After the Gold Rush: McKinsey Perspectives on Telecom 2001-02

1. After the Gold Rush:McKinsey Perspectives on Telecom 2001-02 Doron Fertig Phoenix Center 2001 U.S. Telecoms Symposium July 11, 2001

2. KEY THEMES – TELECOM 1. We expect a period of relative industry stability to emerge, driven by diminishedcompetition, consolidation, and a non-interventionistregulatory environment. This period will favor incumbents, particularly the ILECs. 2. However, we anticipate that meeting growth expectations (top line and bottom line) will become more difficult and, as a consequence, we foresee a decline in industry capex and a dramatic uptick in outsourcing in an attempt to manipulate cost levers. 3. We believe that customer inertia (and other aspects of buying behavior) will emerge as a greater barrier to the success of new services and providers than previously anticipated. 4. Operational and systems issues will continue to hamper the development and roll-out of “next generation” communications services to mass market and SME customers. 5. The combination of regulatory permissiveness, collapsing valuations of attackers, and historic anomalies in valuation (ILECs vs. LD) will drive a potentially massive restructuring of the industry.

3. INDUSTRY SECTORS • Sector • Origin date(s) • Wireless • MANs • CLECs/DLECs • ILECs • Backbone • Edge Networks • CDNs • Hosting • Cable • 1980’s, 1990’s • Late 1990’s • 1990’s • 1870’s • 1900, 1970’s, 1990’s • Late 1990’s • 1970’s

4. INDUSTRY SECTORS • Sector • Origin date(s) • Wireless • MANs • CLECs/DLECs • ILECs • Backbone • Edge Networks • CDNs • Hosting • Cable • 1980’s, 1990’s • Late 1990’s • 1990’s • 1870’s • 1900, 1970’s, 1990’s • Late 1990’s • 1970’s

5. McKINSEY PERSPECTIVES ON THE ILEC SECTOR • Organic growth alone, without substantial investment, will be insufficient to meet long-term expectations for ILEC performance • Residential market growth is anemic (1-2%) • Wireless growth slowing and will not support overall ILEC goals • The lucrative enterprise market remains out of reach for ILECs. Breaking into the market will require massive investments of capital, time, and sales & marketing skill • Consequently, we expect substantial pressure on ILECs to pursue acquisitions of IXCs • Relative valuations are at historically anomalous levels • AT&T and WorldCom, in particular, own enterprise customers that would be highly valuable to ILECs • Merger approval may be no more difficult than plain-vanilla LD entry approval • DSL will continue to grow in value for ILECs who execute deployment strategies effectively • Well executed DSL rollouts generate attractive returns for ILECs (all-in IRRs=32%, all-in ROICs=24%) • However, the standalone DSL business case is substantially less attractive (e.g., dilutive to core business) • DSL will retain a clear advantage in addressing SME broadband needs Source: McKinsey

6. McKINSEY PERSPECTIVES ON THE ILEC SECTOR (CONTINUED) • ILECs are well positioned to compete in the MAN sector • ILECs have the financial and manpower resources to aggressively deploy next-generation technology • ILECs’ ability to deploy a broader, deeper network will be a substantial competitive advantage in the wholesale market • CLEC encroachment • We expect the long-term CLEC threat will not go away, even CLEC industry restructures • The SME market is the ILECs’ to lose—there is a near-term opportunity to capitalize on CLEC problems by building deeper relationships with SMEs and improving sales & marketing execution Source: McKinsey

7. VOICE AND RESIDENTIAL SERVICES ALONE WILL NOT ALLOW ILECS TO ACHIEVE EXPECTATIONS • ILEC revenue growth (1999-2000) • Percent • Data revenue • growth • Data revenues >13% of total ILEC revenues, yet amount for ~50% of revenue growth • Line growth anemic (1-2 residential, 2-3% business) • Data revenue essential to sustaining margins • Total revenue • growth • Voice revenue • growth Source: Legg Mason; company reports; McKinsey

8. Enterprise-related services will post some of the highest growth rates during the next 5 years • ILEC success in residential and SME markets has not carried over to the enterprise segment • Traditional ILEC services are not high value-added for enterprise customers • Difficult for ILECs to make inroads against well-established IXC-enterprise relationships • $414 • $395 • $367 • $340 • $308 MAKING INROADS INTO THE ENTERPRISE MARKET IS A KEY ISSUE FOR ILECS • Telecom services revenue growth • $ Billions CAGR 9.1% Local data 22% • Key enterprise services L-D data 14% Internet 33% Wireless 15% • Traditional and emerging ILEC service areas L-D voice (3)% Local voice 1% Source: JPMS; FCC; IDC; company reports; McKinsey

9. VALUE SHIFT INCREASING ILEC OPTIONS Changes in telco valuation, 1996-2001 • Market cap • Billions • SBC • While IXCs reorganize and CLECs struggle to survive, ILECs will positioned to acquire and invest • ILECs valuations increased an average of 7% CAGR since 1998 while IXCs have declined 15% • CLEC valuations down 50%-100% in last 12 month • Verizon • AT&T • BellSouth • WorldCom • McLeod • Teligent Source: Compustat; McKinsey

10. WELL-EXECUTED DSL STRATEGY GENERATES SUBSTANTIAL RETURNS ILEC DSL ROIC impact based on mass deployment by a large ILEC Percent (2005E) • IRR=32% • NPV=$10.9 • All-in • ROIC** • 17 • ROIC incl. • indirect • operating • benefits* • IRR=22% • NPV=$4.9B • 8 • Stand-alone ROIC • IRR=17% • NPV=$2.7B • 4 * Stand-alone + avoided dial-up capex + opex saving from fiber architecture + value added services margin ** Includes defensive budget of line retention for voice (2010) Source: JPMS; McKinsey analysis

11. DSL BENEFITS ARE DRIVEN BY MORE THAN ACCESS REVENUES • Average ILEC profit from value-added • services* • $/sub/month • Benefit from avoiding line loss (SME example) • ILEC per line economics • $ month • CAGR=122% • 2001 • 2002 • 2003 • 2004 • 2005 • Revenue • Cash cost • EBITDA • Depre-ciation • Operatingprofit • $49 • swing • in  • ~$700M in NPV for a large ILEC • Includes services such as: • Video on demand • Hosted software • Interactive gaming • Streaming audio • ILEC economics if voice line lost to CLEC • $ month 0.0 (18.5) (18.5) (9.5) (28) • Revenue • Cash cost • EBITDA • Depre-ciation • Operatingloss * Based upon mass deployment by a large ILEC Source: JPMS; McKinsey analysis and estimates

12. ILECS COULD DOMINATE THE SME MARKET AT THE CLEC’S EXPENSE • Line loss to CLECs is slowing • Annualized rate of line loss, percent* • SMEs increasingly hesitant to trust telecom needs to unsound CLECs • Value change (4/00-4/01) • CLEC/DLEC • Northpoint • Winstar • Teligent • E.spire • US LEC • Allegiance • (100%) • (99%) • (99%) • (95%) • (83%) • (72%) • Telecom sector • overall high-yield performance (2001): • (12%) * Based upon ILEC reported sequential growth in lines lost (596,000 lines in 4Q00) Source: Legg Mason; Merrill Lynch; McKinsey analysis

13. INDUSTRY SECTORS • Sector • Origin date(s) • Wireless • MANs • CLECs/DLECs • ILECs • Backbone • Edge Networks • CDNs • Hosting • Cable • 1980’s, 1990’s • Late 1990’s • 1990’s • 1870’s • 1900, 1970’s, 1990’s • Late 1990’s • 1970’s

14. McKINSEY PERSPECTIVES ON THE BACKBONE SECTOR • Underlying economics are very challenging and will make returns on capital • unattractive in the near future • Long-haul pricing is in free fall, which we expect to continue (CAGR of -37%, 2001-04) • Next-generation networks will provide cost advantages, but will not provide an economic uplift for the sector overall • We see no credible scenario under which backbone traffic will grow fast enough, • and for a sustainable period, to alter the sector’s unattractive economics • Traffic growth will be strong, but come largely at the expense of higher-margin service offerings • Financial viability is highly dependent upon players achieving economies of scale, which only a few carriers (likely WorldCom and AT&T) will be able to accomplish • Industry restructuring is a forgone conclusion with standalone players unlikely to • survive; potential outcomes include: • Verizon and SBC likely to acquire AT&T’s Business Services and WorldCom’s enterprise business • Consolidation of backbone players and edge service providers (e.g., Qwest-Exodus) • Bankruptcy of several standalone players possible (e.g., Level 3) • While there is some potential for horizontal consolidation this will not solve the margin problem, which stems from a lack of enterprise value-added services penetration Source: McKinsey

15. BASIC IP WILL EXPERIENCE COMMIDITY PRICING, UNDERMINING CARRIER MODELS FOR RETURN ON INVESTMENT • Price per unit of traffic • $/Megabyte • Bandwidth glut will continue to drive down prices • Intermediaries (e.g., hosting • companies, bandwidth traders) bring increasing transparency to pricing • Economic uncertainty may slow traffic growth further, exacerbating oversupply • Long distance voice • Switched non-IP data • Private line* • IP (Internet) * Includes long-distance private line, non-ILEC private line, and special access Source: JPMS; McKinsey analysis

16. CAGR THE PRINCIPAL COMPETITION TODAY IS FOR LOW-MARGIN BANDWIDTH • Forecast distribution of long-haul traffic • Petabytes/month • 100% = • 90 • 125 • 184 • 295 • 509 • 950 • 60% • 9% • 30% • Level 3, Qwest, Genuity, etc. • competing primarily for lower- • margin long distance voice • and IP traffic • AT&T/WorldCom dominate • higher-margin private line and • switched non-IP traffic • Long distance voice • Switched non-IP data • 110% • Private line • IP (Internet) Source: FCC; AT&T Labs; IDC; interviews; JPMS; McKinsey

17. SCALE, NOT NEXT-GENERATION ARCHITECTURE, IS THE KEY DRIVER OF NETWORK ECONOMICS Impact of next-gen network on total capex $ Billion Impact of next-gen network on total opex $ Billion Impact of greater network scale Cost/Tb/month $ Thousand • ~55% cost improvement • ~25% cost improvement • ~90% cost improvement • Existing network capex cost • Next-gen network copex savings • Next-gen network cost • Existing network capex cost • Next-gen network copex savings • Next-gen network cost • 2% • 5% • 20% • Market share Source: JPMS; McKinsey

18. Addressable long-haul data revenues • $ Billions THE PRINCIPAL COMPETITION TODAY IS FOR LOW-MARGIN BANDWIDTH • CAGR, % • 180 • 9 • 170 • Lower margin services • 150 • 41 • 140 • 125 • 115 • 17 • Internet (IP) • Private line* • Switched non-IP • 20 • Higher margin services • Long distance voice • 3 * Excludes special access private lines and local data private lines. IP-VPN revenue excludes cannibalization of private lines Source: FCC; AT&T Labs; IDC; J.P. Morgan Securities Inc.; company interviews; McKinsey analysis

19. CRITICAL ISSUES ILECs IXCs • Can the ILECs meet growth expectations? How (e.g., enterprise)? • Can ILECs successfully increase the profitability of DSL? • How can ILECs protect high-margin wholesale businesses from next-generation MAN entrants and CLECs? • How will the regulatory and business climates evolve in support of ILEC entry into long distance services? • How can ILECs maximize return on capital employed? Should companies look to operational improvements or restructuring of wholesale/retail businesses as the solution to regulatory constraints? • Is there a meaningful likelihood of some event occurring (e.g., unexpected acceleration in traffic growth) that could revitalize the sector? • What kind of restructuring will the sector undergo? • Is there a place for standalone, attacker backbone players (e.g., Level 3)? • What combination are likely to occur (e.g., backbone + hosting, backbone + MAN)? • Is any horizontal consolidation likely? Who would be the potential candidates? • After restructuring, what happens to the enterprise businesses of WorldCom and AT&T (e.g., do RBOCs absorb them effectively)?