Monday, October 31, 2016

Why the Mega-Mergers?

It would be logical if connectivity industry participants have wondered why, in the Internet era, retail prices for virtually all communications services generally fall, while video entertainment retail prices can climb.

The same sorts of questions are logical where it comes to market value of firms in various segments, or the prices paid by third parties to various providers of internet apps and services (advertising prices, for example).

Cable TV prices have risen every year over the past 20 years, and in each year, the rise in cable prices has outpaced inflation, virtually every analysis concludes.

That is part of a bigger story, namely the generation of value within the Internet ecosystem. Analysts at A.T. Kearny, for example, estimate that the total value of the internet value chain has almost tripled (up nearly 300 percent) from $1.2 trillion in 2008 to almost $3.5 trillion in 2015, a compound annual growth rate of 16 percent.

Revenue sources are diverse. The proportion of revenues of online services generated by advertising, for example, has grown to 29 percent in 2015. The majority of revenues still come from direct customer payments, whether they are one-off purchases, subscriptions, or pay-as-you-go services, but that seems to be changing.

In almost all online services categories, the proportion of spend that is online versus its legacy or offline equivalent has increased, as well. That illustrates the generally-disruptive impact of internet apps and services, which nearly always cannibalize some existing industry or revenue stream.

In terms of economic performance, the largest players in any given segment are able to deliver higher returns and profit margins, benefiting from the inherent network and scale effects of the internet.

At the same time, the larger providers are moving into internet adjacencies beyond their original scope of operations. Google might have begun life as a “search provider,” but now operates across a number of internet roles. Likewise, AT&T might have been a fixed network services provider, but now is the largest U.S. linear video services provider, and, if its acquisition of Time Warner is approved, will become a major participant in the content production business.

For regulators, a more-complicated industry structure has to be accounted for. “It is no longer appropriate to develop corporate strategies, or to assess policy situations, with a narrow focus on a single segment of the value chain,” A.T. Kearney argues.

Within the connectivity segment, there is a strong shift towards the use of mobile networks, which now generate more revenue from internet-related services than fixed networks. That probably is among the less-important trends. Longer term, value is shifting away from connectivity and towards the other parts of the ecosystem.

In 2015, connectivity represented perhaps 17 percent of internet ecosystem value. By 2020, connectivity might represent only about 14 percent of internet ecosystem value. In 2015, apps represented about 47 percent of internet ecosystem value. By 2020, apps might represent 52 percent of value.

That explains, simply, why connectivity providers constantly look for ways to move up the value chain, or “up the stack.” Value is shifting to apps, and away from simple connectivity. At the same time, profit margins generally are higher in apps and content.

Where connectivity earnings margins are in the 10 percent to 15 percent range, margins in operating systems are greater than 25 percent. App margins can range from 15 percent to 25 percent.

At the same time, live sports has been a key contributor to higher content rights costs for distributors. The shift to mobile screens likewise is placing a new premium on “live” or “interactive” programming, compared to store-and-forward prerecorded content (movies, for example).

As linear distributors shift to lower-cost bundles, and most distributors move to over-the-top streaming access, there now are new questions about whether such content increases can continue, and if, so, where.

One reason Disney equity is under pressure is concern about dwindling prospects for its flagship sports franchise, ESPN.

What is not easy to contest is the value apps and content have in maintaining value, and hence retail pricing power, in Internet markets where substitutes increasingly are available.

At a large level, value within the internet ecosystem is shifting to apps, content and other app-layer services, diminishing in the connectivity segment, and growing in some other segments of the ecosystem (such as operating systems and app stores) and declining in a few segments such as personal computers and cloud computing.

Cable prices vs. inflation


In a clear sense, linear video prices only illustrate a broader trend within the internet ecosystem.

That noted, linear video prices have escalated in what many now believe are unsustainable ways. Back in 1995, cable cost an average of just $22.35 a month. Now it’s up to an average of $69.03, a 208.9 percent rise.

Inflation alone can’t account for nearly so much change, as inflation has changed by just 55.8 percent over that same period.

On average, cable prices rose 5.8 percent each year, while inflation rose at an average of 2.2 percent per year.

That is why linear providers are moving to “skinny bundles,” and why consumers buy affordable services such as Netflix. Consumer perceptions of value are shifting. So far, though, it is generally true that “content” is being revalued, not necessarily devalued, though ESPN might be a salient exception.

None of that is going to obstruct the bigger trend. If value, equity value, revenue and profit are shifting to apps and other places within the internet ecosystem, and away from connectivity, connectivity providers must seek new roles in those growing parts of the ecosystem.

That is why Comcast bought NBCUniversal, and why AT&T wants to buy Time Warner. Even within the connectivity segment of the ecosystem, higher revenues and profit margin are why CenturyLink wants to buy Level 3 Communications.

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