Saturday, July 25, 2015

DirecTV, Dish Network Know Their Legacy Businesses are Doomed: What about Telcos?

Marginal cost pricing and competition pose growing risks to commercial Internet service providers and communications providers.

That especially is the case because marginal cost pricing absolutely is a core business strategy for market disruptors. In other words, a now-proven strategy is for an “outsider” to disrupt a market by essentially destroying it.

What results is a smaller overall market, but one which the attacker “owns.” Let us be clear: what that all means is that there is a growing risk to the sustainability of traditional telco, satellite, fixed wireless and perhaps cable TV business models.

Google Fiber, and similar efforts by ISPs across the United States, provide evidence that competition is growing, and illustrate the growing “marginal cost pricing” challenge.

Chattanooga's electric utility (EPB), for example, has built the nation's biggest municipal telecom service over the past five years, attracting nearly 74,000 Internet, cable and telephone customers in a venture that netted a profit of nearly $17 million last year.

EPB also sells a gigabit Internet access service for $70 a month. Google created that market pricing umbrella when it launched symmetrical gigabit services for $70 a month.

EPB reported $118.2 million in revenues in the fiscal year ended in June 2015, with net income of $16.9 million.

But competition might the lesser problem, compared to marginal cost pricing (pricing products at the incremental cost of producing the last set of units). The problem is that the actual cost of producing the last unit of a digital product is pretty close to zero, but the sunk cost to sell the first unit is far from zero.

In other words, ISPs run the risk of not recovering the cost of the sunk assets, unless there are other big new revenue streams that do provide the financial return from building the network.

One example: “the large incumbent telephone companies do not earn attractive returns in their wireline businesses,” said Craig Moffett Partner and Senior Analyst, MoffettNathanson. “For example, a decade after first undertaking their FiOS fiber-to-the-home buildout to eighteen million homes, Verizon has not yet come close to earning a return in excess of their cost of capital.”

In other words, Verizon FiOS has actually lost money.

AT&T also has earned poor returns on its fixed network.  AT&T return on invested capital has been declining for a decade and is, like Verizon’s, well below the cost of capital, Moffett said.

In 2014  aggregate fixed network telecommunications businesses earned a paltry 1.2 percent return, against a cost of capital of roughly five percent, Moffett argues.

“For the non-financial types in the room, that’s the equivalent of borrowing money at five-percent interest in order to earn interest of one percent,” said Moffett.

“That’s a good way to go bankrupt,” Moffett said.

Cable operators, on the other hand, are earning returns of 13 percent to 33 percent, Moffett said.

To be sure, “forward pricing” is a common tactic when a firm begins producing any product whose actual initial cost is far above market expectations.

That often leads firms to price at expected future levels, when learning curve effects have kicked in. The corollary is that every unit produced early on is sold at a loss.

The problem comes when the forward pricing does not recover sunk costs, but only marginal operating costs.

The problems are worse when the core products are in a declining, or very mature mode. And that is an issue in many markets, not just “developed” markets.

Mobile subscriptions have been slowing in Brazil, and Dow Jones newswire says growth turned negative in June 2015.

The number of active mobile phones users in Brazil dropped by 1.7 million in June, ending with a monthly total of 282.45 million, compared with 284.15 million in May, government agency Anatel said.

That is why the search for big new markets, especially related to the Internet of Things, is so very strategic.

Already, of AT&T’s 2.1 million net adds in the second quarter of 2015, 410,000 were postpaid accounts,  331,000 were prepaid and one million were from connected cars.

In other words, in the second quarter, connected cars drove AT&T net account adds.

AT&T also added 1.2 million branded (postpaid and prepaid) smartphones added to its base.

Still, the fundamental problem is marginal cost pricing, something I like to call near zero pricing, since it immediately captures the nature of the problem.

Several possible outcomes are possible. Perhaps today’s legacy access providers will indeed find they can create huge new revenue streams from IoT. That will take care of the sunk cost problem.

If not, one cannot rule out business failure. The challenge posed by EPB, similar ISPs and Google Fiber is precisely that they destroy the legacy business model and therefore the sustainability of the businesses supported by those business models.

You might argue that is why DirecTV decided to sell itself to AT&T, and why Dish Network is getting into the mobile business. Both DirecTV and Dish have concluded their old business models will inevitably fail.

Some day, many fixed network operators might have reached similar conclusions.

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