New Proposed DirecTV Asset Sale Makes More Sense

The report that AT&T is in discussions with private-equity firms to sell a significant minority stake in its DirecTV, AT&T Now and U-Verse pay-TV businesses is not surprising. Nor is the way the potential deal is being structured. 

As described, the transaction that would shift legacy assets off AT&T’s balance sheet, but also allow AT&T to retain “majority economic ownership of the businesses.” That is important for its cash flow implications. 

My own analysis of the original value of the DirecTV purchase was its impact on AT&T cash flow. That is the same key issue for any sale of the asset: what does it do to cash flow?

As originally rumored, AT&T was looking to sell most of its DirecTV holding. That seemed unlikely to me simply because, in doing so, AT&T would be parting with an important source of free cash flow, which might have been as much as 13 percent of total cash flow, or possibly more, by some accounts 

In late 2019 DirecTV was said to be spinning off about $4 billion in annual cash flow, which seems low to me, but appears to be about right. In the first full year of ownership, DirecTV likely produced $12 billion of free cash flow. 

That matters as AT&T needs prodigious amounts of cash to support its dividend payouts and to reduce outstanding debt. In 2019, for example, DirecTV cash flow represented as much as 93 percent of total interest payments and a huge portion of revenue. 

Cash flow generators that big are rare, indeed. Though controversial, it is hard to conceive of any other investment AT&T could have made in 2014 that could possibly have generated as much free cash flow as did DirecTV.

To be sure, linear video in general, and satellite linear in particular, have been hard hit since then. The asset value has atrophied, to be sure. But if cash flow is the objective, some of us cannot conceive of any other acquisition that would have been possible and not drawn antitrust objections. 

The new rumored deal would reportedly include 30 percent to 49 percent of the combined pay-TV distribution businesses, moving assets off AT&T’s balance sheet, but preserving much of the cash flow.

That at least answers the question some might have had about any exit from DirecTV in total.

Competition and New Technology Underpin Near-Zero Pricing Trend

It is a truism that competition and new technology, in combination, have fundamentally changed the global telecom business. We all intuitively understand that competition leads to lower prices, or that technology allows disintermediation of value chains, which removes cost. 

source: A.D. Little 

One of the few core assumptions I always have used in my analytical work concerning the connectivity business is near zero pricing is a foundational trend for all connectivity products, as it tends to be also for computing products. Consider internet transit pricing, for example 

Back in 2014, Cloudflare estimated the cost of wide area network bandwidth as being lowest in Europe, in large part because so much internet traffic used peering rather than transit. 

source: Cloudflare

Two years later, in 2016, costs had dropped. The Middle East has the lowest WAN costs, and costs in other reasons had dropped significantly. Where Australia’s costs were as much as 20 times higher than Europe’s costs, two years later the Australian costs were six times higher than Europe’s costs. 

source: Cloudflare

None of you would be surprised if transit prices continued to fall. Transit to Sydney, for example, had declined to about $5 per Mbps, where back in 2014 prices had been about $100 per Mbps. 

source: TeleGeography

Both Netflix and Microsoft business models seem to have been built on an expectation of  

near-zero pricing for a core input, computing cost for Microsoft, bandwidth cost for Netflix. 

The most-startling strategic assumption ever made by Bill Gates was his belief that horrendously-expensive computing hardware would eventually be so low cost that he could build his own business on software for ubiquitous devices. .

How startling was the assumption? Consider that, In constant dollar terms, the computing power of an Apple iPad 2, when Microsoft was founded in 1975, would have cost between US$100 million and $10 billion.

source: Hamilton Project

The point is that the assumption by Gates that computing operations would be so cheap was an astounding leap. But my guess is that Gates understood Moore’s Law in a way that the rest of us did not.

Reed Hastings, Netflix founder, apparently made a similar decision. For Bill Gates, the insight that free computing would be a reality meant he should build his business on software used by computers.

Reed Hastings came to the same conclusion as he looked at bandwidth trends in terms both of capacity and prices. At a time when dial-up modems were running at 56 kbps, Hastings extrapolated from Moore's Law to understand where bandwidth would be in the future, not where it was “right now.”

“We took out our spreadsheets and we figured we’d get 14 megabits per second to the home by 2012, which turns out is about what we will get,” says Reed Hastings, Netflix CEO. “If you drag it out to 2021, we will all have a gigabit to the home." So far, internet access speeds have increased at just about those rates.

The scary point is that prices in the telecom business seem to have a “near-zero” trend. That does not mean absolute zero, but simply prices so low users and customers do not have to think much about using the products. 

That, of course, has fundamental implications for owners of connectivity businesses. Near-zero pricing helps create demand for internet access services, even as substitutes emerge for core voice and messaging services. 

Near-zero pricing enables the construction and operation of the networks and creation of the apps and services delivered over the networks. Near-zero pricing also enables new business models that were impossible in the analog era.

How Much Can Telcos Cut Sales Costs?

Intangible products such as music, video, print content, banking transactions and even communications services are among those most easily sold “online” or “digitally,” displacing physical forms of distribution. 

Communications products also are intangible, so a logical question is how channels of distribution might change over time, with “sales” and “fulfillment” becoming more virtual and less physical. 

source: A.D. Little 

The issue is whether digital fulfillment allows connectivity providers to cut operating costs or capital investment.  

For consumer mobility services, the switch might be experienced as ordering a new phone online and then activating online, with no need to visit a physical retail outlet. Small business customers might find basic data and voice services could be ordered online as well. 

Eventually, even more complicated enterprise services might be sold without use of sales forces. That might seem fanciful, but consider the value of a human enterprise services sales force: expert knowledge of how to match network services with business process support.  

But consider the traditional value of human sales forces, which understand the complexity of network offers as well as the requirements for business process support, and can match needs with solutions. 

Even if we assume that every enterprise situation is custom, to a significant extent, there are patterns, which means rules can be created. 

And any rules-based process can be enhanced by use of artificial intelligence systems. That means, in principle, that the value of human experts should be capable of replication in an AI-enhanced sales and fulfillment process. 

source: A.D. Little 

If one assumes that connectivity providers must reduce operating and capital investment costs to maintain profit margins in slow-growth to no-growth markets, then reducing sales and customer care costs are among the areas where the biggest opportunities for savings might be found. 

Fixed Network Business Models Now Based on "Dumb Pipe"

Intangible products such as music, video, print content, banking transactions and even communications services are among those most easily sold “online” or “digitally.” Another way of describing the change in channels of distribution is to note that, over time, “sales” and “fulfillment” became more virtual and less physical. 

So the issue is the extent to which connectivity services sold to consumers and small businesses might also become more “virtual” over time. For consumer mobility services, the switch might be experienced as ordering a new phone online and then activating online, with no need to visit a physical retail outlet. 

source: A.D. Little 

That retail virtualization is perhaps a mirror of the content and applications virtualization that already has reshaped the connectivity business. 

“Over the top” applications and services are more than a revenue model, a strategy and an asset ownership model. They reflect fundamental changes in how computing and communications networks are designed and operated. 

In a broad sense, OTT represents the normal way any computing network operates, and since all telecom networks now are computer networks, there are clear business model implications. 

Though it is so familiar we hardly notice it any more, communications network architecture, computing and software architecture also mirror a profound change in possible communications, media and content industry business models. 

The separation of access from apps, transport from other functions now is a fundamental reality of communications, software design and applications. The whole idea is to compartmentalize and separate computing or communications functions so development can happen elsewhere without disrupting everything else. 

The desired outcome is the ability to use any app on any device on any network, while making changes and upgrades rapidly within each layer or function. Abstraction is another way of describing the architecture. Devices do not require detailed knowledge of what happens inside the network black box (which is where the notion of “cloud” came from). 

Devices only need to know the required interface. That also explains the prevalence of application programming interfaces, which likewise allow the use of abstracted functions. 

What we often forget is that these technology conventions have business model implications. Simply stated, the business model (all the inputs and operations needed to supply a product to a customer for a profit) mirrors the architecture of software and networks.

source: Henry Chesbrough 

Which is to say business models now are built on abstracted ecosystems and value chains. The clearest illustration of that is the phrase “over the top,” which describes the ability of any third party application or service provider to reach any customer or user on any standard internet connection.

That “open” process contrasts sharply with the old “closed” analog telco model where the only apps or devices that could be used on the network were owned or permitted by the connectivity services provider. 

That is why the terms “over the top” and “dumb pipe” have developed. Where in the past telcos sold services that used a network (voice, messaging, video entertainment), now they also sell “data network access,” where the product the customer buys is, strictly speaking, a “dumb pipe” that enables access to applications. 

The irony is that, to the extent the dumb pipe internet access is the foundatinal service now sold to fixed network consumers, and a core product for mobile network customers, revenue streams now are built on dumb pipe.

Keep in mind that all telecom networks now are computer networks. The value lies in enabling access to applications. Some of those apps are owned by the connectivity provider (public network voice, public network messaging, linear or OTT entertainment video, virtual private network services, private line, hosted voice and--in some cases--enterprise applications. 

But the dominant value of the dumb pipe internet access is access to all other third party applications based on delivery using the public internet. 

The great irony is that, as much as connectivity providers “hate” being dumb pipe providers, their business models now are based on it.

"Digital Transformation" Will be as Hard as Earlier Efforts at Change

New BCG research suggests that 70 percent of digital transformations fall short of their objectives. 

That would not surprise any of you familiar with the general success rate of major enterprise technology projects. From 2003 to 2012, only 6.4 percent of federal IT projects with $10 million or more in labor costs were successful, according to a study by Standish, noted by Brookings.

source: BCG 

IT project success rates range between 28 percent and 30 percent, Standish also notes. The World Bank has estimated that large-scale information and communication projects (each worth over U.S. $6 million) fail or partially fail at a rate of 71 percent. 

McKinsey says that big IT projects also often run over budget. Roughly half of all large IT projects—defined as those with initial price tags exceeding $15 million—run over budget. On average, large IT projects run 45 percent over budget and seven percent over time, while delivering 56 percent less value than predicted, McKinsey says. 

Significantly, 17 percent of IT projects go so bad that they can threaten the very existence of the company, according to McKinsey. 

The same sort of challenge exists whenever telecom firms try to move into adjacent roles within the internet or computing ecosystems. As with any proposed change, the odds of success drop as the number of successful approvals or activities increases.

The rule of thumb is that 70 percent of organizational change programs fail, in part or completely. 

There is a reason for that experience. Assume you propose some change that requires just two approvals to proceed, with the odds of approval at 50 percent for each step. The odds of getting “yes” decisions in a two-step process are about 25 percent (.5x.5=.25). In other words, if only two approvals are required to make any change, and the odds of success are 50-50 for each stage, the odds of success are one in four. 

source: John Troller 

The odds of success get longer for any change process that actually requires multiple approvals. Assume there are five sets of approvals. Assume your odds of success are high--about 66 percent--at each stage. In that case, your odds of success are about one in eight for any change that requires five key approvals (.66x.66x.66x.66x.66=82/243). 

The same sorts of issues occur when any telecom firm tries to move out of its core function within the ecosystem and tries to compete in an adjacent area. 

Consultants at Bain and Company argue that the odds of success are perhaps 35 percent when moving to an immediate adjacency, but drop to about 15 percent when two steps from the present position are required and to perhaps eight percent when a move of three steps is required.

source: Bain and Company

The common thread here is that any big organizational change, whether an IT project or a move into new roles within the ecosystem, is quite risky, even if necessary. The odds of success are low, for any complex change, no matter how vital.

Why 4G Sometimes is Faster than 5G

As always, the amount of spectrum available to any mobile service provider correlates with potential data throughput. As AT&T, for example, has rolled out 5G service, it has relied on low-band assets initially.

And no amount of fancy signal processing is going to compensate for the amount of spectrum available to support 5G, compared to 4G, for example. If you look at the total amount of spectrum available to support AT&T’s 5G coverage, you can see that 4G spectrum is more capacious than 5G. 

source: PCmag 

That means AT&T’s 5G network--for the moment--offers less speed than the 4G network. That will change over time, and likely quite substantially. 

Over the last decade, average (or perhaps typical) mobile data speeds have grown logarithmically, according to data compiled by PCmag. I cannot tell you whether the graph shows median or mean speeds, but the point is that, assuming the same methodology is used for all data, the logarithmic trend would still hold. 

 

source: PCmag 

There is no reason to believe 5G will fail--over time--to continue the logarithmic trend, with the release of huge amounts of new spectrum, expanded use of spectrum sharing and spectrum re-use, plus small cell access.

Need for Global Scale Will Limit Telco IoT, Edge Computing Success

Among other reasons, lack of global scale is likely to prevent most telcos or mobile operators from becoming leading providers of internet of things or edge computing solutions or platforms. Generally, scale economics work against most telcos, no matter how large. 

That is not to say large telcos cannot significantly diversify revenue streams. AT&T has managed to shift its revenue sources enough that perhaps 43 percent of total revenue comes from something other than connectivity services. Softbank (at least until recently) had managed to generate perhaps 33 percent of total revenue from non-connectivity sources, while KT had reached about the same level. 

source: GSMA 

Many other tier-one telcos have managed to add between 10 percent and 25 percent of total revenue from sources other than connectivity. The need for scale seems to apply for those operations as much as it matters for the core connectivity business. But there are issues beyond scale. 

To be sure, new services such as the internet of things and edge computing will make some contribution to service provider revenues. Still, most of the value and revenue from IoT will be created elsewhere in the value chain (semiconductors, devices, platforms, integration, application software), not in connectivity. 

Perhaps edge computing will show the same dynamics, as edge computing still is about computing. That means the leading suppliers of computing--especially cloud computing--have a reasonable chance of emerging as the leading suppliers of workload as a service at the edge. 

Simply, if it is logical to purchase compute cycles from a major cloud or premises computing supplier, it will likely make just as much sense to purchase edge compute the same way. 

In other words, customers tend to have clear preferences about the logical suppliers of various products, beyond scale. The phrase “best of breed” captures the thinking. If an enterprise or other entity is looking at premises computing, it looks to certain brands. If a company is looking for cloud computing, it looks to other brands. 

Almost never is a telco among the logical five potential choices for buying compute cycles or computing platforms. 

That noted, tier-one telcos have made important strides diversifying beyond core connectivity. Among the issues are the extent to which that can happen in the edge computing or IoT realms.