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Transformation Interrupted - Part III: Restoring Growth
(Please note: Originally published in July 2002, exhibits from this report can be seen in the downloadable .pdf copy)
III. Restoring Growth
Beware of Foreign Attachments
In 1956, forty years before the Telecom Act of ’96, AT&T sought an FCC order under the “foreign attachment” rule to ban a device marketed by the Hush-a-Phone Corporation. “Hush-a-Phone”, a molded plastic mouthpiece cup involving no electronics whatsoever, was designed to conveniently improve sound quality in the same way cupping one’s hand over the phone blocks noise or increases privacy. Although later reversed by the D.C. circuit3, the FCC agreed, issued the order and Hush-a-Phone was history.
Until comparatively recently, the public switched telephone network (PSTN) was entirely closed to “foreign” innovation. Improvements, at whatever level, could come from only one source, the vertically-integrated AT&T. By public consent, they operated, maintained, engineered, and manufactured virtually every element of the phone system. Including their Western Electric subsidiary (now Lucent), the Bell System created the network end to end, top to bottom, controlling it in every respect up to and including plastic mouthpiece extensions. It either came from AT&T or it didn’t come at all.
“More”, Not “Different”
At the outset, we said the promise of industry transformation involved new networks, new services, and new business models. So far, we are still only one for three – more networks. It is only by separating transport networks and services (i.e. applications) that there is a genuine possibility of service innovation beyond “me too, but cheaper”, and hence the possibility of new business models as well.
... the promise of industry transformation involved new networks, new services, and new business models. So far, we are still only one for three – more networks.
Regulatory liberalization had the explicit goal of “more”, and the implicit assumption of “probably not different”, competition. More was good, because prices would be lower and a monopoly, by definition, would be eliminated. With this aim in mind, the result of deregulation has been more phone companies – smaller offshoots of Ma Bell (ever recombining to get larger again), and “me too, but cheaper” competitors.
The AT&T business system and the technical workings of the phone system itself were a self-reinforcing monolith. Their network could accommodate outside technical innovations only with difficulty, and their business model and regulated franchise were designed to minimize such threats in the first place
Before the AT&T divestiture, the idea of “different” was a practical impossibility. In the PSTN architecture (its components and interconnections) there were no natural layers, modules, or points of connection where an outsider could insert features and services not already built in, and in doing so make a business out of it. The hubris of squashing Hush-a-Phone notwithstanding, there were legitimate concerns about possible technical (and business) chaos if more technically innovative entrepreneurs, outside the field of plastics, began tailgating on the Bell System infrastructure to offer niche products and services
A modern-day Hush-a-Phone would have focused not on plastic, but software. It would find today’s PSTN much changed and potentially much more technically-compatible with services innovated by outsiders. The “digitalization” of the PSTN completed in the 1980s established an architecture that could now, theoretically, support a remarkable degree of “foreign attachment” in the form of software that did new things for customers. What these 1950s entrepreneurs would find discomfortingly familiar, however, is the business system that goes with the network.
In today’s PSTN, “different” is technically possible but from a business standpoint, as far as incumbents are concerned, highly unlikely. Innovations are possible if the provider can have controlled but direct access to phone company switches. Such innovations can ride the network only in the unlikely event the phone company agrees. Phone companies are not designed to encourage this.
Foreign Attachments in the 21st Century
Let’s say you have a wonderful service for spontaneous, reservationless conferencing with business colleagues, relatives, or friends. At the touch of a button, it automatically conferences you with pre-defined groups of people you frequently talk to – kind of a “group speed-dial”. Delivering this service through a Telco’s network, you’ll share some of your revenues with the phone company, generating for them premium-priced minutes at, say, five times the volume associated with a normal phone call given the greater duration and typical number of parties on the conference. If some of the parties are outside the local calling area, calls will be routed exclusively through the phone company’s own long-distance service generating additional revenue minutes.
If you’d like to sell a lot of this you’ll want to host it at a phone company that has a very large number of customers, a respected brand name, and the desire to steal long-distance minutes away from other carriers. Let’s say our preferred choice is Verizon for this example. To make it easy to use you’d like to have customers access it by pressing *99, or some other “star” code, and, for added convenience, have the charges appear on their Verizon bill at the end of the month.
Take our modest-sounding conferencing example, multiply it many times for all the other kinds of services that might be successfully innovated, and silicon economics reaches the PSTN. Just as with PC software, new applications continuously expand demand for an underlying infrastructure commodity whose unit price falls aggressively and predictably. Applications would use the PSTN as both a marketplace and a delivery vehicle – “Telco as marketplace.” The Telco, the service innovator and, most importantly for long-term success, the customer each benefit.
...the “foreign attachment” doctrine is alive and well, not in FCC rules, but in the business models which are direct descendants of the Bell System era.
Unfortunately for us as aspiring conferencing service innovators, our potential customers, but especially Verizon, the “foreign attachment” doctrine is alive and well, not in FCC rules, but in the business models which are direct descendants of the Bell System era. Phone companies do not have a program of qualifying, testing, co-marketing, or revenue sharing which facilitates, much less encourages this type of entrepreneurship using their network facilities. Their business model is essentially what it always has been.
“Telco as Marketplace”: Why Not?
Examples like Hush-a-Phone and our hypothetical conferencing service may seem amusing, trivial, or even stupid. We happen to like our conferencing idea, but in the open marketplace, who knows? Perhaps it would be a total failure. Even if it were successful, it would surely not be a billion dollar business, and would appeal only to a small sub-segment of Verizon’s subscribers. And both its potential failure and its comparatively small size, even if a hit, are part of our point.
There is no way central planning can invent, deploy, and triage new services successfully.
The “Telco as marketplace” notion, where outside services meet customers and rent the underlying infrastructure, is based neither on an absolutist moral principle of “openness”, nor on the idea of somehow “punishing” the Telcos. It is the means for everyone to make more money by giving customers real value and real choice, not just “me too, but cheaper.”
There is no way central planning can invent, deploy, and triage new services successfully. To make lots of money, you need a collection of these services, and individually they will come and go over time, not be forever frozen as a Class 5 switching feature. Only by creating a marketplace can the few innovative and useful services be winnowed from the majority of the commercially irrelevant.
Returning from imaginary silicon economics to the real thing, it’s worth noting that Intel quietly invests a great deal of energy and treasure in keeping the flywheel of demand turning. While Intel is many levels removed from applications, it is in its interest to ensure that the plateau of desktop PC growth is augmented by lavish consumption of microprocessors in cars, PDAs, servers, phones, music players, and myriad other appliances, and that those devices do useful things for customers.
Better than probably any other technology business except Microsoft, Intel fully understands the grim future that awaits it if and when demand stops co-operating with Moore’s Law. So through new product innovation, special-purpose adaptation of their chips, co-marketing, strategically purposeful corporate venture investments, and just plain influential jaw-boning, Intel is always playing chess a few moves ahead.
Despite its technical possibility, one can almost understand why Ma Bell’s offspring don’t enable services and business models in this marketplace model – they never have in the past. It’s just not part of their legacy, and when their “me too but cheaper” competitors are self-destructing before their eyes, what’s the point? It is also not too hard to understand why incumbent Telcos have not tried to create any of these innovations themselves. Only very recently have they stared down the abyss of actually shrinking revenues.
Harder to understand is why the agenda of those in “bondholders get 8 cents on the dollar” financial intensive-care appears to be: “me too, but now smaller, chastened, and really cheaper”. They would seem to have all the key ingredients to drive their strategies elsewhere: the need to differentiate an ever cheaper commodity, networks as capable as incumbents’ (lots of brand new underutilized equipment), low marginal costs, substantial operating leverage, and desperation.
Imitating the Internet
By now, it’s probably pretty apparent that our “Telco as marketplace” model is lifted straight out of the internet. The design of the internet is that is has no “services”, at least as a customer would understand them. The network itself simply routes packets to where they are supposed to go. It is analogous to a bare bones phone company that only switches phone calls, but gives you access to a large menu of operator services, directory assistance, call waiting, caller ID, etc., provided by others, from which you are free to select.
Because the internet is open, there is no Internet Company deciding which services shall see the light of day.
The key to internet-based innovation is the internet protocol, or IP, a fundamental part of how the internet, as a network, functions. IP is standard, open and free. It enables entrepreneurs and software developers from Albania to Zimbabwe to imagine and construct services which anyone can access from anywhere. IP acts as an anchor, a kind of “guarantee” that, small or large, there is a way to deliver a new money-making service to any customer that can access the internet.
Because the internet is open, there is no Internet Company deciding which services shall see the light of day. No central entity decides whether the internet equivalent of Hush-a-Phone is too threatening, too trivial, or too unworthy to be offered to customers. The marketplace decides that. If you can write code, afford to pay for a connection to the internet so potential customers can get to it, your great service may be “the next big thing.” And it is this very prospect that makes the innovation pipeline bigger.
A River Runs Through It
Our “Telco as marketplace” model adapts a business system from the internet, while recognizing that PSTN network architecture and basic service economics are very different. While no one may any longer take literally the idea of “the internet eliminating phone companies” any time soon, it’s worth setting it to rest by noting three large, practical barriers if you tried:
- the PSTN is excellent at what it does—it doesn’t make economic sense for all telephony to be done over the internet, although it does for some,
- telephony and the internet are like opposite banks of a river. Massive amounts of capital and time would be required to connect the banks into a fully “converged” infrastructure,
- the notion of the internet putting Telcos out of business sounds like the kind of revolutionary technology talk which capital markets are, for now, heartily sick of – grandiose, technology-centric euphoria based on wild, speculative assumptions of customer interest (see reason 1, again).
The eliminating-phone-companies school would require a massive infrastructure replacement equivalent to building the Hoover Dam and drying up the river in order to unify the two banks, telephony and internet services.
New services which bridge the internet and the PSTN could greatly extend the marketplace model, increasing the diversity, utility and revenue from new offers.
But there are some interesting possibilities if you build bridges at strategic points. Confining the new services to the PSTN side of the river, our “Telco as marketplace” model is only the beginning of what is possible. New services which bridge the internet and the PSTN could greatly extend the marketplace model, increasing the diversity, utility and revenue from new offers. You will be hearing more about these “hybrid” services after we explain a strategic piece of what is necessary, and has recently been created, to make them work.
In Warren Buffett’s annual letter to shareholders, he often pauses before the more technical financial matters and announces “spinach time.” Here we must ask you to eat a little spinach, pausing for a detour into a discussion of “Signaling System 7”, or SS7.
SS7 is the lingua franca of the PSTN. Just as IP (internet protocol, as you will recall) is the common denominator that enables the internet to function everywhere, with all brands of equipment, and provides the basis for enabling applications, SS7 plays a similar, cruder role in the PSTN. Think of SS7 as “phone protocol.” (Exhibit 6: Layered Architecture – “Bridge” Technology).
Earlier we mentioned that in the 1980s the Bell System and its immediate successors completed the “digitalization” of the PSTN. Also we said this digitalization theoretically enabled outsiders to add their own services to the phone network via software in a way that wasn’t previously possible. SS7 was a key part of this evolution.
The term “digitalization” was used, because the most visible and sexy part of the multi-billion dollar re-architecting was putting in digital Class 5 switches to cope with the ever-expanding phone traffic, as well as to provide new enhanced or CLASS (Custom Local Area Signaling Services) features we today take for granted (call waiting, caller ID, etc.). Replacing older, sometimes electro-mechanical devices, the new switches are large, powerful computers.
Class 5 switches are much smarter than their predecessors, but the full intelligence of the PSTN, while narrow and limited in comparison to the internet, is distributed over multiple specialized network elements, just as in the internet. Within the PSTN, there are special types of nodes (a Signal Transfer Point, or STP, as an example) where certain intelligence is localized. So when we implied in our “Telco as marketplace” story that outside service providers would need access to just the phone company’s “switches”, it’s actually a little more complicated than that. The good news is that’s what SS7 is for. Just as Lucent, Nortel, and, occasionally, the phone companies themselves can develop new services in SS7 ”language”, so too can outsiders
There is yet more good news about SS7. Until recently, there were two discouraging problems that would make our “Telco as marketplace” model hard to implement, especially the best part: bridging from the PSTN across the river to the internet to create new services.
The first problem was that, like many claimed-to-be-universal standards, SS7 wasn’t. There are multiple different flavors and adaptations, but principally this varies by country. This is not a small concern if you are, say, (today’s) AT&T and have a substantial international long-distance business, or if you are ITXC, a “Voice over IP” carrier that takes international calls from the PSTN, routes them cheaply over the internet, and then puts them back on the PSTN in the destination country.
The second problem was that no one had figured out how to build a bridge between the internet (IP) and the PSTN (SS7). The first few bridges were rickety, had very short spans, and tended to fall down.
Both problems have been solved, thanks in part to companies like ITXC, which created early, real demand both for internet-to-PSTN “bridges” and for translating between many partially-incompatible flavors of SS7 itself.
A Bridge Too Far?
In the mid-1990s, a number of venture-financed companies set out to be in the internet-to-PSTN “bridge” business, i.e. IP-to-SS7 translation. Some of them worked on small pieces of software called “protocol stacks”, others set their sights much higher and developed what came to be known as “softswitches”.
Soon finding themselves on dangerously shaky “me too, but cheaper” ground, the softswitch makers scoured the globe to sell their products…
Envisioned and even advertised as full-scale replacements for the Class 5 behemoths of today’s PSTN, softswitches sought to duplicate their every function but run much more cheaply, with the promise of as-yet unspecified “new services” in the future. Soon finding themselves on dangerously shaky “me too, but cheaper” ground, the softswitch makers scoured the globe to sell their products, especially in countries with simpler networks and phone companies that might be persuaded to “leap frog” to a next-generation network.
The collective result of the more modest protocol stack initiatives, and some of the very grand softswitch programs, is that while not much of it sold, enough of it did to be fairly well tested and teach us a lot about how to make these bridges work. As a result of selling (or at least bidding) to early adopters in whatever country they may be, a large portfolio of SS7 flavors can now be translated between each other, into IP and vice-versa. Adding to early IP-SS7 bridges, protocols such as SIP and MGCP have been developed, and they have helped further the work on hybrid internet/PSTN experimental applications.
The potential is exciting, but it must be said that the hundreds of millions of dollars of venture investment plus unknown, surely large, amounts (probably multiples of the cumulative venture capital) from Lucent, Nortel, Cisco, and Microsoft, have yet to yield a vibrant “Telco as marketplace”, nor really much-of-anything-as-marketplace for new services. This is for several reasons:
- since we didn’t know how to build bridges, much of the investment was expended on fundamental technology: the equivalent of trusses, suspension cables, and the like
- most of these bridge technology vendors found themselves in a bit of a daze when, just as they were trying to sell their new products, nearly the entire telecom and internet infrastructure industries began collapsing around them
- most importantly, the creation of new application-building technologies or even trial applications themselves, while necessary, is insufficient to catalyze the “Telco as marketplace” model.
What the bridge builders produced was a key, previously-missing technology and a few examples of how it might be used. Still largely missing is an entrepreneurial network of service innovators, and entirely missing is a set of Telcos willing, much less wanting, to complement the innovators and help drive their services to market.
The SS7 “spinach” and the bridge-building story are important in order to make clear that strategic, albeit technical, pieces are ready, waiting to be assembled, both for the “Telco as marketplace” (having outside services in the PSTN), and “Telco/internet as marketplace” (blending PSTN and internet services in new combinations). What was limited to being a potential idea after PSTN digitalization in the 1980s could become a practical reality now.
Those tanks seem to be coming from … Redmond?!
The new availability of this “bridge” technology has not gone unnoticed outside the telecom industry.
If you thought the commoditization nightmare and liquidity crises weren’t enough to get phone companies to explore innovation-based growth, what if on top of that, Microsoft, AOL, Yahoo! and Cisco began launching an assault to further erode some of Telcos’ most profitable business—large enterprise communication?
If [the] commoditization nightmare and liquidity crises weren’t enough to get phone companies to explore innovation-based growth, what if … Microsoft, AOL, Yahoo! and Cisco began launching an assault…?
If you use Instant Messaging (IM) programs from AOL or Yahoo!, but particularly from MSN, you may have noticed that these PC-based software “devices” have recently been trying to get you to do more than type text in a chat window. They have quietly, gradually begun adding (paid) services such as starting a web conference and reviewing a PowerPoint presentation together, making a phone call from your computer, communicating directly by voice to another IM user, or even real-time video conferences using little cameras mounted on your PC (just like the ones incessantly advertised in those internet browser pop-up windows).
A few of you that work in larger corporations or institutions may now be using (paid) “company” versions of the same IM software with a pre-loaded departmental buddy list and secure, encrypted communication – a private messaging intranet.
These are small samples of still early, hybrid internet/telecom applications, and are only what’s currently visible on the surface. We’ll use Microsoft and Cisco as our examples in order to get the full flavor of what is potentially in store in the next several years.
In Microsoft’s case, it aims to progressively divert and reshape a good deal of corporate communication, with parties both within and outside the company, into messaging-based applications. With its widely-used Outlook (e-mail client), Exchange servers (server portion of e-mail), and increasingly its Windows Messenger software, Microsoft would like to use those footholds to broaden from e-mail to more real-time communication.
Communication-related applications are a subset of Microsoft’s broader strategy to reshape how enterprise applications in general are architected using, of course, much more Microsoft software. Microsoft is sharply focused on long-term, very well-financed campaigns to break its dependency on the (flattening) desktop software market. Competing against IBM and others, Microsoft is engaged in a strategic battle to reshape corporate applications into “web-based services”, and sell greatly increased quantities of the underlying server operating systems and middleware that entails. Microsoft advertises this umbrella approach and the system software for it under the general label of “.NET”.
If Microsoft’s strategy succeeds, we can expect to see them play the role of enabler in the “Telco as marketplace” business model. While early on the more strategic-feeling services will likely come from Microsoft itself, many might come from small outside innovators, vying to make them available through Microsoft’s messaging environment, or even grafted directly into .NET-based applications which are written by Microsoft’s large corporate customers.
The basic communication itself, over which the messaging services are built, would come from Telcos and internet service providers, or both, depending on how telephony-intensive vs. internet-like these hybrid services are. “Telco as marketplace” – the slight twist being that it’s really “.NET as marketplace” with Telcos relegated to getting a smaller piece of the pie than our more pro-telecom industry model has suggested.
As in the title of Bill Gates’ book about the future of digital technologies, for Telcos this may be “The Road Ahead”.
Surf’s Up at Cisco Beach
Cisco has simpler but equally large designs, which are to “internetize” as many forms of communication as possible. They would now like to replace your company’s phone system.
Unlike Intel and Microsoft, Cisco’s products are by their very nature (remember IP, open and free) difficult to turn into the same kind of architectural and market-dominating franchise like “Wintel”, or IBM in mainframe days gone by.
Almost anyone can make a Cisco-equivalent box, only a few can make an Intel-equivalent chip, and basically no one can make a Microsoft-equivalent operating system. So the challenge for Cisco is to be very early indeed to catch the wave when new uses for its routers come along, lest other vendors start “powering the internet” a bit too much. If you have enough money, one of the best ways to catch the wave early is to try jump-starting it yourself
The threat to Telcos is that Cisco’s approach would take away more of the already-eroding, high-margin business voice traffic using either the internet or alternative carriers to bypass them, and drive margins downwards.
A large proportion of corporate telephone systems are ageing and coming up for replacement. Given this product cycle, Cisco would like to put new “IP phones” on corporate desks, and a router-turned-PBX-replacement in the equipment closets. Inter-office voice communication would be cheaper, more feature rich (those mixed telephony and internet services again), and the new IP PBX would either hand-off “outside” calls to the PSTN (using the IP-SS7 “bridge” technology) or route them over the internet via a Voice over IP carrier. And it could do other useful things too, like manage your secure VPN connections for computers on your local area networks, or teleworkers at home.
The threat to Telcos is that Cisco’s approach would take away more of the already-eroding, high-margin business voice traffic using either the internet or alternative carriers to bypass them, and drive margins downwards. It’s an updated version of the MFS/Teleport nightmare which Nynex endured 15 years ago when these upstart competitors ran fiber through Manhattan and skimmed the cream of highly lucrative corporate telecom spending out of many of the tallest buildings.
See You at the Mall
The business of Telecommunications has become too complex, too vital and too risky for players to succeed alone with vertically-integrated supply chains. Incumbents should not interpret their recent successes in seeing off competition as a vote of confidence in their own business models. A natural response to the events of the last 18 months has been to circle the wagons, cut costs, defend existing business, step up regulatory pressures, potentially exploit the misfortunes of others through creditor-driven M&A, etc.
The business of Telecommunications has become too complex, too vital and too risky for players to succeed alone with vertically-integrated supply chains.
Once the immediate threats to survival have been addressed, players of all stripes are faced with two challenges. First, the pressing need for top-line growth, which has eluded most of the incumbents. This requires launching many new services to market, and marketing existing ones much more creatively.
Second the relentless process of technology innovation, which continues despite the failure of a generation of service providers. Now that everyone is weary of the telecom revolution, the potential for disruption is all the greater. How will a second wave of revolutionaries avoid repeating the mistakes of the past? How can incumbents not only avoid losing to the new challengers, but harness their innovative drive to grow their own top lines? The answer to both questions lies in a concept that is commonplace in many industries, but relatively unknown in telecommunications.■
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11 July 02
