Net Neutrality: The FCC Takes Over the Top Under its Wing

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Paul Sagawa


December 22, 2010

Net Neutrality: The FCC Takes Over the Top Under its Wing

  • The FCC’s new rules on broadband services are intended to protect web-based services, in particular streaming video, from being thwarted by cable companies and telcos. Because these web-based services compete with their lucrative multichannel video businesses, local broadband access providers have ample incentive to use their control of the customers connection to impair performance. The new regulations explicitly prohibit wired access providers from discriminating against specific applications or services, while limiting the ability to sell preferential performance for a fee and overseeing the use of tiered pricing plans for heavier use subscribers
  • The new rules do depend on subjective oversight by the FCC, and could theoretically be subverted to hamper the adoption of on-line video streaming services. We do not believe that this is likely. First, Democratic control of the FCC until at least the end of 2012 should provide teeth to the rules during a critical phase of market development. Second, aggressive action to inhibit performance or drive up the consumer cost of on-line video would likely severely damage political support for the industry and could result in stronger regulation down the road. It is useful to note that the cable industry carriers an unusually poor reputation amongst consumers
  • The primary argument of opponents to the FCC’s approach to the internet presupposes that restrictions on the use of broadband access assets will be a disincentive to investment, and thus, result in a barrier to innovation. Given the uncompetitive status of the nation’s fixed broadband market – cable operators serve more than 80% of households with better than 10 Mbps download capability – the emergence of on-line based rivals to the multichannel television franchise is an even greater disincentive. Cable bull projections of falling capex and rising cash flow after Verizon and AT&T scaled back ambitions for their video investments suggest that concerns about disincentives may be spurious
  • The FCC appears to be supporting wireless as a competitive prod to fixed line providers. Wireless broadband was exempted from the newly issued regulations, save for a prohibition against discriminating against web applications that directly compete with the carriers own business interests. 4G wireless broadband technology has the potential to deliver performance equivalent to fixed broadband networks and is relatively competitive. In particular, we believe the economics for limited mobility services that can compete directly with cable broadband will be far better than many observers suppose once the standard progresses through a few upgrade iterations
  • Moreover, the FCC has identified 415 MHz of additional spectrum that could be authorized for wireless broadband within the next 5 years. This would effectively double the bandwidth available to the industry and likely, enable new entrants to the market. As a note of comparison, both Verizon and AT&T currently operate with less than 90 MHz of spectrum each
  • Today’s FCC action will likely be viewed as mild positive for cable stocks as it preserves some flexibility for tiered pricing and charging web-based businesses for preferential performance. However, we believe that the current FCC will keep the industry on a fairly short leash in this regard and that backlash to aggressive tactics by cable MSOs could be harsh. In the longer term, we believe that wireless competitors will emerge, limiting wired broadband access providers’ ability to extract monopoly rents from their subscribers. In this context, the current market enthusiasm for cable stocks may be overplayed, although no immediate negative catalyst appears likely
  • We are more enthusiastic for the web-based businesses – in particular, video streamers – that this action is intended to protect. We believe Amazon, Apple and Google are ideally positioned to address this market as it develops

Protecting the Free Internet

Yesterday, the FCC culminated years of rancorous bickering by approving regulations on broadband telecommunications providers under the banner of Net Neutrality. The new rules prohibit wired broadband providers from discriminating in the treatment of internet traffic on the basis of application or source, limit their ability to offer faster transmission to web sites for a fee, and control the implementation of metered pricing plans if such plans appear to be intended to squelch particular internet business models (Exhibit 1).

Like most political debates these days, this one has become highly partisan, with the FCC regulation squarely in the middle, taking brickbats from Democrats concerned that the rules do not go far enough to protect emerging internet-based business models, while Republicans object that the regulations are an unnecessary intrusion that will inhibit investment. Amid the rhetorical din, it can be difficult for investors to assess the implications.

It’s All About the Video

Ultimately, we believe this debate is primarily about on-line video streaming. Wired residential broadband service is almost entirely provided by cable operators and telephone companies that also provide channelized broadcast video services. According to the FCC’s survey, just 32% of American internet connections offer typical speeds of at least 3 Mbps downstream and 768 Kbps upstream (Exhibit 2). Of these, nearly 70% were served by their cable operators, with another 25% buying either Verizon’s fiber-based FiOS service or a copper-based aDSL from their local telephone provider (Exhibit 3). At higher speeds, necessary for high quality video streams, cable becomes more pre-eminent, with more than 80% of connections in excess of 10 Mbps downstream.

As such, these operators face a substantial substitution threat from internet-based streaming video providers, such as Netflix or YouTube. With the technical means to block or impair traffic from these competitive services, the cable industry might find the temptation to thwart internet video irresistible. It follows then, that cable operators and telcos have placed their lobbying and PR muscle squarely against Net Neutrality, while silicon valley and most Internet-based businesses have worked and spent fervently in its favor.

The FCC action provides modest protection for 3rd party on-line video. Cable companies will not be able to block video competitors’ traffic, nor will they be allowed to provide slower service for those companies than they do for the rest of the internet. However, they will be allowed to offer faster delivery to companies that pay a fee and to charge users higher prices for the heavy cumulative usage typically associated with video streaming. Applied cynically, these loopholes would give cable companies the means to make “over the top” video prohibitively expensive for subscribers. To insure against this, the FCC is reserving the right to review tiered pricing schemes and preferred delivery contracts to assess their impact on competition for video.

Watchful Waiting

We believe that the FCCs actions will be sufficient to protect the business model for on-line video streamers. Aggressive movement to jack up pricing for high-usage subscribers or to extort unreasonable tolls for unfettered video delivery would likely stimulate more serious controls, such as reclassification of broadband as a telecommunications service subject to price regulation. Moreover, the political air cover that opponents of net neutrality have enjoyed from regulation skeptical Republicans might be lost from blatantly anti-competitive and consumer hostile tactics. Cable companies cannot rely on a wellspring of consumer goodwill to press their political interests. It is notable that in the wake of an enormous financial sector melt down, a March 2010 on-line tournament to name the “Worst Company in America” run by “The Consumerist” web site awarded its “Golden Poo” to Comcast, which beat out Bank of America, Ticketmaster and Cash4Gold in the final four, and leaving high profile foes like United Airlines and AIG far behind in the dust, despite serving less than one in five American households.

What Incentive to Invest?

Opponents of net neutrality have made investment incentives a cornerstone of their arguments, positing that cable operators and telcos will have no incentive to invest in their networks if not given free reign over the use and pricing of their assets. We are unconvinced. A major tenet of most bull cases for cable is that the major costs of supporting high speed internet are already behind the industry, enabling projections of rising returns on capital far into the future. As for telephone companies, both Verizon and AT&T, once aggressive in their roll-outs of alternative broadband networks, have signaled their intention to complete their investment in video capable networks for the foreseeable future (Exhibit 4). Essentially, the telco competitors have thrown in the towel and cable companies can finally relax and reap the benefits of pricing power in a market that they dominate. Against this backdrop, it seems spurious to argue that the FCC action would have any impact on network investment at all.

Why Does Wireless Get Off Easy?

The FCC issued less stringent requirements for wireless broadband, on the basis that these networks are at a much earlier stage of development and that capacity planning is more difficult on a mobile network. (Exhibit 5) The new rules allow wireless carriers to block or slow traffic for specific applications as long as the applications are not competition for the carriers own services. The FCC also reserves the right to reconsider the more lax treatment of wireless broadband at a later date.

We believe the unwritten rationale for the special treatment of wireless lies in competition. First, wireless broadband is more competitive than fixed broadband. There are four national mobile broadband networks in various states of deployment, with a fifth being planned by the Harbinger Capital backed LightSquared with the permission by the FCC to repurpose satellite spectrum for terrestrial wireless broadband (Exhibit 6). Moreover, the FCC has identified 415 MHz of additional spectrum that could be made available for wireless broadband networks over the next five years, a potential doubling of the bandwidth devoted to commercial communications services. Arguably, heavy handed control of applications and web sites by a wireless broadband operator could be impetus for churn.

Could Wireless Broadband Keep Fixed Network Operators Honest?

We believe that 4G wireless will be sufficiently robust to make it a viable alternative to fixed broadband before the end of the decade. The roadmap for LTE, the most commonly adopted 4G technology, points toward mobile speeds of greater than 100 Mbps, with speeds of up to 1 Gbps possible for limited mobility – i.e. residential – applications. Given that the average broadband speed in the US today is less than 7 Mbps and that a single channel of HDTV requires less than 10 Mbps, it is obvious that wireless technology will be able to support the application needs of residential users (Exhibits 7 and 8).

The argument against wireless competition typically begins with capital spending, the point being that wireless networks are expensive and to beef them up to handle the usage of video-hungry residential subscribers would be prohibitive. However, it is important to note that the big cost of a wireless network comes from the need to provide seamless blanket coverage. Such coverage would be unnecessary to support residential wireless broadband. At 700 MHz, a single 4G cell can theoretically cover up to 50 square miles and each cell site requires less than $30K incremental equipment investment for an existing network and less than $100K for a new build. Any household in the serving radius would be able to subscribe to the service. In contrast, fiber overbuilds must invest street by street before marketing the service to consumers, yielding dramatically higher investment costs per home passed. We believe that future upgrades to 4G networks will likely eschew blanket coverage for higher speed services to focus on providing a cost effective alternative to fixed residential broadband. Furthermore, we also believe that some of the 415 MHz of spectrum expected to come to market will likely be put to that use.

Investment Implications

We believe that recent enthusiasm for cable stocks is likely overplayed, although the threats to cable cash flows are still many months in the future. Today’s FCC action will likely be viewed as a mild positive for the sector, as it reserves some flexibility for tiered pricing and traffic prioritization, and could result in a relative exit point for holdings in the industry (Exhibit 9). In contrast, we believe that the position of advantaged Internet players such as Google, Amazon, Apple and Facebook may be underestimated by many investors.

Investors should monitor the progress of new spectrum availability and the uptake of wireless broadband services as indicators of the proximity of the threat of wireless competition to wired operators. We would also follow the pricing trends for broadband service, the implementation of paid prioritization and the response of regulators and the market as measures of the cable industry’s ability to extract further surplus from consumers under the new regulatory rules.

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