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DSL Business Case Report

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Building a Facilities-based Local Loop Infrastructure:

Retail & Wholesale Business Case for CLECs

^{Executive Summary}

Local Services market has emerged as the key battleground for carriers. With over $80B of service revenues (Source: New Paradigm Resources) at stake, it is no surprise that this battle will be heavily contested. With the passage of 1996 Telecommunications Reform Act, the FCC has mandated that RBOCs unbundle 14 different network elements and make them available to CLECs on a wholesale basis. Of these 14 elements, Unbundled Local Loop (ULL) is clearly the most strategic Unbundled Network Element (UNE) and is arguably a key determining factor for success of a Local Exchange Carrier.

For a LEC, access costs represent a huge portion – 55% - of the over-all service cost, with switching and transmission representing 23% and provisioning and other administrative costs representing the remaining 22% of the service costs (Source: Business Strategies). Hence, the LEC which can control the access, or local loop, costs associated with service delivery will be able to control the relative margins, and consequently profit margins associated with local services.

In this battle that is being waged in the local loop, Incumbent LECs, or ILECs, clearly have a distinct advantage since they own the local loop. They have been leveraging DSL technology – HDSL – for both retail and wholesale T1 services for a number of years. With the packaging of DSL and local loop and with investment in HDSL equipment, they have been able to turn a $22/month product into a T1 product, for which they charge anywhere from $200 to $800 per month. The T1 product is available to CLECs on a wholesale basis at 20%+ discounts from the ILECs. Hence, as long as CLECs continue leasing these T1 loops from the ILECs, they will be operating from a position of weakness in competing with the ILECs.

Ultimately, the battle is over control of the local loop. A pure local loop re-sale strategy does not afford a CLEC a sustainable and competitive advantage. However, controlling the local loop requires a CLEC to make investments in building the local loop infrastructure, which involves striking co-location agreements with ILECs and executing interconnection agreements to gain access to UNE in general, and ULL, in particular.

A lot of attention has been given to a genre of carriers known as Packet CLECs, which have built their entire business plan around building their own facilities-based network with ULLs. Northpoint, COVAD, Rhythms represent this new carrier market that is still in its infancy and less than 3 years into its inception. The P-CLECs are benefiting from the full import of the 1996 Telecom Reform Act, including taking advantage of ULLs. As a result, they have shown that the Local Loop Infrastructure they have built with ULL is quite strategic and extremely attractive to two segments of service providers: Inter-Exchange Carriers (IXCs), and Internet Service Providers (ISPs).

P-CLECs have struck partnership agreements with AT&T, MCI/Worldcom, NextLink, Qwest et al. This mix of established and new IXCs clearly recognized strategic assets that the P-CLECs possess: Co-location in C.O. and access to ULL. Together, these assets translate into dramatic local loop cost reduction and end-to-end service provisioning for these IXCs.

The second constituency, ISPs, potentially represents an even greater opportunity. Internet Access is a universal connectivity requirement for any business, large or small. Customers using dial-up and ISDN to connect to the Internet today are prime prospects for a higher-speed service. Again, the P-CLECs have identified the need for wholesale DSL access and have set out to build an ULL-based infrastructure to offer ISPs the ability to provide broadband Internet access over the same local loop that is providing dial-up or ISDN connectivity today.

Can you, a CLEC offering retail business services, also leverage opportunities arising from building a facilities-based DSL infrastructure? You bet. The model, however, is quite a bit different from that for a P-CLEC, who has set out to build its entire business on ULL. You can leverage the ULL for your Retail Business and then having built a DSL infrastructure, take advantage of the opportunity to launch a Wholesale business. The economics of this approach is so compelling that you’ll be hard-pressed to turn it down.

The business case for building a facilities-based DSL Local Loop infrastructure to support Retail data services can be quite compelling. As we will show you, a CLEC can realize an Internal Rate of Return (IRR) of 69% over a 3-year period. Now, that got your attention, didn’t it? Well, that is only the beginning. What if we told you that you are looking at a NPV of $15.8M for a retail business covering about 5000 lines? The business model we are about to present you is, indeed, quite attractive when you look at the standard business metrics, including EBITDA, IRR, NPV, Free cash-flow, break-even point or any other metric you might consider in assessing a telecommunications service business.

When you further look at the strategic assets you’ll own – co-location, ULL, Network Operations Center (NOC), Switching and Transmission equipment, etc. - you will quickly realize that you have all the elements to launch a wholesale business; this presents an even more attractive return on your investment. At an IRR of 84% and an NPV of $9.9M, it is an extremely compelling business opportunity. The wholesale business opportunity will also allow you to ride the coat-tails of the Internet juggernaut and participate in build-out of the next generation public IP network. With an already established and mature channel, i.e., ISPs, you will be able to quickly grow your wholesale internet/intranet access business.

Let’s take a look at what it’ll take for you to build your own facilities-based local loop infrastructure.

^{Blue-print for
Facilities-based Local Loop Infrastructure}

We all know that the biggest margin opportunity for a carrier lies with customers who are ON-NET. Companies like MFS, who pioneered the Competitive Access Provider (CAP) business model with the build-out of fiber-based Metropolitan Area Networks, successfully demonstrated how a carrier could quickly develop a high margin business. This model played itself out in the '80s and '90s with the emergence of a large number of CAPs/CLECs offering a variety of bundled services to ON-NET customers.

Despite its success, however, fiber-based network reaches merely 3% of all commercial buildings in the U.S. today. The remaining 4.5M+ buildings and business locations are served with copper-based local loop infrastructure. These buildings are OFF-NET. Hence, you have had to lease local loops from ILECs to reach these customers. The leased infrastructure business model drops the service gross margins down to less than 50% in the best of cases, and potentially down to 20% depending on the extent to which the leased loop is leveraged. This particular scenario, where the CLEC delivers services out of its own Point-Of-Presence (POP) with leased lines to the customer location is depicted in figure 1.

Figure 1: Traditional CLEC Service Delivery Model

The way to build margins for services delivered to these customers is to put them ON-NET. To do this with a fiber-optic network has proven to be cost-prohibitive. You have an opportunity to put these customers ON-NET with a copper-based infrastructure, anchored in the Central Office (C.O.). This is the quintessential Facilities-based DSL Infrastructure. The technology that enables this business model for you is Digital Subscriber Line (DSL), with which you can turn a voice-grade ULL into a broadband local loop, capable of delivering bundled voice & data services to your retail business customers, or broadband internet or data access service for your wholesale partners.

The Facilities-based Local Loop can be anchored in a C.O. or in a Point-Of-Presence (POP) you establish in a building. We will be looking at the C.O.-based DSL infrastructure business model in this report.

Step 1: Co-location in C.O.

Co-location of local loop access equipment in the C.O. is a pre-requisite to serving all the business customers in a Carrier Serving Area (CSA). While co-location is an expensive proposition, it affords a CLEC a great deal of flexibility and substantial benefits in delivering services. This scenario is depicted in figure 2.

Figure 2 : Facilities-based Local Loop Infrastructure

The primary benefits associated with co-location are:

n Shorter T1 Loops

With local loop access equipment deployed in the ILEC C.O., the leased T1 loops required to reach your customers in the CSA become shorter. Depending on the geography and topography of the C.O., this could result in savings of 50%+ in the recurring expenses associated with leasing T1 loops.

n Reduction in Back-haul Costs

The local loop access equipment deployed in the ILEC C.O. enables you to aggregate services for all the local loops served out of that C.O. and employ a higher-speed bandwidth pipe to connect your access equipment back to your POP. Service aggregation in the ILEC C.O.; over-subscription associated with all data services; and use of a higher-speed pipe results in a dramatic reduction in back-haul costs. Assuming a conservative 4:1 over-subscription, you’ll be looking at a 75% reduction in the back-haul costs! Additionally, as you add more customers you’ll be able to realize a significant economy of scale with a DS-3 back-haul, instead of running individual T1 loops from the customer location to your POP.

Step 2: Do DSL where you can, T1 where you must!

With the co-location space and interconnection agreement in place and T1 local loop access equipment installed, you are ready to ‘do DSL’. With DSL, you can reduce your local loop access costs dramatically. While the T1 loop may cost you from $200 to $800 per month depending on the geography, a ULL loop would cost you $20 to $40 per month, a 800%-1000% reduction in the local loop costs.

Now, with the ability to use DSL to reach as many of your customers as you can from the C.O., and T1 to reach all the other customers, you are able to provide ubiquitous service to all the customers in the CSA. This local loop infrastructure now gives you the ability to generate higher margin on the services and you will have achieved the objective of putting all the customers in the CSA of that C.O. ON-NET!

Now let’s look at what this does to your business. The two fundamental assumptions we have made in the analysis are:

1. Increasing % of your customer base will migrate to DSL local loops over time and

2. Increasing % of your customer base will migrate to higher-speed services over time.

Detailed assumptions for the business case are listed in a separate section.

The business case assumes that the revenue streams associated with private-line, data over private-line (T1) and data over DSL products are the same. The difference lies in the costs and hence, the margins associated with these products. There are several different scenarios presented for the business case:

1. All Private Line

2. All DSL

3. 50% DSL, 50% T1

4. Leveraged Wholesale

5. Stand-alone Wholesale

We will be examining Gross Margins, EBITDA, Net Income, Cash Flow, NPV, Capital Expenditure, and Break-even point for each of these scenarios. Of these five scenarios, the first three apply to your Retail business, examined below; the last two apply to your Wholesale Business (should you choose to pursue it), examined in a later section.

^{Retail Business : Analysis}

The Facilities-based Local Loop Infrastructure, high-lighted above, enables you to compete with ILECs on an even-playing field. Applying the same technology – DSL – used by ILECs to give the local loop a steroid boost, you can now focus on the services you want to deliver to your retail business customers.

Gross Margins (%)

Scenario 1 depicts the pure-resale case, wherein you have chosen not to build your own local loop infrastructure. With the increase in competition and without you adding a whole lot of value to the private-line product, the margin will continue declining from 20%+ in year 1 down to less than 10% by year 5. Clearly, an untenable scenario for a successful business.

Scenario 2 enables you to build additional margins by cutting down on your local loop costs with combination of 50% T1 loops and 50% DSL loops. This enables you to increase your gross margins by 15%+.

Scenario 3 – with 100% DSL loops, you are now able to improve your margins by another 20%+ over Scenario 2, to more than 40%+.

EBITDA (%)

EBITDA, the metric most often used by Wall Street in measuring the financial viability and relative success for carriers, is an indication of the profitability of a service business before accounting for Income-tax, depreciation and Interest changes.

Scenario 1 essentially results in 0% EBITDA over time, since the gross margins have declined to the point where you are barely able to cover your sales & marketing expenses. Scenario 2 demonstrates a 15%+ EBITDA beyond year 2, while Scenario 3 generates 35%+ EBITDA year 2 onwards, a result that the Wall Street would be delighted with.

NET INCOME (%)

Tracking the EBITDA trend, Net Income shows about a 15% increase for Scenario 3 over Scenario 1.

CASH FLOW

The difference in cash flow trend is quite dramatic. Scenario 3 represents a solid business case with cash flow turning positive in Year 2, whereas Scenario 2 – blend of T1 and DSL loops – turns cash positive in Year 3. The caveat here is that we continue our expansion in outer years in more COs as well as number of customers served.

NPV

Scenario 3 turns in a solid $15.9M NPV over three years, compared to $6M for scenario 2. Again, a stellar performance for the DSL Retail business by any standard.

IRR

Scenario 3 represents an astounding 69% IRR for the first three-year period.

Capital Expenditure

Scenarios 2 and 3 are assumed to require the same capital expenditure, although in reality the numbers may be different, with DSL requiring lesser expenditure and thereby making the case for DSL even stronger.

In either case, we are looking at Capital Expenditure starting at $31K per C.O. in year 1, growing to $94K in year 5 to fund the business expansion. The cumulative capital expenditure for the 30 C.O. build-out over 5 years is less than $6M. This consists of $310K capital expenditure in Year 1 growing to $2.8M by year 5 for the C.O. equipment and $100K in Year 1 growing to $3M by year 5 of non-recurring capital expenditure for CPE.

Break-even Point

For both Scenarios 2 and 3, the break-even point is 132 circuits per C.O.

^{Leveraged
Wholesale Business : Analysis}

The Facilities-based Local Loop Infrastructure creates a rare instance in the telecommunications business of a scenario where you can have your cake and eat it too! Having built the facilities-based local loop infrastructure for your retail business, you are now in a position to leverage it for wholesale business. The business could be built around a variety of services, including Internet/Intranet access, Frame Relay access; and to a number of different customers, like IXCs for local loop access for data services, and ISPs for Internet access. The assumption we have made for the business model is that DSL is used to deliver wholesale services.

There are two wholesale scenarios detailed here. Scenario 4 details the “Leveraged Wholesale” business, which leverages the retail business infrastructure, whereas Scenario 5 details a stand-alone wholesale business.

Gross Margins (%)

Scenario 4 generates 20%+ gross margins starting year 2 and growing over the years to 30%, as you get better leverage from the investment you will be making over the years. Scenario 5 also turns in 20%+ margins starting year 2.

EBITDA (%)

Leveraged as well as stand-alone Wholesale business returns positive EBITDA starting year 2, with the former generating 20%+ EBITDA, and the latter generating EBITDA in the 10%-20% over years 2 through 5.

NET INCOME (%)

The Stand-alone Wholesale Business, which is the Packet-CLEC business model, turns income positive in year 2 and generates a solid 10% net income by the year 5.

The Leveraged Wholesale Business delivers an incremental income, also positive year 2 onwards, in the 10% to 15% range over years 2 through 5.

CASH FLOW

The Leveraged Wholesale business turns cash positive in year 2, whereas the stand-alone wholesale business turns cash positive in year 3.

NPV

The Leveraged Wholesale Business represents a NPV of $9.9M over three years.

IRR

The IRR for Leveraged Wholesale business is even higher than for the Retail Business, since it enables you to leverage all the investments you have made in building your retail business. At 84% IRR, it represents a business opportunity unmatched in business and profitability potential.

Capital Expenditure

Since the growth assumptions for the Stand-alone Wholesale business are the same as that for the Retail Business, the capital expenditure requirements for it will be identical to the ones identified for Scenarios 2 and 3. Since the Leveraged Wholesale Business, as the name implies, leverages the investments made in the Retail business, the capital requirements are lower; starting at less than $20K per C.O. in year 1 and growing to about $75K in year 5.

The cumulative capital expenditure for the Leveraged Wholesale business amounts to about $2M.

Break-even Point

Break-even point for the Leveraged Wholesale business is a mere 94 circuits per C.O., once again emphasizing the leverage you can generate from your retail business infrastructure.

^Summary

In summary, the local loop represents a significant strategic element for your business. If you leverage it, you will find huge opportunities to grow the top- as well as bottom-line for your business. If you ignore it and maintain the status quo of leasing loops from ILECs, you will find yourself in a business where profitability will continue declining.

Is there any wonder that as a CLEC “YOU CAN’T AFFORD NOT TO DO DSL?” both for the opportunities as well as the threats that DSL represents to your local services business? On the one hand, you have an opportunity to grab a significant and profitable piece of the $80B local service pie. On the other, you have the threat of competition eroding your margins.

The choice becomes pretty simple, doesn’t it?

^{Assumptions for the Business Case}

1. The business case highlights the difference in revenues and profit margin between DSL-based data-only services and corresponding private line and data over private-line services.

2. Sales and marketing costs will be same percentage for private line, data over T1 and DSL

3. Number of DSL central offices increases from 10 at start of Year 1 to 30 at the end of Year 5

4. Customer ramp in each central office is 20 customers the first quarter, and then 20 customers per quarter after

5. The mix of customers changes over time to be 45% DSL-based customers, 30% private line (TDM) customers, and 25% data over T1 customers

6. The business case covers revenues, expenses and capital associated with DSL-based services.

7. The business case covers a 5-year period, but NPV, IRR and Break-even Analysis is done for the first 3 years.

8. Items such as transfer pricing between entities within a company, regulatory impacts, taxes and cross-elasticity are not included in the business case

9. Model does not account for any service cost elements past the demarcation point for the CLEC POP. Only the expenses within the co-locate space are covered.

10. Back-haul mileage from the co-locate space to the CLEC POP is 5 miles

11. Include monthly recurring charge for DS3 back-haul for each AccessLan DSLAM

12. Include monthly charges for co-locate space and capital charges for the cage

13. Maintenance costs for AccessLan CO equipment is 12% per year

14. Capital costs for AccessLan equipment:

� $10,000 for initial chassis, which will support up to 20 customers

� $ 6,000 for line cards, support additional 20 customers apiece

� $ 550 for customer CPE

15. Installation cost for DSLAM: 30%

16. Customer installation charge: $500

17. Customer installation cost to CLEC: $200

18. 3 year depreciation on the AccessLan DSLAM