Telco Cloud Computing Revenue Opportunity is Still on Training Wheels

CenturyLink, like many other telcos, sees cloud computing as a key opportunity in the enterprise and business services segment of the communications business. There are several reasons for that belief.

Data centers now are primary generators of capacity demand. For example, Cisco’s latest Global Cloud Index estimates that global data center traffic will grow nearly 300 percent between 2013 and 2018.

By 2018, 76 percent of all data center traffic will come from the cloud, while 75 percent of data center workloads will be processed in the cloud.

But that might not even be the most significant prediction. Quantitatively, the impact of cloud computing on data center traffic is clear, Cisco argues.

Most Internet traffic has originated or terminated in a data center since 2008.

Where in the past most traffic (voice) functionally originated and terminate at a central office, though that traffic was passively transmitted to an end user telephone, now most global traffic originates and terminates at a data center.

At the same time, it is possible to argue that “cloud” now is becoming the architecture for computing in the present era, directly embedding the need for wide area and local area communications into the basic fabric of computing itself.

Where one might have argued that the addressable market for WAN transport providers was perhaps $232 billion in 2012, the addressable market now is much bigger. In fact, Bill Barney, Global Cloud XChange CEO argues the addressable market is six times larger.

That includes involvement in the $600 billion "software" business, as most software now is delivered or used "in the cloud."

The market also touches the $965 billion enterprise "information technology" business and the $103 billion data center business as well.

That doesn't necessarily mean WAN transport and services will displace most of the revenue in the extended ecosystem, only that WAN providers now play more central roles in those other areas, and for that reason will be generating additional revenue within the ecosystem.

That noted, cloud services still represent only about five percent of enterprise information technology spending. That is virtually certain to grow, as public cloud remains the first option for a minority of enterprise IT managers at the moment.  

According to Gartner, 75 percent of organizations use public cloud services today, “though sparingly,” while 78 percent plan to increase their investment in cloud services in the next three years.

Some 91 percent of organizations across all industries plan to use external providers to help with cloud adoption, Gartner says. That accounts for the belief that cloud computing can be a new revenue source for capacity suppliers, directly or indirectly.

In some cases, capacity suppliers own data centers as a way of generating direct revenue from data center clients, not just profiting from the communications into and out of the data centers.

By 2018, “data center to end user traffic” will constitute 17 percent of total “data center” traffic. About nine percent of traffic will move from data center to data center.

About 75 percent of global data center traffic will stay within the building, moving from server to server. That illustrates the value of generating direct revenue from data centers. Even if most clients will move data between servers in the center, that in-building traffic still eventually moves out onto the wide area network.

For most suppliers,  the primary revenue opportunity therefore is capacity.

Sometimes, Gigabit Access Primarily Leads to Sales of 20-Mbps and 40-Mbps Access

Investing in gigabit Internet access networks might be among the most-effective marketing tactics for at least some Internet service providers. But it might not be a product that many customers actually buy, in some cases.

Much depends on the range of available offers, the degree of competition in a local market and the positioning of gigabit offers by competing ISPs in a market.

Where gigabit access sells for closer to $100 a month, and is but one of several offers, gigabit headline speeds might lead to higher sales of 20-Mbps and 40-Mbps services, even if relatively few customers actually buy the gigabit service.

In fact, one example of demand dynamics explains why that might be so. In my own neighborhood in Denver, I can buy a gigabit access service for $110 a month, guaranteed for a year.

If what I want to buy is a 100-Mbps service, that costs $70 a month, with the price guaranteed for a year.

The 40-Mbps service costs $30 a month, guaranteed for a year. All those prices are for stand-alone service, with no phone service.

In that sort of environment, many consumers are going to conclude that 40 Mbps is “good enough,” and provides a better price-value relationship.

Where the only speed offered is a gigabit, priced at $70 to $80, take rates might well be higher. The issue is what other choices are available.

While CenturyLink hasn’t seen much demand for the gigabit Internet access service it began selling in Omaha in 2013, the product has helped CenturyLink sell slower speed services, according to Stewart Ewing, CenturyLink CFO said.

“No one takes a gig service,” Ewing said. “But they take a 20-meg or 40-meg service, and that’s fine.”

The other problem is that upgrades to gigabit speeds, or even 105 Mbps, might not actually lead to better end user experience. My own subjective experience is that 100 Mbps does not actually improve my experience, compared to 15 Mbps.

That might not be true for a household where multiple users are using the connection at peak hours. But that is not my own typical use case.

You Can't Forecast Telco Revenues and Costs 20 Years from Now

Projecting telco revenues and network costs 20 years from today is not useless, but likely to be highly inaccurate. 

As early as the 1990s, a rational executive could have claimed that the majority of firm revenue in a decade or two would be generated by products that had not been invented yet. That has largely proven to be the case.

Also, anyone in the forecasting business can look back on projections made 20 years ago and confirm the wisdom of not being too certain about such forecasts.

In the early 1990s, before the passage of the Telecommunications Act of 1996, it likely would have seemed inconceivable that the biggest U.S. telecommunications companies would, with a couple of decades, be minority suppliers of the key fixed network telecommunications products.

But that has happened. In the strategic high speed access business, the largest U.S. telcos have just about 41 percent market share.

Perhaps significantly, the incumbent telcos seem to be slipping further behind. In 2014, cable TV companies added 89 percent of the net high speed access additions, building on the 82 percent net gains cable TV companies made in 2013.

In the voice business that once drove 70 percent of industry revenue, Verizon Communications recently sold $10.5 billion in fixed network assets, to support its capital investment in mobile spectrum, the one area where the tier one telcos still dominate.

From 2000 to year-end 2013, telcos will have lost nearly 62 percent of all traditional phone lines  and 70 percent of traditional residential voice lines, USTelecom says.

For the twelve-month period from mid-2011 through mid-2012, residential and business consumers dropped 10.1 million ILEC switched voice lines, a twelve-month decline of 10.7 percent, according to Federal Communications Commission data..

From 2000 to mid-2012, the number of ILEC switched lines fell from 186 million to 84 million, or a decline of 55 percent. Straight-line trends suggest ILECs will have lost approximately 62 percent of these lines by the end of this year, according to the USTelecom.

Telco switched line losses have been greatest in the residential market, where the annual rate of decline from mid-2011 to mid-2012 was 13.6 percent, USTelecom says.

In 2000, some 120 million consumer voice lines were in service. As of mid-2012, there were approximately 45 million consumer telco lines being purchased, a decline of 63 percent.

Newer services such as linear video entertainment represent a smallish percentage of telco revenues, as both AT&T and Verizon have about six percent market share each, of the traditional subscription TV business.

AT&T’s planned acquisition of DirecTV notwithstanding, entertainment video has been--and always has been--a tough business proposition for any telco, of any size.

One study conducted for an independent U.S. telco in the early 1990s found the video subscription business would reach positive net present value only after eight full years of operation, even with a “first installed cost” of just $800, at $365 annual revenue for a subscriber.

The analysis by our consulting team assumed at 20 percent net income and a 12-percent discount rate. In other words, the venture would make money, but only barely, with breakeven in year nine of the 10-year investment lifecycle.

Even that analysis assumed use of fixed wireless access, as the first installed cost of asymmetrical subscriber line in the early 1990s ranged as high as $8,000 per line, at a time when fiber to the home cost $4,500 per line and fiber to the curb cost about $2500 per line.

Much has changed since the early 1990s. Access costs have fallen. Video revenues have skyrocketed. Significantly, the early 1990s analysis included zero revenue contribution from what we now call “Internet access.”

The biggest conclusion might be the near futility of forecasting network costs and revenue streams as they will develop over a couple of decades.

Are Spectrum Prices Out of Whack?

Equity valuations of Sprint, T-Mobile US and Dish Network seem out of line with the theoretical value of their spectrum holdings. Something does not seem right. Either the market is mispricing those firms, or the market is overvaluing spectrum assets.

It seems like the spectrum valuation is the mistake.

U.S. mobile service provider Dish Network Dish Network is gambling in a big way with its spectrum strategy, assuming it can monetize its mobile spectrum assets in some way.

The fact that some analysts believe 80 percent of the company’s equity value now rests on the deployment of that spectrum for commercial purposes illustrates the magnitude of the gamble.

Dish has assembled a portfolio of about 55 MHz of spectrum to support Long Term Evolution networks, but faces a 2017 deadline to get 40 percent of that spectrum activated, allowing mobile customers to buy service.

If it misses that deadline, Dish Network must deploy enough of its spectrum to reach 70 percent of U.S. consumers by 2020.

If not, Dish loses the spectrum, and possibly 56 percent to 80 percent of its market value.

Dish Network assumes it can either sell its spectrum for $25 billion to $45 billion, create a wholesale mobile business using the spectrum, or perhaps buy one of the U.S. mobile operators.

Dish will get no help from AT&T or Verizon. Sprint and T-Mobile US are viewed as possible partners. But Sprint, T-Mobile US and Verizon are viewed as the likely actors, for any Dish move.

T-Mobile US has been viewed as an acquisition target for Dish Network. Sprint has been viewed as a partner, leasing network facilities to Dish Network so spectrum can be converted into retail capacity.

Verizon has been seen as a buyer of Dish Network Spectrum.

There is a potential obstacle, though. The value of Dish Network’s spectrum, in the wake of prices paid in the recent AWS-3 spectrum auction, are high enough to make any purchase transaction for Dish Network spectrum very costly.

In fact, that auction featured the highest prices ever paid for mobile spectrum. Based on those recent precedents, some expect the 2016 auction for 84 megahertz worth of 600 MHz spectrum

could cost between $15 billion and $30 billion.

That upcoming auction is a part of the very-complicated spectrum acquisition picture. AT&T spent $18 billion in the AWS-3 auction; Verizon about $10 billion. A 2016 auction would require each firm to raise more debt, something neither is keen to do, and which neither Sprint nor T-Mobile US can afford, either.

But other spectrum conceivably will be made available. Shared spectrum in the 3.5 GHz band, new Wi-Fi spectrum in the 5-GHz band and then additional spectrum in the millimeter bands all are expected to be made available for commercial use, at some point.

Also, some spectrum presently not considered available for sale, including low power TV spectrum, could be considered for auction as well. In light of the AWS-3 auction prices and the upcoming 600-MHz broadcast TV spectrum auction, some within the low power TV business think they should have the ability to sell their TV spectrum as well.

There are, in 210 TV markets, 2,650 low-power TV licenses, representing an aggregate 15,900 MHz of spectrum, according to Mike Gravino, LPTV Spectrum Rights Coalition director.

Based on the AWS-3 auction prices, that spectrum might be worth $50 billion dollars, Gravino said.

There are lots of moving parts.

So one way of looking at matters is that, were Dish Network to sell, at AWS-3 prices, that spectrum might cost  $56 billion to $80 billion. The 600-MHz auction might add another $15 billion to $30 billion.

Sprint has talked about selling some of its excess 2.5-GHz spectrum. At AWS-3 prices, that implies a possible value of $155 billion, far in excess of the current market value for all of Sprint, about $21.3 billion.

Also, consider that T-Mobile US just spent $10 billion on AWS-3 spectrum. T-Mobile US current market capitalization is about $26.5 billion.

A rational person might conclude that something is out of whack, and that the likely problem is spectrum valuations, which are too high.

Spectrum valuations might be so costly, in fact, that many conceivable options for buying or selling spectrum might be beyond reach.

Will FiOS Ever Pay Off for Verizon?

Exhaustion of the older revenue models and products means firms such as Verizon increasingly will rely on new services to drive revenue growth in the future, Verizon CFO seems to agree.

With the caveat that AT&T arguably is far more exposed to consumer revenues in it fixed network segment, Verizon’s earnings from its fixed networks show why Verizon was not keen to expand its FiOS deployment.

About 40 percent of fixed network  revenue comes from the residential market, notes Michael Hodel, Morningstar analyst. So an important observation is that Verizon makes its money in the fixed network segment from business customers.

The reason Verizon only earns 40 percent from consumers is that it faces ferocious and successful competition from cable operators. “We estimate Verizon now serves less than 40 percent of the households in its territory, down from nearly 60 percent five years ago,” Hodel says.

In other words, where it has built FiOS networks, 60 percent of the access investment is stranded and does not earn a return. That also means full recovery of invested capital has to be carried by the 40 percent of actual customers.

“We believe that losing customers will make it difficult for Verizon to earn a solid return on FiOS network spending or justify network upgrade spending beyond where FiOS already exists,” Hodel argues.

Verizon's network is future-proof. “But returns on this investment have been poor, as we calculate fixed-line asset turnover and margins trail most peers,” said Hodel.

On the other hand, Verizon generates about 70 percent of its total revenue from its mobile segment.

Verizon Wireless of course is working on new sources of revenue, “but the revenue opportunity in these areas may not prove adequate to maintain the current rate of growth across the industry,” Hodel said.

Irrational pricing by Sprint or T-Mobile US or both could threaten Verizon’s mobile cash flow, as could heavy new spending on spectrum.

If consumer revenue growth stalls or if the enterprise market continues to struggle, Verizon may have trouble expanding fixed-line margins as planned.

And Verizon’s cash flow is not what it once was.  Free cash flow of $13 billion in 2014 was 36.5 percent less than in 2013.

Since the $130 billion acquisition of Wireless from Vodafone in 2013, Verizon's debt has more than doubled to $113 billion, while its shares outstanding has increased almost 40 percent.

That limits both borrowing and equity issuance as avenues to raise capital. For that reason, some might doubt Verizon has the ability to buy Dish Network’s spectrum, and Verizon likely has no interest in acquiring Dish Network’s video business.

Might Verizon be better able to augment its spectrum position by buying excess Sprint spectrum? That might seem more reasonable.

Market Power Issues Lie in High Speed Access, Not Linear Video

Beyond looking at traditional market share and competitive impacts of the AT&T acquisition of DirecTV, and the Comcast acquisition of Time Warner Cable, regulators and antitrust officials also might consider the relative fortunes of the video and high speed access markets as well.

Simply, the high speed access market is growing, while the linear video market has begun declining. It might not be part of the formal mathematical screening, but it arguably makes good sense not to regulate declining markets in the same way as growing markets are regulated.

Virtually all observers believe linear video is a product that already has entered the declining part of its lifecycle, while high speed access arguably remains short of a peak.

Also, few might disagree that the most-important consumer service now is Internet access. That is why U.S. universal service funding now centers on Internet access, not voice.

The 17 largest U.S. cable and telephone providers in the United States acquired three million net additional high-speed high speed access subscribers in 2014.

By way of contrast, the 13 largest linear video providers in the United States lost about 125,000 net video subscribers in 2014. That is about a two orders of magnitude difference in growth rates.

At the same time, cable companies had  51.9 million broadband subscribers while telephone companies had 35.4 million subscribers. In other words, the leading cable companies had 59 percent high speed access market share.

The top cable companies gained 89 percent of the net additions in 2014, and 82 percent of the broadband additions in 2013.

In other words, in addition to commanding market share position, the cable industry seems to be accelerating its market share gains.

At the same time, cable companies continued to lead in video market share.

The top 13 linear video providers had 95.2 million subscribers. The two satellite TV companies had 34.3 million subscribers, while the two top telephone companies had 11.6 million subscribers.

Both AT&T and Verizon had fewer than six million video subscribers each.

The point is that the market concentration problems are in the high speed access area, not video.

Will AT&T Become the Biggest Wireless ISP?

Assuming the AT&T bid to buy DirecTV is approved by regulators and antitrust authorities, AT&T plans to launch a rural areas bundle based on Internet access and TV including Internet access, using fixed wireless technology.

The original plan called for access up to 15 Mbps or perhaps 20 Mbps. That might change now that the Federal Communications Commission has revised the definition of “high speed” to reflect a minimum of 25 Mbps.

Some think the odds of approval are about 50-50. At least so far, public opposition has been fairly muted, compared to the heat the proposed Comcast acquisition of Comcast has generated.

Perhaps that is because the key service, with the greatest strategic implications, is high speed access, not video, in the same way that voice services no longer are the strategic service for other fixed or mobile service providers.

Comcast has argued, with some reason, that video service competition would not be harmed by its acquisition of Time Warner Cable. Many do not agree, but it is true that the two firms actually do not compete head to head very much.

Comcast also has agreed to divest enough video accounts to keep its video market share below 30 percent.

On the other hand, many warn that Comcast’s share of high speed access would climb beyond 50 percent, with a disproportionate share of access at speeds above 25 Mbps.

Perhaps significantly, 63 percent of U.S. homes would have only one provider capable of providing 25 Mbps speeds, and Comcast would provide that access. Historically, antitrust scrutiny has been high whenever a single provider reaches 30 percent share of the market.

AT&T earlier had said it would provide service to about 13 million rural locations using fixed wireless.

Such a development would make AT&T the largest wireless Internet service provider (WISP) in the United States. Up to this point, only Clearwire had tried to build a big business using fixed wireless technology, and even Clearwire had switched emphasis to mobile broadband.

Presumably linear video entertainment would be provided by the DirecTV network.