How Important is Network Effect in Telecom? Not Very, at Industry Level

It is a truism that network effects are key to many businesses and industries, ranging from social media networks to access networks. The network effect describes a situation where the value of a product or service is dependent on the number of others using it.

But there are other “scale” effects that shape the profitability of business models, ranging from “economies of scale” (lower unit costs possible because of customer mass or volume) to “economies of scope” (efficiencies created by product variety, not single-product volume).

source: atkearney.co.uk

Ideally, if one had a choice to operate in any industry, the “best” pick would be an industry with low scale requirements and high barriers to consumer switching behavior. Such industries are hard to find, as many consumer-facing  businesses require scale.

In that respect, internet access is in a difficult environment. It requires lots of capital, tends to earn lower profit margins than many other industries, requires some amount of scale and yet also has low barriers to customer switching behavior.

So scale does matter. Scale helps a supplier cope with high churn and high fixed costs.

There are other nuances. Economies of scale can be built on the producer side (firms get bigger) or the consumer side (more customers join a single network).

In the U.S. mobile service provider business, both producer and consumer network effects are important, but arguably less important than the scale advantages (scale and scope). In principle, every mobile customer, on any network, can communicate with all other customers of all other networks, meaning that the network effect for “mobility” is very high, even if, at the firm level, there is not such a network effect.

In other words, the universe of networks enjoys high network effects, even if no single small mobile service provider can gain such effects on its own.

Perhaps oddly, the network effect no longer confers mobile or fixed service providers much business advantage, since all suppliers must interconnect. On the other hand, economies of scale and scope do matter quite a lot.

Small telcos, cable operators and internet service providers now find they cannot make a profit on linear video subscriptions, for example. Likewise, service providers that offer only a single service (internet access, voice/messaging or video entertainment) will find their business models quite challenging.

New 2-Sided Markets?

Two-sided markets have existed in the content business for quite some time, even if new versions have appeared in the form of ride-sharing and room-sharing services. Such two-sided markets, with one salient exception, might be hard to create, in the mobile industry.

In the older version, a market maker makes money from both “buyers” and “sellers” of some product, even as the market maker primarily connects buyers (content consumers) with sellers (content owners).

Video subscription providers have earned revenue by selling consumers subscriptions (access) to desired content, but also have earned revenue from advertisers and content owners (local advertising the former; carriage fees in the latter case). More recently, content owners have turned the tables and now generally extract carriage fees (affiliate fees) from distributors.

But distributors still earn subscriber fees from consumers and local advertising revenues from third parties.

The strategic issue for at least some tier-one communications service providers is how to create new platforms, supporting new markets, that connect buyers and sellers.

Some of the new platform opportunities are more traditional “one-sided” markets. Consider mobile advertising, where revenue is earned only on one side of the platform, from third parties that want to place messages reaching the platform’s users (mobile customers).

That likely will be true for most internet of things use cases as well, where network operators will earn revenues from enterprises or other organizations that want to place sensors into the environment. Revenues in that case are earned by supplying the connectivity for the sensor networks, from “one side” of the platform.

At least in principle, two-sided markets are conceivable, where the mobile service provider also operates at the application level, owning and then operating marketplaces that connect buyers (job seekers, content seekers, patients) and sellers (employers, content suppliers, medical services providers).

source: digitalpolicy.org

Google Fiber Getting Out of Linear Video: No Surprise

The developing storyline around Google Fiber is that it is getting out of the linear video subscription  business because that business is dying. One need not look so hard for other conventional explanations. As every small telco and cable operator has known for decades, without scale, it is impossible to actual make a direct profit from linear video.

That was true even at the height of demand for linear video subscriptions. A couple of decades ago, as part of a due diligence review by a telco looking to buy cable TV assets, I asked the CEO what would happen to his business model if the subscription rate dropped from the then-current 90 percent rate to 70 percent. He immediately blurted out “then we’re dead.”

Keep in mind that this was before internet access or voice services were part of the bundle. The point is that even for a cable company with hundreds of thousands of subscribers, there was very little room in the business model for a dip in subscribers from 90 percent to a lower figure.

For any firm such as Google Fiber, with less than 100,000 subscribers, the video entertainment business case (as a stand-alone product) almost certainly will not work. For video as for any other consumer service, scale really does matter, a fact small cable TV and telco operators always have lived with.

Peak Mobile? Data is Mounting

It is too early to tell whether one sign of a peak product life cycle has been reached in the U.S. mobile market. It is possible a current bout of price competition will ameliorate and reverse as the U.S. market consolidates.

Also, mobile operator data data revenue growth was negative, for the first time ever, in the first quarter of 2017. That matters because such growth has driven overall revenue growth for 17 consecutive years.

Altogether, about $3 billion worth of quarterly revenue has disappeared from the U.S. mobile service provider market in the second quarter of 2017, representing a $12 billion annual loss, if the trend continues.

Verizon suffered its first ever decline in service revenues, year over year, according to analyst Chetan Sharma. 

Also, for the first time, net adds for connected (cellular) tablets were negative as well. For the first time, while postpaid net-adds were negative as well. 

To be sure, T-Mobile US has taken market share and revenue. But the bigger story is the revenue shrinkage.

source: Business Insider

To be sure, T-Mobile US has taken market share and revenue. But the bigger story is the revenue shrinkage.

source: Business Insider

How Much Market Share Can Independent ISPs Take from Incumbents?

How much market share can independent internet service providers take from cable companies, telcos and mobile operators? In the market as a whole, not so much. The business remains a matter of scale, and scale is expensive.

On a local level, the impact can be quite significant, in principle. In the mobile market, about two percent share is held by all firms other than the four national leaders.

Ting Internet has a rather dramatic set of assumptions for deciding where it enters a new internet access market: it assumes it will get 20 percent market share at launch, growing to 50 percent market share within five years, in markets where a telco and a cable operator already operate.

Aggressive? Yes. Even Verizon, where it has built and marketed fiber to the home services for years, typically gets market share only in the 40-percent range.

To be sure, the U.S. internet access market represents perhaps $160 billion in annual revenue, of which fixed access generates nearly $60 billion annually. But scale is hard to achieve in market so big.

Also, there is some evidence that users are switching to mobile internet access. Fixed network internet access subscriptions in the United States have declined in recent years, falling from 70 percent in 2013 to 67 percent in 2015, for example.

Some 13 percent of U.S. residents rely only on smartphones for home internet access, one study suggests. Logically, that is more common among single-person households, or households of younger, unrelated persons, than families. But it is a significant trend.

Some suggest that service providers are actively pushing mobile services as an alternative to fixed access, for example.

In fact, some studies suggest that U.S. fixed internet access peaked in 2009, and is slowly declining, though other studies suggest growth continues. Still, some studies suggest U.S.  fixed network subscriptions declined in 2016, for example.

source: Pew Internet

In the second quarter of 2017 alone, some 228,000 net new fixed network access accounts were added. Ting probably has about 3,650 total internet access accounts, and generates just over $4 million worth of annual revenue.

source: pwc

So Ting assumes it can, within five years or so, essentially relegate one or more of the two dominant providers to a barely-profitable or unprofitable status. The issue is how big a force Ting eventually could be, since capital is a huge constraint to its achieving meaningful scale in the fixed network internet access business.

Unlike some municipal or government network models, Ting does not assume it will get financial support from one or more universal service funds or a shift of existing government communications spending.

The Ting payback model also includes a fiber access network construction and then customer attachment cost of $2,500 to $3,000, with each customer expected to contribute $1,000 or so per year in gross revenue.

As others now do when building gigabit internet access networks, Ting also builds first in neighborhoods where it believes demand is highest, as demonstrated by customer deposits.

Some question the sustainability of the business model. So far, internet access arguably drives revenue growth for the company. It is fair to note that Tucows remains a small company, booking annual revenues of perhaps US$336 million.

Almost by definition, Tucows does not have the financial ability to take much total market share in the U.S. internet access market, dominated by firms with scores of billions to hundreds of billions in annual revenue.

Vertical Integration is Risky, But Might be Imperative

Vertical integration now is becoming an important strategic issue in the applications and communications industries, welcome trend or not.

Whether or not most mobile and fixed communications operators are able to move up the stack,  Google is clearly moving down the stack into devices, retail internet access, undersea capacity and new access platforms. It is not alone.

Amazon’s purchase of Whole Foods, the grocery store, moves Amazon elsewhere in the distribution chain.

Amazon’s creation of its own air freight operation, and now its moves into retail package delivery provide other examples of app layer integrating backwards into the value chain.

source: wikiwand.com

And Amazon long ago got into the devices business (KIndles, Echos, phones, tablets).

In the video entertainment business, content networks and owners are moving to integrate content distribution platforms to go direct to consumers as well.

Apple designs its own integrated circuits.

As always, the point of such vertical integration is to capture business benefit. "Vertical integration is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial,” say McKinsey consultants.

Generally speaking, value chains that feature adjacencies where there are few sellers and few buyers create business risk.

Reliance on a single, or a few customers, is a source of business risk because of the implications of losing those few customers, or having them significantly reduce buying volume. Likewise, reliance on a single, or just a few products, creates similar risk.

For Google, internalizing undersea capacity assets simply saves it money, while providing better quality control and flexibility. Amazon finds the same motivations drive its creation of air freight and local delivery services.

For Google, creating its own devices supplies the same value as does Apple in tightly integrating software and hardware. On the other hand, intervening in the internet access markets causes all the traditional suppliers to upgrade the existing access infrastructure.

Few firms arguably succeed at vertical integration. But successful moves can create barriers to market entry by other firms. And that is why vertical integration matters.

AT&T believes it can, and likely must, vertically integrate. At the moment, its moves to become a content producer and owner are the most-obvious example. In the future, moves to integrate various internet of things applications, services and platforms are likely to be equally important.

Simply put, the mobile services business model has reached saturation in the U.S. market, and firms such as AT&T must find entirely new services to sell to its customers.

You would be correct in arguing that such vertical integration is highly risky, and that horizontal acquisitions make more sense for most firms, when possible. The problem is that horizontal growth sometimes is difficult to impossible.

In its home market, horizontal expansion is not possible for AT&T, for regulatory reasons. Horizontal expansion is possible internationally, but will not help decline in its core market, absent some significant vertical movement.  

For other firms, such horizontal acquisitions take lots of capital, and that generally means additional debt. That can be difficult in a business that normally requires fairly high levels of debt, in any case.

Winner Take All

Winner take all is major trend in the application business.  In the 2010 to 2014 period, the top 20 percent of companies in the telecom, media and technology industries captured 85 percent of the economic profit in TMT industries.

The top five percent of companies—including tech giants such as Apple, Microsoft, and Alphabet (Google’s parent)—generated 60 percent. You might note that scale plays a role. In most of these businesses, there are network effects: the more users, the more valuable the network; the higher the revenue potential; the greater the profit margin and equity valuation premium.

Telecom providers are not in comparable position to "take all," simply because their ability to reach huge scale is limited: regulatory barriers and capital requirements being the chief obstacles. For that reason, the access services business will remain more fragmented than the applications business.

source: McKinsey