1.1 Private Lines Services Return to Growth

Two factors have conflated during the past year to position the private line marketplace for positive growth. While both factors might have been anticipated as part of a long term planning scenario, they have come together over the past 18 months in such a way as to put the private line market on a positive trajectory for the first time in many years.

In watching various trends across the domestic telecommunications industry, INSIGHT believes that the number of broadband connections reached a critical inflection point in 2006. Broadband penetration is currently at 43 percent-a penetration rate sufficient enough to provide the foundation for mass market video services. Video using the Internet or managed IP networks is a hot growth area for service providers, one that we believe will have a direct impact on private line services.

The other factor is industry-wide consolidation. In a period comprising about 15 months (December 15, 2004 to March 6, 2006) a number of major acquisitions in the telecommunications industry were announced. These mergers have profoundly altered the competitive private line landscape for both retail and wholesale services. Nine leading players in the telecommunications industry are impacted by these announcements, as we note in Table I-1.

Table I-1 Continuing Industry Consolidation

Whether it is delivered in the form of IPTV offered by a wireline provider or streamed to a mobile set, new video services have already grabbed the attention of content providers and advertisers that want to put their video in front of consumers. Consumers want the entertainment content anytime and anywhere. Video, we believe, is the long awaited killer application-the one that will drive up network traffic, the one that will tax existing resources, and the one that will eventually soak up the excess capacity.

Some of this video traffic is going to end up traversing private lines. While video transport is unlikely to generate additional new private line revenue on the national backbones, the local distribution of video typically will require substantial local caching to optimize performance; hence, local private line facilities will need to be upgraded to meet the increased demand.

Not only do we expect traffic to grow considerably over the forecast period, we are also seeing price stabilization across the board and even price increases in some high capacity optical circuits.

This price stabilization is a consequence of the other major force impacting the private line market-that being service provider acquisitions. The two biggest deals resulted in two dominant players: a combined AT&T/SBC/BellSouth, and MCI/Verizon. The competitive landscape has been altered, and in effect the local and long distance portions of the old Bell System have been rejoined. The impact of this new competitive equation is more stable pricing, which is already having very positive impact on private lines.

These trends will certainly make private line a more profitable business, which will, in turn, have a two-fold impact. The profits will likely be used to invest in new IP services, and over the longer term these new IP services might gradually cannibalize revenue from private lines. It is also possible that the increased traffic and industry consolidation may entice a new generation of players that would leverage existing fiber assets or fixed wireless spectrum to enter the market.

Conditions in the local private line market are ripe for new entrants. Imagine a market in which prices charged by the dominant player are set by tariffs, there is only a handful of local competitors (and they tend to vary by specific market), and there is a robust forecast for traffic growth. Add to this a growth spurt induced by video distribution service requirements, and it would seem that the private line market is ready to host a new set of players. Cable MSOs and fixed wireless players are already active in the private line market, but we do not expect they will be the only players competing.

1.2 Traditional Private Lines

A private line is a dedicated non-switched circuit or channel that is leased for a specified period. This channel provides a private and direct connection between at least two sites. Private lines can support voice, data, video, fax or multimedia communications. Private line speeds can be measured by digital signal level (e.g., DS1, DS1C, DS2, DS3), equivalent trunk level (e.g., T1, T3), or optical carrier level....