Empowering the Customer or
Empowering the Telco
State of the Internet 2002: Assessing the Technical, Economic and
Policy Consequences Behind the Collapse of 2001
In its examination of the impact of Internet technology on global
telecommunications during 2001, this report will bring into focus
changes that are reshaping one of the world's largest and most
critical industries in ways unforeseen only a year ago. Neither the
Internet nor the phone companies are going away. However, while
technology continues to reshape possibilities for industry markets,
it is having economic impacts in 2002 that will increase the risks
and opportunities for informed managers, financial planners and
policy makers.
As the reverberations from the collision of the tectonic plates of
Internet and "telco" seek to establish some new equilibrium, the
architecture of the Internet is shifting and becoming more complex.
Issues of control seem more and more important. To the extent that a
nethead versus bellhead philosophy is still meaningful the difference
between the two is reflected less in the technology being used and
more in ideas about where control is to be located.
Trends: Technology and Economics
The most significant technology trend that we see is one that will
present managers, investors and policy makers with a choice pointed
out by the title of this report. Empower the user. Or empower the
telco. Choices are being made. The technologists are driving
control of lambdas into the hands of end users. Peer-to-peer, as
software and infrastructure, is enabling the formation of communities
of users at the network's edges. Here the goal is generally to make
the center and anything associated with it disappear. Huge fortunes
are being wagered on the web based client server model. The bell
heads and walled garden guardians may find out too late that their
centralized content control model is not the only way to do business.
The impact of technology on network architecture will be the most
important trend to watch in 2002.
But, as many have found out to their dismay, we can no longer make
intelligent decisions in telecommunications absent a thorough
understanding of the industry's economic picture. Indeed analysis of
technology trends done without understand of their economic impact,
are, in this climate, of limited use. Therefore, the remainder of
this summary will turn to economic issues.
The COOK Report started publication a decade ago as the Internet was
in its early stages of commercialization. Ten years and a trillion
dollars in global investment later we have witnessed dramatic changes
in global telecommunications. But what we have now is not what any
reasonable person would call "success." The old technology did not
collapse under the onslaught of a triumphant new global packet
network bringing vast amounts of inexpensive bandwidth to every home
and business.
One reason it did not was that the technologists were so certain of
the superiority of their product and were so good at driving the hype
that got them their early stage capital investment they were able to
sail forward without a long term viable business model for what they
were doing. Build it and you will be saved - somehow. The
provisioning of vast amounts of cheap bandwidth was seen as a
sustainable business model for the Internet.
The problem is that ten years on the bandwidth business model has not
proven to be a viable one. The question is whether bandwidth is
something on which a business model can be built? Or is bandwidth,
like a highway, just an enabler? We started out a decade ago talking
about the information super highway and then proceeded to try to
build multiple global privatized versions. Imagine if Ford had spent
tens of billions building a global interstate for its cars. While
GM. Daimler-Chrysler and Honda and Toyota had each done the same
thing. What has been built are highways with largely identical
performance and capable of huge indiscriminate through-put of
"vehicles" or packets. They have lead to an unsustainable business
model. "Become a customer of my commodity system." "No. Not his.
Mine. I just doubled the speed and I will sell you access for 20%
less. I only had to borrow another billion dollars against my non
existent profits." Yes we have a train wreck. Any wonder?
But remember after all the investors were being sold a product that
moved at 'Internet speed' and hyped as a global, winner-take-all,
economy-of-scale, build out where one year in Internet time was said
to equal seven ordinary years and where there would be a 'winner"
with first mover advantage. The new Internet world was hyped as one
where regulation was unneeded because it would slow the rate of
adoption of the new technology.
Consequently, all the big players operated in their own informational
vacuums. Through an informal old boy-girl network, they
interconnected where necessary and as fast as they could spend their
capital. They built global commodity systems frosted with a whiff of
secret sauce that alleged that one system was better than another.
"Trust us," they said as they continued to run full tilt ahead. The
trust that was granted is coming back to haunt us.
Just within the past week we are seeing evidence of a new and
potentially very disturbing basket of problems generated by the all
the hype about the technology that applied Moore's Law to
telecommunications for the first time. We have been spending much of
the past month talking with folk from the financial analyst
community. We heard concerns expressed about sales of 20 year IRUs
on dark fiber among Enron and the other large new global Greenfield
fiber network players. It was asserted that it looked as though
income from the IRU was booked up front at the time of the sale with
the IRU on the same fiber then being resold by the purchaser to
another party so that income from the resale could again be booked as
profit. We asked where we could find some documentation on this and
were told that there wasn't much. That the information had been
gleaned primarily from listening to quarterly phone briefings of
analysts by management.
But suddenly the situation changed. On January 1, 2002 the
Washington Post published a confirming story by Peter Behr. The
headline: Broadband strategy plunged Enron into trouble. Behr
wrote: "Enron's recent financial disclosures show that its claims of
success in broadband included large gains from trades with private
partnerships it had set up itself. And using aggressive accounting
practices, it assigned exaggerated values to the broadband contracts
it traded with others in the industry, greatly inflating its actual
revenue and profit, Enron insiders and analysts say." [Snip]
"The [profit] margins were whatever they decided,'' said a former
Enron vice president familiar with the broadband trading, who spoke
on the condition of anonymity. In many instances ''they were trading
with themselves,'' he said. As prices for fiber-optic circuits
plummeted, Enron tried and failed to lure telecom giants that used
broadband - such as MCI WorldCom Inc. and Verizon Communications Inc.
- to trade with it and create a true market. Carol Coale, an analyst
at Prudential Securities who heard Enron's repeated claims that its
trading operations were growing rapidly, said: ''These guys were
great spin doctors. They had the answers. The answers were lies.''
http://www.washingtonpost.com/wp-dyn/articles/A46876-2001Dec31.html
The entire article is well worth reading. As the self regulated
industry had been saying: "trust us."
So What Were We Trusting?
The "stupid network," taken as a concept, captured important
differences in the operation of the new Internet companies while it
ignored the huge revenues and deeper pockets of the old line telcos.
It was propelled by a reality defying arrogance that allowed a Bill
Schraeder to build a global company with a billion dollars a year in
revenues in a matter of months and then bankrupt it in a matter of a
few more months. Remarkably, we are now - a year after the train
wreck began - watching a growing string of bankrupt or soon to be
bankrupt global super highway builders. The fall out has left the
infrastructure industries that they depend on paralyzed, seen the
loss of trillions in market value, hundreds of thousands unemployed
in the midst of a global recession and left policy makers with no
creative idea of what to do. We are marching toward a denouement
designed to allow the ILECs to try to be the last ones standing by
allowing them to use their control over the "last mile" to
re-monopolize service. This after all, is what the "free market" has
given us. We owe the great boom of the last 20 years to our faith in
the free market so if we just hang on a while longer someone or
something will save us. Indications that the new technology may also
bankrupt the ILECs are not yet on the radar screens of most analysts.
This leaves us in a strange situation. One where we are so smart
that we can shove billions more photons down the same thread of glass
this year than we could last year. But it is also one where we are
also so ideologically blinded that we remain wedded to the building
and maintenance of multiple privately owned systems when experience
now shows us that there is no business model that can pay for
multiple competing privately owned commodity systems.
A dozen years ago we created a Federal corporation to clean up the
savings and loan fiasco. But in 2002, with a critical global
industry on edge, no one can see a large enough picture to understand
what to do. If local and national governments are a public good, and
if a freely accessible global commons of locally built highway
systems maintained from business and user taxes is also a public
good, perhaps the only feasible foundation on which to restructure
telecommunications is a nationally maintained blanket of
publicly-owned glass threads.
Asking about the Internet's business model is like asking about the
Interstate Highway System's business model. Who owns it? Who
controls it? And to whose advantage is it used? How are Ford's
interstates better than those of GM?
[Two paragraphs SNIPPED]
Roxane Googin, Editor of the High Tech Observer, in a short essay in
David Isenberg's Smart Letter 64 has captured the essential problem:
"But even though the attackers are starving, they are forcing
marginal bandwidth prices below the ILEC's cost of provisioning --
not only replacement but also provisioning. So the ILECs are going
to get squeezed because they have this complex, labor-intensive
infrastructure that is no longer supported by a viable economic base."
"In this kind of nightmare scenario, nobody wins. It is just a big
mess because the attackers are [also] going under. Meanwhile, they
have crippled the incumbents. We are witnessing the perfectly
predictable outcome of this process: no equipment sales, and no more
progress." [Snip] "So we have to fix the problem. This means
restructuring the debt and owning up to what the real issues are.
This owning-up hasn't been done yet."
"Then we have to reallocate the assets to the right parties.
Unfortunately some markets don't behave in a traditional market way.
Typically common-good markets, like transportation systems, tend to
be regulated markets, because the capital outlay upfront is
associated with an unknown return in the future. This regulation is
rather contentious, whether it is the old telecom, the airlines, or
even trucking. There are just some markets that don't behave well,
and I'm afraid that this is one of them. So we have a lot to think
about."
"Time is of the essence. The reason that we are in this downward
spiral is because telecom is draining the vitality of the entire
economy. On the margin, this is where our last decade of growth came
from, and now it has stopped. It would be helpful if policy-makers
knew the problem from this perspective."
We think Googin's analysis is correct and we will soon publish a
detailed interview with her showing why. Interviewing her has led us
to wonder if the technology analysts ever talk with the financial
analysts? For years, from the technology side of the fence, we have
pointed out what others have said about how the decreasing costs of
the Internet Protocol and fiber based technologies mean the "end" of
the traditional telco. The conventional wisdom was that the next
generation telco's would succeed and absorb the old circuit-switched
incumbent local exchange carriers. It is beginning to look like the
opposite is true. Furthermore, if Roxane Googin is correct, the
carnage won't stop with the bankruptcy of the next gen companies but
will spread to the incumbent local carriers themselves. This is what
we mean when we suggest that the Internet has yet to find a
successful business model where it can deliver to our homes and
businesses low cost bandwidth as an enabling technology without
destroying the global telecommunications industry on which it depends.
In our coverage in 2002 we shall look in detail at what Roxane Googin
is saying about the phone companies. Here is a summary of her
analysis.
Why the ILECs Are in Trouble as Data Grows and Voice Shrinks
While the general perception is that an over supply of dark fiber is
driving bandwidth prices down to the detriment of everyone, reality
is a little bit more complex. The costs of lighting that fiber are
very large. Considering the ILEC investment in SONET, the costs for
them to light new fiber are so significant that a recent article in
Light Reading pointed out that it is becoming cheaper for them to buy
a lightwave from another carrier's lit fiber than to light their own.
The point is that all the way up and down the circuit switched telco
food chain carriers without the expenses of the first generation
SONET infrastructures are able to sell bandwidth at less than the
ILEC's cost of production.
A major problem of the ILEC is its huge investment in SONET based
networks that bit-for-bit are not as competitive with what can be
delivered by the newer players that have built IP based networks that
rely on newer, cheaper SONET or on gigabit Ethernet and coarse wave
division multiplexing. But the ILECs are locked in with several
hundreds of billions of dollars worth of OSMINE compliant SONET
equipment that their balance sheets say they are amortizing at 25
plus years. As a result they have, and will have long into the
future, huge interest payments to meet. (Of course the new TCP/IP,
fiber based greenfield players are also heavily invested in SONET and
have themselves large interest payments due.)
The ILEC's ability to meet those payments is contingent on their
ability to continue to deliver profitable voice minutes. Given their
enormous investment in local plant and in the people needed to
maintain that plant, they need to protect, at any cost, their
installed base of voice traffic. For many years voice traffic has
been growing at a few percent a year and data traffic growing two to
three times as rapidly. While data traffic is now a majority on all
their networks, voice traffic still accounts for 80% of their income.
According to RHK revenue per megabit of voice is seven times that for
a T-1 (1.5 megabit) Internet connection. Clearly efficiencies in the
cost of production are to be found on the data side of the equation,
given the impact of both dense wave division multiplexing and the
efficiency of IP.
The voice minutes on which the ILECs and older carriers depend to pay
the costs of running their infrastructure on a month-to-month basis
are being siphoned away from the telco's SONET based networks. The
Internet has caused digital to be perceived as "cool." The ILECs
brag about their new digital infrastructures in their quarterly
reports. For example on November 5th 2001 BellSouth bragged that
over the preceding decade it had invested in "749 broadband
(ATM/Frame Relay) switches and 20,000 SONET rings in service in its
network." BellSouth "expects to end 2001 with approximately $4.5
billion in data revenues." It "projects to end 2002 with 22-25%
growth in network data revenues." But note that there is not a word
that we have been able to find in this ILEC statement or in any other
that data is profitable for them.
As Googin explains it: "while they tell us they get 80% of their
revenues from voice, they never say they get 80% of their profits
from voice. They simply do not tell us this information. Given that
data represents over 50% of their network traffic and about 20% of
their revenues, it is probably not profitable for them at all. They
therefore do get 80% of their revenues on under 50% of their traffic.
Since their network is monolithic, and largely of fixed cost, one can
assume that data runs at a loss."
The Data Voice Mix Begins to Change
In 2001 the trends in data growth that had long been forecast finally
began to hit home. Softswitch services pioneered by next gen
carriers like Level Three digitized vast amounts of voice traffic and
sent them over IP networks as data. Sky rocketing phone card sales
at less than two cents for a voice minute siphoned voice data from
ILEC networks. On December 14 in a promotional announcement from
Singapore for Cisco's voice-over-IP products Andrew Vlachiotis,
Director of New Technologies Group of Cisco quoted a study that
stated that for the first time since 1993, the Private Branch
Exchange (PBX) market has declined 16.2 percent in the second quarter
of 2000 from the same period in 1999. This is remarkable when
compared with 10-15 percent growth rates for the previous five years
according to Vlachiotis. [Editor: the fact that the timing of the
change may be Y2K related adds another lever of uncertainty into the
process of figuring out what these numbers really mean.] Furthermore,
as we have documented in the lead article of our November 2001 issue,
the release of Windows XP and the maturation of a whole family of SIP
based proxy servers has come together with Softswitch technologies to
enable the corporate PC to become a desktop voice phone. We are
beginning to witness what will become a flood of circuit switched
voice minutes exiting the ILEC's expensive networks. But these voice
minutes don't evaporate. What they do is become encapsulated inside
inexpensive IP data packets.
Sure enough, examination of ILEC quarterly reports shows that ILEC
voice minutes delivered starting with the June 2001 quarter have not
only turned flat but have actually started to DECLINE. Now if each
data minute brings in about one cent, each voice minute brings 7 to
ten cents in revenues. Since 80% of their income is from voice under
these conditions a 5% decrease in voice minutes could mean a 20%
decrease in revenues. The technology changes being brought on by IP
ALTERNATIVES to ILEC circuit switched SONET services are going to
deprive the ILECs of the income needed to operate their networks,
repay bondholders, and make a profit.
[Ten paragraphs SNIPPED]
Michael Powell utterly misses the point. Not only about size
enabling price reductions for, as the market consolidates into larger
players, the players are raising their prices. Powell also has no
clue about the technology cost changes that are now building. A year
from now his pronouncements on Internet broadband may seem like a
minor blip before the on-set of the whirlwind. Still, absent major
complaints from an educated public and from sectors of the telecom
industry that understand there will be no role for them if we allow
government to turn voice and data communication over to cash rich
Microsoft to charge whatever prices they can extort, we are headed
for ugly day of reckoning. As the current telcos fold what is not
yet clear is whether even Microsoft's $35 billion in cash will be
enough to pick up the pieces. Certainly it and Cisco (19 billion in
cash) can pick up a lot of the carnage. Others will no doubt step in
as well. Of course it is possible that the Feds may act in time to
"save" the ILECs.
What is clear is that our free market blinders, especially under
this Republican administration, will prolong the impact of the
collapse by destroying the last vestages of the public commons on
which the Internet was built. In doing so, it will ensure that the
ability of small companies to innovate instead of having to beg for
niche roles in the delivery of monopoly services is destroyed.
The COOK Report's On-Going Mission
Whatever happens, we shall follow, as they progress, the continuing
technology developments that are reshaping the global telecom
industry. By observing changes in the ability of users to implement
their own networks and architectures, we shall help readers identify
trends in the changing locus of power during a time of upheaval. By
watching the cash rich players develop new strategies and following
varied attempts to build alternative infrastructures, we identify
those who will likely be able to pick up the pieces. Finally, we
shall advocate a public policy that sees the Internet as a family of
enabling technologies rather that a means of more efficient
monopolies for distribution of content. In doing this, we hope to be
able to influence an increasing awareness that the quickest end to
the troubles of the industry will be found in a path that uses the
financial power of the government to create a new foundation that
will be open to innovators and not run solely to benefit a new set of
would be monopolists.
[ Final Three paragraphs SNIPPED]
Postscript: One fascinating and intuitively obvious solution was just
raised by Peter Cochrane, the former CTO of British Telecom in an
article Broadband Won't Happen by Accident. See the Canarie list on
12/30/:
http://www.canarie.ca/MLISTS/news2001/0228.html. Here Cochrane
suggests that as the ILECs collapse those who step into to pick up
the pieces could affordably run fiber to neighborhood POPs where
802.11b nodes could enable a wireless local loop.
For complete table of contents and ordering information for this 458
page report, point your browser at
http://cookreport.com/empowering.shtml
Gordon Cook, Editor and Publisher
January 6, 2002
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Empowering the Customer or Empowering the
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