Net Neutrality: Treating the Symptoms Rather than the Disease

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December 22, 2014

Net Neutrality: Treating the Symptoms Rather than the Disease

The debate on net neutrality is poised to intensify as the FCC considers the President’s request to regulate broadband as Title II common carriage and as it evaluates CMCSA’s proposed merger with TWC. We see merit on both sides of the issues as advocates argue past each other from very different premises. Net Neutrality is a Myth – The internet has a long history of companies paying for superior performance, and outlawing the practice would destroy a market feedback loop that, theoretically, drives investment and ensures value to the consumer. Broadband is a Monopoly – 60% of Americans have no choice, and most of the rest have just 2 choices for broadband service. This concentration has already yielded unusually high prices and poor service quality, and carriers have begun to exert their market power to extract potentially egregious rents from internet content providers. Consequences – Market valuations assume that broadband operators will NOT face constraining regulation or vigorous competition. This is likely true in the next 2-3 years, although it is possible that the FCC will accede to the White House and reclassify broadband. Longer term, rising prices, content throttling outside the paid “fast lane”, and continued poor service and investment, could yield consumer unrest and strengthen support for regulation. Moreover, we continue to believe that wireless could be a viable alternative by the end of the decade. As these outcomes become more likely, the narrative for stocks like CMCSA, TWC, CHTR, VZ and T will turn gloomy.

  • Net neutrality in the headlines. The FCC’s 5 commissioners are appointed by the President but it answers to Congress and must have no more than 3 members from the same party. Thus, Chairman Tom Wheeler is not beholden to follow Obama’s recent request to regulate broadband providers as “common carriers”, particularly given the anti-regulation sentiment in the Republican controlled House. Still, public sentiment appears firmly behind rules to keep cable operators and telcos from throttling access to sites unable or unwilling to pay “fast lane” tolls. The commission is expected to reveal its net neutrality strategy soon, with possible approaches ranging from Title II reclassification to voluntary self-regulation. In the same timeframe, the FCC is evaluating CMCSA’s plans to acquire TWC.
  • Arguing different questions. Opponents of net neutrality correctly point out the internet has always featured “fast lanes” and that these agreements can spur investment and give consumers better service for high-value and technically demanding services like streaming media. Heavy handed regulation could stifle innovation. Advocates counter that broadband is uncompetitive, and that left unregulated, operators will seek monopoly rents from both consumers and content providers while holding back capital investment, all at levels that would price out the poor and the small while thwarting the development of the digital economy. Both views have significant merit but ignore the bigger picture.
  • The net has never been neutral. The public internet works by facilitating the delivery of data across multiple private networks. Historically, data speeds were regulated by the ability of small networks to negotiate direct connection to the largest networks for a fee – otherwise, connection was via low performance public exchanges. With time, internet protocols gave carriers the ability to prioritize some data packets over others, and services were offered to commercial customers for “fast lane” service. On the consumer side, high volume content providers began to negotiate the co-location of servers directly with distribution networks to speed delivery. Opponents of net neutrality are concerned that innovations like these, which have clearly benefitted consumers, would be stifled by regulation.
  • Cable has won broadband and is poised to exploit its market power. Cable broadband is the only option for 60% of US households. For most others, their telco offers a viable alternative but does not compete aggressively on price. The result has been broadband bills growing at over 6% to $51/mo. in 2014, a ~30% premium vs. Western Europe at 30Mbps. Significantly greater value is delivered in US cities with vigorous competition, like Kansas City or San Francisco. We also note that cable companies’ capital spending has run far below operating cash flow in recent years, belying the assertion that the light regulation stimulates investment. Comcast’s much hyped Xfinity X1 service is installed in just 11-12% of its customer households more than 2½ years after introduction. It is easy to see the risks inherent in allowing cable MSOs to exert their market power against internet-based services as well as consumers.
  • Strong regulation would crush the cable investment narrative. If the FCC designates broadband providers as Title II common carriers, it could require service pricing and content provider connection fees to be approved by the commission, perhaps holding operators to a modest return on investment and mandating upgrades for underserved geographies. In this scenario, assumptions of extraordinary future cash flows would almost certainly be false, and the CMCSA/TWC merger would be impossible.
  • Mild regulation is built into current expectations. Consensus expects 4-8% cable sales growth and margin expansion across the industry. P/E ratios hover around 20x, reflecting expectations for strong long term earnings growth. Given that broadband is a growing 30% of industry revenues and nearly 2/3rds of its profits, analysts are not anticipating risk to broadband in their cable market forecasts. With FCC Chairman Wheeler dithering, a Republican Congress, and upcoming Presidential elections, the status quo is a plausible outcome. While we expect fixed wireless broadband to offer real competition by 2020, this risk is not yet well appreciated and cable stocks could be expected to perform well.
  • Compromise regulation and future wireless competition is realistic. We expect reality to play between the extremes. One proposed solution could see Title II designation imposed, but with wide forbearances and significant pricing leeway. Such a move would have little impact on current operations, but would give the FCC a vehicle to act quickly should it perceive more egregious exertions of market power. In this scenario, the CMCSA/TWC merger seems unlikely to be approved and analyst models of unfettered long term growth in broadband pricing are overoptimistic.
  • Cable MSOs/incumbent telcos likely overvalued. The range of regulatory outcomes is wide, and while there are plausible scenarios where cable and telco valuations are reasonable, we believe that risks outweigh potential rewards. We believe that the advent of real competition is upon us in wireless, and see TMUS, and possibly S, taking share and pressing prices for market leaders T and VZ. We continue to believe that the best opportunities for internet-based businesses will accrue to scale players with strategic moats, led by GOOG, AMZN, FB, NFLX, TWTR and others.

Between a Rock and a Hard Place

Considerable verbiage has been sent on Net Neutrality, with notables like President Obama and Senator Al Franken joining most of Silicon Valley and millions of comments on the FCC website in pressing strong regulation of the broadband industry, while Mark Cuban, Libertarian think tanks, and the cable and telecom industries remain in staunch opposition. At the core is the FCC’s pending decision whether or not to regulate the ability of broadband providers to sell superior speed and availability on their networks to individual internet content providers for a fee.

We believe that the two sides of the debate are arguing about very different questions, and that each has an important point. Those against net neutrality regulation are concerned that government oversight would squelch innovation and remove incentives for network operators to invest toward better performance. The commercial internet has never been neutral – big network operators have always struck deals to transfer data away from crowded public internet exchange points, and content delivery networks (CDNs) have paid access providers to allow collocation of servers that put popular content as close as possible to consumers. Opponents see the recent deals between NFLX and various cable operators and telcos as more of the same, and see cries by Silicon Valley for net neutrality as demands for a ride on someone else’s dime and an invitation for regulators to plant their tendrils into another branch of the economy.

Proponents are concerned that the broadband monopolists have found another pot of surplus to siphon. The Telecom Act of 1994, which classified fledgling internet access nets as unregulated Title I services, did not anticipate the future growth and concentration of broadband service. Today, 80% of US households subscribe to a broadband service. 60% of those households have no choice other than their cable operator for service fast enough to adequately stream video, and most of the rest have just two options. On average, Americans pay a 30% premium vs. Western Europeans, while cable CAPEX has been just 40-50% of operating cash flow since 2010 after running at 70% or more for most of the previous industry history. Broadband now delivers >30% of cable profits on extraordinary 80% operating margins and 9-10% annual sales growth. The fear that, left unregulated, the MSOs would continue to squeeze consumers while simultaneously shaking down internet content players for fees seems reasonable.

Meanwhile, the FCC’s degrees of freedom are narrow after VZ’s successful court challenge of the commission’s authority to impose operating rules on services designated as Title I. Given the substantial public support for “net neutrality”, it now seems likely that broadband will be reassigned as a Title II regulated telecom service, with attempts to soften the impact by exempting it from direct price regulation or universal service fees. We note that the architecture of cable broadband makes it impractical to impose unbundling, which might otherwise promote healthy competition as it has in other countries where telco broadband is the dominant architecture.

We believe that investor expectations assume unfettered growth and profitability for broadband – a scenario that is plausible but unlikely. We see the risk/reward as unattractive and would avoid cable stocks and the VZ/T telco duopoly. We remain confident that wireless residential broadband will be a viable alternative by 2020, and expect the secondary carriers TMUS and S to benefit over time. We also see firmer oversight of broadband pricing and upstream fees as beneficial for the leaders of the consumer internet – NFLX, GOOG, FB, AMZN, TWTR, and others.

Universal Service is Not Net Neutrality

The term ”Net Neutrality” has come to describe a principle that Internet service providers and governments should treat all data on the Internet equally and not discriminate or charge differentially by user, content, platform, application, or device. While the concept of giving communications service end users equal access predates the coining of “Net Neutrality” in legal scholar Tim Wu’s 2003 article “Network Neutrality, Broadband Discrimination,” Internet and legacy communications providers have a long history of companies paying for access and performance (Exhibit 1).

Exh 1: Historical Timeline of Telecommunications Milestones

The first networks were connections between phone companies, which interconnected with each other to offer services between areas served by different companies. As Alexander Graham Bell’s patents for the telephone expired in 1894, thousands of new entrants began to wire the country with phone service and the volume of calls increased tenfold by 1910 and Bell’s company, which by then adopted the name AT&T and lost significant market share. That year Congress also passed the Mann-Elkins Act, which was the first legislation to regulate telephone service, giving authority to the Interstate Commerce Commission (ICC) and classifying telephone companies as common carriers. The 1910 Act however, failed to give an adequate definition of what constitutes a common carrier and didn’t specify one carrier’s obligations to other carriers setting in motion a debate over defining telephone service not dissimilar to today’s debate over net neutrality. Following passage of the Act, AT&T focused on buying out or bankrupting competitors attracting the attention of antitrust regulators which investigated the company.

The early Ma Bell refused to connect its long distance network with local independent carriers and the antitrust investigation culminated in the Kingsbury Commitment of 1913 that established AT&T as a government sanctioned monopoly. Regulators allowed the company to continue making acquisitions as long as the ICC approved. In return, AT&T divested its controlling interest in Western Union and allowed for some independent local carriers to connect to its network. Despite agreeing to allow other carriers to connect with its network, AT&T was able to leave out competing long distance providers and competing local carriers when it saw fit. For those carriers not deemed a threat, AT&T imposed access charges.

Though AT&T owned most telephone infrastructure assets in the US by the early 1930s, the universality of telephone service to everyone was not codified into law. With FDR taking office in 1933 and launching a wide range of New Deal reforms, he pressed his Secretary of Commerce to appoint a committee to study electronic communications. The result was a recommendation to create a single regulatory body to regulate communications. The FCC was born with the Communications Act of 1934, which combined and reorganized existing provisions of law covering radio and telephone. The act also set to define common carriers under Title II. With telephone companies classified as common carriers under Title II, they were now required to provide service “upon reasonable request” at a “just and reasonable” rate. Title II also made it “unlawful for any common carrier to make any unjust or unreasonable discrimination in charges, practices, classifications, regulations, facilities, or services.”

The consumer protections and universal access afforded by Title II are the backbone of today’s net neutrality arguments. They came at a time when telecommunications was deemed to be so important and vital to society, that public policy dictated such a business couldn’t be subject to market forces. Title II was crafted to regulate a monopoly serving the public interest and helped force the build out of the country’s telecommunications infrastructure by making it available to everyone. The common carrier definition of Title II effectively mandated that AT&T wire unserved areas such as rural communities, which may have been too cost prohibitive in a competitive environment. There was, however, no end-to-end neutrality between users. Even during the heyday of AT&T’s telephone monopoly, the company was forced to cede 15% share to other independent telephone companies, each of which paid access fees, albeit on a nondiscriminatory basis, to Ma Bell.

Exh 2: Early Internet Architecture

The Rise of the Machines

Fast forward to 1985 when the National Science Foundation Network (NSFNET) was created to link the nation’s NSF-funded supercomputing centers located at a handful of universities. Though the Department of Defense’s ARPANET effort created the protocols for connecting computers and creating networks, NSFNET became the first major Internet backbone (Exhibit 2). Within a year, NSFNET expanded to include hundreds of universities and government agencies with the creation of regional networks that were able to use economies of scale to lower costs for everyone. These regional networks were founded as non-profits, but given the NSFNET network had an acceptable use policy (AUP) that precluded purposes not in support of research and education, demand for commercial use emerged. Given commercial activity was not allowed on the NSF network, commercial backbone companies emerged creating their own AUP-free networks. Some of these companies were spun out of non-profit regional networks. PSINet, which was later acquired by Cogent, spun out of the New York regional network.

Weary about violating the NSF’s AUP, these companies decided to interconnect their own commercial networks and created the Commercial Internet Exchange (CIX), effectively creating an alternative to the NSFNET and giving birth to the commercialized Internet. Companies connecting to the CIX in many cases had to pay membership fees to cover expenses. By late 1992, a revised AUP allowed private sector firms to use NSFNET and Sprint, MCI, Ameritech, and Pacific Bell were awarded contracts to host the first network access points, though these quickly became congested and the major telecoms began building their own faster networks and private access points. By 1997, major Internet backbones like UUNET, Sprint, and AT&T were charging smaller ISPs fees for access to their higher performance networks.

Many of the same terms extended to the Internet’s most popular websites that needed to be able to handle traffic – AOL and Yahoo paid these fees. The practice continues to this day with Google, Facebook, and Netflix paying interconnect fees either to backbone providers or to ISPs. The Netflix-Comcast interconnection spat that emerged earlier this year was the product of a sub-par peering arrangement with Cogent. The sheer volume of Netflix streaming necessitated the company peer directly with the ISP, which Comcast would only do for a fee. With a proposed merger with TWC on the table, CMCSA likely caved in and gave NFLX good pricing.

For Internet backbone providers like Cogent and Level 3, which are not classified as carriers, they are able to operate in secrecy and do not have to publicly disclose the networks with which they peer nor the terms. The fiber glut of the early 2000s put many of these companies into bankruptcy, but unlike ISPs, which are mostly a monopoly in the US, they operate in a fiercely competitive environment. Even then, the major Internet names including Google, Facebook, Microsoft, and Amazon are heavily investing in their own backbones, adding a wrinkle to the competitive dynamic. Google also has data centers and co-location centers sprinkled around the globe to cut latency and increase web performance. The company’s internal Internet backbone comprising of over 100,000 miles of fiber optic cable, coupled with the most powerful data centers in the world, is a Goliath compared to any upstart with the courage to start a new search engine. Both GOOGL and MSFT have PP&E balances of over $28B, with significant allocation to web infrastructure. Cloud leader Amazon clocks in with just over $15B in PP&E, while FB had $5.3B in the most recent quarter (Exhibit 3). With these levels of assets driving high performance data centers and infrastructure, the Internet is clearly not an equal playing field. Even with a net neutral last mile, these web properties will handily beat the performance of any other site on the web.

Exh 3: Net PP&E of Internet Companies

De-mystifying Net Neutrality

Supporters of the principle are largely from the Silicon Valley tech establishment and argue an “Information needs to be free” ethic. They focus on the ability of broadband service providers to squelch free speech by giving significant performance advantages to their own content, or to content from companies willing and able to pay for privileged access to end users. In this way, small voices will be throttled, louder voices must pay the toll to be heard, and the loudest voices will be those of the system operators themselves. These proponents often cite the success of companies like GOOGL, FB, and NFLX as the possibilities that emerge with a network neutral Internet. The major web platforms are also the strongest voices for strong form net neutrality as it would not only cut their costs, but also benefit from increased broadband usage if rules lead to lower priced Internet services. With more eyeballs turning to faster and unadulterated Internet with strong form net neutrality, the likes of GOOGL and FB can display and sell more advertising. AMZN can sell more stuff and offer better cloud experiences through AWS. NFLX can grow sub rolls across more households and serve more movies. All these companies also promise more innovation from yet to be invented businesses.

On the other hand, opponents of Net Neutrality regulation focus on the property rights of those that connect networks and make the infrastructure of the Internet possible. Since cable operators and telecom companies have invested billions of dollars in building out their broadband distribution assets, why should Internet companies ride that investment for free? Why shouldn’t these companies be allowed to make the best return on that investment that they can? To opponents, asking content providers like NFLX, who use the vast majority of bandwidth on the networks, to pay a fee to ensure excellent performance is a fair assertion of the rights of a private property owner. After all, interconnection fees have been a standard for generations in communications. Strong form net neutrality could also discourage investment in network upgrades to provide ever faster and more reliable service stifling innovation. Both sides have arguments with merit, but both seem to miss the most important point – the US consumer broadband market is a monopoly.

Monopoly Money

Though dial-up made up most internet connections in the early days of the Internet, cable grew quickly to become the most prevalent technology delivering internet services by the mid-2000s and into today (Exhibits 4-5). Cable companies in the US with few exceptions are monopolies that exercise market power, which, according to economics 101, is the ability of a firm to profitably raise the market price of a good or service over the efficient market clearing price while investing below an efficient level resulting in a good or service that is priced higher and of a lower quality than if offered in a competitive environment. Cable companies have historically been a regulated monopoly, with municipalities and local governments assigning franchise rights for cable systems to operate. The Cable Act of 1984 formalized regulation of the franchise process, but did nothing to address competition. The latter half of the 1980s saw cable operators exercise market power with rates growing faster than inflation and sub optimal investment leading to legislation in 1992 that established consumer protections and provisions for competition. The 1992 cable act opened the door for competition by encouraging overbuilders to enter the market, but tacit collusion among major cable players kept the status quo. Rather than compete, the industry embarked on consolidation giving rise to a handful of cable companies dominating the market today.

Exh 4: Consumer Internet Connections by Technology 1997-2009

Exh 5: Residential Fixed Connections by Technology

Exh 6: Cable Gross Margins by Product, 1Q2012 – 3Q2014

Today some 60% of American households have only one option for broadband connectivity to get speeds fast enough to deliver video. For cable companies, their monopoly has been lucrative and helped them reap margins in excess of 80% on a broadband product that uses the same coaxial cable infrastructure that was built out for TV services (Exhibit 6). Beholden to protecting their TV bundles, cable companies are notorious for ratcheting up prices for cord cutters looking for standalone Internet services to stream Netflix (Exhibit 7). Comcast has been successful moving single play customers to double and triple play packages with such tactics. About 31% of Comcast customers are currently single play subscribers, versus over 35% two years ago. With most Americans having no alternative, a household cutting the cord from cable TV typically faces a high bill for standalone Internet service that often includes data caps and aggressive marketing to return to the bundle. The companies have used broadband margin contribution to offset the earnings impact of stagnant to declining TV subs. In markets where there is a viable alternative, it is usually a copper/fiber service provided by the local telephone company that doesn’t compete on price.

Exh 7: CMCSA and TWC Broadband ARPUs, 1Q2010 – 3Q 2014

Not surprisingly, US broadband prices are higher than those in other parts of the world for equal or better services. The Cost of Connectivity report issued by the New America Foundation found that for $35-$50 USD, subscribers in Seoul, Hong Kong, and Paris get speeds well over 300Mbps, while internet subs in San Francisco, Los Angeles, and New York get sub 50 Mbps performance. For about $39, users in Paris and Tokyo get 1 Gbps speeds on Fiber networks (Exhibit 8). For almost the same price, Time Warner Cable subs in New York and LA get 15 Mbps.

Market concentration not only keeps prices high, it allows operators to skimp on capital investment. While opponents of net neutrality regulation routinely decry the potential disincentives for carriers to invest in improving service, the reality is that the monopolists began seriously scaling back their investment years ago. Cable industry CAPEX as a percentage of operating cash flow is trending to historic lows below 50%. The measure was consistently over 70% prior to 2008, about the time that cable broadband hit 50% penetration into US households (Exhibit 910). Cable companies have also been slow to introduce innovations, despite big talk. Comcast CEO Brian Roberts showed off a 3 Gbps DOCSIS connection as part of his company’s X3 Xfinity platform during last year’s industry cable show. Unfortunately, Comcast’s X1 platform, launched more than 2 and half years ago, is available to just 5 million of its 22.4 million video customers. We would not be holding our breath waiting for the upgrade to X2, much less X3.

Vibrant competition drives prices lower and keeps rivals keenly focused on customer service. In the UK, where the incumbent telco distribution network is open to all comers on a wholesale basis, prices are less than half of the US average. If a competitor in London decided to deliberately limit the connectivity to a popular service like NFLX, seriously hampering the performance of that service for its subscribers, the result would be rapid share loss to competing services able to advertise their superior performance for streaming movies.

Exh 8: Average Speed for Broadband Plans Priced Between $35 and $50

In contrast, earlier this year in New York, oligopolists Time Warner Cable and Verizon both refused to broaden their connections to NFLX earlier in the year despite rising complaints about buffering delays during prime time, using their customers’ pain as leverage to wrest payments back from the content streamer. Verizon and NFLX eventually came to a deal, but it took the telecom carrier several months to engineer the interconnect. Interestingly, this back-door service throttling isn’t even covered under the weak FCC net neutrality regulations that were successfully challenged by Verizon in Federal Court.

Exh 9: Best Home Broadband Deals Under $40

Exh 10: CAPEX / Operating Cash Flow of Major Cable Companies, 2003-2013

Exh 11: American Customer Satisfaction Index – Subscription Television

Exh 12: American Customer Satisfaction Index – Internet Service Providers

Cable companies are also amongst the most hated companies by consumers in America, routinely making the Consumerist’s worst company tournament that coincides with and follows the same single elimination format as NCAA March Madness. Comcast beat Monsanto in this year’s final for its second win since the Consumerist began running the tourney in 2007 and has routinely made the final four nearly every year losing to the likes of BP in 2010 and Countrywide Home Loans in 2008. Cable Internet Service Providers have also received some of the lowest satisfaction ratings among any company in the US according to the American Customer Satisfaction Index with the category getting a 63, which is well below companies in other customer service challenged industries like Airlines, Health Insurance, and Subscription TV. Time Warner Cable and Comcast’s ISP businesses had the lowest ratings of any company, with their ISP ratings even lower than their cable TV rankings (Exhibit 11-13).

Exh 13: American Customer Satisfaction Index – Top 5 and Bottom 5 Industries

Where do we go from here?

Despite President Obama’s November statement calling on the FCC to reclassify broadband under Title II with provisions to forbear rate regulation, the commission has no timeline for voting on proposed net neutrality rules. Commissioners continue to review the 4+ million public comments and question constituents at Internet companies and service providers, but it seems the focus is on weighing legal options that could stick. For Wheeler, the January ruling in the Verizon case against the 2010 rules was a setback on a technicality with the DC Circuit court ruling affirming some legal authority through Section 706 of the Telecommunications Act of 1996 to regulate broadband, but throwing out rules governing no-blocking and non-discrimination of edge providers. The Court’s rationale was that these areas are covered by another provision of the telecom act: Title II and the FCC violated the act in applying common carrier obligations to Title I information services. Rather than pursue the first obvious option – an appeal to a higher court, Wheeler has avoided going that route and is instead looking for options that avoid the courts. An FCC statement issued in the aftermath of the Verizon case, outlines Wheelers net neutrality goals in that he wants strong rules with no blocking, throttling of apps, and no fast lanes. He also understands no matter what the outcome, lawsuits will be filed. There are several possible scenarios that can play out.

First, the FCC could reclassify fixed broadband as a Title II utility and apply to it the full range of oversight granted it under the Telecom Act of 1934, as modified by the Telecom Act of 1994. This would include a range of regulations considered as onerous or impractical for broadband providers, including price controls, universal service fees and obligations, required approvals for network innovations/service extensions and network unbundling. While this tack has the benefit of fitting squarely within the FCC’s legal mandate, and thus, more likely to withstand court challenges, this “nuclear option” would destroy the investment case behind cable and telco stocks and saddle the commission with a burden of oversight far beyond its current resources.

Exh 14: 2013 Top Lobbying Spenders – All Industries

It could also ignite a political firestorm with the industry raising lobbying efforts to bring the Republicans back in the White House in 2016. Cable and Telecom companies are already among the most entrenched companies in Washington, with the likes of Comcast, AT&T, and Verizon routinely making top lobbying spend lists (Exhibit 14-15). We would expect a Republican led Congress to push new telecom regulations revising the FCC’s authority and reversing a reclassification. Reclassifying broadband under Title II would most certainly benefit Internet companies like GOOG, FB, and NFLX as well as the secondary wireless carriers: S/TMUS, which do not offer fixed broadband services. But less than vigilant regulation could allow egregious behavior and doesn’t solve for the real problem, which is a lack of competition.

Exh 15: 2013 Lobbying Spend by Cable and Telecom Interests

The second option is to issue more rules rather than reclassify, perhaps engaging industry leaders to self regulate rather than face Title II reclassification. This approach runs the risk of giving insufficient rein to exercises of market power, requires the FCC to anticipate and codify standards of behavior in advance, and is still vulnerable to court challenge. Essentially, this would likely yield status quo, with carriers constantly testing the limits of public perception and lobbying legislators for greater freedoms, doing nothing to promote competition and paring back only the most egregious displays of their monopoly power. Broadband prices would continue to rise and investment would continue to lag.

Based on the comments of industry and political players, the most likely option may be reclassifying broadband under Title II but carving out significant forbearances from the full set of regulatory implications for the newly designated “common carriers”. Operators would have concerns that the commission would have an easier path to applying those onerous conditions in the future – perhaps stepping in to squelch price hikes or opening the set-top-box to competitive video services. For Wheeler, such an approach would establish a regulatory framework for “non-discrimination” rules protecting consumer access to internet content on the most firm legal footing, although litigation over any decision appears inevitable. Investors would likely see the risk to the long term thesis of unfettered growth in the profitability of broadband.

But what about competition?

Yet no option on the table addresses the real problem in broadband, which is a lack of competition. From a practical standpoint, it is difficult to enforce or create competition in fixed wired internet in an economically feasible manner. European regulators have had success with unbundling, with virtual network operators leasing the regulated telco’s physical network at a regulated wholesale price and using it to offer a competitive service to consumers. This is impractical in the US, where the dominant broadband architecture, cable modem, relies on households sharing capacity with 200-500 other customers on the same distribution loop (Exhibit 16).

Exh 16: DOCSIS 3.0 Wideband with Channel Bonding and Examples of Shared Data Rates Supported

Google and others have found some success in building fiber-based competitive networks, with successful initial builds in Kansas City and Austin delivering the best price/performance broadband in the country and forcing incumbents to upgrade service and lower prices. While Google has reported adequate returns for these overbuilds, the hurdles to using this approach for more than a tiny portion of US households are prodigious. The capital costs likely restrict overbuilds to service areas with relatively high population density and attractive user demographics. We also note that Google has had the advantage of highly motivated municipal governments, who have fast tracked issuance of franchise rights, rights of way, construction permits, etc., and who have not imposed significant fees. In less friendly jurisdictions, local red tape would add time and money to such projects.

The most practical approach to solving the lack of broadband competition is high speed fixed wireless broadband, which is already in limited deployment in some areas. New technologies like carrier aggregation, enhanced multiple antennas (MIMO), and small cells are poised to increase capacity enabling speeds that rival fiber. Qualcomm, Ericsson, and Australian carrier Telstra achieved 450Mbps speeds over 60 MHz of spectrum last month, in a test of the LTE-Advanced release 12 forthcoming in 2015 (Exhibit 17). The 3GPP organization, which has responsibility for driving wireless standards forward, releases major new specifications every two years, with release 13 already under development even as release 12 comes to market. Release 13 promises faster speeds, applicability to broader ranges of spectrum, tighter integration with WiFi, and, importantly, lower network costs. Today, per cell capacity constraints and network costs leave fixed wireless broadband only viable for sparsely populated geographies, but this is NOT a permanent circumstance. With spectrum efficiencies higher and new spectrum enabled, per cell capacity should increase by at least a factor of 10 in the next release, while per cell capital and operating costs could be cut in half. If true, wireless broadband competitive in all but the densest urban environments should be available by the end of the decade.

Exh 17: Wireless Data Standards Release Timelines by Technology

Moreover, wireless operators will have the advantage of easy cherrypicking – selectively deploying high-capacity base stations to serve large and attractive clusters of potential subscribers. While a wired competitor must specifically choose to invest and roll-out on a street by street basis, a wireless operator addresses every household within reach of its signal as soon as it turns up a site. This is a substantial boon to spectrum holders, like Sprint or Charlie Ergen’s Dish Network, who need not bear the expense of exhaustive investment in unbroken coverage.

Who Wins?

With an FCC ruling on the horizon, those in Washington policy circles now seem to expect that Wheeler will proceed with reclassification of broadband under Title II, as public comment supporting the concept of net neutrality has been overwhelmingly strong and the risk of legal challenges to rulemaking under other provisions of the commission’s charter is too great. While a reclassification would undoubtedly come with specific forbearances in the application of Title II status to broadband, such as a refusal to set strict price controls, a waiver of commission approval for capital investment plans and a disavowal of universal service fees and obligations. Still, the specter of future application of these and other potentially onerous provisions would likely be enough to temper cable industry plans for aggressive consumer pricing and hardball negotiations for back-end fees from internet content providers. We also note that the conditions driving the FCC toward Title II reclassification are also bad news for the Comcast/Time Warner Cable merger that is now under review, and we expect the deal to be rejected.

This is not the outcome that investors have been expecting, and despite the likely caveat, the legal challenges and the potential of legislative action in the supposedly cable-friendly congress, it would be a serious negative catalyst for the stocks. We would be sellers of CMCSA, TWC, CHTR, CVC and other cable names ahead of this potential. We would also be sellers of T and VZ, which would also face regulation of their broadband offerings and which also face growing competition in their bread and butter wireless franchises. We believe that the shift in wireless from voice to data has eroded the natural advantages inherent in the two market leaders’ spectrum holdings, yielding an opportunity that at least TMUS has leapt forward to attack. Technology developments will lower the cost of competition for the secondary players, including S, while driving them toward future network standards that will be able to play seriously for residential broadband. As such, we favor spectrum holders like TMUS, S, and DISH, and wireless innovators like QCOM.

Finally, regulation of broadband is an unequivocal plus for companies providing streaming media services over the internet, such as NFLX, AMZN and GOOG. We believe that these and other players will siphon eyeballs and advertising dollars away from traditional channelized TV networks, which have benefitted greatly from the cable industry domination of broadband.

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