Why it is Hard to Move up the Stack, Much Easier to Move Down the Stack

Vertical integration and adding new roles in any value chain are traditional ways firms seek to increase value or control costs and value. As much as connectivity providers talk about “moving up the stack,” app providers also can move “down the stack.”

And we might as well just acknowledge that it is easier for an app provider to move down the stack than for a connectivity provider to move up the stack. 

The reasons are somewhat obvious if you think about the issue long enough. Any app, service or product provider already knows lots about their customers. In other words, a business operating above the app level knows what its customers want, why they buy and how much they prefer to pay. 

A connectivity provider has to learn what its connectivity customers want, but typically has no direct knowledge of the intimate details of how those connectivity customers actually create value in their businesses.

In other words, firms operating at higher levels of the stack are intimately involved with the actual business functions connectivity supports. Transport and computing functions at the lower levels are less involved--if involved at all--in the higher level business processes. 

source: Vermont IT Group 

Bluntly, a connectivity supplier only knows what a class or type of customer typically wants to buy, in terms of computing and connectivity services, but has no direct and detailed knowledge of the connectivity customer’s actual business. 

That is why connectivity provider enterprise sales forces have to build domain knowledge. Those in the domain already know all that, in detail. 

It no longer is unusual for an app provider to become an access provider, for example. Google Fiber provides only one example, operating as a retail internet service provider and as an owner and builder of substantial wide area networks across the globe. Meta, Microsoft and other app providers also are anchor tenants if not full owners of WAN assets. 

Tucows, originally a domain name registrar, has become both a mobile services provider and now a gigabit Internet service provider. 

There also is movement by new providers into existing connectivity roles. Cable companies, satellite companies and other original equipment manufacturers likewise have moved into additional parts of the retail connectivity services business, ranging from internet access to mobile services. 

Facebook now leases transponder time to support internet access operations in sub-Saharan Africa and sponsors the Telecom Infra Project that develops new open source tools across the connectivity ecosystem. 

In other words, it is far easier to move down the stack than to move up the stack. 

Where are the Enduring Business Moats for Fixed, Mobile Operators?

As more digital infrastructure assets shift into private equity or institutional investor hands, a logical question is whether there is a change in the perceived business value of network and facilities ownership, or simply a change in network costs and business models. 

In the past, ownership of scarce network access assets was considered to provide value because the cost of such facilities was so high that a business moat was created for the owner of the assets. 

Of course, 50 years ago such business moats also were complemented by government  monopolies as well. These days, under competitive frameworks, only the business moat matters. 

With the caveat that business strategies can change over time, there has been some movement towards layered, disaggregated facilities models in both fixed and mobile realms. In the mobility business, open radio access networks, virtualized functions, tower asset sales and the whole mobile virtual network operator model provide examples of a shift away from vertically-integrated formats.

In the fixed networks business, some countries have moved to “single wholesale network” approaches, which can, in some cases, eliminate the business value of facilities ownership nearly entirely, as all retailers use the same network, with the same features and underlying network cost structures. 

In markets where a range of options are possible, more instances of joint ventures are visible, in large part a means of reducing the risk and cost of new fiber-to-location facilities while arguably also speeding deployment timetables. 

In such cases, it is not yet possible to say the perceived value of an access network (scarcity value) is diminished. In fact, the need to deploy first or early, before other contestants can deploy their own facilities, might tacitly support the notion that the network remains a scarce asset with moat value. 

In other words, if deploying the first FTTH network leads to 40 percent take rates, while following networks only manage to gain about 20 percent each, then the scarcity value remains, even if not as robustly as in the monopoly era. 

That noted, in some cases, fixed network operators have traded a local monopoly in exchange for government permission to expand on a wider geographic basis. Few remember it now, but Rochester Telephone in 1993 opened its network to competitors in exchange for the right to enter the long distance business. 

Singtel essentially did the same thing later, giving up its Singapore monopoly for freedom to expand elsewhere in South and Southeast Asia. 

Those are examples of strategic decisions that do not directly bear on the issue of the business value of access networks produced by their scarcity. 

At least so far, mobile operators have been able to shed tower assets without harming their franchises. They should be able to virtualize their networks--assuming no business or technology missteps--without marketplace damage. 

It is not so clear yet how value could change in the fixed networks business. So far, most joint ventures to build FTTH infrastructure arguably are driven by a need to build faster than the competition, so the value of the joint venture is lower cost and time to market, and not a change in the perception of value. 

In the data center market, changes in ownership have not necessarily signaled a change in belief about scarcity value, either. Whether an owner is one commercial entity or another, or even if ownership changes from private to public, or public back to private, does not intrinsically change the scarcity value of the assets. 

Indeed, the surrounding issues of water scarcity; energy consumption; location and scale all suggest scarcity value remains key. First movers in any geography often have advantages. Environmental and social constraints are starting to limit unbridled expansion as well. 

Still, in the data center market, facilities ownership does not seem to have lost any luster, with the obvious caveat that even the largest hyperscale data center operators lease facilities all the time, rather than building and owning their own assets. 

That pattern appears more open to change in the fixed networks and mobile businesses, where facilities scarcity value has essentially been eliminated, in some markets where a wholesale-only model prevails and a neutral third party provides the network facilities. 

In other markets where a former incumbent also owns the wholesale facilities, some additional scarcity value is retained by the former incumbent. In markets with no restrictions on facilities-based competition, scarcity value remains, but perhaps at a lower level than in the past. 

A typical pattern is ownership in core geographies and sharing or leasing in out-of-region markets. Again, that speaks more to conservation of capital than scarcity value. 

Still, questions about scarcity value seem destined to grow as formerly-vertically-integrated firms adapt to the possibility of a layered approach to their operations. The debates access providers now have about outsourcing operations support to public cloud services providers is an example of that deepening debate. 

At its heart, all such debates are about value, and where value lies.

Service "to Persons" has Key Revenue Implications, Compared to Service "to a Location"

For anyone who has covered or analyzed the U.S. connectivity business for some decades, it now is somewhat shocking how much revenue is produced by the mobility business, compared to the fixed networks business, even granting the importance of the fixed network for business and home broadband. 

Keep in mind one salient element of each business: fixed services are “to a location” while mobile services are “to a person” or “to a sensor.” So revenue per locations is one number while mobile revenue is a compound number based on the humans and network-connected sensors at a given location, 

In other words, mobile revenue can easily be 2.5 to 5 times the revenue of a fixed network connection. 

AT&T mobility average revenue per postpaid account was $55.43 in the fourth quarter of 2023, while home broadband accounts served by optical fiber had $64.82 average revenue per account. 

So you can see the total revenue per account implications when multiple mobile accounts are purchased, compared to a single home broadband connection. 

AT&T, for example, earned $31.3 billion in the fourth quarter of 2022. Mobility generated $21.5 billion of that amount. The fixed networks business generated $8.8 billion. In other words, mobility drove nearly 69 percent of total revenue. 

source: AT&T

The fixed networks business revenue was $5.6 billion, or about 18 percent of revenue, while consumer fixed network revenues represented about 10 percent of total revenue. As important as the fiber-to-home business is, it is responsible for less than 10 percent of AT&T revenues, as voice revenues and copper access are part of those revenues. 

 

 

source: AT&T

Of course, each product has different profit margins, so revenue does not tell the whole story. Business service, consumer broadband (fiber versus copper) and consumer and business mobility all likely have distinct profit margins. 

So smaller revenue contributions might generate higher amounts of firm profit. Still, the law of large numbers is evident. A one-percent improvement in mobility segment revenues or profit should have higher firm impact than a similar one-percent increase in either business or consumer fixed network services. 

Home broadband probably has the highest margins, and those margins might be getting better. Because of federal government subsidies for fiber-to-home construction. Those subsidies might reduce the cost of FTTH builds by 20 percent, in rural and other difficult-to-serve areas. 

We Used to be Able to Count Trans-Atlantic bandwidth in T1s

Back in 1979 when the PTC was formed, trans-Atantic bandwidth was about 1,000 Mbps total, or about 647 T1 circuits. In early 2023 trans-Atlantic capacity is likely above 75 Tbps. 

source: AI Impacts

Sometimes One Has to Stop and Remember How Much Things Have Changed

When PTC was founded in 1979, there was no internet. The Apple II had barely been commercialized. The IBM PC did not exist. Globally, about 4/100 of one percent of humans used a cell phone. We did not text, we called--from a phone connected to the wall. 

There was no World Wide Web, home broadband or consumer GPS. There was no social media, no video or audio streaming. We did not use email. 

Ethernet was not yet commercialized. It did not become a standard until four years later. 

In the U.S. market, consumers could not legally attach their own phone or modem to the network: it was illegal. Phone service was a monopoly. Only one firm could be in that business. 

The amount of bandwidth linking North America and Europe could be measured in T1 circuits. 

So yes, much has changed. 

Nomenclature Change Shows Business Change

Private equity firms say they invest in fiber to premises providers instead of “telcos.” That is the key to understanding the restructuring opportunity they see.

Access providers don’t want to be known as “telcos” anymore. They don’t want to be known as “cable TV” companies, either. Instead, they are internet service providers, or home broadband providers. That trend has been nearly two decades in the making and tells us much about how the business has changed. 

But the very fact that private equity firms invest in digital infrastructure also tells us some other possible things about the business.  

Historically, the private equity business model requires acquiring assets that can be transformed in some way to add value. Sale of those assets is the exit. That might imply there is a “problem” of some type with the asset that PE can fix, before flipping the asset. 

 Institutional investors are the other group that traditionally buys real estate type assets ranging from hotels to airports and toll roads to gas pipelines and electrical utilities. They are more interested in predictable cash flow generated from slow-growth assets with some degree of natural advantage in the form of business moats that protect them from competition. 

The issue that we might contemplate is what the new interest in digital infra assets indicates about business models. Some PE investments are vertical: airport operation, gas pipeline operations, toll road operations and produced cash flow are the value. The physical assets underpin operations. 

In other cases, the model is more horizontal. The value of a wholesale broadband access network is the ability to lease access to the network, rather than operating the retail business to generate cash flow. 

The analogy in the classic real estate business is the “asset light” model used by some hotel, hospitality or entertainment businesses where the retail business operates without land ownership, sometimes without building ownership, sometimes without indigenous management or branding. 

So the issue is how far similar concepts can be applied within the connectivity industry. Everyone is familiar with the “asset light” mobile virtual network operator model in the mobile industry. 

Fixed network operators are moving, in parts of their businesses, in that direction, at least in the form of joint ventures that share ownership of access network assets. 

Up to a point, hyperscale app providers have moved vertically, to integrate transport functions (wide area networks). Google Fiber is an example of full vertical integration, in some ways. So are hyperscale data centers. 

Just how far the fixed network unbundling can go is a question, as is the degree of vertical integration by hyperscalers. 

Bill Barney, PTC Chair on 2023