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Merger of Little-Known Telecoms May Mean Rival for Heavyweights
By Kim Hart, Staff Writer
Washington Post
Wednesday, September 19, 2007

Paetec Holding, a little-known New York telecom operator, built its business selling phone and Internet services to corporate customers. McLeodUSA of Iowa was battered by the 2000 telecom market crash, twice forced into bankruptcy and major rounds of layoffs.

Paetec's $557 million bid this week to acquire McLeod could make the combined company one of the largest rivals to AT&T and Verizon Communications in selling services to businesses. The business market is one of the most profitable for phone companies as the number of residential phone customers dwindles.

Paetec and McLeod would also compete for business with Sprint Nextel of Reston, serving most metropolitan areas, including the District and Baltimore.

Such mergers have become increasingly common over the past few years as independent carriers try to compete with the dominant incumbent companies, which have grown through their own acquisitions.

"Companies like Paetec are arriving at the realization that they need coast-to-coast coverage in order to compete," said Craig Clausen, an analyst with New Paradigm Resources Group, a consulting firm.

The deal would give Paetec access to McLeod's $2.5 billion fiber-optic network in 20 states, an asset Paetec says will offer faster Internet speeds to a wider range of customers. Paetec said it will be able to serve 47 of the country's largest 50 metropolitan areas.

The acquisition, which the companies hope to complete early next year, comes as many independent carriers are fighting potentially adverse regulatory changes and fierce competition from much-larger rivals.

The Federal Communications Commission is considering, in some markets, allowing regional giants such as Verizon, AT&T and Qwest to raise rates they charge companies like Paetec and McLeod that depend on leased lines to reach their customers' buildings.

AT&T, Verizon and Qwest argue that smaller carriers benefit from artificially low, government-set rates for leasing their networks.

The smaller carriers, including XO Communications of Reston, Cavalier Telephone in Richmond and McLeod, are demanding that the FCC clarify its rules governing pricing negotiations. They are hosting a press conference today in Washington. These companies say they will be forced to pass on higher costs to customers if the regional carriers are allowed to raise the price of network access. McLeod, for example, said Qwest's proposed rate increase in Omaha could force the company to pull out of Nebraska altogether.

"When one player controls the facility and there's no break on pricing, they can squeeze out competition very easily," said McLeod chief executive Royce Holland, whose position at the combined company has not been determined.

XO and Cavalier are among dozens of companies that formed in the Washington region after the passage of the Telecommunications Act of 1996, which opened the local phone market to competition. Those upstarts garnered billions of dollars in investment.

After borrowing too much money to build expensive fiber-optic networks while not securing enough customers, many of the new companies filed for bankruptcy protection or sold assets. McLeod carried $4 billion in debt before it filed for bankruptcy protection for the second time in 2005 and went private. In March, McLeod announced plans to sell shares to the public again but instead accepted Paetec's offer.

With its purchase of McLeod, Paetec expects annual revenue of $1.6 billion, making it the largest independent carrier, surpassing XO, Level 3 Communications and Time Warner Telecom. Paetec, which was founded in 1998 and primarily serves large businesses, hopes to assume McLeod's roster of small- and medium-sized companies.

It is the second major acquisition for Paetec in as many years, following its 2006 purchase of US LEC of Charlotte.

But Paetec will face challenges, some analysts said. It could take two or three years to integrate the companies and make a dent in Verizon's or AT&T's sales, said Donna Jaegers, a financial analyst with Janco Partners.

"They're still dependent on incumbent networks, which still have significant market dominance," Jerry James, acting chief executive of Comptel, a group that represents independent carriers.

Smaller carriers will eventually need to rid themselves of the dependence on the regional carriers, said Clausen of New Paradigm Resources.

"Some of the smaller guys want regulators to keep protecting them," he said. "The question is, at what point do they have to grow up and find their own solutions?"