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February 15, 2005

How the Telecom Mega-Mergers Might Make Sense (but probably don’t)

Yesterday morning my friend Fred Wilson, super-VC and super-blogger (A VC, naturally), performed the difficult feat of forwarding the announcement from wsj.com about the Verizon deal for MCI to me before I got my copy directly from wsj.  I blogged last week that the time for vertical integration, if there ever was one, has passed. So I tried to think whether there are any reasons why mergers such as this one and the SBC-AT&T deal might make sense in a business world where horizontal is best.

Horizontal Delamination

One good reason to put together two or more vertically integrated companies would be to delaminate the resulting entity into large standalone horizontal organizations.  For example, the regional network of SBC plus the national and international networks of AT&T make sense as a horizontal company.  Another horizontal company would be the former business service units of both companies.  A third could be their fledgling retail VoIP operations.

These horizontal business delaminated from the SBC-AT&T behemoth would compete with similar horizontal businesses spun out of the Verizon-MCI combination.  Size does count in horizontal businesses.  In fact, except at the top retail layer, size seems to be an important determinant of horizontal success.  By size, in this context, I mean both relative market share and coverage of the horizontal space.  Microsoft and Intel are obvious examples of companies who have become near monopolies by blanketing a horizontal layer.  In the case of a physical network business, size is measured in geographic coverage, economies of scale, and market share.

According to Metcalfe’s Law, the value of a network is proportional to the square of the number of endpoints; and so size matters squared in a network business whether the network is physical or logical.  There are n*(n-1)/2 physical endpoint connections in a physical network with n endpoints.  There are n*(n-1)/2 customer connections possible in a logical network with n customers – say a VoIP network.  In a physical network, profit is higher if connections stay on-net.  In a logical network, competitive advantage can be gained by passing the advantage of network size on to customers.  MCI did this decades ago with their Friends and Family pricing.  Mobile operators do it with various on-net plans.  Skype and Vonage do this today by allowing unrestricted “free” on-net calling  to their customers regardless of where the customers are physically located. 

For these VoIP companies, the size of their networks (defined as their number of users) capitalizes on their advantages as early movers.  A VoIP startup now has the handicap of not having an interesting on-net to offer its prospects.  A combination of telecom giants would do well to create an immediate size-of-network advantage for the combined customer base.  If they were following my advice (which they’re not), they would completely divorce the important job of creating combined physical networks from the equally important job of creating combined customer networks.  These are different horizontal layers and any attempt to optimize vertically during the post-merger will slow down the more important horizontal integration.  Then I would advise spinning out the new horizontal entities as separate companies with distinct markets and freedom to optimize in their respective layers.

Savings on Lobbying

One easy-to-achieve advantage in these combinations will be a savings in lobbying costs.  AT&T and MCI have long used their powerful and expensive lobbyists to fight for law and regulation which advantages them against the RBOCs.  Similarly, the RBOCs have used their (at least) equally powerful and expensive lobbyists to achieve competitive advantage against the long distance carriers.

These combinations may do more for campaign finance reform than all the half-hearted measures congress has ever passed.  At least there are less entities to buy tickets to fund-raising affairs and establish PACs.  At best, the remaining entities will compete in the marketplace rather than in the legislative and regulatory arena (OK – that’s wishful thinking).

Conclusion

I don’t really think these mergers happened either to create more effective horizontal entities or for the savings in lobbying costs. I think they happened because, ever since the first breakup of AT&T, both the long distance companies and the regionals have felt like starfish with a limb missing: it must be regrown (or, in this case, reacquired) at any cost.

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