Why a Massive New Gigabit Upgrade, Instead of DirecTV Acquisition, Made No Sense

Two years ago, when DirecTV was acquired by AT&T, it would have been easy to find detractors arguing that AT&T should have spent that money investing in fiber to home infrastructure. With linear video cord cutting possibly accelerating, the new version of that story is being heard again.

So what should AT&T have done with $67 billion, assuming a 4.6 percent cost of capital? Cost of capital is the annualized return a borrower or equity issuer (paying a dividend) incurs simply to cover the cost of borrowing.

In AT&T’s case, the breakeven rate is 4.6 percent, which is the cost of borrowing itself. To earn an actual return, AT&T has to generate new revenue above 4.6 percent.

First of all, AT&T would not have borrowed $67 billion if it needed to add about three million new fiber to home locations per year. Assume that was all incremental capital, above and beyond what AT&T normally spends for new and rehab access facilities.

Assume that for logistical reasons, AT&T really can only build about three million locations each year, gets a 25-percent initial take rate, spends $700 to pass a location and then $500 to activate a customer location. Assume account revenue is $80 a month.

AT&T would spend about $2.1 billion to build three million new FTTH locations. At a 25-percent initial take rate, AT&T spends about $525 million to provide service to new accounts. So annual cost is about $2.65 billion, to earn about $720 million in new revenue (not all of which is incremental, as some of the new FTTH customers are upgrading from DSL).

The simple point is that building three million new FTTH locations per year, and selling $80 in services to a quarter of those locations, immediately,  does not recover the cost of capital.

The DirecTV acquisition, on the other hand, boosted AT&T cash flow about 40 percent.

Basically, even if AT&T had not purchased DirecTV, and began a new program adding three million new gigabit passings per year, those investments would not increase AT&T cash flow in the near term, and possibly never would do so.

The same logic applies to the Time Warner acquisition, which not only moves AT&T into new segments of the content ecosystem, but also boosts cash flow and profit margins.

But the linear video business is declining, many obviously will note. All true. But linear assets create the foundation for over-the-top assets, which also come with lower operating cost (much lower fulfillment and provisioning, for example).

Also, no matter what the long-term impact might be, a huge boost in free cash flow still matters, as markets evolve.

The point is that the alternative of plowing capital into faster gigabit upgrades sounds reasonable, but simply fails to move the needle on cash flow.

SD-WAN Growing 70% Annually, MPLS 4%

Only one fact about software-defined wide area network services is incontestable: its growth rates dwarf  growth rates for MPLS, a service some believe eventually could emerge as a replacement for some portion of MPLS demand.

A new forecast from International Data Corporation estimates that worldwide SD-WAN infrastructure and services revenues will see a compound annual growth rate of 69.6 percent and reach $8.05 billion in 2021.

MPLS, on the other hand, will grow at about four percent rates through 2021.

source: Ovum

The most significant driver of SD-WAN growth over the next five years will be driven by increased reliance on cloud computing, big data analytics, mobility, and social business, IDC says.

Use of those tools generally increases network workloads and elevates the network's end-to-end importance to business operations, including support at all branch locations.

Which Way for Retail Internet Access Pricing?

We are about to see an unusual test of internet access pricing; unusual only in the sense that the direction of retail pricing in the internet era has been down, in a cost per bit basis and generally even in an absolute cost basis.

The test is a thesis some advance that U.S. cable companies--especially Comcast--will be able to boost retail internet access prices dramatically in coming years. That would run counter to past trends, and assumes that competition in internet access space will not increase.

Prices are complicated though, as one broad pattern has been for prices to remain roughly flat while speeds have grown dramatically, in some cases as fast as Moore’s Law might predict, at the high end of the market (what it is possible for a consumer customer to buy from an internet service provider such as Comcast).

That means sharp declines in cost per megabyte per second of speed might not be seen in posted retail prices. Also, pricing trends also reflect consumer decisions to spend more for their access, in the form of tiers of service that are faster.  

Still, there is much anecdotal evidence prices are dropping, in developing and developed markets, including prices as a percentage of gross national income per capita.

According to the International Telecommunications Union, broadband prices have declined as much as 50 percent in developing nations, between 2008 and 2010, for example, and about 35 percent in developed nations.

source: ITU

source: ITU

Granted, as a supplier, Comcast might “need” to raise prices to counter lost video revenues.

That effort would aim to sustain average revenue per account as the linear video business declines.

But supplier “need for higher prices”  always must contend with market dynamics. And there, one might well question whether Comcast will be able to maintain pricing power. Not only will mobile alternatives become more reasonable in the 5G era, new suppliers are entering the market (both new retail providers, such as Google Fiber, Ting Internet and others, as well as enterprises building their own networks and removing demand from the market).

So the interesting test is whether Comcast and cable can maintain pricing based on market power, in the 5G era, or whether competition will escalate, diminishing both market power and the ability to raise prices.

Netflix, AT&T, Comcast: Same Strategy?

Netflix strategy has been clear for some time: “Become HBO faster than HBO becomes us.”

By that, Netflix means becomes a source of original programing, not a retransmission or distribution vehicle for third party content.

Not just incidentally, the Netflix strategy sheds light on what AT&T and Comcast have done, despite criticisms of AT&T for doing so. Netflix occupies what formerly were a few distinct roles in the video entertainment ecosystem: content owner, program network and content distributor.

TV Channels of the Future - AtticTV Pte Ltd from Johnson Goh

In the old model, programming networks were one segment of the business, while distributors (broadcast TV, cable TV, telco and satellite TV) were in a distinctly-different part of the ecosystem. The content creation business (studio function) was a third role.

But what Netflix has done is create a new position that simultaneously combines those several former roles.

Its investments in original programing make it a content owner, like a studio. Its distribution function (streaming) makes it a distributor. But its total content assets also make it a programming network.

“Our future largely lies in exclusive original content,” says Reed Hastings, Netflix CEO. “Our investment in Netflix originals is over a quarter of our total P&L content budget in 2017 and will continue to grow.”

Netflix already has $17 billion in content commitments “over the next several years” and a growing library of owned content ($2.5 billion net book value at the end of the quarter).

Netflix expects to spend $7 billion to $8 billion on content in 2018.

“Just as we moved from second-run content to licensed originals and then to Netflix-produced originals, we are progressing even further up the value chain to work directly with talented content creators,” Hastings says.

In other words, Netflix, aside from being a content network and a content distributor, now is moving in the direction of becoming a content owner and developer, like a studio.

By buying Time Warner, AT&T is using the same strategy, moving from one role to several: distribution to content creation; distribution to content network.

AT&T Critics are Simply Wrong About Linear Video

Inevitably, aside from claims that the “wheels are coming off” the linear video business, there will be renewed criticism that AT&T should instead have spent the capital used to acquire DirecTV, and then (if approved by regulators) Time Warner, to upgrade its consumer access networks.

The critics are wrong; simply wrong, even if it sounds reasonable that AT&T could have launched a massive upgrade of its fixed networks, instead of buying DirecTV or Time Warner (assuming the acquisition is approved).

AT&T already has said it had linear video subscriber losses of about 90,000 net accounts in the third quarter. In its second quarter, net losses from U-verse and DirecTV amounted to about 351,000 accounts.

Keep in mind that, as the largest U.S. linear video provider, AT&T will lose the most customers, all other things being equal, when the market shrinks.

Some have speculated that AT&T potential losses could be as high as 390,000 linear accounts.

Such criticisms about AT&T video strategy might seem reasonable enough upon first glance.

Sure, if AT&T is losing internet access customers to cable operators because it only can offer slower digital subscriber line service, then investing more in internet access speeds will help AT&T stem some of those losses.

What such criticisms miss is that that advice essentially is an admonition to move further in the direction of becoming a “dumb pipe” access provider, and increasingly, a “one-service” provider in the fixed business.

That key implication might not be immediately obvious.

But with voice revenues also dropping, and without a role in linear or streaming subscription businesses, AT&T would increasingly be reliant on access revenues for its revenue.

Here is the fundamental problem: in the competitive era, it has become impossible for a scale provider (cable or telco) to build a sustainable business case on a single anchor service: not video entertainment, not voice, not internet access.

In fact, it no longer is possible to sustain profits without both consumer and business customers, something the cable industry is finding.

So the argument that AT&T “should have” invested in upgraded access networks--instead of moving up the stack with Time Warner and amassing more accounts in linear video with the DirecTV buy--is functionally a call to become a single-service dumb pipe provider.

That will not work, and the problem is simple math. In the fiercely-competitive U.S. fixed services market, any competent scale player is going to build a full network and strand between 40 percent and 60 percent of the assets. In other words, no revenue will be earned on up to 60 percent of the deployed access assets.

No single service (voice, video, internet access) is big enough to support a cabled fixed network. Period.

That is why all scale providers sell at least three consumer services. The strategy is to sell more units to fewer customers. Selling three services per account is one way to compensate for all the stranded assets.

Assume revenue per unit is $33. If one provider had 100-percent adoption, 100 homes produce $3,000 in gross revenue per month. At 50 percent penetration (half of all homes passed are customers), just $1650 in gross revenue is generated.

At 40-percent take rates, gross revenue from 100 passed locations is $1320.

But consider a scenario where--on average--each account buys 2.5 services. Then, at 50-percent take rates, monthly gross revenue is $4125 per month. At 40-percent adoption, monthly revenue is $3300. You get the point: selling more products (units) to a smaller number of customers still can produce more revenue than selling one product to all locations passed.

The point is that it is not clear at all that AT&T could have spent capital to shore up its business model any more directly than by buying DirecTV and its accounts and cash flow.

That the linear model is past its peak is undeniable. But linear assets are the foundation of the streaming business, and still throw off important cash flow that buys time to make a bigger pivot.

One might argue AT&T could have purchased other assets, though it is not clear any other assets would have boosted the bottom and top lines as much as did DirecTV.

What is relatively clear is that spending money to become a dumb pipe internet access provider will not work for AT&T, even if all the DirecTV capital had been invested in gigabit networks. At best, AT&T might have eventually slowed the erosion of its dumb pipe internet access business. It would not have grown its business (revenue, profits, cash flow) enough to justify the diversion of capital.

Would AT&T be better off today, had it not bought DirecTV, and invested that capital in gigabit internet access? It is hard to see how that math would play. Just a bit after two years since the deal, AT&T would not even have finished upgrading most of the older DSL lines, much less have added enough new internet access accounts to justify the investment.

AT&T passes perhaps 62 million housing units. In 2015, it was able to deliver video to perhaps 33 million of those locations. Upgrading just those 33 million locations would take many years. A general rule of thumb is that a complete rebuild of a metro network takes at least three years, assuming capital is available to do so.

Even if AT&T was to attempt a rebuild of those 33 million locations, and assuming it could build three million units every year, it would still take a decade to finish the nationwide upgrade.

In other words, a massive gigabit upgrade, nationwide, would not have generated enough revenue or cash flow to justify the effort, one might well argue.

Assume AT&T has 40 percent share of internet access accounts in its former DSL markets. Assume that by activating that network, it can half the erosion of its internet access accounts. AT&T in recent quarters has lost perhaps 9,000 accounts per quarter. Assuming AT&T saves 10 percent of those accounts, that amounts to only about 900 accounts, nationwide.

That is not enough revenue to justify the effort, whatever the results might be after a decade, when all 33 million locations might be upgraded.

source: Bruce Kushnick

The simple point is that AT&T really did not have a choice to launch a massive broadband upgrade program, instead of buying DirecTV, and instead of buying Time Warner. The financial returns simply would not have been there.

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