May 18, 2010 The FCC “Gets It” – Competition, Not Market Power, Drives Innovation and Investment

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The FCC’s plan to reclassify wired broadband as a regulated telecommunications service, combined with its published National Broadband Plan and numerous public comments, makes clear its intention to press a policy of “net neutrality”, heightened competition, low rates and universal availability for broadband. While opponents voice concern for lost incentive for investment and innovation, we believe that the FCC sees the growing domination of cable operators for higher speed service as an even greater threat.

While the cable industry has just over half of all U.S. broadband subscribers, it has over 80% share of connections capable of better than 4Mbps. With less than a third of US households passed by either Verizon’s fiber-based FiOS or AT&T’s high-speed copper U-Verse services, and investment in both of those services winding down, broadband rivalry is less than fierce. Against this backdrop, cable industry capex has already begun a sharp decline with further future declines projected.

While the FCC has promised “forebearance” in its use of its regulatory powers on broadband, the potential use of these powers is likely sufficient motivation to keep broadband operators from using pricing power to drive excess returns and block cable MSOs from hampering access to internet TV options. While the FCC’s stance may be challenged in court, an aggressive industry opposition could catalyze Congress to pass net neutrality legislation that would make challenges moot.

Historically, competitive threat and regulatory pressure have been the only real spurs to investment in telecom networks. CAPEX as a percent of sales has been higher during periods of greater competitive intensity and in business areas, such as wireless, with more competition. The FCC appears to be favoring 4G wireless broadband as a competitive alternative to cable, fiber and DSL, and will exclude it from reclassification. While initial speeds are not competitive with wired services, new spectrum, new competitors, favorable regulation, investment in system capacity and a technical upgrade path to 100Mbps+ could make wireless-only a viable solution for broadband users well before decade end. Wireless churn, already a significant phenomenon for voice, would then be the catalyst to reverse the already strong downward trend in fixed broadband investment.

In this scenario, wired carriers could not under-invest, hinder access to on-line alternatives to multi-channel video, or apply pricing power without a heavy regulatory backlash. As such, we believe that valuation models that assume more than modest long term cash flows from wired broadband businesses may be overaggressive, that multi-channel video franchises will likely begin to show serious erosion to internet TV by decade end, and that the strong trend toward wireless-only voice users will accelerate.

This is bad news for cable MSOs (Comcast, TimeWarner Cable, Cablevision, et al.) and wireline telcos (Verizon, AT&T, Qwest, et al.), and perhaps not as bad for wired equipment suppliers as many have feared (Cisco, Motorola, Arris, Harmonic, Alcatel-Lucent, et al.). It is good news for would-be purveyors of internet TV (Google, Netflix, Apple et al.) and the associated technology suppliers (TiVo, Cisco, et al.). We expect strong investment in building out 5-7 national 4G wireless broadband networks, followed by regular upgrades for speed and capacity, good news for wireless equipment companies (Ericsson, Nokia, Huawei, et al.), chip suppliers (Qualcomm, Broadcom, et al.) and tower companies (American Tower, Crown Castle, SBAC, et al.). Outcomes for wireless carriers (Verizon, AT&T, Sprint, et al.) will depend on execution, although it appears likely that competition will be intense.

Member: FINRA / SIPC 

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