App Providers Should Beware Unintended Consequences of Title II

As much as arcane and esoteric as communications regulatory debates often can be, there is a good reason so much attention gets paid to it. Such rules create the framework that determines who can be in the business, how they can be in the business and to some extent how much money they can make in the business.

There are a few interesting angles to the possible new network neutrality framework the Federal Communications Commission is expected to propose, and a person might be forgiven a bit of uncertainty about whether the proposal will be deemed lawful, whether it is workable and whether the actual outcomes will be as its supporters hope.  

The plan now under consideration would separate broadband into two distinct services, with different rules.

The Internet access business, where ISPs sell connections to the Internet, would be less regulated, using the “information services” framework.

But the “back end” relationships between access ISPs and content providers would be regulated as a common carrier utility service under Title II of the Communications Act.

Some question whether the FCC has authority to regulate in that manner, so any such move would immediately be met with legal challenges. At least in part, that line of reasoning is based on Commission precedent.

The FCC has found, on four separate occasions, that broadband Internet access providers do not offer a common-carrier telecommunications service, and instead offer an integrated information service exempt from common-carrier regulation under Title II, Verizon argues.

Though some support Title II regulation as a way of preventing “paid prioritization” of consumer apps delivered by access ISPs to end users, Title II might ironically create new payments by those same app providers to access ISPs (which would become the functional equivalent of terminating carriers), it would seem.

In other words,  such “back end” regulation under Title II could lead to interconnection tariffs that reflect carrier interconnection principles, namely that imbalances in traffic exchanged trigger payments to the traffic receiving carriers by the traffic delivering carriers.

One of the clear features of network interconnection under Title II are termination payments made to network operators who deliver traffic.

Presumably the FCC already is thinking about how its new rules for interconnection would obviate the traditional traffic-based payments, but how that could be done is not clear.

Also, the new rules would essentially acknowledge that retail ISPS now act as “content delivery networks” for application and content providers.

The irony is that content and app providers have vocally opposed the notion that ISPs act in that manner, in the sense of accelerating content delivery, a service Akamai and other content delivery networks routinely provide.

Still, the new rules would be based on the principle that the key feature of the modern Internet is that it has become a content distribution vehicle.

“We ask the FCC to recognize that technological evolution has led to two distinct relationships in the last mile of the network: the current one, between an ISP and an end user, which is unchanged, plus a “remote delivery” service offered by an ISP to an edge provider...connecting the provider to all of the ISP’s end users,” argued Chris Riley, Mozilla senior policy engineer.

“Edge providers” are app providers, essentially, though the term can include any consumer hosting a server or a backbone network as well.

The idea of bifurcated regulation, essentially categorizing end user retail Internet access as a more lightly regulated information service, while “back end” interconnections between access ISPs and content or app networks would be considered “common carrier” or regulated services, initially was proposed by Mozilla.

Unintended consequences occur all the time. If the FCC bifurcated Title II proposal is adopted, and if it withstands legal challenge, app provider ISPs might wind up paying new sums to access ISPs, even if that was not foreseen.

Are Retail High Speed Access Prices Too High?

What is more important, nominal prices or prices expressed in terms of local purchasing power? That, in a nutshell, is why international comparisons of any goods or services have to be adjusted for purchasing power parity.

If that is not done, one can conclude U.S. Internet prices are too high. Adjusting for local prices, as when comparing the cost of an Internet access subscription to national income statistics, yields a different answer, namely that prices are quite low.

One might argue that consumer purchasing of products that are too expensive would be reflected in actual buying behavior.

In 2012, European Community adoption of fixed network access was about 27 percent of households, where U.S. adoption was in excess of 72 percent. So in which market are prices effectively too high, or value too low?

In the MENA region, fixed broadband costs about 3.6 percent of the average monthly income per capita, while mobile broadband costs around 7.7 percent of monthly income per capita.

The point is that cost is relative to local prices. What Internet access “costs” is relevant only in the context of prices for other products people buy. The point is that Internet access is most affordable in developed markets, even if nominal prices might be “higher.”

In the 46 countries studied, the cost of entry-level broadband exceeds on average 40 percent of monthly income. That is the case in nations where daily income is US$2. In other instances, Internet access represents 80 percent to 100 percent of monthly income, according to the Alliance for Affordable Internet.

Depending on the type of Internet access, a better metric is either price as a percentage of household income or price as a percentage of per person income. According to the International Telecommunications Union, developed nation prices per capita were about 1.7 percent of gross national income, where prices were 31 percent of gross national income in developing regions, in 2012.

What if There is No Way to Survive an OTT Attack?

Control of the value chain is a new concept for communications service providers. In the old world, where apps (voice) were vertically integrated with access, there was no question but that telcos controlled the value chain.

That is the fundamental difference between the past and the present. By definition, Internet Protocol separates apps from access. New business models at different layers are inherent in the protocol.

“Because connectivity costs are paid by the user, OTT players have great flexibility in their business models,” says Vision Mobile. “OTTs can monetize ads, downloads, analytics or acquisitions, and are thus able to price their services either free (Viber), close to free (Whatsapp), or even less-than-free (in the case of Google sharing app revenues with operators).”

The vertically integrated, “all-in-one” telco business model of bundling connectivity and service costs makes it impossible for telcos to compete with free or less-than-free OTT alternatives, Vision Mobile argues.

Skype for a time was seen as a direct competitor for telcos. Google apps have from time to time likewise is viewed as a direct competitor. Obviously, Google Fiber does make Google an ISP, and in that capacity is a direct competitor to other ISPs.

In theory, Internet access is a complement to Google, Facebook and other apps. Theoretically, demand for Internet access grows as consumption of apps grows.

In practice, most ISPs probably would see matters differently. In the prevalent view, Internet access is an input to the app business, a necessary foundation for the existence of the app business, but not necessarily a direct beneficiary of app segment success.

“As OTT players put increasing pressure on traditional telco profit centers, it is tempting to see them as direct competitors,” says Vision Mobile. “Yet, OTTs do not compete for telco service revenues; instead, they compete to control key links in the digital value chain, with business models that span consumer electronics, online advertising, software licensing, e-commerce and more.”

Connectivity is as important to the app provider business model as gas to a car. But the relationship is not necessarily symmetrical. In other words, one can prosper even if they other does not do so well.

Such asymmetric business models now are a fundamental fact of industry reality. There are many implications. In some cases, the success of any particular initiative is not measured by direct revenue, but by enhancement of the earning power of the access provider overall.

Also, even if some think telcos can compete directly with OTT providers, others would argue that is not a likely tactic.

The unknown issue is what other assets access providers control that can be monetized. Vision Mobile argues localization, user targeting, privacy controls or MVNO service customization are potential areas where access providers can create revenue.

The other big problem is that companies can get an unfair competitive advantage by breaking industry boundaries. In many cases, that means expanding into ecosystem adjacencies. So an app provider becomes a device supplier; a device supplier gets into e-commerce; a content supplier becomes an ISP or video services supplier.

That can create new business models based on monetizing in some indirect way. So Google makes money not on search, email, maps or other sales or subscriptions, but on advertising.

Amazon expects to make money not on profits from hardware, but sales of content to device owners.

Apple expects to make money not on mobile payments, music or apps, but on sales of devices that use those apps.

When confronted with the disruption of asymmetric competitors, incumbents face the choice between the decline of their business, or a grueling restructuring of their core business model, Vison Mobile argues.

The key point is that an asymmetric competitor when an asymmetric competitor enters a market, it often destroys most of the value in that market.

Redistribution of profits away from incumbents is a relatively secondary impact. The big change is that the total value of an affected market shrinks.

One illustration is that when consumers use over the top services that displace paid alternatives, some amount of usage, and therefore revenue, shifts away.

But the biggest impact is that the availability of “free to use” alternatives actually shrinks the size of the former market. Not only does some market share shift, the market itself shrinks.

Service providers hear all sorts of advice about “what to do.” Much of that well-intentioned advice will prove impractical, ineffective or successful, but not at magnitudes that really make a difference.

So far, it is questionable whether any major incumbent really can claim to have found a viable and sustainable model to survive an asymmetric attack, except by expanding into new lines of business.

Ultimately, that might be the only sustainable answer: legacy markets have to be replaced by new markets and products. There might not be a sustainable way to counter a direct asymmetric attack on a legacy market.

Uncertainty Threatens Investment in Gigabit Networks?

The reason service providers abhor “uncertainty” is the same reason any entrepreneur, investor or saver objects to uncertainty: making long-term decisions is a risky proposition when there is high uncertainty.

That is as true for Brazil as for the United States, the European Community or Mexico.

Many economists, in fact, would argue that much poverty around the world is caused because people are not assured that the fruits of their labor are safe from sudden confiscation.

It is not rational for a farmer to plant a crop if the farmer is not fairly certain he or she will be able to reap the harvest, in other words. The rule of law is a prerequisite for economic development, though not sufficient.

The problem at the Federal Communications Commission, argue Dr. George S. Ford, chief economist and Lawrence J. Spiwak, president, of the Phoenix Center for Advanced Legal and Economic Public Policy Studies, is that, despite public assurances that “regulatory certainty” is an FCC objective, the agency is behaving in ways that increase uncertainty.

And that will have consequences for capital investment.

“The reality remains that over the last few years the FCC has become entirely unpredictable, largely, we believe, because of the increased politicization of the agency's deliberative process,” say Ford and Spiwak. “Over the past five years, the FCC either has reversed, or is threatening to reverse, some of the most significant bipartisan deregulatory achievements of the past two decades.

“This dramatic reversal of FCC policy” means investors and carriers can no longer predict the agency's actions.

But some might argue that the Commission’s actions are clear, if unhelpful: increased market intervention that will lead to lower financial returns for investing in facilities.

Still, very long-term investments require “certainty,” or at least “stability,” which comes from a credible commitment to a long-term policy, the authors say.  

“Yet, the FCC has proven it will not make such commitments; its policies are anything but stable,” Ford and Spiwak say.

“Special access” circuits generally had been deregulated since 1999. But in 2012 the Commission suggested it would reimpose regulations on a product that is declining, being replaced by Ethernet connections.

Another example is the agency's decisions on forbearance from the 1996 Act's unbundling obligations. In 2005, at the request of Qwest Communications, the FCC used its authority under Section 10 to forbear from the application of (many of) the Act's unbundling mandates in parts of the Omaha Metropolitan Statistical Area based on the presence of a facilities-based competitor.

In 2009, a nearly identical forbearance request was made by Qwest for the Phoenix MSA. Not only did the FCC reject the petition, but it rejected its own precedent and created a new barriers to granting future requests.  

The agency's radical reversal towards forbearance between the Omaha and Phoenix petitions is significant, the authors say. “In these two cases, you had (a) the same carrier (b) submitting data showing a comparable competitive landscape and (c) a FCC whose staff was probably 90 percent unchanged.”

Yet, the agency reached two entirely different and conflicting decisions, Ford and Spiwak say.  

When the FCC first squarely addressed the issue of state laws restricting or prohibiting municipal broadband back in 2001, the Commission unanimously ruled that the agency lacked any legal authority to preempt such laws, a ruling which was ultimately upheld by the United States Supreme Court.

But FCC Chairman Tom Wheeler has said he believes “the FCC has the power--and I intend to exercise that power--to preempt state laws that ban competition from community broadband.”

This sharp reversal in policy and change in the agency's interpretation of its legal authority is troubling for a wide variety of reasons.

First, the law remains clear that the FCC lacks the authority to preempt state laws that restrict or prohibit municipal broadband deployment.

Second, should the agency decide to grant the Chattanooga petition, it will nakedly pick a fight with both the National Governors Association and the National Association of State Legislatures.

Third, the FCC is disregarding the advice of its own National Broadband Plan which explicitly recognized that “[m]unicipal broadband has risks” because it “may discourage investment by private companies”.

But perhaps the biggest issue is the potential reclassification of broadband Internet access from a lightly-regulated Title I “information service” to a heavily regulated common carrier “telecommunications” service under Title II.

Over a period of years, the FCC has classified cable broadband, wireline broadband, wireless broadband and even broadband over powerline as Title I information services.

“These four cases are but a sample of actions taken by the FCC that signal uncertain times for investors in this sector, especially investors in infrastructure upon which all else depends,” argue Ford and Spivak.

The mobile wireless industry has been deemed “effectively competitive” for some time. Yet, In the agency's last several reports, the FCC has refused to reach such a determination.

The great danger is that investment incentives are diminished.

Starz to Create OTT Service?

Starz is the latest programming network to say it is looking at launching its own over the top service.

But Starz also is careful to say it will work with its linear video distributors, primarily focusing efforts on broadband-only homes and homes that do not buy any premium channels.

Separately, Verizon now is offering a free year of Netflix for new customers buying a $89.99 triple play service.

That offer includes symmetrical 75 Mbps high speed access service, a $150 Visa gift card and a full year of Netflix.  

BTIG analyst Walt Piecyk thinks the marketing message is noteworthy. Though a major supplier of linear video subscriptions, Verizon actually does not mention that fact as part of the promotion.

Instead, the new offer banks heavily on high speed access and over the top Netflix. What that means is that Verizon is dead serious in viewing linear video as a product with less relevance for future revenue than over the top video.

The recent decisions by HBO and CBS to launch their own branded over the top video streaming services naturally have refocused questions about when OTT services will start to challenge the linear video business model in a significant way.

At least so far, HBO and Starz are trying to walk a fine line, assuring their linear video distributor partners that the new OTT services are complementary, while also creating direct-to-consumer services.

It isn’t so clear how much longer that stance will be necessary.

Up to this point, however, any number of would-be providers, ranging from Sony to Dish Network, have found content rights a barrier. Whatever the thinking about the long-term distribution market, any network widely carried on cable, satellite and telco TV networks would think very hard about jeopardizing the lucrative current business, for what most expect would be a smaller business, overall.

But the Federal Communications Commission might relatively soon move to make content rights less burdensome.

In Title VI of the Communications Act, Congress created rules to ensure that cable companies that own video content can’t raise artificial barriers to competition by refusing to let their video competitors have access to the programming they own. The rules allow apply to local TV broadcasters, who cannot refuse to license their content, if reasonable commercial terms are offered.

Those rules helped the satellite industry create a competitive offer, and now also telco TV providers. The FCC wants to include over the top streaming services within that framework, a move that would essentially compel cable-owned networks, and local broadcasters,  to license content to streaming providers, on relatively equivalent terms.

In other words, new streaming buyers would pay about as much as linear distributors would pay, at equivalent volumes.

Chaiman Tom Wheeler has asked the Commission to start a rulemaking that would update access rules pertaining to “multichannel video programming distributors” (MVPD) that would include over the top streaming providers, not just satellite and telco TV partners.

The result would be that streaming services using the Internet (or any other method of transmission) have the same access to programming owned by cable operators and the same ability to negotiate to carry broadcast TV stations that Congress gave to satellite systems and then to telcos.

That rule change, if adopted, would not directly alter the economics of the streaming business. But the change would mean would-be streaming service suppliers would be able to negotiate contracts giving the OTT providers much of the programming supplied by linear distributors.

In one way, any such rule change would eliminate a political (business) problem for the content networks, who have been reluctant to jeopardize their lucrative distribution agreements with cable, satellite and telco TV distributors.

Under the new rules, that essentially becomes a lesser problem, as many of the networks would simply be following the rules, and would have no choice in the matter.

In the end, the ability to create a sustainable business model does not change. But market entry gets easier.

How Do You Replace $400 Billion in Revenue in 10 Years?

We can disagree about how much new revenue some communications service providers will have to create over a decade’s time, to replace lost legacy revenues.

If global telecom revenue is about $1.6 trillion to $2 trillion, and assuming about half the revenue is earned in mature markets, then the revenue subject to disruption ranges from $800 billion to $1 trillion.

Half of that represents $400 billion to $500 billion. That, hypothetically, is the potential amount of global revenue that might be lost, and would have to be replaced.

What is more certain is that a huge amount of revenue from new services will be necessary, even if consumer purchases of Internet access continue to grow.

One fundamental rule of thumb is that, in mature markets,  service providers must plan for a loss of about half of current revenue every decade or so. That might seem shocking, but simply reflects historical developments.

Nor is that rate of change unusual. In the digital consumer electronics business, it might not be unusual for an executive to predict that half the products that drive sales volume in 10 years “have not been invented yet.”

What is new for the telecommunication business is that product replacement now is a fundamental issue, even if for 150 years the only product was voice.

source: IBM

In 2001, in the U.S. market, for example, about 65 percent of total consumer end user spending for all things related to communications and video services went to "voice."

By 2011, voice represented only about 28 percent of total consumer end user spending.

Over that same period, mobile spending grew from about 25 percent to about 48 percent. Again, you see the pattern: growth of about 100 percent (losses of 50 percent require gains of 100 percent, to return to an original level,  as equity traders will tell you).

Video entertainment spending likewise doubled.

In the U.S. market, one can note roughly the same pattern for long distance and mobile services revenue. Basically,mobile replaced long distance revenue over roughly a decade.

At one time, international long distance was the highest-margin product, followed by domestic long distance.

That changed fundamentally between 1997 and 2007.

Over that 10-year period, long distance, which represented nearly half of all revenue, was displaced by mobile voice services.

In the next displacement, broadband is going to displace voice.

That is not yet an issue in some regions that still are adding mobile and fixed network subscribers, but already is an issue in most developed regions, where voice and messaging revenues already are declining.

source: STL Partners

Though some might continue to hope that higher Internet access revenues will offset voice and messaging revenue dips, the magnitude of voice revenue declines will be so sharp that in many markets, even additional Internet access revenues will be insufficient in that regard.

In fact, rates of revenue growth have been dropping in all regions since at least 2005, according to IBM.

At least so far, ability to fuel growth by extending service to customers with low average revenue per user will continue to drive revenue growth, even for legacy services, for a while. The only issue is when saturation is reached in each particular market.

When that happens, the same pressure on voice and messaging revenue already seen in mature markets will be seen in presently-growing markets.

What Drives "Cord Cutting" and "Cord Avoidance?" Will Lower Prices Make a Difference?

Some 14 percent of U.S. households do not buy a linear video subscription, according to a new study by The Diffusion Group, up from about nine percent in 2011.

That has many linear video service providers trying to create lower-cost packages, on the assumption that price is the issue (actually price for perceived value). But lower prices might not attract buyers who do not value the product.

At this point, most observers would expect that "declining subscriber" trend to continue, driven by customers who decide they can live without the product, and those who so far never have bought the product.

About 6.5 percent of U.S. households have cut the cord, meaning they used to buy a linear video service but no longer do so. On the other hand, those statistics do not include respondents who never have purchased a linear video service.

The differences between the two groups--those who used to buy, and those who never have bought--are so pronounced that any company targeting these consumers must think in terms of two distinct packaging and pricing strategies, according to Michael Greeson, TDG president.

It often is tempting simply to say such cord cutting or cord avoiding behavior is driven by younger consumers. That is not an unreasonable observation.

Millennials are significantly more likely than their older counterparts to not subscribe to cable or other pay TV services. In fact, 18-34 year olds are 77 percent more likely than average to be a cord never” household and 67 percent more likely to be a “cord cutter” household.

But the issue is a bit more complicated. In fact, it is not clear whether the causation or correlation is household size or parental status, even more than age.

Some 60 percent of single-person households and 52 percent of households without children are “cord never” households. So single-person homes, and homes without children, are highly correlated with refusal to buy linear video service.

And that arguably is the bigger problem for linear video providers. Though some customers desert, others simply have never had any reason to buy the product. The difference is substantial.

The former group might be behaving in a way that suggests “I like the product, but it costs too much,” while the latter group is behaving in a way that suggests “I don’t find your product compelling enough to consider buying.”

More-affordable linear packages might turn the former into buyers again. That is not likely to work for the latter group.

What is so far largely untested is whether an over the top linear programming service would be substantially more favorably received by cord never households. It isn’t hard to imagine why the question exists.

About 40 percent of U.S. households subscribe to a paid digital video subscription service,

with Netflix being the leader (32 percent), followed by Amazon Prime Instant Video (19 percent) and Hulu Plus (9 percent).

Across all of these services, Millennials have significantly higher subscription penetration, with nearly half belonging to Netflix. That suggests a possibility that shifting former linear delivery services aimed at TVs to over the top services aimed at PCs, tablets and smartphones could represent a different, and more-attractive proposition for cord nevers.

Among Netflix subscribers, the preferred method of watching (44 percent) is through internet-connected TV devices such as Apple TV and Google Chromecast.

Computers (27 percent) and gaming consoles or Blu-Ray players (21 percent) also have strong levels of preference among the Netflix subscriber base.

On the other hand, the issue of household size and presence of children in the home could still be a key issue.

Netflix subscription has a strong relationship with household size, with the presence of children in the household likely a key factor. Among one person or two person households, Netflix penetration is less than 25 percent, but penetration jumps significantly to well over 40 percent among households of three and greater.

The point is that it remains unclear whether over the top streaming services or cheaper linear video services will appeal to each of the two groups (former buyers and those who never have bought).

The former might respond to a better value-price proposition. The problem with the latter group is that some might not value the product enough to pay. It isn’t the price; it is the product itself which is unwanted.