How Facilities-Based Competition Dramatically Increases Business Risk

Facilities-based competition in access markets qualitatively increases business risk.

Consider sales expectations in a monopoly environment. If voice adoption was high--90 percent to 95 percent--revenue per passed location was a number nearly identical to revenue per customer location.

All that changes when there are two or more competitors with roughly equal capabilities and market share.

The business model for fiber to premises networks using industry-standard fiber-to-home platforms provides a clear example.

Depending on the deployment situation, the cost per location might range somewhere between a high of US$2,250 per site and US$660 per location on the lower end, including activated drops, but not including any required customer premises equipment.

Assume an “average network cost” of $1455 per location passed. If customer adoption is 95 percent, then the “per-customer” cost is about $1528.

In a duopoly market, the investment costs are radically different. Assume the network is expected to have a 50-percent adoption rate (one out of every two locations buys at least one service). Then the per-customer cost is $2910.

The economics obviously get worse in a three-provider market where expected take rates are 33 percent (again assuming three equally-skilled and capitalized competitors). In that scenario, a new provider might have to expect network costs of $4365 per actual customer.

You readily can see the business model problem. In a monopoly environment, per-customer network cost is just $1455. In a duopoly  market the per-customer network cost might be $2910. In a three-provider market, network cost might be as high as $4365 per customer.

In other words, investment in a monopoly environment is three times higher, per customer, in a three-contestant market, and roughly twice as high as in a duopoly market.

Against that, assume $70 to $130 of revenue, in some cases. Over a three-year period, that is about $2520 to $4680 in revenue, per customer.

By rough estimate, assuming a customer life cycle of 36 months, the network might not even break even over three years, based solely on network costs.

Some U.S. ISPs, such as Sonic.net, are retailing gigabit connections plus voice for $40 a month, though. That implies three-year revenue of just $1440 per subscriber.

Assume a smaller operator could manage to connect a customer and activate service (including customer premises equipment) for about $300, where a telco connection might cost as much as $800.

So add network cost, plus service activation cost, of only $300 per site. That implies direct network-related activated customer investment of $1755 in the monopoly case, $3210 in the duopoly case and $4665 in the three-provider market.

Assume the ability to earn $130 a month of revenue requires selling video entertainment services, with higher customer premises equipment investment. So then use the $800 per customer figure for an activated location.

That implies monopoly scenario investment in network and CPE of $2255, growing to $3710 in the duopoly case and $5165 in the three-provider scenario. Recall that a three-year customer life cycle at $130 a month represents $4680 in account revenues.

All of that is before operating costs, franchise payments and marketing. Clearly, service providers are counting on longer customer life cycles, incrementally higher revenues and muted operating costs, to make the business case work.

source: Telecom Circle

The fundamental point is that the economics of a competitive fixed network business case are radically more difficult than in a monopoly environment.

Three Decades of Telecom Disruption

To say the global telecom business is “different” now since a wave of worldwide deregulation, privatization, investment and emergence of the Internet is a vast understatement. But consider just a few of the biggest changes.

Pre-1980, most national telecom infrastructures were dominated by a single monopoly provider, often owned by the government. In fact, telecommunications was widely believed to be a natural monopoly.

So prices were high, profit margins were high, innovation was low, revenue growth very limited, and the size of the market quite stable.

After deregulation and privatization, prices dropped dramatically, investment increased, total revenue increased, profit margins dropped and rates of innovation climbed dramatically.

In 1991, state-owned telcos numbered about 150. By 2008, that number had dropped to about 70, according to the International Telecommunications Union. By 2008, some 125 nations had fully or partially privatized former state-owned telecom companies, lead especially by mobile operations.

At the same time, the emergence of the Internet and mobility reshaped platforms, the way applications are developed, the power and influence wielded within the ecosystem, business models and value drivers.

At the same time, communications capabilities were rapidly extended to those who previously had no access, rather suddenly transforming a market where perhaps half the world’s people could not “make a phone call” to a world where most adults now have such access, after just a few decades.

And while a similar change, allowing everyone Internet access, is only now underway, it is reasonable to expect that challenge also will be solved, more rapidly than anyone originally might have believed possible.

Three Decades of Disruption
1980	2015
Natural monopoly	Oligopoly
High margin	Moderate to low margin
Low to moderate adoption	High adoption
Low innovation	High innovation
Stable markets	Unstable markets
Compete on quality	Compete on price
Fixed network dominates	Mobile network dominates
Tightly integrated apps and network	Open network
Voice business model	Internet access, mobile business model
Similar business models globally	Growing diversity of business models
99.999% uptime	99.9% or “good enough” availability
Few lead apps	Many lead apps

End of Natural Monopoly

It is worth remembering that, until the 1980s, most analysts and regulators assumed telecommunications was a natural monopoly, akin to roads, bridges, sewer services, water and electrical services.

The corollary was that “competition” was believed not to be possible.The best regulators believed they could do was manage the social contract, balancing monopoly supply with price and profit controls.

In wider context, the 1980s was a time of new thinking about regulation of businesses formerly thought of as natural monopolies. In a growing number of instances, regulators decided telecommunications actually was not a natural monopoly, and began deregulating the business.

source: ITU

source: ITU

In many markets, especially with the advent of mobility, we now see that telecommunications is not, in fact, a natural monopoly. There is at least some room for facilities-based competition, though the number of viable contestants will be limited.

That does not generally mean “unlimited” competition is sustainable. Telecommunications is so capital intensive that only a few viable contestants can sustain themselves, long term.

So fixed and mobile telecommunications are best thought of as oligopolistic, where only a few leading suppliers actually can exist in a market.

There are key implications. It likely never will be possible for more than a few facilities-based competitors to survive in any market.

That naturally will lead to thinking about regulatory policies based on robust wholesale obligations. The downside: robust wholesale tends to depress both investment by the existing carrier, and market entry by new carriers.

So the issue is not monopoly versus widespread market entry, but between monopoly and the best-possible (sustainable) level of competition among a limited number of contestants. That always will be a judgment call.

But that also poses issues for telecom regulators. If the regulated markets will, under the best of circumstances, only support a few suppliers, where is the boundary between oligopoly conditions where there is not enough competition, and oligopoly under which there is reasonable competition?

“High market concentration levels in a given market may raise some concern that the market is not competitive,” the Federal Communications Commision says. “However, an analysis of other factors, such as prices, non-price rivalry, and entry conditions, may find that a market with high concentration levels is competitive.”

In other words, says the FCC, even high levels of concentration do not necessarily mean a market is uncompetitive. Such markets might, in fact, be substantially competitive, even when other measures say they are not competitive.

We might not like the situation, but in some industries--including telecommunications--oligopoly is the pattern. There always are smaller niches within the market, but typically the amount of activity is a small fraction of total market revenues.

What is Happening to Revenue, Profit in the Access Business?

The state of the global telecommunications business, even the U.S. telecom market, or any of the industry segments, is hard to explain in a single number, or even a time series.

At one level, it is easy to point to continual growth. In fact, it would be hard to find a single year where aggregate revenue failed to grow, globally or in any single country.

But what that growth means for various providers, and different product segments, often is a different matter altogether.

                                         U.S. Telecommunications Revenue

source: Trading Economics

The top line paints one picture.

From 2015 to 2020, U.S. wireline revenue will grow from $270 billion to $276 billion, at a compound annual growth rate of 0.4 percent, while U.S. mobile revenue will grow from $217 billion to $271 billion at a CAGR of 4.5 percent, according to Insight Research Corp.

Globally, communications revenue is projected to grow from $2.2 trillion to $2.4 trillion at a compounded annual growth rate of 2.3 percent from 2015 through 2020, Insight Research Corp. estimates.

The detail might tell a very different story.

In 2002, the U.S. telecommunications industry’s gross revenues were $385 billion (including cable and satellite TV), and its net revenues (after interconnection costs, program content, and handset subsidies) were $315 billion.

By 2013, even while consumer revenues grew, aggregate business segment revenues fell at least 15 percent.

And that understates the changes. Fixed network revenue fell by half. All the net revenue growth came from mobility or linear video services.

More significantly, where 85 percent of total Verizon earnings were driven by the fixed network, by 2013 the fixed network represented just 21 percent of earnings.

source: Phil Wilson & Geri C. Gibbons

From 2015 to 2020, fixed network revenue will grow from $1.0 trillion to $1.1 trillion at a CAGR of 0.8 percent, while mobile revenue will grow from $1.1 trillion to $1.4 trillion at a CAGR of 3.5 percent.

Mobile revenues passed fixed network revenues a few years ago and by 2020 mobile revenue will be 25 percent higher than fixed revenue, according to Insight Research.

source: Global Telecommunications, International Telecommunications Union

source: Insight Research Corp.

source: Insight Research Corp.

The point is that gross revenue alone does not tell you what is happening with product demand or profitability.

International long distance, fixed voice, and now mobile voice and messaging, have suffered. High speed access, Ethernet access, cloud computing and mobile data have benefited.

Cable TV operators make more money, but many competitive providers make less, or are out of business.

New contestants, such as Google Fiber, Comcast and independent Internet service providers are demonstrating that facilities-based competition is more feasible than once believed.

So “total revenue” does not tell the story of what is happening “inside” the communications business, even at the level of access revenues, to say nothing of how application markets are changing.

With Fixed Network Revenues Cut in Half, U.S. Service Provider Strategies are Diverging

In 2002, the U.S. telecommunications industry’s gross revenues were $385 billion (including cable and satellite TV), and its net revenues (after interconnection costs, program content, and handset subsidies) were $315 billion.

By 2013, wireline gross and net revenue both had fallen by more than 50 percent compared to 2002.

Disruption of that magnitude is bound to affect core business strategy in ways that likely will lead to firms taking disparate paths forward. Vodafone started out as a “mobile-only” company that now operates both fixed and mobile networks.

Verizon started out as a fixed line provider that by 2016 should generate 85 percent of Verizon earnings (EBITDA).

In 2014, mobile contributed 70 percent of Verizon revenue, so that expectation is not out of line. In the first quarter of 2015, mobility contributed $22.3 billion in revenue and $10 billion in earnings. The fixed segment generated $9.5 billion in revenue and $2.2 billion in earnings (EBITDA).

AT&T had a similar profile as Verizon, originally, as both began life as “Regional Bell Operating Companies” that provided voice and other services on local networks, but no long distance services.

AT&T has greater exposure to fixed network revenue. AT&T earned 54 percent of total revenue from mobile services and got 60 percent of its 2013 earnings from mobile services.

Mobility represented 67 percent of earnings after subtracting required capex. The percentage of revenue earned from other sources has changed, however.

On an annualized basis, AT&T will earn about 46 percent of its revenue from business sources and about 54 percent from consumer services in 2015.

That is a big change from the prior year, when AT&T earned about 54 percent of revenue from its business solutions category.

The perhaps-shocking change is that AT&T, on an annualized basis, will earn just 22 percent of revenue from consumer mobile services, making AT&T almost a mirror image of Verizon, which earns about 85 percent of total revenue from mobile services.

Altogether, about 41 percent of AT&T’s total revenue is earned from mobility services (business and consumer). About 38 percent of business solutions revenue was generated by business customer mobile services.

In the third quarter of 2015, AT&T earned about 45 percent of total revenue from business solutions, 28 percent from entertainment and Internet services and 24 percent from consumer mobility.

The operating income story is more skewed, at least before the impact of DirecTV’s video business is fully reflected in full-year results.

Business solutions represented 66 percent of total operating income in the third quarter of 2015.  

Consumer mobility represented 38 percent of operating income. Entertainment and Internet Services had negative operating income, as did the International segment.

In terms of operating income, it all came from business solutions and consumer mobility. That will change in 2016. Stil, AT&T is likely to earn a disproportionate share of operating income from business services, compared to Verizon.

AT&T’s markedly higher profile in linear video should be reflected in 2016 results. Where Verizon has a bit more than five million linear video subscribers, AT&T now has more than 25 million.

Verizon’s strategy also contrasts with AT&T and CenturyLink, the second and third largest legacy telecom providers.

AT&T already has committed to an international growth strategy, while CenturyLink has a U.S. wireline focus.

The point is the differentiation of business strategy. Companies increasingly are taking different strategic approaches to growth.

105% Increase in U.S. Internet Access Speeds Over Last 12 Months; Cable TV ISPs Drive Almost All the Increase

With the caveat that mobile and public Wi-Fi now play growing roles in the U.S. Internet access function, the Federal Communications Commission now illustrates the power of the cable TV hybrid fiber coax network where it comes to rapidly increasing Internet access speeds, compared to use of telco digital subscriber line.

“When DSL is used to provide broadband service, the maximum advertised download speeds among the most popular service tiers has remained generally unchanged since 2011,” the FCC reports.

“In contrast, when cable is used to provide broadband service, the maximum advertised download speeds among the most popular service tiers has increased from 12-30 Mbps in March 2011 to 50-105 Mbps in September 2014.”

“We find that, over the course of our reports, the average annual increase in actual download speeds by technology has been 28.2 percent for DSL, 61.2 percent for cable, and 19.2 percent for fiber,” the Measuring Fixed Broadband report says.

“Generally, speed tiers at 15 Mbps and below are dominated by DSL, while speed tiers above 15 Mbps are dominated by cable and fiber,” the FCC says.

Perhaps significantly, cable has achieved a speed advantage even over telco fiber-to-home services. But data in the next report could show changes, if data from independent providers including Google Fiber are included.

All that noted, between September 2013 and September 2014, there was a 105 percent increase in the maximum advertised download speeds among the most popular service tiers across the studied ISPs, with most of the increase coming from the ranks of cable TV providers.

                  Maximum Advertised Download Speed (Most Popular Tiers)

source: FCC

Generally speaking, latency performance was best for fiber access, good for cable access, less good for digital subscriber line and worst for satellite, as you might expect. However, latency performance for any the fixed network providers is unlikely to negatively affect experience. That might not be true for the satellite ISPs.

                                             Fixed Network Latency Performance

source: FCC

                                                Satellite Latency

source: FCC

Several studies have suggested that, beyond about 10 Mbps, users are unlikely to perceive any incremental improvement in experience, no matter how much faster downstream access speeds get.

The latest FCC data suggests that remains true. Beyond 15 Mbps, web pages do not load any faster, for example.

                            Average Webpage Loading Times, by Downstream Speed

Words Matter

Words matter. YouTube says T-Mobile US is throttling its video. T-Mobile US has not directly responded, but T-Mobile US does process video, as part of its Binge On program, for bandwidth efficiency, in ways that can reduce image quality. The trade-off is that viewing Binge On video does not count against mobile data usage.

YouTube is not part of Binge On, so some think the issue is that T-Mobile US has not yet figured out a way to identify YouTube video content, one way or the other.

So is video encoding, for better bandwidth efficiency, at the risk of lower image quality, throttling or only processing?

Some might argue, oh by the way, that processing media types for better performance (lossless) is a good thing. Image degradation that is not asked for, or wanted, is not a good thing. But Binge On partners have agreed to have their video processed as part of the program.

Nor, some would argue, should content providers be prohibited from coding that actually boosts image quality or loading times. That is, after all, what they pay Akamai and others to provide.

Why IoT is Necessary

There is an easy way to illustrate why there is so much interest and effort in the mobile industry around “Internet of Things.” Simply, every other major product category is mature, or declining.

The next wave of products to drive revenue growth must be discovered or created, and IoT seems the best candidate for such growth.

Though we might not have always seen telecom products as having life cycles, that appears to be the case.

First fixed network voice, then messaging, then “talking” have experienced either declining usage, or declining revenue, or both. Now linear video entertainment also seems to be past its peak. The only two services that so far have defied decline are mobile service and Internet access, both of which continue to grow.

Mobile service revenues, which had been the growth driver for more than a decade, not have reached maturity in Europe, for example.

source: 451 Research