Private Equity Feels Impact of Higher Real Interest Rates

Exuberance in public markets seems to have been matched in private markets, as ultra-low interest rates shaped the investment climate in all markets. Higher real rates are having the opposite effect, as Adams Street Partners data suggests. 

source: Adams Street Partners

Deals will be smaller and the volume of transcations will drop as a result. Less money raised also means less money invested. That should mean longer runways to exits.

Fixed Wireless Really is Affecting U.S. Home Broadband Share

Fixed wireless has emerged as the clear producer of “new revenue” for 5G networks. At least for the moment, FWA seems to be crimping cable operator home broadband net additions. 

In the third quarter of 2022, for example, Comcast added 14,000 net new subscribers. T-Mobile, using FWA, added 578,000 net new accounts. Verizon’s FWA service added 342,000 net new accounts, according to Leichtman Research Group figures. 

Legitimate questions can be asked about how long that trend can last, as most observers would agree that FWA appeals mostly to customers without significant need for, or desire for, the faster services. In other words, for a significant portion of the market, speeds up to 100 Mbps to 200 Mbps are good enough. 

But that is not the whole market. In the third quarter of 2022, for example, it is possible that a quarter of all customers, perhaps as many as half, only “needed” speeds up to 200 Mbps. Only about 15 percent of households bought service at 1 Gbps or faster. 

source: OpenVault  

At some point, the “lower-speed is good enough” segment will be saturated. At that point, Verizon and T-Mobile will have to do the same thing as Comcast: boost speeds for existing customers and those who want higher speeds. 

Cable executives predictably expect that FWA will not be able to keep up. Verizon and T-Mobile obviously say they disagree, and that they will be able to keep boosting FWA speeds. 

At the moment, Comcast’s strategy seems to acknowledge the new competition, as it no longer says it will grow home broadband revenue by increasing market share or the number of subscriptions, but rather by upgrading speeds to faster tiers that cost more. 

Competition from fiber-to-home providers is the other part of the market dynamic, as more FTTH is being activated by many ISPs, competing with the fastest of cable home broadband speeds. 

For all those reasons, cable’s revenue growth hopes likely hinge on taking greater share in the mobile phone business.

Can ISPs Really Build Ecosystems?

If you have been in the connectivity business long enough, you are used to hearing visions of how connectivity providers can “revolutionize” their businesses by creating  new lines of business, crafting new products and building new revenue models. 

So Telstra CEO Vickie Brady says the role of the operator is to become an “ecosystem builder,” even if that means “not always being in control of the end-to-end solution.” 

There is a clear logic. Many industries based on software and computing resemble ecosystems. Large data centers these days might be likened to ecosystems, where it is not simply servers, but the connections between firms, servers, apps and software and connections to other locations that create value.

The same observation might be made about the Applie iPhone business, which increasingly is an ecosystem of products built around the device. Even an airliner or an electric vehicle might be said to be an ecosystem that creates value only when the extensive wraparound exists.

Planes need many things to become part of an airline operation. Branding, training, reservation systems, airports, maintenance facilities, business alliances, loyalty mechanisms all are necessary. But the airline industry also is part of a larger travel ecosystem including lodging, local transporation, destinations and attractions.

Cars are themselves an ecosystem of parts and systems, but also require fueling stations, maintenance, insurance, road systems, parking, driving instruction or training. Cars are part of a broader transportation infrastructure that includes other transport modes and also shapes where housing and businesses are located.

We can add "ecosystem builder" to the list of stock phrases such as “telcos becoming techcos,” or becoming “platforms,” trying to create app stores, getting into financial services, mainframe computing, system integration, devices or more recently, edge computing. 

Telcos tried to create their own “over the top” voice over IP services to compete with the likes of Skype, their own messaging apps, their own content services (with more success). 

That is not to throw shade at the companies we once knew as “telcos,” but many decades of efforts at reinvention have had modest success. The big problems are changes in customer demand, competition, product substitutes and the chosen architecture of service provider architectures. 

When connectivity service providers chose TCP/IP as their next-generation architecture over asynchronous transfer mode and the whole suite of ISDN-derived standards, they also chose a layered model that not only permits, but encourages, third party app development 

Since functions are logically separated, no business relationship has to exist between a particular app delivered over the IP network and the owner of the access facilities. So “over the top” is an architectural rule, not a term for streaming video. 

The practical effect is to separate app creation from network services. The former no longer requires ownership of the latter, a contract with the latter or the permission of the latter. And while connectivity providers had developed voice and texting, they had no special competence in creating apps for computers or computing devices. 

And these days, that is most of app development. 

At the same time, competition has taken away monopoly-era profits and gross revenue and market share. Customers, meanwhile, prefer mobility services over fixed network voice services, and messaging over short message service. 

All of this challenges the business model. 

To be sure, one might point to growing global services revenue, as more people become mobile subscribers, in particular. But most legacy tier-one service providers have seen flat or declining revenues, challenged profitability, profit margin squeezes and declines in average revenue per account. 

That, one might argue, bolsters Brady’s argument that massive change has to happen. But for the rise of mobility services and the internet, legacy service providers would be in even worse shape than they are. 

So Brady’s call to create new ecosystems with connectivity providers at the center is not untimely. Skeptics will question which entities actually could emerge at the center of new ecosystems of value, or whether additional revenue actually would accrue to connectivity providers in such ecosystems. 

One might, for example, question whether the sale of functions necessarily nets more revenue than the disaggregated elements. Many observers already fear any relegation of access providers to the role of “bit pipes” or “dumb pipes.” Some might say the sale of deconstructed features could help or hurt, in terms of maintaining relevance and value. 

There is gold, there are gold miners and there are many other roles that support gold mining, from hardware to services. What Brady suggests is that connectivity providers could organize or participate in the equivalent of a gold production ecosystem. That is fair enough. 

The issue always is core competence and how additional competencies in additional roles can be created. That has tended to be the problem in the past. 

“We need to change” is not the same as “and this is how we will do it.” After all, investors have punished connectivity providers who unsuccessfully try to diversify, over and over again. Changing or diversifying always is applauded if it succeeds. But fail and executives will be urged to “stick to what they know.” Been there. Done that.

Valuation Envy Isn't a Problem, Valuations Are

Connectivity providers always “suffer” from lower market valuations than do software and internet-related app providers. As a practical matter, that makes it hard for connectivity providers to use their stock currency to buy higher-valued assets. And, of course, lower valuations make every unit of earnings less valuable than for some other industries. 

Consider that enterprise value to EBITDA ratios for app providers are at least double what they are for connectivity providers. Where cable TV firms might have an EV/EBITDA ratio of about seven, while “telecom services” have a ratio less than six, and mobile firms garner a ratio close to nine, software segments have ratios from 11 to 21. 

Looking at price to sales ratios tells the same story. 

source: CB Insights 

That remained true in 2022. “Telecom services” earned an EV/EBITDA ratio of 6.6. Information services garnered a 25.8 ratio; software a 32.7 ratio; internet software a 23 ratio. 

source: Statista 

As a management professor once told us, if one has a choice, pick a high-growth industry to work in, rather than a slow-growth industry. High growth tends to be associated with higher equity multiples, more opportunities and higher wages.

When Interconnection is About Business Models

At least theoretically, proposals requiring a few hyperscale app providers to pay fees to internet service providers might lead to lower consumer prices for broadband access. Such payments, some believe, could also lead to higher levels of network investment by ISPs. 

A report prepared by Oxera for the Dutch Ministry of Economic Affairs and Climate concludes that advantages likely would be small, and also have a negative impact on content provider business models, which would lead to higher prices for consumers of those products. 

Broadband consumers might benefit if some of the payments were used to lower home broadband or mobile broadband costs. Others might argue that the improved cash flow would not necessarily result in price reductions for consumers, but only higher profits margins for ISPs. 

Also, consumer gains in the form of potential lower internet access prices would be balanced by higher costs for consumers of hyperscale app and content services, as the new costs necessarily would have to be passed on to users of those apps. 

source: Oxera 

Two items are worth noting. First, the relationship between end users of the internet and app providers is a somewhat classic two-sided market, with ISPs and internet backbone providers arguably acting as the “platform.”. On the other hand, the direct business relationship is between an ISP and its own access customers, or between an ISP and a peering fabric or internet exchange point. 

Since the internet is a “permissionless” environment, no app provider requires a direct business relationship with any ISP to be reached by any internet user. 

source: Oxera 

“Overall, our analysis of the proposals for a levy shows that such a policy cannot robustly be shown to increase economic efficiency, and would potentially bring substantial transaction and set-up costs,” Oxera analysts say. “From an economic perspective, once welfare losses in the market for content are accounted for, the net welfare gain from the policy is relatively small.”

“Without a consumer price reduction, the effect of a charging scheme is simply to transfer money from CAPs (content application providers) to telcos,” the report states. 

Oxera also questions the assumption that app providers “cause” network demand. Instead, traffic is typically caused by a consumer of an ISP. “For example, the streaming of music or a film occurs because the consumer sent a request to the CAP to send them the film,” the report says. “The CAP then obliges.”

Traffic is caused by the ISP customer’s initial request, not the fulfillment of that request. As in the case of natural gas, electricity or water consumption; use of toll roads, airports, seaports, public parking or other “utility or infrastructure” assets, it is customers who directly or indirectly pay for usage. 

The point is that, overall, any subsidies extracted from app providers boosts the business case for telcos, while harming the app provider business case. 

source: Oxera

But this battle is likely not about consumer welfare. Rather, it is about ecosystem participant business models. The effort to tax a few hyperscalers is designed to help ISPs and slow down the hyperscalers; help domestic industries at the expense of foreign. So far, few ISPs have 

argued against the hyperscale tax.

In principle, why would they? Hyperscaler taxes shift cash towards ISPs, bolstering ISP business cases.

Wider API Use Could Support Either Horizontal or Vertical Business Models

A layered business model might be viewed as a value chain turned 90 degrees. Where a value chain is depicted horizontally, with stages leading to end user purchase of products, so a layered business model resembles a value chain turned 90 degrees to show that layers of function each contribute to a complete business model. 

source: McKinsey 

The thing about value chains is that they feature distinct roles. In principle, those roles can be vertically integrated or remain horizontally distinct. Decentralization or virtualization do not necessarily alter the type of integration. 

source: Blockchain Hackathon 

Wholesale business models, on the other hand, do affect integration patterns, as they are based on a horizontal model: wholesalers supply essential network functions, but customer-facing operations are typically disaggregated. 

Many other potential innovations might shift vertically-oriented telcos in a more horizontal direction, but not necessarily. 

GSMA Open Gateway is a new framework of universal network Application Programmable Interfaces (APIs) designed to provide developers with access to operator network features. That could, in principle, lend itself to new horizontal roles, but might also simply add a revenue stream to an existing vertical model.

"Radical Shift" of ISP Business Models?

There are platitudes and there are threats and opportunities in business.

When European Commission Internal Market Commissioner Thierry Breton says “we need to leave behind our long-standing perception of the way (communications) networks operate,” ecosystem participants have to take notice. 

Speaking at MWC Barcelona, Breton reiterated some themes heard often these days:  “telecommunication networks transforming into platforms;” copper networks are being replaced by optical fiber media; virtual reality is coming; Web 4.0 is coming; coming connectivity networks will be a blend of “transmission, storage and computing.”

None of that is too surprising when uttered by a regulator. But ecosystem participants are right to pay attention when a regulator talks about a  “radical shift” of business models, specifically questioning “the traditional model of vertical integration.”

To be sure, in context, Breton was referring to the “digital industry” in a broad sense. Referring specifically to connectivity providers, Breton said “telcos are demonstrating that they are on their way to become service platform providers.”

Specifically, Breton seemed to be referring to telcos “becoming network-as-a-service providers.” None of that is necessarily a radical shift. In fact, most service providers see “network as a service” as an ancillary revenue stream, and not necessarily as a “revolutionary” move. 

The heart of the matter addressed in his speech is funding mechanisms for gigabit infrastructure, specifically proposed new concepts that would have a few hyperscale app providers paying access providers for the right to land traffic on those networks. 

Those of you familiar with communications network interconnection practices might not find that terribly controversial, in one sense. Public service providers (telcos) always have compensated each other for landing traffic on interconnected networks. 

So internet service providers peer with each other when traffic is roughly equal, outbound and inbound, or assess fees when traffic is asymmetrical. 

Others might find the notion highly controversial. Interconnection applies to asymmetrical inbound traffic between public carriers. The proposed new rules taxing content providers would treat a few hyperscalers as though they were public carriers, even when it is ISP customers who are initiating the sessions and causing the inbound traffic loads. 

Historically, any access provider would bill its own customers for use of the network, using both flat fee and usage-based charging mechanisms based on its own customers’ demand. “Use more, pay more” is the general idea. That has included use of other service provider networks to terminate traffic off the local network. 

Hyperscalers are not public networks. Nor do they initiate access network customer requests. Instead, each ISP’s own customers create the inbound traffic load. In virtually every other industry where usage of network resources happens, customers pay for consumption.

That applies to toll roads, seaport access, natural gas consumption, electricity use, wastewater facilities or airport landing gates, for example.

In this case, as in the other instances, ISP customers are driving the inbound demand, invoking video content, for example, as they might in earlier times have made long distance phone calls, or sent text messages. When customers have paid for linear video subscriptions, the networks fulfilling that demand were not charged because network resources were used. Instead, the subscribers paid. 

In the end, consumers wind up paying for all costs. In the case of taxes on a few hyperscalers for landing traffic, it will be the users of those apps who wind up paying. But that is the point.

ISPs want more money for building their networks and they want somebody else to pay for upgrades. That “somebody else” is users of a few hyperscale apps or business partners of the firms offering those apps. That includes advertisers, merchants and end users. 

And then there are the industrial policy drivers. European and East Asian firms would like to promote indigenous suppliers at home in their battle against competitors based in the United States. Taxes on a few U.S. hyperscalers are viewed within that context by policymakers as well.