subscriber through a cable service.  

HBO clearly recognizes that selling video services on an “a la carte” basis will begin to erode the entrenched customer base of the cable companies. While HBO could probably survive such a transition, their profit margins and prominence in the cable world would evaporate. 

There is no way that the cable companies can “fix” this competitive disadvantage of not having cellular customers.  It is simply too late. 

The acceleration of the cable company decline would be the first effect of a Verizon/AT&T merger, in our view. 

We therefore think it virtually impossible that such a merger would be approved. 

The Loss Of Jobs

The final argument on why such a merger would never be approved by the Justice Department is that the loss of jobs in a combined company would be enormous. 

In any merger, one of the benefits is spreading G&A costs over a larger customer base. There would undoubtedly be large layoffs in the merged company, as many employees would become redundant. 

In today’s political environment, this aspect of a potential merger would probably be enough – all by itself – to prevent the merger from being approved. 

Conclusion 

There is no doubt that both Verizon and AT&T would benefit from merging. It would make them the virtual giant in the telecommunications world – and probably allow them to erase the cable companies entirely in less than ten years. 

If that were to happen, the merged company would be more like the AT&T of old than AT&T itself was – since telephone service rates are no longer regulated.  

We think it is virtually impossible that such a merger would be approved – despite the hoopla this idea has been receiving in the mass media and at some investment houses. 

Nevertheless, we still think that Verizon Communications is perhaps the single best investment in the entire stock market – from a risk/reward standpoint. Their eventual dominance is likely even without a merger. 

Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com