The FCC “Gets It” – Competition, Not Market Power, Drives Innovation and Investment

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Paul Sagawa

203.901.1633

sagawa@sector-sovereign.com

May 17, 2010

The FCC “Gets It” – Competition, Not Market Power, Drives Innovation and Investment

  • The FCC’s plan to reclassify wired broadband as a regulated telecommunications service, combined with its published National Broadband Plan and numerous public comments, makes clear its intention to press a policy of “net neutrality”, heightened competition, low rates and universal availability for broadband. While opponents voice concern for lost incentive for investment and innovation, we believe that the FCC sees the growing domination of cable operators for higher speed service as an even greater threat.
  • While the cable industry has just over half of all U.S. broadband subscribers, it has over 80% share of connections capable of better than 4Mbps. With less than a third of US households passed by either Verizon’s fiber-based FiOS or AT&T’s high-speed copper U-Verse services, and investment in both of those services winding down, broadband rivalry is less than fierce. Against this backdrop, cable industry capex has already begun a sharp decline with further future declines projected.
  • While the FCC has promised “forebearance” in its use of its regulatory powers on broadband, the potential use of these powers is likely sufficient motivation to keep broadband operators from using pricing power to drive excess returns and block cable MSOs from hampering access to internet TV options. While the FCC’s stance may be challenged in court, an aggressive industry opposition could catalyze Congress to pass net neutrality legislation that would make challenges moot.
  • Historically, competitive threat and regulatory pressure have been the only real spurs to investment in telecom networks. CAPEX as a percent of sales has been higher during periods of greater competitive intensity and in business areas, such as wireless, with more competition. The FCC appears to be favoring 4G wireless broadband as a competitive alternative to cable, fiber and DSL, and will exclude it from reclassification. While initial speeds are not competitive with wired services, new spectrum, new competitors, favorable regulation, investment in system capacity and a technical upgrade path to 100Mbps+ could make wireless-only a viable solution for broadband users well before decade end. Wireless churn, already a significant phenomenon for voice, would then be the catalyst to reverse the already strong downward trend in fixed broadband investment.
  • In this scenario, wired carriers could not under-invest, hinder access to on-line alternatives to multi-channel video, or apply pricing power without a heavy regulatory backlash. As such, we believe that valuation models that assume more than modest long term cash flows from wired broadband businesses may be overaggressive, that multi-channel video franchises will likely begin to show serious erosion to internet TV by decade end, and that the strong trend toward wireless-only voice users will accelerate.
  • This is bad news for cable MSOs (Comcast, TimeWarner Cable, Cablevision, et al.) and wireline telcos (Verizon, AT&T, Qwest, et al.), and perhaps not as bad for wired equipment suppliers as many have feared (Cisco, Motorola, Arris, Harmonic, Alcatel-Lucent, et al.). It is good news for would-be purveyors of internet TV (Google, Netflix, Apple et al.) and the associated technology suppliers (TiVo, Cisco, et al.). We expect strong investment in building out 5-7 national 4G wireless broadband networks, followed by regular upgrades for speed and capacity, good news for wireless equipment companies (Ericsson, Nokia, Huawei, et al.), chip suppliers (Qualcomm, Broadcom, et al.) and tower companies (American Tower, Crown Castle, SBAC, et al.). Outcomes for wireless carriers (Verizon, AT&T, Sprint, et al.) will depend on execution, although it appears likely that competition will be intense.

Cable Domination

FCC Chairman Julius Genachowski has delineated six principles that he asserts are crucial for safeguarding the free and open internet. These principles are unambiguous and fully consistent with the policies promoted by the commission, including the recent decision to reclassify wired broadband services as “telecommunications services” rather than “information services” and thus, subject to a range of regulations heretofore used to manage the competitive conduct of traditional wired voice telephone network operators under Title II of the Telecommunications Act of 1996. This reclassification explicitly recognizes broadband as a market without sufficient competition to drive efficient behavior.

Setting wireless aside for a moment, the nation is largely wired with twisted-pair copper telephone wire and thick coaxial cable television connections. By the physical nature of these networks, the cable network is dramatically advantaged for the provision of broadband services. Cable operators can provide greater access speeds to households with lower levels of incremental capital investment than can telephone companies using their traditional copper. Over the past five years, both Verizon and AT&T have made heavy investments to try to reduce that advantage. Verizon tried to leap-frog cable with an even more capable fiber optic network passing 14.5M US households, and capturing a bit less than a quarter of them as subscribers. AT&T tried to narrow the gap by upgrading to the most technologically advanced twisted-pair based technology, and has captured just 10% of the 23M households it passes.

Meanwhile, the cable industry has 34.5M broadband subscribers, most of whom either receive or could easily be upgraded to speeds superior to AT&T’s U-verse and close to Verizon’s FiOS. This gives cable a better than 6 to 1 market share advantage for the “Big B” high-speed broadband that could make high-definition internet-based video entertainment a reality. Now, Verizon has more or less cried “No Mas!”, signaling that the end of its fiber investment is in sight. The cable industry is happy to respond in kind, cutting its capital spending in 2009 and reaping expanding cash flows, with apparent plans to keep cutting and reaping on an even grander basis going forward. Extended in perpetua, this scenario imagines that cable MSOs would be allowed to use its technology superiority to over-price and under-invest their way to broadband domination.

Cable domination of broadband is also troubling on another front. The primary threat to the multi-channel video service that remains at the core of the cable and satellite TV industry is high quality video delivered via a broadband connection to the internet. Services like Google’s YouTube, Netflix and AppleTV are beginning to siphon eyeballs from traditional broadcast video. As a monopoly provider of broadband fast enough to support these services for most Americans, the cable industry has ample incentive to make things as inhospitable as possible. Cable industry control of the set-top-boxes and software interfaces that drive remote control clicks on the living room couch is a serious stumbling block to online services hoping to move from PC to TV. Beyond this, Comcast has implemented a technical speed-bump to hamper users of video download services like BitTorrent. The FCC moved to block Comcast’s policy, but lost its case before the DC federal appeals court, which ruled that the commission lacked authority given the classification of broadband as an information service. Hence, the reclassification.

The Great Wireless Hope

The FCC has a different scenario in mind. First, The National Broadband Plan makes clear that the commission is not dismissing wireless broadband as real competition. A primary goal of the plan is that “The US should lead the world in mobile innovation, with the fastest and most extensive wireless networks of any nation”. To that end, the commission advocates making as much as 500 MHz of prime radio spectrum available for 4G wireless broadband network build-outs over the next decade, with 300MHz to be added before 2015. We believe 5-7 different operators will take the bait and build out 4G.

Of course, cable executives and industry watchers don’t seem particularly threatened as yet. 4G is trickling into the market – Sprint’s first WiMAX handsets are just coming to market and Verizon and AT&T’s LTE networks will not go live for a year. The initial network speeds will likely deliver well less than 10Mbps to users on a consistent basis, an obvious deficit vs. cable broadband which typically tops the 10Mbps level and is projected to go to a theoretical 50Mbps with the next network upgrades. The prices for 4G will be considerably higher than wired broadband as well, justified by the inherent mobility, but uncompetitive for fixed applications.

The problem is, technology does not stand still, particularly when a new paradigm is beginning its evolution, which is the case with 4G wireless. Just as 3G wireless data delivered a 10 fold increase in real user throughput during its first decade, so shall 4G wireless broadband. 4G speeds are limited only by the ability of microprocessors to handle the increasing computational load within the constraints of portable size and battery powered operation. The industry roadmap for the most widely chosen 4G technology, LTE, specifies 100Mbps speeds once the technology matures, more than sufficient to give cable a run for its money and to give investors pause before using a growing perpetuity on presumed 2020 cash flows as a terminal value for valuation.

Net Neutrality and Common Carriers

Over the past several years, the internet community has been embroiled in a heated debate over “net neutrality”. This concept asserts that the operators of any network connected into the internet should not discriminate against legal data traffic on the basis of type, application or origin. The concern is that the owner of a network bottleneck – broadband access, for example – could restrict access to services perceived to be competitive with the network owner’s own interest, thus squelching innovation, thwarting competition and driving pricing unnaturally higher.

The FCC has been unambiguous in its support for net neutrality. However, in April, the US Court of Appeals for the District of Columbia overruled an FCC decision to sanction Comcast for blocking its customers from accessing a bandwidth intensive video file sharing service called BitTorrent. In its decision, the court questioned the FCC’s authority to regulate broadband and other services designated as “information services” by Title I of the Telecommunications Act of 1997. This decision is the direct genesis of the commission’s decision to reclassify broadband as a Title II “telecommunications service”, over which its authority to regulate is well established.

Under the 1997 law, telecommunications services are recognized as “common carriers”, a term dating back to the monopoly days of AT&T and roughly equivalent to a regulated utility. Because of the enormous fixed cost associated with replicating the network assets of a common carrier, it is recognized that it is unlikely that any competitor would emerge using similar technology. Common carriers have traditionally been subject to price and rate of return regulation, and have been required to allow competitors to access their network on an unbundled, a la carte menu basis. In 1997, broadband was a brand new technology offered by telephone companies, who successfully argued that a heavy regulatory hand would eliminate incentive to bring the service to market.

So in the wake of the BitTorrent decision, the FCC has taken a new tack and will reclassify broadband as a telecommunications service, subject to the same regulatory framework as a “common carrier”. The FCC is also promising that it will be gentle in the application of that regulatory framework – the official term is forbearance – asserting that its primary motivation in reclassification is to protect the net neutrality that it sees as endangered by the appeals court decision. Of course, the reclassification is also subject to court challenge, but legal observers believe that the commission is on much, much firmer ground than with the BitTorrent case. Moreover, Congress could act to pass the net neutrality legislation promised by President Obama during his campaign and bring the debate to a close.

What Does the Government Really Want?

Amidst the net neutrality debate, the National Broadband Plan and reclassification, the FCC has not been shy about sharing its policy objectives. First, the commission does not intend to allow broadband service providers to dictate choices to their customers. They should not impair access to any internet based services by blocking access, degrading performance, or controlling user hardware. To that end, the BitTorrent affair is one piece of evidence, as is the National Broadband Plan’s specific mandate to end the cable industry monopoly on set-top-boxes and the critical navigation function that they serve. If agreed to by Congress, the cable industry will have to provide all new and upgrading customers with an inexpensive box to terminate the multi-channel video service. The box would have no advanced functionality, such as DVR or even navigation tools, rather, it would have anti-piracy conditional access technology and a standardized interface for relaying channels to other electronic devices. In this way, the living room TV would be liberated from the set-top-box allowing much easier access to alternative programming options.

Neither does the FCC intend to allow broadband service providers to use monopoly/oligopoly pricing power to jack up prices and tamp down investment. It is a bit disingenuous for industry supporters to argue that regulation will discourage investment, when lack of real competition has seen investment fading already. As a percentage of sales, capital spending has been trending down for three years, with operating cash flows at all-time highs for cable operators. Capex was at its highest, not during the cash flow boom of the past 7 years, but during the 2000-2001 height of the internet bubble, when the competitive intensity was at the boiling point. Meanwhile, amongst wireless operators, where competition has remained a bit more vigorous, rising capex has exceeded operating cash flow since 2004, and is currently more than double the spending by cable operators as a percentage of sales. Bottom line: with gross margins on broadband and broadband-enabled telephone service exceeding 75% on double digit revenue growth for cable operators and capital investment, nonetheless, in decline, it is difficult to see how government regulation could remove investment incentives that appear to have evaporated years ago.

In the National Broadband Plan, the FCC lists six primary goals. The first of these asks that at roughly 85% of US households have “affordable access to actual download speeds of at least 100 Mbps”. The third posits that “every American should have affordable access to robust broadband service, and the means and skills to subscribe if they so choose”. The inclusion of the word “affordable” is instructive, and resounds throughout the 300+ page plan. In our view, the FCC’s promise of forbearance comes with a sizeable asterisk. If the cable industry doesn’t exercise pricing restraint, the commission may not exercise forbearance. Moreover, 100Mbps is not an unreasonable 2020 target for broadband speeds to the 100M households that already have access to cable broadband, given the existing technology trajectory. The FCC is serving notice that it expects that trajectory to be maintained.

So Broadband Regulation ISN’T Bad for Equipment Makers?

In a knee-jerk reaction, many market observers have equated a heavier regulatory hand on broadband with dim future for telecom equipment makers. While we have already tried to make the case that the future was already quite dim, at least on the wired side, due to the market domination by cable operators, we see the FCC’s motivations as profoundly equipment friendly.

For wireless technology companies, the stance is unambiguous. The commission advocates freeing 300 MHz of spectrum for wireless broadband deployments ASAP, with another 200 MHz to be identified and made available by decade end. This nearly doubles the amount of spectrum dedicated to mobile communication services and more than triples the allocation from the extremely attractive 700 MHz frequency range. Some of the spectrum, including 53 MHz controlled by mobile satellite player Harbinger Capital, need only be authorized for terrestrial mobile use, fast-tracking plans to build out new networks. The big winners? Ericsson, Nokia Siemens Networks and Huawei control more than 70% of the wireless network equipment market and will all profit here. Alcatel-Lucent has been bleeding wireless market share globally, but has longstanding supply relationships with both Verizon and AT&T – this could be a lifeline to a business that is otherwise in trouble.

New networks mean new base stations that must be installed on towers. American Tower, Crown Castle and SBAC should see sharply increased demand as the build-outs commence. New networks will also mean new devices. Historically, each new technology has been a serious early challenge for handset makers, perhaps yielding an adrenaline shot for technology rich, but strategically outplayed, Nokia to re-energize its North American smartphone business with 4G LTE. We would expect the usual suspects in US smartphones – Apple, Google, HTC and Blackberry – to attack the market, as soon as the merchant chip makers deliver appropriately small and power efficient silicon solutions. Qualcomm, which has the further benefit of being the leading IPR holder for 4G technology, is a likely prime arms merchant.

The wireless data traffic juggernaut will continue to pressure capacities on core networks, meaning router sales for Cisco and Juniper, and fiber optic gear for Alcatel-Lucent and Ciena. The FCC’s protection for internet TV will help the primary providers – Google, Netflix, Apple, et al. – while also pressuring core network performance – hello Cisco and Juniper again – and adding to the value add from internet performance companies like Akamai. It will also help companies looking to sell set-top-box substitutes out from under cable dominance – Sony, Microsoft, Apple, TiVo, Cisco, Motorola, Google, and others will join the resulting scrum. Meanwhile, short term cutbacks in wireline broadband investment are already underway, but we don’t project them to be nearly as bad as some gloom-and-doom prognosticators project, and expect a reprieve a year or two down the line for Motorola, Cisco, Arris and Harmonic, amongst others.

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