Is Verizon Behind in the Telco Race?

Verizon certainly raised a ruckus in the industry with their views on consolidation.  The sense of their CEO’s comments was that Verizon was open to a merger that offered them content ownership, and that says a lot about the industry overall.  Here we have a giant telco saying that without content ownership their position is at risk, and there’s some support for that negative view in their most recent quarter.  So why is that, is it true, and what does it mean for us all?

To set the business stage, Verizon had subscriber loss issues in the mobile space—over three hundred thousand according to their quarterly report.   The company lost revenue in wireline, and FiOS video net losses were about 13,000 connections.  While Verizon is seen as having the “best” wireless and FiOS is seen as the best wireline Internet and video, the company faces competitive pressure on all fronts, and it’s increasingly doubtful that buyers will pay for premium service.

The core issue facing Verizon (and other operators) is the explosion in video delivery to mobile devices.  It’s not that this represents a massive shift away from channelized real-time TV viewing, but it does demonstrate a shift in video behavior, two in fact.  First, mobile broadband gives people video access when they have no opportunity to use traditional tethered TV.  Second, viewers are much more into time-shifting than before and if you’re not going to watch what’s on when it’s on, you are open to watching it differently, on a different device.

Mobile video has been a problem for operators because competitive pressure prevents them from usage pricing in a way that would realize much incremental revenue from the shift.  They’re stuck with another reason for revenue per bit to decline, sinking into the realm of dumb, cheap, plumbing.  And, of course, if the road is becoming free, then you have to make money on what’s traveling the road, which is video content.  To make things more complicated, TV advertisers want strong mobile video presence.

With market trends challenging enough, rival AT&T has messed things up further for Verizon, in two ways.  First, it’s been offering video from its DIRECTV property to its mobile customers, without having the viewing count against usage, a move Verizon had to follow.  Second, it’s done much better at moving its services and infrastructure toward that elusive telco goal of “transformation.”  Verizon had two natural advantages over AT&T at the start of this decade, and now they’re far less relevant.  We’ll look at Verizon’s lost edge first, then at the two ways AT&T helped them lose it.

What I call “demand density” was the first of Verizon’s natural assets.  The value of network infrastructure, its ability to return on investment, is proportional to the economic value of the homes and businesses that infrastructure passes.  My own modeling showed decades ago that this was very roughly related to the GDP per square inhabitable mile, which I called “demand density”, and by that measure Verizon had nearly a 7x advantage over AT&T.  That’s why Verizon could jump on FTTH for at least a good-sized chunk of its market, and AT&T had to be satisfied with a hokey IPTV-over-DSL approach.

The second of Verizon’s natural assets was on the business side.  The easiest place to make a business sale of telco services is at the corporate HQ.  Verizon had more corporate HQs than AT&T, a lot more in fact.  Their edge has eroded because of a general shift of industries from the northeast to California and Texas, but they still hold a lead.  The problem is that business services are under incredible pricing pressure, and the winner in the race to the bottom will always win in that sort of situation.

The mobile-broadband focus of the market gave AT&T an opportunity to focus its “video” on a combination of satellite TV and their my-content-isn’t-counted-against-usage approach to mobile video.  Mobile services in general bypass the demand density issue because you’re not stringing wire, and the no-usage-charge video model promotes synergy between their satellite TV approach and mobile services.  You can see from Verizon’s price hikes on FiOS TV (and customers squatting in unexpected numbers in their cheapest offerings) that demand density and FiOS aren’t guaranteeing victory any more.

The transformation win AT&T is now posting is even more troublesome.  Process opex, the operations costs directly attributable to network services, accounts for about 28 cents per revenue dollar today across operators of all types, and if left unchecked that will grow to over 33 cents in five years.  Transformation, in theory, could reduce process opex by fifty percent or more.  With a cost advantage that large, AT&T could kill a non-transformed competitor—like Verizon.  AT&T’s ECOMP is becoming a de facto model for operators globally, but one Verizon can’t easily adopt for competitive reasons, and so Verizon is grappling with the question of how to counter ECOMP.

The AT&T proposal to buy Time Warner is the potential nail in the coffin.  Here’s AT&T already pushing hard against Verizon’s market advantages.  Then Comcast jumps in, first to buy NBCU and then to announce their own MVNO service that, no surprise, will deliver Comcast’s own video to mobile users without usage charges.  Then AT&T wants to buy a content company, giving it even more power in the mobile video space and better margins “above the network” to offset declines in profit per bit.  Given that AT&T could transform itself out of an immediate profit-per-bit problem, this is not good news.

Hence, the Verizon CEO’s comments on selling out to Disney or someone like them.  This is more than “Hey, Mom, every kid on the block is buying a content company!”  Verizon probably knows it would be difficult for it to actually do an acquisition of a good one, and harder to get regulatory approval.  Getting acquired by a content company might be easier, though regulatory approvals might still depend on the more permissive view of regulations held by the current administration.

Regulatory policy may hold the big wild card here.  Recall that the original neutrality order promulgated by the FCC under Genachowski didn’t close the door on settlement or paid prioritization.  Those were added by the Wheeler FCC.  Might the current Chairman, Pai, revert to a more ISP-friendly view and open the door to one or both?  That could open the possibility of Verizon obtaining revenue from OTT vendors, and even to new Internet-based services.

The question here is whether, even if regulatory relief were granted, it would be sufficient to redress the negative long-term issues Verizon faces.  Cost advantages held by competitors who are more aggressive with automated service lifecycle management aren’t wiped out, regulations would just open new areas to compete in.  And if you can charge for priority content delivery and your competitors who own content assets elect not to, how do you respond other than by not charging?

Verizon seems to be doubling down on fiber deployment, based on its Corning deal, and that could suggest either a doubling-down on “quality” service or a hope that their cost base could be improved by shifting capex more to transport.  It may also hope that somehow buying OTTs (Yahoo, recently) will give it a leg up in that space.  Perhaps all of this will help, but I really think that the weak spot for Verizon isn’t content ownership, but service management automation.  They need to outdo competitors like AT&T in that space, and I don’t see any clear signs that they’re on the road to doing that.