The Investment Incentive Problem

Do monopolies lack an incentive to invest? I suppose they did in the ‘old world’, where business was guaranteed and a government-based owner didn’t care much about maximizing value.

However, things are different in today’s telco marketplace. Governments have largely backed out and the market has taken over. Monopolies are on the brink of extinction. Add to that the natural monopoly of fiber (which gets to be pushed deeper into networks everyday, until we will finally end up at homes (FTTH) and businesses (FTTB) networks) and the rise of IP (which is indifferent to whatever is inside a packet, be it voice, video or data), and what do we get?

Exactly, new monopolies of all-IP, all-fiber networks – whoever may own them.

Now, does the investment incentive problem still exist? I believe not, as long as owners are sensible and try to maximize the value.

Maximizing value in the first place means, quite simply, maximizing sales and thus the number of clients. This entails the end of the retail/wholesale dichotomy and an appreciation of doing business on the wholesale level, as I have stressed before. Competitors should now be looked upon as partners and clients too.

Of course, investing can also have a different purpose: cutting costs in the long run. This is why investing in NGNs and NGAs makes perfect sense.

Attracting wholesale clients entails expanding your portfolio of services, which implies investing in every aspect of your business. Different wholesale clients will focus on different market segments (which at the same time relieves your retail division of marketing to all those different niches), each demanding a different portfolio of services.

It also entails entering adjacent markets. Take a look at utility companies building BPL networks (run by third party service providers) to capture a piece of the broadband market, but also to cut costs (using the network for monitoring services).

In a word, ‘sweat your assets’, as Telefonica’s Santiago Fernández so eloquently put it.

This reasoning is why I keep being surprised when I read about incumbents claiming that (structural) separation would take away the incentive to invest. Which by the way seems to be the conventional wisdom. In the wake of the new EC regulations, telcos like France Telecom (c. 30% state-owned) and Belgacom (53% state-owned) have been making such statements. No Telco 2.0 points for them, I presume.

(PS: BT is quite explicit over their separation costs. Would it be a weird idea to allow incumbents to pass on any separation cost to the government?)

KPN: away from network ownership and toward FTTH

Today I had the honor to meet with Joost Farwerck, director of Wholesale and Operations at KPN. Most striking were unequivocal belief in FTTH ('the endgame', as I have referred to it before) and an apparent decline in interest in being a network operator.
Joost very tellingly was able to see me in between a trip to Australia and New Zealand and a meeting with bbned (Telecom Italia).

Here are my edited notes.

1. All-IP

• KPN is planning the migration to an NGN, as I have written about before. Many MDF locations, LLU and ADSL2+ will be phased out and replaced by SDF locations, SLU and VDSL2. Fiber will be pushed deeper into the network, to reach all the way to 28k street cabinets (FTTC) and bypassing 1300 MDF locations. No FTTH as yet, only in greenfields and selected towns (Enschede and Almere).
• Currently, details of an MoU are worked out. The MoU was signed over the summer by both KPN and the main unbundlers (bbned, Tele2 and Orange). The new agreement is to be published around December 15. The details are about phasing out the MDF locations, the migration and KPN will present an alternative to line sharing (this product is on the way out anyway, as it is replaced by full LLU). Apparently, street cabinets offer enough space for SLU. Bbned is going the way of SLU.

2. Network operator v. service operator

• KPN believes WBA (wholesale broadband access) is a good product that will ensure competition, based on equivalent access.
• Joost seems to think that OPTA nor the new EU regulations, will lead to functional separation. I think KPN is a case in point where proper accounting separation and a good wholesale strategy + portfolio can fend off functional separation.
• By the way, accordin g to Joost, a wholesale customer can be more valuable than a low-end retail client.
• Outsourcing is becoming a major part of KPN's strategy. At Joost's division up to 50% of current employment levels will disappear.
• Joost seems to be much more of a services man than a network operator. I have noticed this before at both Tiscali and Telecom New Zealand. Network control is less important in a regulated all-IP world.

3. Co-op

• I am a big fan of cooperation. So is Joost, but challengers seem to think differently. KPN tried to team with Tele2/Versatel several years ago, but was turned down. Also, unbundlers are sub-scale in many cases, but (foreign) owners appear to be 'believers', as Joost put is. They all seem to think that they can make it work on their own. Too bad that there are few G9 (Australia) type of intitiatives.
• Joost seems to be similarly at a loss when it comes to long-term commitment of the large Dutch unbundlers. Tele2 is selling off many assets; T-Mobile may sell on the Orange BB unit; Telecom Italia may get rid of bbned.

4. FTTH

• "FTTH is the endgame". I couldn't agree more.
• However, VDSL gets deployed 5-7 times faster (and is written-off in 3-4 years), so it cannot be skipped. Here Joost is very much on the same track as Belgacom.
• KPN recently teamed with 'public enemy #1', Reggefiber, for the city of Almere. Joost told me they will own the passive infrastructure together (I was under the impression it would be 100% Reggefiber); KPN will serve as network operator; KPN (and others, if they wish) will be service provider.
• KPN beefed up its Belgian mobile operator by acquiring Tele2 Belgium. That obviously begs the question: will E-Plus make a similar move in Germany? Joost seems to see better business opportunities for some German expansion (out of the Netherlands), e.g. to the Ruhr area, than for doing FTTH in some rural Dutch areas.

Whither Orange NL's broadband unit?

When France Telecom finally sold its Orange NL unit to T-Mobile NL, the focus was on the mobile unit. Deutsche Telekom will, over the next few months, decide what to do with the broadband unit (the former Wanadoo NL, an unbundler).

Here are the possible outcomes I envision:

• Hang on to it. T-Mobile could kick-off a major strategy shift, away from being a mobile pure-play and go the way of Orange and Vodafone. Not impossible, but highly unlikely, I believe.
• Sell it to KPN or Vodafone. That's a double no. KPN has reached the limits of its market share, and Vodafone has just launched a complicated resale arrangement with the former Tiscali NL (now part of KPN). Also, T-Mobile wouldn't want to strengthen a competitor!
• Sell it to another unbundler, i.e. Tele2 or Telecom Italia's bbned. Why not. In time, it could be a way for cooperation between T-Mobile and the buyer of the Orange BB unit. Also, Tele2 is selling lots of assets (Denmark, Portugal, Hungary, Italy, Spain, Austria), and in the meantime focuses on other regions (Scandinavia, Baltics, Russia). It will be interesting to see if Tele2 is really committed to the Netherlands, where consolidation is making the market a lot more attractive. Sort of the same goes for bbned. Or is Telecom Italia only readying the unit for a sale, by beefing it up first?
• Sell it to Reggefiber. Unlikely, since Reggefiber focuses on building infrastructure (FTTH), and it doesn't seem to have access to unlimited cash. However, the argument could be: add a service provider business and in due course migrate the customers to the Reggefiber network (where possible).
• Sell to a new entrant. A wild card. Maybe Telefonica is willing to do a relatively small deal, since it turned away from larger ones. Also, Belgacom could be a candidate (as I have hinted at before).

So, my order of likelihood would be:

1. Sell to Tele2 or bbned (TI).
2. Hang on to it.
3. Sell to a new entrant like Telefonica or Belgacom.
4. Sell to Vodafone, Reggefiber or KPN.

Telcos should embrace the wholesale market

Yesterday I had a short meeting with an industry executive in my hometown Utrecht. Another very valuable meeting - by way of reality check.

We mainly discussed two topics.


1. Wholesale

I think of wholesale as a very attractive business. Obviously, there is a strong connection to the separation stance.
In the old days, incumbents like KPN instructed managers pretty explicitly to frustrate their wholesale clients. Even today, Deutsche Telekom thinks it can only recoup their FTTN/VDSL investments by demanding a regulatory holiday, effectively allowing its retail organisation sole access.
Now, this is all reversing – maybe not at DT but I do think at KPN (a finalist for Light Reading’s Awards). More incumbents acknowledge that independent service providers (let’s call them BSPs) have something to add – things that are not in the incumbents’ DNA. Think innovation. Also, marketing to specific niches can handily be left to focused BSPs.

Linked to this is the telco stance that the investment incentive supposedly disappears when full (structural or ownership) separation is forced upon the company by the regulator. Again, I do not see this. Extending the portfolio, and opening the platform to third-party developers, looks like a sound business strategy to me. It will attract BSPs large and small. Sure, investing carries risk, but that’s part of doing business, isn't it?

Speaking of which – applications. Please allow me to wander off for a moment. I have been putting together a very short overview.

Fixed
Back in April, BT took the lead by restructuring and establishing a BT Design and BT Operate unit, granting developers access plus a SDK. AT&T may be planning a similar move.

IPTV
See my post on Orca Interactive and SeaChange. IPTV seems to me the one area that could benefit most from adding apps, in order to strengthen the telco vis-a-vis
the cableco or satco.

Internet
Facebook did very well, allowing third-party developers access to the APIs, even if monetization is not quite so easy. In any case, the apps worked well for the valuation of Facebook.
Yahoo! may follow.

Mobile
Motorola launched a ‘solutions Catalog’ into beta to invite third-party developers.

2. KPN

Few will contest the strategic logic of the string of acquisitions (Telfort, Tiscali NL, Getronics, iBasis, etc.) by the Dutch incumbent, KPN. Right now, it looks like brand rationalisation will happen, but what does that mean when the company has a multi-brand strategy?
Of the above takeovers, obviously Tiscali is the one that will have to return its brand to the mothership in Italy. Normally, they would probably have 36 months or so. After that, I think KPN will revert to one of the existing brands. I guess XS4ALL, the premium brand, could be a candidate.

So, which holes are left in the KPN portfolio? After the Tele2 Belgium deal (which effectively precludes a Belgacom merger), KPN may shift its attention to Germany. I think E-Plus will be beefed up by an LLU operator. Some are not for sale (subsidiaries of Vodafone, Telefonica and Telecom Italia), many others probably lack sufficient network coverage. What’s left is Versatel Germany or QSC. The latter has a wholesale business only, so combining it with E-Plus may not be a bad idea at all.

Finally, for my readers at Belgacom – check out this Trouw article (in Dutch) on Reggefiber, the stealth FTTH builder in the Netherlands. Get back at those KPN guys who bought Tele2 Belgium, and enter the Netherlands by buying Reggefiber!
Some will argue that owning an (open access) network is at the lower end of the value chain, but I believe it can produce great returns, especially since a FTTH network is future proof. Granting independent BSPs open access not only allows you into the wholesale market, it will keep the regulator happy too. Furthermore, you can always start or buy your own retail organisation!

UPDATE (thanks Dirk 'FTTH' van der Woude: "It's been quite a while since I last reported something remarkable from the Netherlands, but I think this falls in that category.")
Reggefiber and KPN are teaming up in Almere, reports Trouw. That adds a twist to any Belgacom/Reggefiber speculation. Of course, all we need is a single FTTH network. KPN and Belgacom could dump all their FTTH assets into a Reggefiber Joint Venture and turn into service providers.
Here is an English translation of the Vincent Dekker story (translated by Vincent himself):

KPN has decided to join forces with Reggefiber to speed up the roll out of FTTH in Almere, the fifth largest city in The Netherlands. Reggefiber already owns some networks in smaller towns and in parts of cities, like the project in Amsterdam. This time they will build a network for the whole of Almere. KPN will deliver services on that network. It will bean open network though, so KPN will have no monopoly on it.
Then why would KPN do this? Well, I'm not sure, but it looks as if KPN has no other options. KPN is losing customers in great numbers to the TV-cable networks nowadays. These networks can offer full triple play, whereas KPN kan only deliver ADSL and telephony on its network. IPTV is not a success as yet. And its Digitenne (DVB-T) is also not good enough to really compete with the cablecos. KPN has a plan to roll out All-IP in the next 4 years, which is fiber to the street cabinets and old copper from there to the homes, but this VDSL will also not be good enough to protect marketshare.
So KPN needs FTTH badly. In Almere Reggefiber was already chosen to build the FTTH network and now KPN has decided to join forces with Reggefiber. It will encourage its customers to switch from the KPN POTS network to the fiber network. That should make the new network profitable in a very short time. On that network it will most probably not only offer very fast internet (100/100 to start with) and cheap IP telephony, but also DVD-quality analog video and digital hdtv. With that offering people might be persuaded not to switch to the cable company and even drop that cablecompany for their tv-service. In the Netherlands some 90 percent of all homes now still get TV via cable, the rest via satellite and a few percent via Digitenne.
KPN will keep its POTS network alive for the time being, but that can't last very long. So in a few years this incumbent will no longer own a network that covers the whole of the country. My guess is that Almere could very well be the start of much more cooperation between Reggefiber and KPN in other parts of the Netherlands, Amsterdam and other big cites to start with. KPN needs a network to compete witch cable, and it needs it fast. The news of todaycould therefore be good news for everybody in The Netherlands: the start of a national FTTH network at last. We're a few years behind Japan and quite a few other countries already, so it certainly is not too soon...
Almere is an interesting city for FTTH. The cable company there is UPC, owned by Liberty Global of John Malone. If Almere will show the same pattern as seen in other towns where Reggefiber already has fibernetworks, UPC can expect to lose some 70 percent of its customers in the next 2.5 years. After Amsterdam and Rotterdam Almere is UPC’s biggest market. So losing most of its customer there will hurt. And ater Almere, Amsterdam or Rotterdam could be next on the agenda of Reggefiber and KPN.
KPN has decided its POTS network in Almere has only marginal residual value. That's one message we got today. How long will it take before cable companies will admit that this is true for their network too?

How to prepare the investment community for FTTH

Yesterday I met with an executive of a leading European telco. He invited me to exchange views. For me, these are always excellent opportunities for some reality checking.
FTTH once more demanded most of our attention. As I see it, telcos are trying to pursuade the investment community to get to grips with it.
Below are my take-aways.

1. VDSL
My companion strongly believes in the viability of VDSL, mainly because FTTH embodies a difficult business case, but also because FTTH simply cannot be rolled-out quickly enough.

Being a member of the Smiling Fiber gang, I of course have no doubts as to the demand side of the equation. FTTH is the end game. Moreover, a back-of-the-envelope calculation shows that you need at least something like 30 Mbps in the mid term (to support several HD TV sets, BB and voice). In order to guarantee this kind of bandwidth, you really need peak performances of around 100 Mbps. QED. (Buffering a few seconds will also go a long way in raising QoS.)

As to the roll-out speed, I suppose telcos do have a point when they install VDSL – for the interim. Look at Verizon: most of the FiOS assets are built in greenfieldish places, which leaves the company extremely vulnerable in places like Manhattan, where Cablevison (Optimum) et al are upgrading. Who knows how many years before Verizon starts digging up those streets of Manhattan (the potholes could come in handy).


2. FTTH
As I have noted before, no matter what telcos say in public, they are all aware of the necessity to move to FTTH, even if this may be some years away.

Public telcos are very much aware of investor focus on FCF and concern over FTTH. However, I see them working on multiple fronts subtly preparing the investment community for the big leap into fiber. PR-related strategies include:

• Stress the reality of fiber today. Thousands of miles are fiberized already, ‘only’ the local loop remains.
• Talk about greenfields. Both KPN and BT say they will roll-out to new boroughs. Now I happen to live in a big new housing development area (no crisis here), but what I have is … copper. A friend of mine who has recently moved into this area (see Map to the right) hasn’t had her home connected yet, but I am pretty sure it will be copper. In other words, committing to greenfields must be taken with a grain of salt but it is great PR.
• Acknowledge the benefits. Capex may be high, but opex will drop dramatically. And superior services can be delivered.
• Point to international developments. Not only PTT-like companies (Verizon, NTT, KT, Telekom Slovenije), but altnets as well (Iliad, Neuf Cegetel, SoftBank, Orange Slovensko), and even MSOs (Numericable, a Japanese co-op).
• Drive the costs down. Verizon publishes decreasing costs for both passing and connecting homes, benefitting from its scale. Mergers will generate some economies of scale. Further, choose point-to-multipoint (sharing a fiber strand) PON technology (however, sharing fiber up to the OLT location may not be sufficient in the longer term, so you may prefer active ethernet over dedicated fiber all the way to the ONT). Also, make sure you have a sound in-home strategy ready, in order to avoid a costly addition to your opex. There is a variety of wired (HomePNA, MoCA, HomePlug for using copper, coax, PLC) and wireless (WiFi 802.11n Draft 2.0, WiMedia UWB) standards available.
• Try to get state subsidies. This strategy worked well in Korea. Point to the economic and social benefits of a FTTH network.
• Wait until greenfield (and other) FTTH build-outs represent let’s say 5% of your access lines. That will be the time to say: “We are at 5% already, and these homes have double the ARPU and a tenth of the churn of the copper base. And you didn’t even see our FCF suffer!”

3. Separation
We disagreed over the issue of investment incentives. Conventional wisdom is that full separation is, if not unnecessary, expensive and bad for network investments. It is supposed to take away any incentive for the NetCo to invest.

Personally, I do not quite see this. In my view, the NetCo would do wise by investing for the long term, enabling it to offer an extensive portfolio to its (wholesale) customers. Of course, there are the usual investment uncertainties; who could guarantee take-up of your shiny services? But I believe this can be dealt with. There are many new services waiting to be (built or) expanded, including monitoring, eHealth, video telephony, home access to corporate VPNs, etc.


4. Consolidation
We briefly spoke about KPN, and its Telfort, Getronics and Tele2 Belgium deals.

After our meeting was over, I got the idea for the perfect answer for Belgacom. If KPN are not stearing toward a merger with their Belgian counterpart and instead go for head-to-head competition, why not make some acquisitions in Holland? (Not unlike Swisscom buying FastWeb).
Tele2 seems to be committed to the Netherlands (a large scale ad campaign has started in relation to its 10th anniversary), DT is buying Orange NL (but may sell-on the former Wanadoo LLU assets to Tele2, bbned, Scarlet or Vodafone) and even bbned (Telecom Italia) is here to stay (it has just started a campaign for the Alice brand, which is new to Holland).
So what is left? Reggefiber! Perhaps Dik Wessels is ready to sell out of this FTTH vehicle, and with Belgacom funding roll-out could be accelerated. Reggefiber appears to be a very disciplined company, which is making a success out of FTTH. In addition, it would be a nice testing ground for Belgacom.

REGULATION://Extending fiber deeper into the network challenges LLU

Deutsche Telekom is switching back to ADSL2+, apparently to have wider coverage for IPTV (T-Home). VDSL roll-out is haulted and stays at 10 cities (original target: 50).

Big changes are ahead in the European telecom sector. DT cites regulatory uncertainty for haulting the VDSL deployments.

Upgrades to ADSL2+ left the competitive landscape, based on LLU, unchanged, but VDSL and FTTH have created different environments. I believe Europe will support the survival of 'inter-copper' competition, but now it has to come up with an alternative to LLU. This is a hot topic in Germany, but even more so in the Netherlands, where OPTA has to come up with a fully-fledged alternative to LLU. Watch out for this to happen in Q2. OPTA will host an analyst meeting in The Hague next Friday (Jan 19).

So now operators have a choice:

• ADSL2+, with fiber not extending beyond the exchange. This is the case at BT, which sees no business case for FTTN/FTTC, let alone FTTH. This makes the UK an attractive market for LLU-based competition.
• FTTN + VDSL: KPN, Belgacom, DT (now haulted), TI. This renders LLU-based competition quite uncertain at the moment. Will regulaors find a fully-fledged alternative, and/or will altnets be prepared to step up their investment program to keep track with the incumbent?
• FTTH: FT (at least partly, further decisions in 2008). FT is responding to both Iliad and neuf cegetel (and Verizon), by making the network future-proof.
• A mixture of all: Most notably at Swisscom and Telefonica, but I suppose in many other countries too. FTTH is probably pretty common now for new builds.