War of the Worlds - Part III: Beyond Networks
Making Repairs – Telcos are transforming their networks, but not yet themselves
Capacity vs. Capability
Telecom’s traditional playbook is biased toward managing what are by now largely uncontrollable, secular declines in the connectivity business – the “race to the bottom” – and barely at all on how and where to gain competitive advantage in the midst of a structural migration of profits. Two new, related, pages have recently been added to telcos’ game plan: network convergence, and television.
Media and analysts have frequently conflated transformation of network infrastructure with transformation of a telcos’ business prospects
Despite its nominally forward-looking sound, “convergence” – rebuilding and integrating existing networks – is the replacement of assets before they are stranded. It is ante to stay in the game with cheaper, more capable infrastructure, but not a strategy to win. Media and analysts have frequently conflated transformation of network infrastructure with transformation of a telcos’ business prospects.
Network convergence gives carriers an up-to-date, strategy-neutral platform supporting wherever they may choose to go on what BT Group (NYSE ADS: BT) CEO Ben Verwaayen has referred to as the “capacity vs. capability” spectrum, i.e. lots of bandwidth for a penny less vs. premium, differentiated features and services.
It is for the telco to then decide what strategic ends to make of these new converged-network means – driving steady-state costs to be, say, 10% less than competitors, or increasing revenues by supporting copies of competitor services (multi-channel television, for example), or enabling new service innovation for differentiated offers.
Network Convergence
At the turn of the twentieth century, Theodore N. Vail built the colossus that was once AT&T – the model for national carriers worldwide. He coined the succinct slogan, ‘One Policy, One System, Universal Service’, putting most of today’s empty corporate mission statements to shame. AT&T is gone, but the technical aspirations to unify network services live on with a rationale the legendary Bell System architect would easily recognize.
Telcos have known for a long time that the advent of broadband would eventually make much of their investment in the existing public switched telephone network (PSTN) obsolete. Eventually, phone calls would become just one more broadband “application”, eroding both the economic rationale for a operating a separate circuit-switched network in parallel to the broadband one, as well as the hundred year-old voice-centric business model itself.
Accordingly, a great deal of telecom’s strategic mind share (outside of M&A) has been occupied with the pace and economics of network conversion – how, and at what pace, to move from the PSTN towards an all-IP, all-in-one, “converged” network. This is a problem which preoccupies almost all incumbent local exchange carriers (ILECs), with the notable exception of those with massively government-subsidized broadband deployment programs, such as in Korea.
Broadly speaking, there have been two schools of convergence thinking which can be roughly described as incremental migration vs. full-speed-ahead conversion. The first is by far the predominant approach. With billions in legacy network plant and price-regulated connectivity services, ILECs saw no economic incentive to pre-maturely cannibalize their traditional business and treat the PSTN as a stranded asset.
So, under the incremental plan, the existing network is progressively transformed to deliver DSL, with indirectly-related improvements of the network core and edge (principally the deployment of MPLS) done selectively and gradually, often on a “just-in-time” basis to meet growing traffic requirements. The overall pace of this upgrade process is driven by balancing perceived demand and economic affordability of the required investments – the latter a subject of huge and distracting regulatory fights.
Despite its conservative intent, the nature and timing of incremental migration has turned up some major land mines – the target keeps moving, and its complexity is multiplying exponentially.
There is now the question of how to fold multi-year deployments of 3G wireless networks into the convergence agenda, both at the level of overlapping transport infrastructure, and enabling fixed-mobile convergence (FMC) at the level of subscriber-visible services.
Then, there is the further problem that the slower, incremental upgrade plan may deliver competitively inadequate performance versus cable, or prospective broadband wireless (e.g. WiMax 802.16) competitors. This would require ILECs to reallocate considerably greater investment towards new fiber-based networks, and do so well ahead of original spending assumptions.
A multi-service carrier is therefore confronted with a “three-body problem” of:
- accelerating and upgrading conventional DSL deployments to gain market share,
- deploying new high-performance fiber-based networks, and
- rolling out 3G wireless, while figuring out how to subsequently harmonize as much of these three initiatives as possible into a unified low-cost, opex-saving network of the future (Exhibit 6)
“Full-speed ahead” conversion is the second school of thought in dealing with broadband’s obsolescing of the legacy network.
BT’s 21st Century Network, or “21CN”, initiative surprised the industry and has become the much-watched benchmark of this approach by a major incumbent. For an array of strategic and regulatory reasons, BT undertook a multi-year, end-to-end, near-total replacement of their network. The plan includes decommissioning the remnants of the PSTN (most notably TDM switches) starting somewhere around 2010, depending on how well the effort goes. One of BT’s rationales for full-speed deployment is the belief that operating multiple, parallel networks for any longer than absolutely necessary is too costly and complex, thus best to bite the bullet and get on with it. Another, we would infer from their actions, is they believe it is in their long-term interests to actively push the transition – by contrast, US ILECs appear to believe a reactive approach is economically optimal.
BT makes a clear distinction between the 21CN undertaking and separate service innovation initiatives, whether at the level of consumer functionality (e.g. BT Fusion wireline/wireless integration), or much larger business model shifts (BT Global Services, an IBM-style enterprise professional services business unit).
Service Innovation: Worlds Apart
While it’s true that an all-IP network could lead to, and certainly support, new services, it is neither sufficient nor a pre-requisite to doing so. The telecom industry’s long-standing Culture of The Network reinforces the notion that with the right infrastructure, services will somehow follow in due course. Yet service innovation and multi-purpose network convergence are two distinct strategic goals – innovation is about the P&L’s revenue line, convergence largely about capital and operating expenses. New services are created through a layer of business-related capabilities (marketing, application development, pricing, etc.), above and apart from the network itself.
The ability to innovate significant new services without a converged, all-IP network has been proven in very different and instructive ways by the satellite radio and cable industries.
“Satellite” radio (see again Exhibit 6) is delivered over a purpose-built hybrid network of direct broadcast satellite transponders and large numbers of terrestrial signal repeaters. The network’s economics are narrowly optimized for a digital radio broadcast application, possibly extensible to mid-band broadcast video services. But XM Satellite Radio’s (Nasdaq: XMSR) or Sirius Satellite Radio’s (Nasdaq: SIRI) service innovation is driven not by network economics, but business capabilities. Despite owning network infrastructure, these are media companies focused on talent acquisition, commercial-free genre-oriented channel line-ups, ancillary information services (auto, marine navigation), device partnerships, and distribution.
Satellite radio’s network alone, however, poses serious challenges to telco aspirations to provide mobile broadband media through cost-disadvantaged, general-purpose, 3G cellular networks. And for satellite broadcasters, “integration” of, say, phone and radio or TV functions can be done comparatively easily right at the handset device – little in the way of complex converged network architectures is required.
cable is delivering services which are simultaneously differentiated and beginning to leverage the economics of network convergence
In a broader sense, North American and UK Tier 1 cable Multiple System Operators (MSOs) are case studies in first creating new customer value with very little network convergence, followed by pursuing convergence to extract incremental economic returns, including the introduction of telephony.
Cable offers digital multi-channel television and music, high-speed broadband, digital video recording, video-on-demand (VoD), and telephony, all with comparatively little integration at present either “behind the wire” (application servers, head ends, subscriber management, etc.) or in front of it (i.e. the set-top box).
MSOs have followed a dual track, in many ways the converse of telecom industry philosophy (Exhibit 7). Cable trials focused first on service innovations and establishing their business value, followed by technical backfilling, converging and integrating the underlying network and IT architectures.
Now, this convergence at multiple layers of the cable network (GigE backbone, video switching, combined cable modem and VoIP gateways, etc.), is rapidly accelerating to optimize scale and scope benefits from a proven services portfolio. Ultimately, re-engineered cable networks will make the acronym “MSO” obsolete (a vestige of commonly-owned but separate systems) as Tier 1 operators morph into super-regional “ISOs” (integrated system operators).
A telco might view cable’s business-first approach as ad hoc, technically risky, not “carrier grade.” But in fact it is considerably more conservative than an infrastructure- or network-centric approach for two reasons.
First, the primary emphasis is on establishing and refining features and services for which subscriber demand and economic value can be demonstrated, not just technical feasibility, so network upgrades are driven by near-term revenue potential.
Secondly, through evolutionary cable industry engineering initiatives (DOCSIS standards, other Cable Labs programs), a pragmatic architecture can be selectively deployed, allowing not just general network performance upgrades, but service-specific investments (video server capacity, CMTS upgrades, softswitches, etc.) to be prioritized by actual service demand.
Whereas telcos are grappling with the convergence problem, Tier 1 MSOs are, in large measure, arriving at their destination. North American and UK Tier 1 MSO’s multi-year drive toward digital cable and broadband resulted in massive plant upgrades, started well before ILECs made the transition from posturing to serious broadband deployment. As a result, cable is delivering services which are simultaneously differentiated and beginning to leverage the economics of network convergence.
At the end of the day, converged networks alone can only enable lower-cost and/or “me too” services. Becoming a differentiated, “capability” player means focusing on service innovation, and the business capabilities which enable them. This, Tier 1 cable has done.
Each of its principal revenue streams enjoys significant growth potential, in contrast with multi-service telecom carriers (Exhibit 8). What is most notable about today’s industry turning point is that telcos are confronting exponentially increasing competitive complexity without yet having a clear alternative to the old “playbook.” And this is where telcos face their greatest challenge and opportunity – envisioning and implementing alternatives to their historically successful, but regulation- and network-centric business models. ■
Encore Performance – Telco TV faces a strategic minefield of disadvantages
It’s Not TV. It’s a Media Business.
One of the most widely-followed developments in broadband telecom is the return of video services, with its attendant growth expectations. “Return”, because video first made a meteoric appearance in telecom strategy over ten years ago (see sidebar – Telecom’s Lost Decade).
Media remains an industry where, for better or worse, the US indisputably dominates both economically and culturally. Shifts in the US video services landscape have reverberated globally, but nowhere are they more evident than in US telcos’ home markets. Much has changed in ten years and telcos’ (re-)entry into video is a strategy minefield:
vertical integration: media companies have increased their market and economic power considerably through de-regulation4, consolidation, and a series of large mergers throughout the mid-to-late ‘90s5. The result is that virtually all Big Media spans end-to-end content creation through distribution, with some (News Corporation – NYSE: NWS and, for the time being, Time-Warner – NYSE: TWX) owning satellite or cable delivery networks as well. In addition, Tier 1 MSOs such as Cox and Comcast (Nasdaq: CMCSA) have “backed in” to complete or partial channel ownership, further blurring the lines between content and delivery.
- cable powerhouse: many cable systems have (1) morphed from fragmented, debt-laden analog video “pipe” businesses to regionally-consolidated digital networks, (2) obtained enormous market share in broadband connectivity – a “telecom” business – with cash flow that in turn strengthens cable’s core multi-channel video business, and (3) turned what was once a local afterthought, cable advertising, into another revenue stream with double-digit annual growth.
- not-so-New Media: leading internet brands (eBay – Nasdaq: EBAY, Google – Nasdaq: GOOG, Yahoo! – Nasdaq: YHOO, Amazon – Nasdaq: AMZN, Netflix – Nasdaq: NFLX, etc.) are now well-established, fast-growing destination sites. Increasingly, they can be expected to be important outlets for retailing digital content (video and music downloads, etc.) and interactive or communication-centric services.
- personalized consumption: long-standing media product concepts, such as “prime time”, “release window”, or “music album” are breaking down. The proliferation of specialty cable channels and DVRs (e.g. TiVo – Nasdaq: TIVO) has fragmented what was once a near-monolithic mass market audience, given viewers unprecedented control over their media consumption, and begun redistributing advertising revenues. Similarly, album-oriented music retailing increasingly gives way to a growing market for singles and custom-playlist purchases. The economic impact of the shift towards personalized consumption is substantial – in filmed entertainment, for example, escalating marketing costs for wide-release films combined with consumer appetite for home-viewing convenience have radically shifted the revenue mix towards DVDs (Exhibit 9).
- technology investment: Tier 1 cable and satellite players have strategic joint ventures or ownership stakes in emerging video- and internet-related technologies, such as video servers, ad tagging and insertion, conditional access, interactive program guides, etc. These positions are analogous to previous cable investments in the programming “ecosystem” – creating equity, preferred customer advantages, and barriers to competitors.
The multi-channel television delivery model has moved well beyond buying channels, marking them up and packaging them for subscribers. News Corp., Cox, Comcast, and for the moment Time-Warner, are all examples of vertically integrating TV delivery and content, with revenue streams spanning content ownership and carriage fees, advertising, premium tier subscriptions, video-on-demand, broadband, and now telephony.
The scope of their content control ranges from partial equity interests in specialty channels, to participation in sports rights, all the way to outright ownership of film studios and television production businesses. It is in this environment that telcos are mounting a video services challenge.
4 the removal of Financial Interest and Syndication Rules (or “Fin-Syn”) in the early ‘90s unleashed a major shift in the economics of filmed and television entertainment, starting with consolidation of TV production. Fin-Syn had previously restricted broadcast networks from having a financial interest in programs beyond first-run exhibition, and prohibited the creation of domestic syndication arms.
5 the principal video-related mergers were Disney/Cap Cities, Viacom/CBS, Time-Warner/Turner Broadcasting. In the mid-‘80s News Corporation had already purchased Twentieth Century Fox and later established the Fox television network, followed in the ‘90s by cable channels.
Me Too TV
Telco entries into television services are a major strategic milestone. They signal a willingness to address the challenge of expanding their business scope from connectivity into value-added content and services. But thus far, the North American initiatives appear to be largely belated, “me too”, cost-disadvantaged arrivals.
The multi-channel television delivery model has moved well beyond buying channels, marking them up and packaging them for subscribers
In the US, telcos face a long uphill battle for economic viability by stealing share from entrenched Tier 1 competitors like News Corporation’s DirecTV or Comcast, just as they in turn are raising the bar on functionality, value, and further diversifying their own revenue streams.
Stripped of impressive-sounding network technology (fiber, unicast, IPTV, etc.), the current telco TV initiatives from SBC (NYSE: SBC) and Verizon (NYSE: VZ), while different from each other, are both unremarkable.
To customers, what has been announced so far is indistinguishable from direct broadcast satellite’s value proposition: digital, cheaper than cable, same channels, free DVR, “interactive” services … still being worked out. Telcos’ late entry and scale disadvantages are driving initial programming costs to more than 50% of revenues, a huge near-term disadvantage also calling their long-term economic viability into question. Telco TV’s primary challenges are:
cost disadvantages: programming costs 15%+ higher than Tier 1 competitors, large labor and equipment subsidies required for multi-room residential inside wiring
- revenue-disadvantages: sub-scale VoD libraries, advertising revenues unsupportable by medium-term subscriber base, no carriage fees as they have neither proportional nor outright channel ownership
- capital expenditures: large new investments are required, only a portion of which can be allocated to the underlying high-performance broadband network, and none of which can any longer be directly subsidized by regulated or tariffed legacy businesses
- technology risk: every hiccup in early telco TV technical deployments is reported by the media as though it were the brink of disaster, with prurient interest in which vendor is to blame. Difficulties should be expected in first-time deployment and inter-operation of new technologies at commercial scale in a very complex architecture. Through engineering and tuning capital expenditures, telcos and their partners are very likely to overcome these obstacles, although not on schedule. Telco TV’s greatest business risks lie not in technology, but in the three factors above.
Burned by the failed media buying clubs they tried to organize in the ‘90s (Americast, TeleTV), US telcos have opted to largely duplicate video competitors’ business models with go-it-alone program sourcing and video distribution plant. Absent a significant redirection, it is hard to see how telcos can create a sustainable video business through revenue- and cost-disadvantaged head-to-head competition in the very tiered programming models deftly pioneered and managed by cable and satellite competitors.
Television is perhaps the first major test case of whether telecom will begin understanding and exploiting media industry vulnerabilities and opportunities. Doing so might allow telecom to develop alternative video services which are a profitable, complementary addition to telcos’ broadband business. And not all is well in content’s kingdom.
Content’s Tarnished Crown
The content industry’s own strategic challenges create potential opportunities for telecom
Viacom (NYSE: VIA) Chairman Sumner Redstone famously declared “content is king!” It’s good to be king, but not as good as it used to be. The content industry’s own strategic challenges create potential opportunities for telecom to offer alternative delivery models—monetizing content in new ways without directly threatening (at first) established media industry supplier-distributor relationships.
The major drivers of those potential opportunities are the media industry’s growing production risk, challenge to broaden the revenue mix, and the breakdown of the advertising model.
Production Risk
Filmed entertainment and mass audience television production are analogous to technology venture investing: returns usually come from “home runs”, not from across-the-board, above-average performance. The competition for home runs inflates “above-the-line” and marketing costs, in turn escalating business risk.
Not long ago, it appeared the home-run syndrome and the boom-bust cycle might be tamed by capturing revenues from syndication, home distribution, and ancillary rights. These were innovative enhancements to the bottom line, often exceeding returns from first-run exhibition, but profitability still depended on budget discipline.
Now, many projects already assume those formerly-incremental revenues in their break-even analysis, thus ratcheting financial risk back up again. This turn in the cycle is again whetting media’s appetite for more new ways to syndicate their intellectual property at lower cost, whether Video on Demand (VoD), broadcasting to mobile devices, or cross-licensing with video games.
Revenue Mix
Today’s studios, television production companies, music labels, and even videogame developers are principally in the business of acquiring and managing intellectual property rights, none more jealously guarded than those of “home run” products. The job of the rights owner is to maximize lifetime value of a content asset over various exhibition and distribution formats, and locations. Like airline yield management systems, the goal is to get the mix and pricing right so as to maximize total revenues from a perishable commodity.
In response, marquee content owners aim to do three somewhat contradictory things: (1) slice their rights even more finely, creating new classes of annuity revenues, while (2) continuing to minimize the overlap of rights categories – hard to do as new electronic delivery formats emerge (e.g. VoD, broadband rental, DVR-based file sharing), and (3) if they own delivery networks as well, discourage competitor networks from licensing rights to new formats ( i.e. cable VoD may cannibalize the DVD revenues at the content owners’ home entertainment division).
In other words, content owners are eager to have their cake and eat it too. They look for new ways to monetize what they own, but worry about cannibalizing proven syndication categories (e.g. DVD sales), or reducing the aggregate value of their library, or playing into the hands of evolving competitor business models (e.g. cable VoD). So finding new ways of monetizing content is becoming harder as potential overlaps become more likely.
Take, for example, what on the surface may sound like a simple example: Comcast would like to help its subscribers time shift Thursday evening network broadcasts of the medical drama ‘E.R.’ by retaining each week’s episode in a VoD library for twenty-four hours post-broadcast. Note that this sort of time shifting is something a DVR-equipped subscriber routinely does for free. Regardless of how or whether Comcast charges its subscribers for this short-term VoD convenience, it conceivably triggers up to a four-way battle over which other rights holders are being infringed (See Exhibit 10).
Those parties could include: NBC Universal, the broadcast network with first-run exhibition rights, NBC affiliates (through which first-run exhibition occurs) in Comcast markets claiming infringement of retransmission consent, The WB Network, as the holder of domestic syndication rights, and Warner Bros. Television studios, which produces ‘E.R.’, claiming infringement both of syndication and DVD distribution rights.
Distribution
In the largely de-regulated US video market, negotiating carriage agreements – licensing a channel to appear on a delivery system – is often adversarial, and not because of any real technology-based capacity limitations in cable or satellite. On the one hand, this reflects the natural economic tug-of-war between what content owners think they should get and what delivery system owners think they should pay. But the antagonism also reflects the growingly awkward fit of niche interest programming within a delivery network whose business model is fundamentally geared towards mass market uptake.
There is growing consumer and entrepreneurial interest in à la carte choice of channels as an alterative to subscribing to large, pre-packaged tiers. While à la carte offers from mainstream US cable or satellite are improbable in the near term, market pressures may result in less expensive, more granular, and smaller programming tiers being introduced.
Such is already the case with a few US cable overbuilders, early-stage entrepreneurial broadband ventures such as Akimbo, and the mainstream UK television market. As with the global trend toward offering “no frills” broadband and cellular connectivity, a maturing media market will also create new opportunities to break away from “one size fits all” packaging, and better penetrate lower-spending market segments—potentially a fit for Telco TV reconsidered.
Advertising
Many technology forecasts eventually come true, just much later than predicted. So too with long-expected (and feared) changes in advertising, the lifeblood of much of the media industry. Competition for ad revenues is intensifying driven by the continuing erosion of network television audiences, the ascendancy of cable channels, the explosion of internet paid search ads, the deployment of audience measurement (e.g. Nielsen Media Research’s “local people meter”, or LPM) and ad customization technologies (e.g. localized cable and satellite ad inserts), and most dreaded of all, commercial-skipping DVRs.
War or Diplomacy?
Mass media’s innovation focus and celebrity centers on the creative side of the business. Innovations in delivery have almost all been reactions to disruptive outside innovations (television, VCRs). In both those cases the industry at first panicked and/or resisted, but went on to adapt and prosper.
Media is facing the television or VCR challenge again, in spades. Today, industry leaders are bombarded by an unprecedented array of new delivery choices that they control poorly or not at all (e.g. DVR, satellite radio, internet portals, music download services, and multiplying video distribution technologies).
Media is facing the television or VCR challenge again, in spades
From this proliferation comes an exponential increase in media’s strategic challenge – figuring out which delivery innovations might be the most threatening, under which scenarios, whether they might compete with each other, which (incomplete) technical standard is likely to dominate, with what implications for content, etc. And the overarching strategy question is whether and how any of this might be turned to media’s advantage.
Like telecom, media’s industry boundaries are shifting. Competitive incursions into media turf by internet-based players such as Yahoo! (Nasdaq: YHOO), Google (Nasdaq: GOOG), and Apple have triggered skirmishes, “friend or foe” debates, wary partnerships and, recently, outright acquisitions.
These challenges intensify the pressure to alter or enhance long-standing media business models, acknowledging their interdependence with connectivity. With broadband penetration now at critical mass, there are (finally) opportunities for telecom to partner with media and play a value-added role. But a passive stance by telcos further clears the way for media, device manufacturers and retailers – all of them accomplished and brand-aware consumer marketers – to further exclude telcos from accessing application-related revenues. ■
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12 October 05
