June 16, 2008

Broadband expansionist
BY JOAN ENGEBRETSON

You could say that Steve Oldham, CEO of SureWest, has gotten RGU religion. When he took the helm at the 100-year-old telco in January 2006, the company was facing a problem common to many incumbents — it was losing lines in its core voice business.

“We knew we had to get more revenues on our network business, and the only way to do that was to deploy more products,” said Oldham, who was formerly a member of SureWest's board of directors. As a publicly held company, SureWest was subject to telecom investors' new math, which no longer tallies subscribers but instead focuses on how many services — or revenue generating units (RGUs) — each customer takes.

But the broadband networks required to deliver triple-play services don't come cheap, and telcos entail considerable risk with their technology and buildout decisions. SureWest has distinguished itself by finding a way to minimize that risk. The company likes to buy and operate networks that someone else built.

Headquartered in the Sacramento suburb of Roseville, Calif., SureWest originally was a monopoly phone company serving the area around California's state capital, which has grown dramatically over the years. In 2002, the company saw an opportunity to gain an advanced fiber-to-the-home (FTTH) network extending into several neighboring communities by buying the assets of WinFirst, a failed CLEC.

When SureWest bought the WinFirst network, it already passed about 25,000 homes. Since then, SureWest has expanded the network, leveraging WinFirst's headend and switching investment to pass a total of 120,000 homes, including 14,000 within SureWest's ILEC territory. As take rates have climbed, the network has given SureWest an RGU boost.

“Most customers are at least taking a double play, and more than half are taking a triple play,” said Oldham. “We're moving from $50 a month average revenue for phone customers to $110 a month when a customer takes all three services.”

Earlier this year, the company moved further afield by purchasing Everest Broadband, which had constructed an advanced hybrid fiber/coax (HFC) network passing 91,000 homes in the Kansas City area.

“This is the highest-capacity, best-deployed network of any we looked at,” Oldham said. SureWest also liked the fact that Everest was “self-contained,” he said. “It was owned by private equity and had a management team in place, so it didn't matter that it was far away.”

SHEDDING WIRELESS
When Oldham took over at SureWest, the company's line loss problem was exacerbated by the fact that its own wireless business was not competitive. Customers opting to go wireless-only were choosing to do so with a competitive carrier.

SureWest had no less than 11 competitors in the wireless market, and as Oldham recalled, “We were behind the curve in offering national plans.” Because its license area was so small — equating roughly to its wireline territory — the carrier couldn't compete on roaming, and its relatively low subscriber numbers prevented it from being able to obtain the latest handsets. To support the wireless business, SureWest also had to operate retail stores, while all of its other services could be sold over the phone.

Oldham concluded that SureWest would be better off selling the wireless business and using the money it received for acquisitions. Last month, the company completed the sale of most of its wireless assets to Verizon Business — and while some industry observers expected SureWest to offer wireless through a resale agreement with another carrier, the company has not made that move.

Oldham argued that his company continues to benefit from overall wireless growth because, as an incumbent, it is well-positioned to provide backhaul connectivity for other carriers. The downside is that the company risks missing out on emerging quadruple-play opportunities.

But Oldham dismissed such concerns. “It's no cheaper to provide wireless in a quad play,” he said. Although the triple play improves service economics by delivering voice, video and data over a single wire, “adding wireless provides no economies of scale,” he said.

“The lure of a quad play is having a wireless handset that will talk to a computer at home or a security camera,” Oldham said. And because some of the major wireless carriers do not have local infrastructure of their own in SureWest's area, he believes those carriers eventually will want to partner with SureWest to deliver converged fixed and mobile services.

The sale of its wireless business brought SureWest $69 million, and the company gained another $110 million through the sale of its directory business. That gave the company enough cash to buy Everest, which cost $173 million — and Oldham is confident that SureWest could fund more acquisitions. But the type of company that it would consider is scarce.

“Our stated goal is to have the most capable network anywhere we serve,” Oldham said. “If we could find another Everest, we'd buy it.”

In the mean time, SureWest will continue to expand its triple-play infrastructure as it gets wind of new housing construction. “We have very strong relationships with developers,” Oldham said. “Before they're digging a trench, we know about it.”

Current plans call for expanding the FTTH network to pass 50,000 more homes in SureWest's ILEC territory, expanding the HFC network in Kansas City to 2000 more homes and building a new FTTH network that will pass 8000 additional homes there within five years. The company also has identified as many as 50,000 more homes in Kansas City that it may overbuild.

Both SureWest markets have excellent demographics. Average household income in the Sacramento area is well above $70,000, and a large percentage of customers have college degrees. As Oldham puts it, “they're people who are familiar with and unafraid of technology, and they have the income levels to support it.” SureWest's Kansas City service area has an even higher average household income and similar education levels.

In its ILEC territory, where DSL has been available to 100% of customers for several years, SureWest has obtained a penetration rate of more than 40% — a high take rate for a metro area with broadband competition from cable. And of the 211,000 homes in California and Kansas City that SureWest has passed with either fiber or HFC, the company has obtained substantial penetration rates of 32% on data, 25% on video and 19% on voice.

YET MORE SERVICES
SureWest attributes its comparatively low voice take rates, in part, to the success of voice-over-IP (VoIP) providers such as Vonage. Although such companies initially made inroads through low pricing, high-tech Sacramento-area consumers also are impressed by IP-enabled features such as find me/follow me

In response, SureWest recently introduced its own VoIP offering in California, claiming to offer a broader feature set than competitors. SureWest offers four different price packages and 22 features, which Peter Drozdoff, vice president of marketing, said is more than competitors offer. And because the service runs over a managed network, the company claims that voice quality is better than with Internet-based services.

“Consumers have a great appetite for our feature set,” Drozdoff said. “We're offering more for less money.”

New California customers outside of SureWest's ILEC territory automatically receive VoIP if they sign up for voice service. Previously the company delivered voice to its FTTH customers through a VoIP gateway connected to a Class 5 central office, but the new service is softswitch-based, explained Bill DeMuth, chief technology officer for SureWest. FTTH customers who signed up for voice service previously will continue to be served through the Class 5 infrastructure, but they can switch to the VoIP service if they prefer.

Although the VoIP service is priced lower than the original voice offering, Oldham insisted that it has not reduced the average revenues that SureWest generates from its FTTH customers. “Customers re-deploy how they spend the money,” he said. “Oftentimes they will spend more overall by getting more triple-play services.” For example, he said, some customers use the savings toward premium television channels. SureWest's cost to deliver VoIP also is less than for its earlier voice offering because the company avoids some regulatory fees, Oldham said.

Today, the average SureWest customer served by HFC or FTTH takes 2.6 services. The company hopes to expand that number, not just by getting more people to take voice, video and data, but also by adding more services.

Oldham pointed to a recent home monitoring launch as an example. “We're trying to get products and services to customers that are inexpensive and work on our existing network,” he said.

The home-monitoring service, which costs $10 per month, is available to SureWest broadband customers or anyone inside or outside SureWest's territory who has a broadband connection. Customers pay a one-time charge of $200 for an equipment package that includes a wireless gateway, an IP camera and a sensor they can attach to a door, window or even a liquor cabinet. Customers install their own equipment, which communicates over their broadband connection and can send text messages to customers' cell phones to let them know that someone has arrived home or that a child may be venturing into a prohibited area. Customers also can remotely view the video camera through a password-protected Web portal.

“It's cheap to use, easy to install and is a value-add to customers,” Oldham said.

Another recent launch could be described more accurately as an experiment. SureWest recently began offering free Wi-Fi service from two hot spots in Roseville — one in an upscale shopping mall and the other in a common area within a multidwelling unit. “We launched it to whet people's appetite in the multidwelling unit,” Drozdoff said. While declining to provide specifics, he said that the service has been received very well. “People are showing that they're using it, and they're really liking it.”

Wi-Fi may be the best way for SureWest to serve multidwelling units or people who don't have a landline connection, Oldham said, adding that the company is considering giving free Wi-Fi to customers who take relatively low-speed data connections if they will upgrade to a faster connection. At higher data rates, Oldham said, “there's more margin in it for us — we want customers to train themselves to want more bandwidth.”

PERFORMANCE METRICS
Since taking over at SureWest, another important focus for Oldham has been to decrease costs by outsourcing functions that are not core competencies. “If it was not network-related, it was on the table to look at,” he said. To date, the company has outsourced accounts payable, payroll processing, cash remittance processing and other functions. “Other institutions do those things faster and for less money,” he said.

SureWest is not, however, expecting to see big savings by introducing similar measures within the Everest business, for the simple reason that Everest was already a lean operation. Instead, Oldham said, “we're borrowing ideas from them.” He pointed to the example of the one-time amnesty that Everest traditionally offered its customers. Although Everest's policy was to disconnect customers who did not pay their bill for two months, the company would make an exception the first time, eliminating the expense of a truck roll to reconnect the customer. Customers who have received amnesty also tend to be more loyal, Oldham said.

Measured by certain metrics, Oldham's overall strategy seems to be yielding real results. Revenues and EBITDA for the first quarter of 2008 were up 64% and 16%, respectively, over a year earlier — and even though the Kansas City acquisition accounted for most of the uptick, the California broadband business showed positive growth in its own right. Perhaps more importantly, SureWest's total RGUs have been climbing at a pace that offsets traditional access line loss.

The company's stock value, however, has been trending downward for several years. After selling at more than $50 a share in 2002, the stock sold for between $20 and $30 between 2004 and 2007 and was trading around $10 at press time in early June.

“They need to make sure they can make money with what they already have,” said Bill King, president and managing principal of JSI Capital Advisors, a financial consulting firm that focuses on Independent telcos. SureWest's performance is particularly disappointing, considering the bargain price the company paid for WinFirst, added King. “We haven't seen the uptick we would have expected,” he said.

SureWest always claims that a turnaround is right around the corner, King said, “but it's been around the corner for a long time, and they don't seem to be getting traction.”

Some people within the financial community also have begun to question whether incumbent telcos pursuing their own multiplay strategy can grow that business enough to make up for what they're losing in their traditional business. The problem, they say, is not the top line but the bottom line. Noting that margins on traditional voice services generally are higher than those on multiplay offerings, such critics — including Craig Moffett, vice president of Sanford Bernstein — say it will be difficult for incumbent telcos to get the penetration rates in new services necessary to offset the lost high-margin business.

“We do have a higher margin in telecom,” said Oldham. “It's in the 50% range, but we're only getting $50 a customer.”

SureWest's margin on triple-play services is in the range of 35%, which Oldham attributes to the high cost of video content. He noted, however, that even at lower margins triple-play customers yield more profit than voice customers because the average triple-play customer generates revenues of $110 a month.

Another concern, however, is how much more SureWest's relatively high triple-play take rates can grow. Teresa Mastrangelo, principal analyst for broadbandtrends.com, noted that in metropolitan areas, new market entrants rarely achieve penetration rates of more than 40%, even after 10 years or more in a particular market. But although SureWest is unlikely to gain more than a few percentage points in the areas it already serves, she believes the company has more room for growth as it continues to overbuild the surrounding communities.

“If they can continue to reduce churn and creep up their penetration, there's still a fair amount of opportunity left for them,” Mastrangelo said. “They're still transitioning a fair amount of copper over to fiber, and as they put more of their base on fiber, they will be able to capture more revenue. If they can continue to grab subscribers, there's a good chance they can convert them to a double or triple play.”

Mastrangelo also expects to see an increase in SureWest's average revenue per user as the company expands its video capabilities. “And VoIP will help them with their triple-play take rate because they will be able to offer a more attractive package,” she said.

Mastrangelo attributes SureWest's recent stock performance to investors' increased pessimism toward the telecom industry overall. “As a company, they're not doing anything wrong,” she said. “They're probably doing everything right.”

A DIFFERENT KIND OF NETWORK
Until Verizon got serious about deploying fiber to the home a few years ago, SureWest Communications had the distinction of having more FTTH customers than any other carrier in the U.S. The company served those customers over a network it first bought from failed competitive carrier WinFirst and then expanded.

Because WinFirst was one of the first carriers to deploy FTTH, it made a different technology choice than most carriers are making today. Rather than a passive optical network (PON), the company deployed equipment from Allied Telesyn and Cisco Systems that uses active elements in the network.

At the time WinFirst made the deployment, the only passive equipment available was based on the broadband PON standard. “With BPON, we wouldn't get the bandwidth we wanted,” said Bill DeMuth, chief technology officer for SureWest. Higher-bandwidth gigabit PON equipment was not yet available.

The downside to using active equipment is that SureWest doesn't benefit from the economies of scale that Verizon's massive PON deployment is driving in that market. SureWest's planned Kansas City FTTH network will likely use PON, and the company could easily change out to GPON in California, DeMuth said. But DeMuth has not seen a need to do that because “it has been a very efficient network.”


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