Net Neutrality: Reining in the Dumb Pipe Oligopoly
SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak
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February 10, 2015
Net Neutrality: Reining in the Dumb Pipe Oligopoly
The Title II reclassification of broadband reflects a sea change in policy and is a substantial threat to the long term growth and profitability assumptions at the core of cable and telco valuations. The overwhelming public support for restraints on wireline and wireless carriers trumps the aggressive industry political spending, and even without explicit price controls, the proposed action would create an empowered FCC clearly aligned to act on the interests of consumers. We do not expect legal or legislative challenges to bear fruit, given the firm FCC mandate in law, the weight of public opinion, and the growing ability of the internet community to drive political action. We also believe that the perspective reflected by this proposal makes it unlikely that the FCC will approve the pending CMCSA/TWC merger.
- FCC proposes to reclassify broadband as a Title II utility. The action would set strict prohibitions against blocking, throttling or paid prioritization, add oversight to interconnection agreements, and provide a mechanism to intervene in carrier behavior deemed harmful to consumers. The proposal forbears price regulation, universal service obligations/fees, and network unbundling – historical aspects of telecom regulation particularly objectionable to carriers. On its face, the move would have little impact on the near term sales or profits of cable or telco companies.
- FCC can act aggressively to protect consumers. The proposal includes a catch-all that empowers the FCC to intervene against carrier conduct that harms either consumers or internet content providers, with a clear mechanism for receiving and adjudicating complaints. Moreover, having already reclassified broadband as Title II, the commission would be positioned to reverse its forbearance of price controls or network unbundling more easily in response to aggressive moves by carriers.
- The law and public opinion will thwart industry challenges. The FCC’s proposal appears on firm legal ground, based on its historical mandate and affirmed by the Telcom Act of 1996. Moreover, public sentiment is overwhelmingly in favor of it, a key factor in Chairman Wheeler’s about face on reclassification over the past 9 months. The defeat of the industry backed SOPA anti-piracy legislation by a grass roots internet campaign was early testament to the changing political calculus that will now play against cable/telco interests. Political air cover for unfettered broadband pricing is an artifact.
- Cable/telco stocks threatened. Current valuations hinge on rising prices and exceptional margins for residential broadband service. With a newly empowered FCC and overwhelming consumer opposition, we believe that investor assumptions for the long run performance of cable and telco stocks are unwarranted. While we do not expect near term results to be affected, news flow and longer term revisions will work against the stocks and we advise rotating out of them toward the internet names – NFLX, GOOG, AMZN, etc – that will benefit from the proposed regulation.
A Decent Proposal
Last week, FCC Chairman Tom Wheeler offered his set of net neutrality proposals, which include reclassification of broadband under Title II of the 1996 Telecommunications Act with forbearance provisions, bright line rules banning paid prioritization, blocking, and throttling of lawful content and services, and the authority to hear complaints and take enforcement action against Internet Service Providers found to violate internet rules (Exhibits 1-3). The scope of the proposal was expected given months of buzz over reclassification after pressure from the White House, public opinion that resulted in over 4 million comments to the FCC, and most recently Wheeler’s appearance at CES last month touting the benefits of Title II with forbearance. It also fulfills one of our 2015 predictions outlined in a research note last month:
For Wheeler, who was once the cable and telecom industry’s top lobbyist when he headed the National Cable & Telecommunications Association (NCTA) in the 1980s and the Cellular Telecommunications & Internet Association (CTIA) from 1992 through 2004, his “New Rules for Protecting the Open Internet” are a major flip flop from his previous stance. Just two months after Wheeler took office in November 2013, the FCC’s Open Internet Order of 2010 was largely vacated by the DC Circuit Court of Appeals, which ruled in favor of Verizon’s challenge of the Commission’s authority. The court affirmed the FCC’s general legal authority to regulate broadband through Section 706 of the Telecommunications Act of 1996, but threw out rules that governed the blocking of service and discrimination against internet content providers. The decision held that these rules could only be applied against services classified as Title II telecommunications services, not to Title I information services. Essentially, net neutrality regulation could only be instituted if broadband services were reclassified as Title II. Rather than appealing the decision to a higher court, Wheeler spent months looking for sounder legal strategies to avoid litigation, appearing to favor approaches that would not reclassify broadband. In May, he offered a draft proposal that once again relied on Section 706 to justify a weakened version of the previous order that would have allowed for Internet “fast lanes” to survive.
But after further months of public discourse, hearings, those 4 million plus comments, and a high profile public plea from the White House for reclassification, he has abruptly changed his tune. The FCC is taking a strong stance against the broadband providers. Designating these operators as Title II common carriers, even with the most onerous provisions on ice, provides the FCC with the power to step in should consumer pricing, connectivity agreements with internet content providers or network investment fail to meet its perception of the public interest. While the proposal forbears rate regulation, universal service fund contributions, and new taxes or fees, it applies core provisions of Title II to prohibit unjust and unreasonable actions, allowing the FCC to step in and investigate consumer complaints and enforce actions against providers. Explicitly calling out such an authority to address complaints about ISP practices is a big win for consumer advocates and grass roots efforts. For the cable and telecom establishment, it means egregious anti-consumer actions, such as those pilloried in recent viral stories about Comcast customer service, will not go unpunished. It also means that pricing and service quality will be noted, and future attempts to exert market power could bring a far more heavy handed regulatory response.
Exh 1: Proposed Bright Line Rules
Exh 2: Title II Provisions Applied to ISPs under Wheeler’s Proposal
Exh 3: Title II Provisions Subject to Forbearance under Wheeler’s Proposal
Exh 4: Broadband Competition at Key Service Thresholds
Broadband Consumers are Mad as Hell, and They are Not Going to Take it Anymore
The FCC proposal takes pains to side with consumers, offering a process to hear complaints and redress against ISP practices that cause them harm. Having redefined broadband as services offering at least 25Mbps throughput downward and 3Mbps up, the FCC places cable operators in the crosshairs. By these standards, 55% of American households have no choice other than their monopoly cable operator for broadband service, and another 23% can choose from cable and a single alternative (Exhibit 4). After removing the 19% of consumers who have no option that meets these standards at all, over 90% of U.S. broadband customers have little or no choice in carriers. Economics 101 tells us to expect these firms to exercise market power by charging prices considerably higher than the competitive market clearing price, while investing less capital back into their business.
Not surprisingly, US broadband prices are unusually high, while average speeds are unusually low compared to other developed economies with more competitive markets (Exhibit 5). Cable operators are reaping margins in excess of 80% for a broadband product that largely piggybacks on the same coaxial cable infrastructure already bought and paid for by TV services (Exhibit 6). Rates of investment among cable companies, as measured by CAPEX as a percentage of operating cash flow, are trending to historic lows below 50% (Exhibit 7). Rollouts of new technologies have been slow – Comcast’s X1 Xfinity platform is available to just 5 million out of its 22.4 million video households despite its launch almost 3 years ago. This all would seem to be evidence of ISP practices that cause consumer harm.
Of course, Wheeler’s proposal sidesteps the problem of broadband market power, promising to avoid price regulation through forbearance, but Title II reclassification will leave the door open to revisit pricing at a future point if broadband providers act unreasonably against a standard of causing consumer harm. Given the enormous and longstanding dissatisfaction that Americans have for their broadband providers, the FCC’s proposed system for logging and investigating consumer complaints will be busy indeed.
Exh 5: Average Speed for Broadband Plans Priced Between $35 and $50
Exh 6: Cable Gross Margins by Product, 1Q2012 – 3Q2014*
Exh 7: CAPEX / Operating Cash Flow of Major Cable Companies, 2003-2013
Internet-based businesses, including net neutrality poster child Netflix, will also celebrate once the new proposal is enacted. The broadband cabal has only recently turned its oligopoly market power toward the network side. Last year, Comcast, Verizon, AT&T and Time Warner Cable all shook down Netflix by refusing to increase the bandwidths of their interconnections, thus drastically constraining the performance of the streaming video leader’s service to their customers (Exhibit 8). Despite the flood of complaints about buffering delays during prime time, the carriers used their own customers’ pain as leverage to wrest payments from Netflix, taking months to “re-engineer the interconnect” even after the agreed ransom was paid. Title II reclassification would give the FCC the authority to investigate interconnect activities and take steps to enforce penalties if they are not “just and reasonable”, giving NFLX some leverage of its own when its interconnect agreements come up for renegotiation.
Exh 8: Average Netflix Connection Speed by ISP, Jan 2013 – Jan 2015
How Many Lawyers Does it take?
With Title II authority over broadband almost certain to be assumed by the FCC in a matter of weeks, the cable and telecom establishment will fight back with a flood of lawsuits challenging the reclassification in the courts and by ratcheting up its already robust lobbying effort to seek legislative redress. However energetic, these efforts will be, more than likely, futile.
The FCC’s footing for instituting Title II reclassification is unambiguous within the language of the Telecom Act of 1996, and while the carriers will challenge the commission’s conclusion that modern broadband services are communications services, without the value-added functionality necessary to be deemed “information services”, the legal burden of proof will be on the operators rather than the FCC. The DC Circuit ruling strongly suggests sympathy with reclassification, while arguments that the action would not serve consumer interests are easily countered by the industry’s well reported track record of customer abuse and frugal investment.
That track record will also prove an albatross, as the newly minted common carriers vie for a Congressional lifeline. While cable MSOs have been amongst the most profligate spenders on lobbying and campaign contributions, they are also routinely rated amongst the most hated companies by American consumers. According to the American Consumer Satisfaction Index, cable broadband providers score well below other service challenged industries, like airlines, subscription TV and health insurance, with Time Warner Cable and Comcast’s ISP businesses receiving the lowest ratings of any company in the survey (Exhibit 9-10). The Consumerist website runs an annual tournament, by which its visitors vote to select the “Worst Company in America”. Comcast and Time Warner Cable are perennial final four competitors, Comcast having won twice in five years. It is this customer rancor that the industry must fight, in an era where the voice of the people can be rallied in serious numbers, evidenced by those 4 million public comments in support of Net Neutrality logged to the FCC website and by the stunning defeat of the SOPA anti-piracy legislation that had been sponsored by the equally lobby-happy entertainment industry (Exhibit 11). Republican Representatives may be paying lip service to the evils of FCC regulation now, but they will change their tune when their offices are inundated by the non-partisan army of angry cable customers.
Exh 9: American Customer Satisfaction Index – Internet Service Providers
Exh 10: American Customer Satisfaction Index – Top 5 and Bottom 5 Industries
Exh 11: 2014 Lobbying Spend by Cable and Telecom Interests
The main argument by the anti-regulation crowd today is that reclassification would stifle investment and innovation. Those cable customers can rightly respond “What investment and innovation?” Cable capex as a percentage of sales is at a historical low, and ballyhooed so-called innovations, like Comcast’s Xfinity platform have rolled out at a glacial pace. Meanwhile, broadband prices have risen at a better than 6% CAGR to levels at the highest echelon on a global basis, for average connection speeds that are at the low end of developed nations. Operators can’t play poor man here either – the contribution margins for cable modem service run better than 80%. It would seem that a Telecom Act of 2015 aimed at protecting these poor, abused cable operators and telephone companies would be a tough sell to any constituency and an exceedingly poor use of political capital for lawmakers of any stripe.
We expect Title II reclassification to stick, and we expect the FCC to reconsider its pledge to keep out of pricing should operators proceed with a plan to drive broadband prices higher to make up for their deteriorating subscription TV businesses. We also expect the FCC to extend its new found suspicion of the broadband market to its evaluation of the pending Comcast-Time Warner Cable merger. This deal, once considered a slam dunk, now contends with the harsh light of the FCC’s recent redefinition of broadband service from 6Mbps downstream to 25Mbps. Under this new standard, the proposed combination would control nearly 60% of the nation’s broadband customers, most of whom have NO other choice for service. It is hard to imagine Wheeler justifying a rubber stamp approval.
Sell, Sell, Sell! Buy, Buy, Buy!
Title II reclassification is unequivocally bad for the current broadband establishment. Assuming the CMCSA/TWC merger falls through and that plans to ratchet up broadband pricing to offset TV cord cutting and rising network fees are largely thwarted, it is difficult to see the impetus for investing in these stocks. Wireless broadband will see less impact from reclassification, but only because competition from an aggressive T-Mobile USA and a desperate Sprint will make it hard to exert oligopoly power over increasingly fickle mobile customers anyway.
Indeed, regulation is only necessary because of the market power available to cable operators and telcos. Injecting competition into residential broadband markets is impractical, at least today. Cable broadband architecture, with common blocks of bandwidths shared amongst all customers in a neighborhood make it impractical to mandate network unbundling – a common technique to drive competition in markets where telephone companies are the primary broadband carriers. Network overbuilds, such as Google’s Fiber initiative in Kansas City, Austin and Provo or municipal fiber projects springing up around the country, are effective but necessarily modest in scale, given costs and bureaucratic obstacles. Current wireless technologies are still impractical for high-volume residential broadband use. Right now, government regulation is the only constraint keeping the cable operators and telcos from strong arming both consumers and internet-based businesses in pursuit of those monopoly rents.
However, we see the cavalry on the horizon. While current wireless networks, particularly those operated by participating oligopolists Verizon and AT&T, are unlikely to serve as competition to fixed broadband in other than rural settings, new technologies and additional spectrum may change the story. Every two years, the 3GPP organization ratifies new versions of wireless technology standards – user speeds are increased, cell site capacities expand, new capabilities are introduced. The organization also makes clear its technical roadmap for the next few releases, and has maintained an enviable record of consistency in meeting the past objectives that have been defined in these roadmaps. By the end of the decade, wireless networks will likely be capable of speeds exceeding 500Mbps, with cell sites with enough capacity to support more than 100 active households with residential service (Exhibit 12).
Exh 12: Wireless and Wireline Advances, 2000-2020
New spectrum will aid in making wireless networks more competitive. The FCC recently concluded a auction for a big slice of the AWS-3 band, with T-Mobile winning $18.2B in licenses followed by wild card Dish taking some $13B in spectrum, and VZ, which won about $10.4B in new bandwidth (Exhibit 13). Next year, the commission is expected to offer an even more attractive swath of spectrum in the highly coveted 700 MHz block. This spectrum will accommodate the massive thirst for mobile data in highly dense locales, but opens room for fixed service for residential communities. Add in Dish Network’s fallow 40 MHz and Sprint’s seriously underutilized 150 Hz 2.5 GHz and the room exists to make wireless home broadband a reality. Top this with new wireless network architectures which will be substantially cheaper to deploy, vigorous price competition amongst network equipment manufacturers eager to supply the network build-outs, and the wildcard of Internet businesses, such as Google, stepping in to contribute to the cost of deployment. We believe wireless will begin to effectively compete for residential service by the end of the decade.
Exh 13: US Mobile Wireless Frequencies and Auctions
Considering this future, we are obviously concerned for the incumbent providers of broadband, such as CMCSA, TWC, CHTR, CVC, VZ and T (Exhibit 14). The investment case for these stocks relies on a rising tide of broadband revenue and profit that now appears tenuous at best. We prefer the cloud-based leaders, such as GOOG, AMZN and NFLX, who will benefit from assurances of an open internet and can compete more aggressively for subscription TV cord cutters without fear of retribution. We also see opportunity for the secondary wireless carriers, particularly TMUS, but also S if it can resolve its ongoing operational issues and better leverage its spectrum assets. The boost in wireless could also be a substantial opportunity for components suppliers, such as QCOM.
Exh 14: The SSR TMT Heat Map, February 2015