Article

Broadband Services—Success Second Time Around

Depending upon a company's starting position, one of several distinct competitive strategies will garner a broadband service provider healthy results.

Par Vince Tobkin and Michele Luzi

First published on avril 01, 1999
min


Broadband services are back at the financing trough—this time with their hunger for growth financing backed by adequate consumer and small business demand. Global capital markets will be asked for more than $100 billion of broadband network construction funding over the next three to five years. Individual projects to be financed include several global broadband satellite systems at $10-20 billion each, several trans-oceanic cables at $3-10 billion each, and a handful of global terrestrial broadband networks at $5-10 billion each, as well as both wireless and wired access networks in most major countries at $1-5 billion each. However, broadband networks were a uniform failure for telcos earlier this decade, as demand failed to develop for the initial set of broadband services. Abandoned projects amounted to more than $20 billion world-wide. They included numerous failed trials, two partnerships with Hollywood for content, and several wireless LMDS or CATV acquisitions. Key equipment and software suppliers such as Microsoft, Hewlett Packard, Nortel and Silicon Graphics also wrote off major product development projects, when orders did not materialize. Leaders of major telcos, equity investors and key lenders are now pondering whether this generation of broadband services and their associated broadband networks will be more successful than the last and are asking what the key drivers of demand will be. Recently, apparent problems with demand and network start-ups in the adjacent business of global voice satellite services have heightened their concerns. Based upon analysis of these issues for numerous clients, we see broadband services poised for major success this time. Depending upon a company's starting position, one of several distinct competitive strategies will garner a broadband service provider healthy results, once this market takes off. Background The launch of first generation broadband services was fuelled by grossly optimistic demand forecasts, but stalled on uneconomic equipment costs and false expectations about the actual services to be used. Assessing future demand has been the Achilles' heel of the telecoms industry. Starting with video-phones in the 1960s, followed by ISDN services in the 1970s and 1980s and later broadband services in the 1990s, actual demand for new services has often fallen far short of projections. Fortunately these investments did not become financial disasters for shareholders, since the industry was regulated into the rate base. However, under new open market conditions, similar failure could result heavy losses. These early-stage projects stumbled in part, because they launched with new technology relying upon an over-optimistic picture of user needs. Market research was often targeted only at early adopters and was used for what were more appropriately venture capital type decisions, given the early stage of market development. Software and hardware vendors only exacerbated this problem, energizing network technologies early on by hyping hoped-for access capabilities. Corporate broadband demand estimates were closer to the mark, because they did not require deployment of new access technologies. These factors all played a role in the poor decisions surrounding broadband services earlier this decade. Suppliers oversold their ability to facilitate broadband access and related SONET transport at reasonable costs. Early market research verified limited demand for broadband services at prices required to break even, but forecasters then presumed that consumer attitudes would change, once services were deployed and better understood by users. Some management teams downplayed initial profitability estimates and/or circumvented them, citing the potential of other, still-emerging technologies, such as digital LMDS. Other telco leaders proudly announced major network visions and presented them to regulators and unions for approval. In addition, competitive pressures from the threat of CATV firms providing telephony and computer services through cable modems heightened the need for prompt decisions and announcements. Entering CATV through broadband services was rarely attractive on its own, given predictions of broadband's low growth and low profitability outside of content. But the move appeared attractive to telcos on an incremental basis because of projected cost sharing and prospects for meaningful, long-term revenue growth, given the size of the potential market. Overall, the initial launch of broadband services was marked by too little critical analysis, too much haste and too much optimism. The implementation of broadband services also proved troublesome. They were envisioned in the early 1990s as a combination of the following: entertainment, such as video-on-demand, pay-per-view, basic cable, and inter-active games; work-at-home services, largely high-speed dial-in modem access; on-line services, such as CompuServe, Prodigy and AOL; and home shopping. Yet little was really known about end-user preferences and several surprises emerged from early user trends. These included: limited appetite for video-on-demand of, say, two to three movies a month/consumer; lower than expected home shopping volumes in other categories, indeed low enough to be exceeded by postage stamp sales; and higher-than-expected volumes associated with X-rated materials (which some telcos wanted to avoid completely). User equipment was also a source of problems. Only a minority of homes had PCs: in addition, many of the PCs were poorly equipped for high-resolution graphics. TVs were often too small in screen size to create a home theatre experience, while broadband services merely substituted for low-tech VCR tape rentals. Receiver boxes were not standardized and many had to be purchased by the user. Connection sharing among multiple users in an office or a home was difficult or impossible. Lastly, the cost of broadband services required prices too high for most users, with no relief foreseeable from increased sales volumes. Consumers thought of broadband services as a substitute for a $20-$30/month CATV bill, a $2-$10/month pay-per-view bill and a $20/month computer access charge - or a total of $40-$60 monthly expenditure. Instead broadband service profitability required a monthly charge in excess of $100 a month to account for the full costs of equipment and content, in view of the projected low penetration levels. Market conditions Fortunately, most of these factors have changed for the better. Today's outlook for broadband services is overall much more favourable. Corporate broadband demand continues to grow rapidly. Now small business and consumer demand is sizeable and growing rapidly. First of all, consumers now know, in some detail, the value of higher-speed access and seem willing to pay more for service. Current price levels for broadband services are profitable, given equipment and operating costs. Accordingly, start-up capital is available for new competitors. The market for broadband services is being driven first and foremost by the Internet. Consider its impact: cost-effective, high-speed access to the Internet is in high demand from small businesses, home workers, and middle-income to affluent consumers. In addition, Internet users can knowledgeably judge the value of high-speed access to the world-wide web and other information services. The deployment of powerful PCs in homes and businesses is widespread enough, so that most users only need a new receiver/modem. There are enough varied and valued uses of these services, such as information, shopping, financial transactions, games, education, e-mail and others, that most users now feel that they need such services. Awareness and interest has developed to the point that commercials for broadband services have replaced PC commercials during Super Bowl games. The vast majority of users now spend $20 to $40/month for 56 Kilobit access. Many would readily pay up to $100/month for dependable, high-quality and high-speed service. World-wide consumers now need faster access, have the ability to value it and are willing to pay the required price. Upper-income residents of Brazil, Korea, or Switzerland are just as knowledgeable as home-owners in the Silicon Valley. The global information network of the computer industry; including books, shows, courses, magazines and press coverage, has featured broadband services for over a year. Fortunately, today's access equipment can provide relatively rapid access for just $50 to $100 a month. Cable modem (256 kilobits/sec to 1.5 megabits/sec), XDSL (110 kilobits/sec to 1 megabit/sec), satellite down-links (400 kilobits/sec) and wireless access (up to 1.5 megabits/sec) are all available at these prices, depending upon local geography, physical plant conditions and regulatory authorizations. However, increased access speed represents only half the picture. As valuable as high-speed access is to users, it will not alone increase overall transmission volumes. In fact, it may worsen service near-term by increasing peak traffic levels on transport networks. Higher-speed access must also generate a higher volume of traffic for network projects to be financially successful. Certain activities (such as checking the weather or ordering a book) occur faster, but not necessarily more often or in greater detail. Other activities (such as e-mail) tend to generate larger files and thereby place additional demands on transport owing to more attachments. Higher speed enables certain new data-intensive uses, such as streaming video or full screen 3-D graphics. It also enables a more sophisticated and insightful portrayal of data (for example www.smartmoney.com/ marketmap, which provides a visual map of the stock market by segment that updates in real time, expanding or contracting elements of the visual display, based on actual market conditions). The separate value of higher-speed transport is less clear to end-users. It is now bundled into their monthly price for service and is hard to track separately. Bottlenecks in access, local or long-haul transport all feel the same to most users. However, those few consumers with multiple access options (satellite, modem, ISDN, ADSL or cable modem) rapidly assess differences in overall speed and quickly factor this into their usage and purchases. This combination of proven price points, acceptable equipment costs and increasing demand for high-speed access has created conditions under which greenfield start-ups (Covad and Teledesic for example) are attracting capital. This trend confirms the expected profitability of this maturing market. The overall result of these favourable conditions is massive capital inflows for new broadband networks and service, an explosion in the number of competitors and rapid technological improvements in equipment and services. These conditions have also triggered major strategic moves by significant players. For example, IBM has exited the broadband market by swapping lines of business with AT&T. Meanwhile, AT&T has accelerated its entry into the access market by acquiring TCI and launching the first of many expected global alliances with British Telecom. Future trends Clearly the current generation of broadband services is poised to create a major new market. Both today's and future generations of broadband services will continue to be viewed by users as delivering good value - much the way cellular services have been viewed for the past decade. The transition into a mass market will be completed with widespread adoption of broadband services for both business and home use. Broadband services should continue growing in terms of both quality and quantity. Expect to see near-term success for streaming video, voice-over-IP and Internet-based commerce. And expect to see prices ranging from $50 to $100 a month, with increasing speed and quality of service at each price point as equipment costs decline. Competitors will add capacity, both in access and transport, as quickly as they obtain financing. Some capacity additions will be massive, such as the start-up of a global satellite system, but others will be incremental, route by route, geography by geography. Competition will focus on three areas: local access and customer control; wholesale transport both globally and locally; and globally branded bundles of access and transport from a few dominant suppliers. Near-term risks will shift from shortfalls in demand to managing capacity and costs. Investors will need to be sure that they back the right technology choices, that the networks are built in the right places and that over-capacity situations are avoided. The long-term returns realized from investments in broadband networks will depend less upon being a first-mover or technology leader and more upon traditional factors of customer retention and control, overall scale and branding. As such, there should be three types of successful business strategies in the market long term: the first strategy will be to offer consistently the lowest cost by adopting only proven and standardized technologies, featuring price-based promotions and advertising and offering minimal customer support or service - the Southwest Airlines of broadband services. This position is being pursued in transport by Level 3 and Qwest. An alternative strategy is to emphasize overall value at an acceptable price. This strategy is strengthened through unique features, content or bundling with other services and products. In some ways AOL, Equant, Microsoft, and @Home are all executing this strategy. The last strategy is to develop scale and brand advantage to overcome price, feature or quality shortfalls. AT&T and AOL are both pursing versions of this strategy. The breadth of strategic options will present many telcos with a strategic challenge. Most telcos have been the first to bring broadband services to their markets, but they often did so while retaining their reputation for high prices, slow and inconsistent service and lack of entrepreneurship or motivation. Now many of these telcos already face immediate competition from CATV, satellite and wireless broadband competitors for this next generation of broadband services. Soon telcos will also need to address the issue of scale, service differentiation and the provision of access to Internet sites outside their territory. Fortunately these same skills and issues are already being addressed to compete with competitive access providers (CAPS) and competitive local exchange carriers (CLECs). Conclusions The broadband networks now seeking financing are very different than those of the early 1990s. Demand has surged, access has changed and the costs of equipment and content have dropped. These networks will now find it much easier to produce a profit. Strategic imperatives will shift from demand creation to capacity and cost management and customer retention. Operators and suppliers should all find this market profitable over the next few years. And this time around financiers should take note of a high reward for their capital at a lower risk.

Broadband services are back at the financing trough—this time with their hunger for growth financing backed by adequate consumer and small business demand. Global capital markets will be asked for more than $100 billion of broadband network construction funding over the next three to five years. Individual projects to be financed include several global broadband satellite systems at $10-20 billion each, several trans-oceanic cables at $3-10 billion each, and a handful of global terrestrial broadband networks at $5-10 billion each, as well as both wireless and wired access networks in most major countries at $1-5 billion each.

However, broadband networks were a uniform failure for telcos earlier this decade, as demand failed to develop for the initial set of broadband services. Abandoned projects amounted to more than $20 billion world-wide. They included numerous failed trials, two partnerships with Hollywood for content, and several wireless LMDS or CATV acquisitions. Key equipment and software suppliers such as Microsoft, Hewlett Packard, Nortel and Silicon Graphics also wrote off major product development projects, when orders did not materialize.

Leaders of major telcos, equity investors and key lenders are now pondering whether this generation of broadband services and their associated broadband networks will be more successful than the last and are asking what the key drivers of demand will be. Recently, apparent problems with demand and network start-ups in the adjacent business of global voice satellite services have heightened their concerns.

Based upon analysis of these issues for numerous clients, we see broadband services poised for major success this time. Depending upon a company's starting position, one of several distinct competitive strategies will garner a broadband service provider healthy results, once this market takes off.

Background

The launch of first generation broadband services was fuelled by grossly optimistic demand forecasts, but stalled on uneconomic equipment costs and false expectations about the actual services to be used. Assessing future demand has been the Achilles' heel of the telecoms industry. Starting with video-phones in the 1960s, followed by ISDN services in the 1970s and 1980s and later broadband services in the 1990s, actual demand for new services has often fallen far short of projections.

Fortunately these investments did not become financial disasters for shareholders, since the industry was regulated into the rate base. However, under new open market conditions, similar failure could result heavy losses. These early-stage projects stumbled in part, because they launched with new technology relying upon an over-optimistic picture of user needs. Market research was often targeted only at early adopters and was used for what were more appropriately venture capital type decisions, given the early stage of market development. Software and hardware vendors only exacerbated this problem, energizing network technologies early on by hyping hoped-for access capabilities. Corporate broadband demand estimates were closer to the mark, because they did not require deployment of new access technologies.

These factors all played a role in the poor decisions surrounding broadband services earlier this decade. Suppliers oversold their ability to facilitate broadband access and related SONET transport at reasonable costs. Early market research verified limited demand for broadband services at prices required to break even, but forecasters then presumed that consumer attitudes would change, once services were deployed and better understood by users. Some management teams downplayed initial profitability estimates and/or circumvented them, citing the potential of other, still-emerging technologies, such as digital LMDS.

Other telco leaders proudly announced major network visions and presented them to regulators and unions for approval. In addition, competitive pressures from the threat of CATV firms providing telephony and computer services through cable modems heightened the need for prompt decisions and announcements. Entering CATV through broadband services was rarely attractive on its own, given predictions of broadband's low growth and low profitability outside of content. But the move appeared attractive to telcos on an incremental basis because of projected cost sharing and prospects for meaningful, long-term revenue growth, given the size of the potential market.

Overall, the initial launch of broadband services was marked by too little critical analysis, too much haste and too much optimism. The implementation of broadband services also proved troublesome. They were envisioned in the early 1990s as a combination of the following: entertainment, such as video-on-demand, pay-per-view, basic cable, and inter-active games; work-at-home services, largely high-speed dial-in modem access; on-line services, such as CompuServe, Prodigy and AOL; and home shopping. Yet little was really known about end-user preferences and several surprises emerged from early user trends. These included: limited appetite for video-on-demand of, say, two to three movies a month/consumer; lower than expected home shopping volumes in other categories, indeed low enough to be exceeded by postage stamp sales; and higher-than-expected volumes associated with X-rated materials (which some telcos wanted to avoid completely).

User equipment was also a source of problems. Only a minority of homes had PCs: in addition, many of the PCs were poorly equipped for high-resolution graphics. TVs were often too small in screen size to create a home theatre experience, while broadband services merely substituted for low-tech VCR tape rentals. Receiver boxes were not standardized and many had to be purchased by the user. Connection sharing among multiple users in an office or a home was difficult or impossible.

Lastly, the cost of broadband services required prices too high for most users, with no relief foreseeable from increased sales volumes. Consumers thought of broadband services as a substitute for a $20-$30/month CATV bill, a $2-$10/month pay-per-view bill and a $20/month computer access charge - or a total of $40-$60 monthly expenditure. Instead broadband service profitability required a monthly charge in excess of $100 a month to account for the full costs of equipment and content, in view of the projected low penetration levels.

Market conditions

Fortunately, most of these factors have changed for the better. Today's outlook for broadband services is overall much more favourable. Corporate broadband demand continues to grow rapidly. Now small business and consumer demand is sizeable and growing rapidly. First of all, consumers now know, in some detail, the value of higher-speed access and seem willing to pay more for service. Current price levels for broadband services are profitable, given equipment and operating costs. Accordingly, start-up capital is available for new competitors.

The market for broadband services is being driven first and foremost by the Internet. Consider its impact: cost-effective, high-speed access to the Internet is in high demand from small businesses, home workers, and middle-income to affluent consumers. In addition, Internet users can knowledgeably judge the value of high-speed access to the world-wide web and other information services. The deployment of powerful PCs in homes and businesses is widespread enough, so that most users only need a new receiver/modem.

There are enough varied and valued uses of these services, such as information, shopping, financial transactions, games, education, e-mail and others, that most users now feel that they need such services. Awareness and interest has developed to the point that commercials for broadband services have replaced PC commercials during Super Bowl games. The vast majority of users now spend $20 to $40/month for 56 Kilobit access. Many would readily pay up to $100/month for dependable, high-quality and high-speed service.

World-wide consumers now need faster access, have the ability to value it and are willing to pay the required price. Upper-income residents of Brazil, Korea, or Switzerland are just as knowledgeable as home-owners in the Silicon Valley. The global information network of the computer industry; including books, shows, courses, magazines and press coverage, has featured broadband services for over a year.

Fortunately, today's access equipment can provide relatively rapid access for just $50 to $100 a month. Cable modem (256 kilobits/sec to 1.5 megabits/sec), XDSL (110 kilobits/sec to 1 megabit/sec), satellite down-links (400 kilobits/sec) and wireless access (up to 1.5 megabits/sec) are all available at these prices, depending upon local geography, physical plant conditions and regulatory authorizations.

However, increased access speed represents only half the picture. As valuable as high-speed access is to users, it will not alone increase overall transmission volumes. In fact, it may worsen service near-term by increasing peak traffic levels on transport networks. Higher-speed access must also generate a higher volume of traffic for network projects to be financially successful. Certain activities (such as checking the weather or ordering a book) occur faster, but not necessarily more often or in greater detail.

Other activities (such as e-mail) tend to generate larger files and thereby place additional demands on transport owing to more attachments. Higher speed enables certain new data-intensive uses, such as streaming video or full screen 3-D graphics. It also enables a more sophisticated and insightful portrayal of data (for example www.smartmoney.com/ marketmap, which provides a visual map of the stock market by segment that updates in real time, expanding or contracting elements of the visual display, based on actual market conditions).

The separate value of higher-speed transport is less clear to end-users. It is now bundled into their monthly price for service and is hard to track separately. Bottlenecks in access, local or long-haul transport all feel the same to most users. However, those few consumers with multiple access options (satellite, modem, ISDN, ADSL or cable modem) rapidly assess differences in overall speed and quickly factor this into their usage and purchases.

This combination of proven price points, acceptable equipment costs and increasing demand for high-speed access has created conditions under which greenfield start-ups (Covad and Teledesic for example) are attracting capital. This trend confirms the expected profitability of this maturing market.

The overall result of these favourable conditions is massive capital inflows for new broadband networks and service, an explosion in the number of competitors and rapid technological improvements in equipment and services. These conditions have also triggered major strategic moves by significant players. For example, IBM has exited the broadband market by swapping lines of business with AT&T. Meanwhile, AT&T has accelerated its entry into the access market by acquiring TCI and launching the first of many expected global alliances with British Telecom.

Future trends

Clearly the current generation of broadband services is poised to create a major new market. Both today's and future generations of broadband services will continue to be viewed by users as delivering good value - much the way cellular services have been viewed for the past decade. The transition into a mass market will be completed with widespread adoption of broadband services for both business and home use. Broadband services should continue growing in terms of both quality and quantity. Expect to see near-term success for streaming video, voice-over-IP and Internet-based commerce. And expect to see prices ranging from $50 to $100 a month, with increasing speed and quality of service at each price point as equipment costs decline.

Competitors will add capacity, both in access and transport, as quickly as they obtain financing. Some capacity additions will be massive, such as the start-up of a global satellite system, but others will be incremental, route by route, geography by geography. Competition will focus on three areas: local access and customer control; wholesale transport both globally and locally; and globally branded bundles of access and transport from a few dominant suppliers.

Near-term risks will shift from shortfalls in demand to managing capacity and costs. Investors will need to be sure that they back the right technology choices, that the networks are built in the right places and that over-capacity situations are avoided. The long-term returns realized from investments in broadband networks will depend less upon being a first-mover or technology leader and more upon traditional factors of customer retention and control, overall scale and branding.

As such, there should be three types of successful business strategies in the market long term: the first strategy will be to offer consistently the lowest cost by adopting only proven and standardized technologies, featuring price-based promotions and advertising and offering minimal customer support or service - the Southwest Airlines of broadband services. This position is being pursued in transport by Level 3 and Qwest.

An alternative strategy is to emphasize overall value at an acceptable price. This strategy is strengthened through unique features, content or bundling with other services and products. In some ways AOL, Equant, Microsoft, and @Home are all executing this strategy. The last strategy is to develop scale and brand advantage to overcome price, feature or quality shortfalls. AT&T and AOL are both pursing versions of this strategy.

The breadth of strategic options will present many telcos with a strategic challenge. Most telcos have been the first to bring broadband services to their markets, but they often did so while retaining their reputation for high prices, slow and inconsistent service and lack of entrepreneurship or motivation. Now many of these telcos already face immediate competition from CATV, satellite and wireless broadband competitors for this next generation of broadband services.

Soon telcos will also need to address the issue of scale, service differentiation and the provision of access to Internet sites outside their territory. Fortunately these same skills and issues are already being addressed to compete with competitive access providers (CAPS) and competitive local exchange carriers (CLECs).

Conclusions

The broadband networks now seeking financing are very different than those of the early 1990s. Demand has surged, access has changed and the costs of equipment and content have dropped. These networks will now find it much easier to produce a profit. Strategic imperatives will shift from demand creation to capacity and cost management and customer retention. Operators and suppliers should all find this market profitable over the next few years. And this time around financiers should take note of a high reward for their capital at a lower risk.