Negative Scale Returns in Fixed Networks Business?

We might be in the early stages of another evolution of the U.S. fixed network business. The first stage had new providers, especially cable TV companies, emerge as key contestants in the fixed networks business, reducing incumbent telco market share by about half.

With Google Fiber and now a growing range of gigabit access networks by smaller firms, we might see the first of a wave of shifts to yet another wave of providers, namely independent and smaller providers.

Some might argue that if the trend continues, the smaller providers will simply be absorbed by larger providers, as has happened in the business in the past. That might not happen this time.

For starters, the advantages of scale might be diminishing, in certain respects, in the fixed networks business. In fact, some might argue the advantages of scale never have been so great in the fixed networks business, where as much as 80 percent of the capital investment has been in the local access network where costs are not shared, or not shared very much.

If that is the case, then scale might not be as big a value as has been believed. As we now are seeing many forms of decentralization and localized supply in the U.S. economy, perhaps we now are getting a glimpse of localism in fixed network supply, where many smaller and independent firms might emerge, in smaller city markets.

Though perhaps some consolidation could occur, the limits of scale might kick in fairly quickly, making large roll-ups uneconomical.

Dramatically lower prices will propel the localization moves. As retail prices dive, the advantages of larger provider scale become disadvantages, as there is less room in the business model for the overhead associated with tier one operations.

Some Internet service providers continue to push at dramatically-lower retail pricing levels for high speed Internet access, including gigabit prices. Sonic.net, for example, now is launching gigabit access plus voice for $40 a month, in Brentwood, Calif.

Sonic.net plans to bring its new service to about 8,000 homes within the next 15 months. Sonic.net also will provide a free 5 Mbps Internet access service (without phone service) for up to five years, after payment of an activation fee of $300 to $400.

To be sure, Sonic.net is a small ISP, and no matter what it does, it cannot affect many consumers in the U.S. market. On the other hand, the offer does suggest Sonic.net believes the economics work, for a bundle of gigabit Internet access and voice service, billed at $40 a month.

That does not mean a tier one service provider could do so, but a smaller firm, with lower overhead and operating costs, arguably can do so.

Paradoxically, as some claim there is too little competition in the U.S. Internet access business, competition is busting out all over. Existing municipal broadband providers have dropped prices for gigabit service from about $300 to about $70 to $80 a month.

Google Fiber has expanded to seven metro areas and another five metro areas are under evaluation. Brooklyn Fiber is firing up gigabit service for business customers in a part of the New York market, and some believe the firm eventually will start pitching service to consumers as well.

Even some incumbents, including CenturyLink, are offering gigabit service in Colorado markets, with plans to build in 16 metro areas. AT&T, for its part, has said it would build gigabit networks in neighborhoods in as many as 100 U.S. communities.    

As more “overbuilders” enter the Internet service provider business, providing more consumer choices, the exercise of that choice makes the business model harder for legacy providers (telcos, cable TV companies, satellite Internet providers, wireless broadband ISPs, municipal broadband providers).

It is easy enough to predict what likely will happen, longer term. Tier one service providers will start to invest capital elsewhere (international expansion, non-access assets, mobile or other technologies).

That will put tier one service providers that do so at a competitive disadvantage, but that also will allow more market share to be gained by smaller providers with lower operating and overhead costs.

One might note what has happened already in the tier one segment of the business. Verizon and AT&T now drive revenue volume and growth in the mobile segment, not the fixed network business.

Verizon has been divesting smaller landline markets to Frontier Communications, now perhaps the largest former-rural operator that has transitioned to a new business anchored by services provided to small business customers.

At the same time, Comcast and other cable TV companies, operating with lower costs, have begun taking serious market share from AT&T, Verizon and CenturyLink. It might not be unfair to characterize the change as cable becoming the dominant consumer services provider, while

AT&T and Verizon become mobile firms.

Price wars that destroy profit margins are virtually inevitable. In fact, some would argue, that is precisely what Google Fiber hoped would happen.  

Sonic.net , based in Santa Rosa, California, has been aggressively building its fiber to the home ISP business, using an approach similar to Google Fiber, selectively building in neighborhoods or communities where it believes it has a chance to disrupt market dynamics by offering more for less.

So far, Sonic.net has targeted smaller communities in northern California, including

Brentwood, Sebastopol, the Sunset neighborhood of San Francisco, Novato’s Hamilton Neighborhood, Healdsburg, Santa Rosa, Petaluma, San Francisco’s Bernal Heights neighborhood, Berkeley and San Francisco’s Castro neighborhood.

We might be seeing something new in the fixed network business: an age where scale economics apply in a lesser range of cases.