Even as a "Platform," Telcos Would Not Escape Near Zero Pricing

The reality of very low and declining per-unit prices is well attested in the connectivity business. Many suggest a way out of the conundrum is for at least some connectivity providers to transform themselves as platforms. 

Ignore for the moment whether this is generally possible, and to what extent. 

Life as a platform would ultimately be based on very low per-unit prices. In fact, as many platforms feature zero marginal cost, they also tend towards near zero pricing. 

Virtually all platforms feature lower prices per unit than rival pipe businesses, for a number of reasons. Typically making extensive use of internet and computing resources to radically lower transaction and information discovery costs, etailing platforms inevitably push cost out of retail transactions. Platforms reduce friction. 

In other cases, platforms are able to mobilize and put into commercial use assets that otherwise lie fallow. Uber provides a good example. Personally-owned vehicles tend to sit parked and unused 95 percent of the time. Uber allows those otherwise idle assets to be put to commercial use. 

And though firms often are urged to become platforms, few actually can do so, and not for reasons of technology deployment, skill or type of product. Successful platforms are relatively rare because they require scale, and few businesses can afford to invest to scale. 

Most firms in the connectivity business will not be able to transform as platforms, leaving only other possible options. If one believes that prices for telecom products are destined to keep declining, or that more for the same price is the trend, then there are a couple of logical ways to “solve” such problems. 

Firms might try to gain scale to lower unit costs, change the cost model in other ways to enhance profitability, exit the business or change the game being played. Moving “up the stack,” across the ecosystem or into new or adjacent roles within the value chain can “change the game.” That is the strategy behind Comcast and AT&T moving into the content ownership business, or moves by other tier-one service providers into new lines of business outside the connectivity core. 

That is one way to attempt to escape the trap of marginal cost pricing, which might be the connectivity industry’s existential problem. 

But it also is reasonable to assume that even a successful shift to a platform model will be based on near zero marginal cost, and near zero pricing. The reason is simply that most platforms also feature near zero pricing.

Telcos Not Much Closer to Success in Enterprise Solutions Market, ABI Research Says

Telcos might not be much closer in 2021 to a goal of becoming relevant in the cloud-based enterprise solutions market, Don Alusha, ABI Research senior analyst suggests. 

That should surprise almost nobody, as the application value chain now rests on the internet, software platforms, and the cloud. That allows near-zero distribution and near-zero transactional costs, Alusha says. 

Direct competition from hyperscalers is a factor as well. Amazon offers multiple devices for either edge or on-premises deployments: Snowcone, Snowball, Wavelength, Outposts, and Greengrass IoT, for example. 

Hyperscalers also are already deploying enterprise digital solutions, most of which are usage- or subscription-based instead of upfront, capex-based solutions that telco solutions arguably require, says Dimitris Mavrakis, ABI Research senior research director. 

Telco operators will need to adapt to opex models to survive, especially in the small and medium enterprise (SME) segments of the market, he says.

“2020 has seen AWS, Google, and Microsoft all advancing and underlining their telco ambitions to provide enterprise connectivity solutions” says Mavrakis.

“Their existing ties with enterprises for cloud storage, as well as their general openness toward service-based offerings, will make them particularly attractive to enterprises,” says Leo Gergs, ABI analyst. 

That might also include hyperscalers supplying access services as well, he says. 

Hyperscalers are leading the market in consumption economics, says Alusha. In a sense, that is a continuation of a trend we saw a decade or two ago, as the enterprise software business became “consumerized,” with many consumer apps adopted first by employees and then supported by enterprise IT. 

Enterprise IT of the past was based on high switching costs, relatively low volume, high price, and a pay-up-front capital investment model. 

The future purchase pattern will instead be based on high volumes, low pricing, and an opex model. 

Telcos and their suppliers are not yet ready to fully embrace consumption economics, says Alusha. 

Telecommunications is an asset-intensive industry with expertise in managing factories and supply chains, developing technologies, and understanding the cost of goods sold, inventory turns, and manufacturing. 

Human-intensive services are entirely different, Alusha says. For example, in services and opex-based models, technology providers do not manufacture a product to then sell it. Instead, they sell a capability or knowledge, created “at the same time they deliver it,” he says. In other words, software is sold as a service, not a product. 

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.

What Does Your Business Look Like if the Key Constraint is Removed? You Get Microsoft, Netflix, Google, Facebook, Amazon

What does your business look like if the key constraint is removed? It is a question so challenging--and often so seemingly impossible--that most of us never ask it. As a much younger profit center manager, I was once asked “what would it take to destroy our competition.” Truth is, I had no immediate answer. 

There was a most-likely answer. But I also knew that one thing would “never happen,” as the stakeholders who could authorize the change were--and remained--steadfastly unshakeable in supporting our only competitor. 

But young Bill Gates, before Microsoft was a household name--in fact when the company name actually was Micro-Soft, and was based in Albuquerque, N.M.-- did ask the question. So did Reed Hastings, founder of Netflix. 

If you are a user of computing or communications, what is your behavior if both are nearly free? 

If you are a supplier of computing or communications, what are the implications for your business? What business are you in, and what business should you be in?

Those remain the key strategic questions for connectivity providers.

“The original insight for Microsoft was this: What if computing was free? ” Bill Gates, former Microsoft CEO and chairman, once said. He has said similar things several times, more recently about price trends in communications. 

In 2004, then Microsoft Chairman Bill Gates argued that "ten years out, in terms of actual hardware costs, you can almost think of hardware as being free--I'm not saying it will be absolutely free--but in terms of the power of the servers, the power of the network will not be a limiting factor," Gates said. 

About a decade before, in 1994, Gates mused that  “we’ll have infinite bandwidth in a decade’s time.” In 1995, Gates said “And for this new era, communications is what’s becoming cheap.  So you get to thinking, well, what if communications was free, what could people do?” 

My own analysis is that Gates believed in Moore’s Law and its impact. That analysis would lead you to believe that computing costs would in fact decline substantially, every 18 months, upending assumptions about the use of computing.

Reed Hastings was very clear about the application of Moore’s Law to the foundation of Netflix. 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,”  Reed Hastings, Netflix CEO, said.  “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.

So as crazy as it might seem, what Moore’s Law has enabled, in computing, communications, applications, hardware and business opportunities, is precisely a clear understanding of what is possible if the key constraint in any business is removed. 

Near zero pricing is the term I use to describe the larger framework of connectivity provider pressures towards ever-lower prices. Others might prefer to emphasize marginal cost pricing. The point is that there is a reason the phrase dumb pipe exists. What we need to remember is that dumb pipe now is the foundation of the whole connectivity business. 

A caveat is that what people usually mean by “dumb pipe” is that a product is sold at low prices and generates low profit margins. But think about it: industry revenue growth now is lead by broadband services (internet access), which is, by definition, a dumb pipe service. It is a way to get access to applications, not an actual application itself. 

You might call that trend another example of the impact of Moore's Law on business and economics. And near zero pricing is a big industry issue. It might be the single-biggest issue. 

In a recent survey by Telecoms.com, the number-one threat to long-term business success was “increased pressure to lower prices” and “lower profit margins,” for example. 

source: Telecoms.com 

Agility or “speed” was also a major concern. Third on the list was competition from webscale firms including Google, Amazon or Microsoft. 

But there are good reasons why “lower prices” and “lower profit margins” are the top issues. Simply, they are the most-important result of other industry threats causing the price compression and lower profit margins: competition, the shift to internet protocol as the next-generation platform and the embedding of the whole connectivity function within the larger internet ecosystem.

Aside from deregulation of the telecom industry, which lead to competition and price competition, technology is among the root causes of price pressures. Near zero pricing is a scary thought for a connectivity provider, but it is reality.

Near Zero Pricing Remains the Top Issue Connectivity Providers Face

Near zero pricing is the term I use to describe the larger framework of connectivity provider pressures towards ever-lower prices. Others might prefer to emphasize marginal cost pricing. The point is that there is a reason the phrase dumb pipe exists. What we need to remember is that dumb pipe now is the foundation of the whole connectivity business. 

A caveat is that what people usually mean by “dumb pipe” is that a product is sold at low prices and generates low profit margins. But think about it: industry revenue growth now is lead by broadband services (internet access), which is, by definition, a dumb pipe service. It is a way to get access to applications, not an actual application itself. 

You might call that trend another example of the impact of Moore's Law on business and economics. And near zero pricing is a big industry issue. It might be the single-biggest issue. 

In a recent survey by Telecoms.com, the number-one threat to long-term business success was “increased pressure to lower prices” and “lower profit margins,” for example. 

source: Telecoms.com 

Agility or “speed” was also a major concern. Third on the list was competition from webscale firms including Google, Amazon or Microsoft. 

But there are good reasons why “lower prices” and “lower profit margins” are the top issues. Simply, they are the most-important result of other industry threats causing the price compression and lower profit margins: competition, the shift to internet protocol as the next-generation platform and the embedding of the whole connectivity function within the larger internet ecosystem.

Aside from deregulation of the telecom industry, which lead to competition and price competition, technology is among the root causes of price pressures. 

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. Basically, I believe he asked himself what his own business would look like if computing hardware was free. 

How startling was that question? 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.

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.

As frightening as it might be for executives and shareholders in the telecommunications industry, a bedrock assumption of mine about dynamics in the industry is that, over time, retail prices for connectivity services also will trend towards zero.

“Near-zero pricing” does not mean absolute zero (free), but only prices so low there is no practical constraint to using the services, just as prices of computing appliances trend towards lower prices over time, without reaching actual “zero.”

No Surprise, Net Profit Margins are Generally Lower than in Monopoly Era

Globally, a  typical retail connectivity service provider selling to consumers and businesses, likely with universal service obligations, tends to have net profit margins in the five percent range, according to Deloitte, perhaps six percent in the first quarter of 2020, making the business more profitable than low-margin grocery retailing but far less profitable than finance or technology services. 

source: Factset

Ironically, those sorts of net profit margins are close to monopoly-era margins as well. In the monopoly days, profit margins were set at guaranteed rates of return not much different, often in the six percent to eight percent range. The difference is attributable in large part to competition, which tends to lead to lower prices and therefore lower profit margins for suppliers. 

But product substitution also plays a part, as consumer and business demand shifts from legacy to new products, not all of which require purchase of a service provider product. Better technology also plays a role in enabling supply of better or more product at equivalent or lower prices. 

That illustrates a near zero pricing trend for basic connectivity products, especially on a per-bit, per-incremental-unit or per-use basis. Over time, connectivity prices have tended to mirror computation prices: better performance and declining prices over time. 

In fact, some major business models are premised on near-zero pricing for computing and communications goods. Microsoft’s software business, Netflix, Amazon, Google and 
Facebook provide examples of major business models built on the assumption of cheap communications and cheap computing. 

That can be seen in declining average revenue per user or commoditization.

Transit Pricing Illustrates "Near Zero Pricing" Conundrum

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

Perhaps for every problem there actually is a solution, though perhaps sometimes the answer is not what we might prefer, expect or want. Back around 1995, I ran into one of those problems.

The context was voice pricing trends. To make a long story short, the problem was a confluence of trends that all seemed to suggest voice revenues were headed south. The process of deregulation and privatization of former monopoly networks was one such early trend.

But in addition to competition, technology trends all suggested prices would drop. Among those trends: optical fiber, microwave transmission, Internet Protocol, client-server architectures, Moore’s Law and declining microprocessor and storage costs. I cannot recall whether I believed at the time that mobile communications would put pressure on voice pricing as well.

The phrase near zero pricing came to mind. The imponderable, at the time, was what would become of telecom service providers if their core product--voice--actually reached a point where retail prices were very low, very close to “zero.”

The concept would reappear about 1999 and 2000, when the phrase “bandwidth wants to be free” was bandied about. The key concept is that prices do not actually have to drop to actual zero; prices simply have to drop to “nearly zero.” If that happens, the revenue model for nearly every business has to shift. 

What was once a revenue driver becomes something more accurately described as a “feature.” The whole point is that technology makes “near zero pricing” in any number of contexts a foundation for business strategy. The key point is not that prices actually hit zero, only that they drop so precipitously that access to computing and memory no longer are constraints to what can be done.

But that’s a problem for incumbent providers who have built substantial businesses on scarcity, either scarcity of bandwidth, processing or memory. And that was the conundrum when asking what impact near zero pricing would have for telcos.

So far, the industry has dodged a bullet by creating new core revenue drivers to supplant voice services that no longer can support the industry’s business models. Mobility and internet access are key cases in point. But prices for bandwidth show the same drift to near zero that we originally saw in long distance and voice pricing. 

Marginal cost pricing is an important principle in many markets, including growing parts of the telecom business. 

Products that are "services," and perishable, are particularly important settings for such pricing. Airline seats and hotel room stays provide clear examples. Seats or rooms not sold are highly "perishable." They cannot ever be sold as a flight leaves or a day passes. So it is rational for an airline to price seats at whatever price it can get shortly before a flight departs. Or at least, that used to be the case.

These days, airlines are more likely to attempt to raise “just before departure” revenue in other ways, such as selling upgrades to roomier seats. 

Whether marginal cost pricing is “good” for traditional telecom services suppliers is a good question, as the marginal cost of supplying one more megabyte of Internet access, voice or text messaging might well be very close to zero.

Such “near zero pricing” is pretty much what we see with major VoIP services such as Skype but also increasingly for bandwidth products in general.  Whether the traditional telecom business can survive such pricing is a big question.

“Forward pricing” is related to marginal cost pricing, where suppliers price at the incremental cost of producing the next unit (marginal cost) or at some future cost when scale is obtained (forward pricing). 

In some part, the value of becoming a platform is precisely a solution for “pipe” sales in many industries. Platforms are alternative business models. They are not necessarily built on selling a particular product, much less products whose prices tend to trend inexorably towards zero.

Are Communications Services Commodities?

Is communications a commodity? The answer matters, as commodity products tend to be priced at levels just barely above the marginal cost to provide the product. 

One can see this clearly in voice pricing, text messaging and even internet access (easier to explain in terms of cost per bit, but even absolute pricing levels have declined).

In fact, telecom product prices have a tendency to drop towards zero. 

That, in turn, posed key questions for business models, especially relating to the cost of producing the products sold. The core problem with pricing at marginal cost (the cost to produce the next unit), or close to it, is that the actual recovery of sunk costs does not happen. 

source: Christensen Institute

As the point of depreciation is to recover the cost of replacing an asset, so communications service providers must replace the cost of the underlying networks. In essence, that means pricing, longer term, at prices that allow recovery of the cost of rebuilding the network. 

Strictly speaking, pricing at marginal cost does not allow that recovery of sunk network investments.  

In fact, one of the biggest long-term trends in the communications business is the tendency for connectivity services to constantly drop towards “zero” levels. 

That is arguably most true in the capacity supplier portions of the business (bandwidth), the cost of discrete computing operations, the cost of storage or many applications.

In large part, marginal cost pricing is at work. Products that are "services," and perishable, are particularly important settings for such pricing. Airline seats and hotel room stays provide clear examples.

Seats or rooms not sold are highly "perishable." They cannot ever be sold as a flight leaves or a day passes. So it can be a rational practice to monetize those assets at almost any positive price.

Whether marginal cost pricing is “good” for traditional telecom services suppliers is a good question, as the marginal cost of supplying one more megabyte of Internet access, voice or text messaging might well be very close to zero.

Such “near zero pricing” is pretty much what we see with major VoIP services such as Skype. Whether the traditional telecom business can survive such pricing is a big question.

That is hard to square with the capital intensity of building any big network, which mandates a cost quite a lot higher than “zero.”

source: Quartz

Surplus is part of the reason for pricing at marginal cost, though. That was why it once made sense for mobile service providers to offer reduced cost, or then eventually unlimited calling “off peak,” when the network was largely unused. 

Surplus capacity caused by declining demand also applies to text messaging, where people are using alternatives. If there is plenty of capacity, offering lower prices to “fill up the pipe” makes sense. And even if most consumers do not actually use those resources, they are presented by value propositions of higher value.

Video entertainment and internet access are the next products to watch. Video is more complicated, as it is an “up the stack” application, not a connectivity service. Retail pricing has to include the cost of content rights, which have not historically varied based on demand, but on supply issues.  

Linear video already has past its peak, while streaming alternatives are in the growth phase.

Internet access, meanwhile, is approaching saturation. That suggests more price pressure on linear video and internet access, as less demand means stranded supply, and therefore incentives to cut prices to boost sales volume.

source: FCC

Marketing practices also play a big part, as the economics of usage on a digital network can be quite different than on an analog network. And some competitors might have assets they can leverage in new ways.

In 1998, AT&T revolutionized the industry with its “Digital One Rate” plan, which eliminated roaming and long-distance charges, effectively eliminating the difference between “extra cost” long distance and flat-fee local calling.

Digital One Rate did not offer unlimited calling at first, but that came soon afterwards. In the near term, lots of people figured out they could use their mobiles to make all “long distance” calls, using their local lines for inbound and local calling only.

With unlimited calling, it became possible to consider abandoning landline service entirely.

At least in part, the growth of mobile subscriptions from 44 million in 1996 to 182 million by the end of 2004 is a result of the higher value of mobile services, based in part on “all distance” calling.

Mobile revenue increased by more than 750 percent, from 10.2 billion dollars in 1993 to more than 88 billion dollars in 2003.

source: FCC

During this same time period, long distance revenue fell by 67 percent to 4.3 billion dollars, down from 13.0 billion dollars.

The point is that connectivity prices and some application (voice, messaging) prices have had a tendency to drop closer to zero over time. Moore’s Law plays a part. Open source also allows lower costs, and therefore more-competitive prices.

That is why the question of whether communications products are commodities does matter. Commodity prices drop, over time, to just above marginal cost. And that implies pressure on business models.