Merger Mania and the Nature of Network Competition

by on February 16, 2005

There’s been a lot of hand-wringing going on in the media and in Washington this week over the announced mergers of SBC-AT&T and Verizon-MCI. The Chicken Little crowd is out in force with their claims that the sky is going to fall on consumers should these mergers go forward.

The problem here is that too many people are still thinking about telecommunications in 1980s terms. We still talk about “local” versus “long-distance” providers as if they are distinct sectors. This is just silly. We have been witnessing the rapid death of what we used to call the long-distance sector. The rise of the wireless industry long ago decimated the long-term viability of long-distance sector. Consumers have always desired simple, flat-rate pricing for all their communications services and that’s what wireless gives them. With everyone now thinking in terms of buckets of minutes, it was only a matter of time before long distance was shown the door by most customers.

And then came VoIP. It’s the final nail in the coffin of traditional long-distance service. (And maybe traditional local service as well). With wireless plans and VoIP out there now, there isn’t a youngster in America today who would ever think about signing up with AT&T or MCI for a long-distance voice plan. Most of them don’t even know what “long-distance” means. The very term is a relic of the regulatory past. Ask any teenager you meet if they can name a single friend who doesn’t currently carry a cell phone. Or try walking around a shopping mall these days without bumping into a teenager with a veritable Batman-belt full of mobile devices on their hips. That’s how much the world has changed, it’s just taking the older generation (and regulators) a long time to catch up.

OK, so you might agree with all of this but say “There’s just not enough competition out there if these mergers go forward.” More than a few lawmakers on Capitol Hill are already saying as much.

The problem with this thinking is that fails to understand the nature of competition in network industries. The economics of network industries are not those of a corner lemonade stand. We’re never going to have hundreds or even dozens of companies providing the underlying backbone over which bits of information travel. There are significant sunk costs associated with providing network services. Deploying all the wires alone is a nightmare, but just the cost of every truck roll to a neighborhood to fix tiny problems can get incredibly expensive. Wireless networks help lessen some of these costs, but its still costly to deploy a sophisticated and reliable wireless architecture. Just siting all the towers, for example, can get quite expensive.

The bottom line is this: The networking business is for big boys. REALLY big boys. And there are only going to be so many big boys that will ever be able to stick with it and turn a profit to be able to keep those networks functioning properly while also planning for future upgrades. We learned this lesson the hard way over the past decade as we witnessed the FCC conduct a grand experiment with infrastructure sharing in an effort to create more competition in the telecom business. The idea was simple: Let’s provide small telecom resellers every possible incentive to share the networks owned by incumbent telecom companies so that we can create the illusion of competition. It was obvious that this scheme was never going to produce any legitimate new network competitors, but what was so interesting about this misguided episode was that it didn’t even produce any reliable “fake” competitors either. The resellers that were given access to existing networks were never able to concoct a legitimate business model to convince investors (or even that many customers) that they were worthwhile investments. These resellers create networks built of paper instead of honest-to-God networks. As a result, almost all of them have gone under. Again, the hard lesson here was that the networking business is not a Mom-and-Pop operation.

THIS IS NOT TO SAY THAT THE NETWORKING BUSINESS IS A NATURAL MONOPOLY. Indeed, from everything we know today, we can safely conclude that the communications / broadband networking business can be very competitive with 2 or 3 or even 4 major backbone providers in each region providing some mix of voice, video and data services. If you don’t believe that, I encourage you to take a look at two articles in today’s papers. Today’s Wall Street Journal features a cover story entitled “To Meet the Threat From Cable, SBC Rushes to Offer TV Service,” which outlines the significant investments telecom giant SBC is making to become a full-fledged video competitor to cable and DBS. And then on page A5 of today’s Investors Business Daily you will find an article entitled “Comcast Counting on a Phone Pickup” discussing the efforts by the cable giant to become a major player in the telephone business.

No one knows how this battle will play out, but the important point is that you now have large telco and cable giants spending significant sums of money to compete in each other’s traditional lines of business as well as new businesses, such as broadband. (In my neighborhood of McLean, Virginia, my front yard has been ripped open three times in the past year–twice by Verizon and once by Cox cable–to lay new high-speed lines.) And this competition is slowly spreading to rural communities as well. Meanwhile, we’re still waiting to see how the wireless wars shake out. Very large wireless carries–both terrestrial and satellite-based–are making investments to provide more reliable high-speed networks. Finally, power companies continue to sit on the sidelines and slowly upgrade their networks to offer broadband connectivity. If these giants come off the bench and deploy legitimate high-speed services as part of your local bundle of energy services, everyone else listed above could be in real trouble. After all, power companies already have a wire into every home in America. If they can reconfigure their networks to make broadband work, and do it cheaply, things could get really exciting.

So what we’re talking about here is a 3- or 4-wire world in which one of those wires isn’t a wire at all but a wireless connection. (In fact, there could be multiple wireless options in the form of proprietary cellular networks, open wi-fi networks, or satellite links).

But that’s likely it. We’re not going to have 15 broadband providers in each community. For all the reasons stated above, we’re probably not even going to have 5. But that doesn’t make any difference because competition in a 3- or 4-wire world can, nonetheless, be incredibly intense. Still, many will persist an argue that that’s just not enough. We need more networks to have “real” competition they will say. But, again, the economics of networking will simply not allow it. There is just no way that more than a few providers of backbone services will be able to remain profitable in direct competition with each other. To amortize the sunk costs of network deployment, maintenance and upgrades, carriers need to have a steady base of support.

Moreover, every mature industry usually shakes out to just a handful of providers in the end. We can live with just 3 or 4 major backbone providers. Especially with the threat of wireless entry always hanging over their heads, incumbents will have to stay on their toes and not make bone-headed moves.

So, next time you read an article predicting the gloom-and-doom to come because of telecom mergers, step back, take a deep breath, and ask yourself if it really makes any difference. The world is changing in exciting ways and these mergers are just an acknowledgment by these carriers that they will need to be well-positioned–and have the assets and scale necessary–to be one of the handful of players there to provide us with service in the long-run.

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