Price-Driven Growth Strategies Signal Desperation among NSPs

Lowell McAdam, chairman & CEO, Verizon Communications

Lowell McAdam, chairman & CEO, Verizon Communications

August 8, 2012 – The latest pronouncements on future directions in broadband service strategies attest to how unnerved industry leaders have become in their efforts to keep shareholders happy as old business models come unraveled.
In the eyes of some observers plans taking shape at major telcos and cable MSOs raise a strong possibility that short-term benefits to the bottom line may come at grave costs to the general welfare of an information-driven economy. Decision makers respond they have little choice but to take action in response to changes in their financial prospects that have set off alarms on Wall St.

But, regardless of the impact on the country’s economic wellbeing, there’s reason to question whether these moves are really in the long-term interests of the companies themselves.

With wireline voice and broadband customer attrition rates at record levels, both Verizon and AT&T have signaled they want to abandon use of all-copper DSL plant in urban and rural markets alike without committing to more aggressive build-outs of their next-generation fiber-rich access networks. Verizon, in the midst of a big copper plant selloff, is looking to its LTE mobile plant as the replacement for broadband access in rural areas. AT&T remains uncertain as to its alternatives after weighing sale of its copper-based holdings over the past few months.

Meanwhile, leading cable operators find themselves under less competitive pressure than ever, not only because of the looming DSL retrenchments but also in light of their new cross-promotional and proposed wireless partnerships with Verizon Wireless. Given cable operators’ growing reliance on broadband revenue as a firewall against ROI falloff, the situation creates an environment conducive to rate inflation that could impede market expansion and the long-term benefits that might accrue with higher broadband penetration.

Verizon Rides LTE

The depth of the conundrums and uncertainties at the telco giants have been on vivid display at recent investor conferences. In late June Verizon Communications chairman and CEO Lowell McAdam told a Guggenheim Securities gathering that “LTE is the big engine for us” and that video over LTE “is going to be the cornerstone of the changes and the future of the business.”

That’s why, he added, “this relationship with SpectrumCo [the cable MSOs] is important to us.” Of all the new growth areas, including cloud service, machine-to-machine and security services, that Verizon is counting on to “compensate for some of the falling off of copper-based services like DSL and voice…I think the video piece will have a much steeper ramp to it, especially if we go forward with the SpectrumCo arrangement,” he said.

McAdam acknowledged the departure from the way things have always worked in the highly competitive cable-telco market was hard to accept in some quarters. “It is interesting that a lot of people have said, well, I can’t believe you’re going to partner with them,” he said. “You are not going to use their Wi-Fi are you? Well, of course, we are.”

Along with off-loading traffic a big part of the SpectrumCo deal is the cable operators’ promotion of Verizon Wireless to their customers and, depending on future dealings, the possibility MSOs may leverage the mobile network on a wholesale basis through MVNO (mobile virtual network operator) agreements with the carrier. With the LTE network tying everyone’s services together, the goal is to offload as much traffic to the fixed networks as possible, whether FiOS or someone else’s, McAdam noted.

“I don’t expect anybody to sit in their home watching video over LTE,” he said. “I want them to be able to watch it on their tablet anywhere in the house using the Wi-Fi network. And the same thing, if you are around the city and there is a Wi-Fi hotspot, we are happy to have you offload onto that.”

Noting he expects approval of the SpectrumCo deal from the FCC and Department of Justice by summer’s end, McAdam stressed what the deal will mean to the bottom line if Verizon can give FiOS and cable customers alike a seamless video-rich experience wherever they are. “Think about if you could take, whether it is your e-mail, whether it is your DVR content, whether it is streaming sports, whether it is being able to do a video from your car to your home or to your PC or whatever,” he said. “You [could] tie every device that you have that has a screen on it together and seamlessly be able to take the content back across it.

“I mean customers will flock, I think, to a service like that. So that probably dwarfs anything else that we would do from a top-line revenue growth.”

Under these conditions the old wireline infrastructure becomes dispensable, allowing Verizon to accrue major operational cost savings to the bottom line even if it cedes fixed broadband coverage to other providers. “[T]he vision that I have is we are going into the copper plant areas, and every place we have FiOS we are going to kill the copper,” McAdam said. “We are going to just take it out of service, and we are going to move those services onto FiOS.”

He continued: “And then in other areas that are more rural and more sparsely populated, we have got LTE built that will handle all of those services, and so we are going to cut the copper off there. We are going to do it over wireless. So I am going to be really shrinking the amount of copper we have out there….[W]e can grow the top line through FiOS, and we can leverage the cost efficiencies on the network side. So margins can improve.”

The upshot of the “exponential leap” to LTE is that Verizon will not be positioned as “your cell phone provider” but rather as “your network provider wherever you are,” McAdam said. “[I]f I know that I can do everything I want in my car that I can do in front of my TV set or my PC or on my tablet, I think it just takes away a lot of the restraints.”

But, despite the positive spin McAdam put on the carrier’s position, there’s an air of desperation to a strategy where these factors are the dominant facts of life:

• Economic justification for fiber-based expansion has hit a wall even as a vast DSL infrastructure is viewed as disposable. Verizon, rather than building out to more than 18 million homes as expected two years ago or even more as expected earlier, has slowed FiOS construction to where only 14 million homes have access to the service and only another three to four million are slated to be passed by fiber under existing video franchise commitments, leaving huge regions, including the cities of Boston, Baltimore and Buffalo, without fiber service.

McAdam said that by eliminating DSL in fiber-served areas the carrier will try to bring DSL broadband customers onto the fiber plant. But over time the primary broadband option for DSL customers in non-fibered areas of its incumbent footprint will be cable or LTE, unless the company commits to new fiber builds. McAdam cited union contracts as a key gating factor on any such decision, but didn’t say whether a relaxation in union rules which currently force antiquated copper-based maintenance and personnel costs on fiber areas would lead to fiber expansion.

• The ability to leverage the video potential of LTE while gutting DSL depends on cooperation from regulators at the state and federal levels. McAdam, while sounding optimistic about the chances for FCC and DoJ approval of the SpectrumCo deal, was far less upbeat when speaking about the regulatory environment in general. “I do feel right now the pendulum has swung a bit more to the regulators putting their thumb on the scale, and we don’t like that,” he said. “We think we ought to let the market do that.”

At the state level, Verizon has gained freedom in Florida, Virginia and Texas to have the flexibility to “start to sunset some of the older technology,” he said. However, New York and New Jersey regulations “are frankly pretty backward compared to the rest of these states, so we have got some work to do there.”

• Ultimate bottom-line success depends on a partnership with competitors and the willingness of consumers to accept higher prices. Speaking of the seamless video-everywhere vision on which the envisioned upside greatly depends, McAdam said, “Is it going to cost them [consumers] more money? Yes, but it will probably shift their wallet spend from other things that they do individually into this sort of a bucket of gigabytes. And so I think it will be a significant stream for us.”

Befuddlement at AT&T

The story, sans the cable connection, is similar from the AT&T side. The company says it has ended expansion of its U-verse network at 30 million homes passed while sending various signals as to what it plans to do with its “obsolete” all-copper DSL access links passing about 15 million homes and another five million copper lines running at distances too long to support DSL.

In various appearances this year AT&T CEO Randall Stephenson made clear all options are on the table, including sale of the plant and reliance on LTE to reach customers who don’t have a fixed service option. He also voiced hope that new packet-based DSL technology might allow the company to use those networks to deliver broadband services at lower operating costs. And sources report the company has also looked at a combination DSL/Wi-Fi access solution.

Selling off the networks has proved difficult owing to regulatory hurdles that have to be cleared on a state-by-state basis, Stephenson said at a Sanford C. Bernstein conference in June, although he indicated a final decision as to whether to sell or upgrade the networks was yet to be made. Possible upgrades using IP DSLAMs (DSL access multiplexers) were proving less costly to deploy than anticipated, he noted

IP DSL eliminates the need to convert signals from the old ATM (asynchronous transfer mode) platform, making it easier and cheaper to provide Web-based video and other IP services to customers. Speaking at a JPMorgan conference in May Stephenson was widely quoted as saying the new approach to DSL might lead to “a better revenue profile than perhaps we would have thought two years ago.” He added, “We are giving this a hard look.”

But his remarks during a January earnings call remain the operative view on the conundrum as the company weighs whether to continue trying to sell or to upgrade the old plant: “We have been apprehensive on moving, doing anything on rural access lines because the issue here is, do you have a broadband product for rural America? And we’ve all been trying to find a broadband solution that was economically viable to get out to rural America and we’re not finding one to be quite candid.”

Yet it’s hard to imagine that the carrier will put a lot of effort into selling its rural base, given the outcomes experienced by buyers of various segments of Verizon’s holdings over the past several years. Both Hawaiian Telecom, which bought property in the late ‘90s, and FairPoint Communications, buyer of properties in New England a few years later, ended up filing for bankruptcy, and Frontier Communications, which purchased vast holdings in various parts of the country two years ago, has had mixed results through a challenging period of integration.

Moreover, AT&T would have to compete for buyers with Verizon, which still has 10 million lines on the sales block that it has been unable to move since 2004. In addition, sources speculate Verizon will eventually try to unload more areas in Pennsylvania and Virginia plus Baltimore and Boston.

Of course, as one wag puts it, speaking on background, all these questions of what to do with the plant may become moot before such sales are consummated in the current down market. “At the rate they’re losing DSL customers, attrition could put them out of their miseries before they find buyers,” he says.

Given the upside potential of the broadband ecosystem as a major force in the 21st Century economy it’s hard to imagine these telephone giants are so constrained by near-term bottom-line considerations that they can’t make the investments that would turn all this valuable plant into a viable revenue base. What’s missing is faith in fixed-line operations amid the euphoria over booming returns on the wireless side. The upshot is the de facto solution for both companies will likely be reliance on LTE to compete for cord-cutting or cord-terminated broadband subscribers, with Verizon enjoying the advantage of having cable partners to work with to expand the multiscreen bundled service solution across a much vaster urban and suburban footprint than would otherwise be possible.

Cable Rides Rate Curve

Meanwhile, cable operators are plagued by their own attrition woes with losses or slow growth at best in digital TV subscribers from one quarter to the next and largely flat customer growth in voice. But broadband is booming, with the result that MSOs generally are reporting strong bottom-line performance, helped no doubt by the broadband retrenchments on the telco side.

Comcast, for example, reported it added 156,000 high-speed Internet customers in the second quarter, resulting in an 8.9 percent revenue gain for broadband over the same quarter a year earlier. Despite a loss of 176,000 cable TV customers, which marked a 26 percent improvement over Q2 2011, the company reported a six percent increase in revenue to $15.2 billion for the quarter compared to a year earlier, with operating income up by 4.8 percent.

Time Warner Cable had a similar, though not quite as upbeat story to tell. The MSO reported its broadband subscriber base grew by 59,000 in the quarter and that it lost a record 169,000 video subscribers with “essentially flat” growth in voice, yet recorded a 7.2 percent jump in operating income from a year earlier.

But it wasn’t just broadband subscriber growth that fueled these companies’ bottom-line improvements. Along with strong gains in commercial services, consumer rate increases played a big role as well.

Comcast reported the average monthly bill for bundled services jumped eight percent to $148.57 from the previous year, which along with rate increases reflected an uptick in the number of services taken by some households. Time Warner Cable said price increases as well as tier upgrades contributed to higher revenues in broadband services while higher prices helped offset losses in video revenues.

All of these developments point to a diminishing level of broadband choices for consumers, with broadband cable service becoming the dominant if not only fixed-service option in many areas and LTE looming as the only option in some rural areas. And, with price increases easier to assess as low-cost DSL disappears, service providers’ reliance on higher broadband rates to keep profits rising as other service categories weaken points to a diminishing returns scenario where growth will last as long as higher prices don’t begin to choke broadband subscriber growth.

The Google Opportunity
The scenario appears ripe for new competition, where newcomers willing to invest in advanced infrastructure that leverages the latest cloud-based and intelligent networking technologies to drive out much of the traditional operating costs may have an opportunity to undercut the duopoly pricing of incumbents. Google, for one, seems ready to test this proposition as it contemplates building out new territories beyond its all-fiber operating base in Kansas City and environs.

At this early stage Google is pricing its 1 gigabit-per-second broadband service at $70, with another $50 charged for pay TV service, which puts the pricing in the ballpark of the Verizon FiOS broadband service. But the company is also offering free 5 megabit-per-second service to anyone willing to pay an upfront $300 access line construction fee, which hints at pricing options that could be implemented if the company chooses to expand service elsewhere.

Regulators will have a lot to say about where the telcos go from here, including the potential of the Verizon-cable strategy, which means the entire house of cards could fall in a matter of weeks. But, assuming it doesn’t, one of two scenarios is likely play out across the metro regions of the country.

Either the combination of a de facto monopoly over quad-play service in some places and a duopoly elsewhere engenders an Internet economy enjoyed by those who can afford the access costs with a wider-then-ever gap between government broadband goals and the reality on the ground. Or a new lineup of aggressive providers emerges to turn the short-term ROI strategies of the incumbents into long-term nightmares.