Telecom Value Chain

This article in Techdirt brought a smile to my face. Before I explain why, let's summarize the article: cable companies and telcos want to charge more for broadband because, not only are the big content providers like Google getting a "free ride", so are consumers. The poor abused broadband providers are getting hit from both groups who simply don't appreciate the tremendous value they are getting and so they must pay more for broadband.

Of course the you and I and the content providers do pay for broadband, and the broadband providers are making a decent profit from our business. Their dilemma is that they are getting pushed down the value chain, and that is always a problem when your job is to make as much money as you possibly can. In other words, they are in danger of being relegated to, once again, becoming a utility. This may be unclear so let's look at the issue more deeply.

All bit carriage is alike and is only distinguished by price, reliability and speed. This makes broadband much like any conventional commodity, be it wheat, copper or natural gas. Commodities are at the bottom of the value chain, therefore every business that uses these commodities as inputs creates something of greater value to the end user (bread, wire or hot water, respectively). Because they add value, they always derive more revenue and, potentially, profit. This is the reason, for example, farmers bemoan how little of the retail price of baked goods goes into their pockets.

The same situation applies to broadband. Google provides products that consumers value, such as search and YouTube, and their revenue from advertising dwarfs how much they and we pay the broadband providers for bit carriage. The broadband providers don't much like this; they, too, want to be further up the value chain. They have tried competing with the content providers with walled-garden and other services, but consumers prefer to go elsewhere for content. When competing fairly has not worked out for them, they have sought to impair the competition with application filters, DNS poisoning and intrusive injection of javascript-driven ads into the content provided by other companies. Hence the fight over network neutrality.

While this may seem like a new type of fight, it isn't: the value chain in telecom has always been there, just as it has been there for any commodity. Think of the lowly telephone. Whether you call your mother or you call your stockbroker, the telco gets paid the same amount. This is despite the potentially lucrative benefit you earn when the trade you place through your broker works in your favour. Long ago the telcos were content enough with this situation since they did very well out of it, having their profits virtually guaranteed by the regulators. Although little more than a boring utility, they were a very profitable boring utility. Then competition arrived.

At first the telcos struggled to introduce new vertical services that would appeal to consumers. After years of industry effort (the pace was often quite slow in that olden time) there came call forwarding, voice mail and caller id. They successfully moved up the value chain with these features and profited enormously. It got to the point where the marginal cost of these services was so low that just about 100% of every dollar of revenue from these services went straight to the companies' bottom lines.

Of course this irritated companies like Nortel (who were even further down the value chain) since they didn't benefit from this windfall. I don't recall exactly but it was something like for every dollar the telco paid Nortel for their switching equipment (hardware and software), the telco earned $50. Nortel and Lucent did both try to get a piece of the telco service revenue, but failed because they had little leverage due to the availability of competitive alternatives such as Siemens, which was itching to win big switching contracts in North America.

Now it's the major broadband providers -- the telcos and the cable companies -- that are finding they have little leverage. Every action they take to assert themselves in the internet value chain achieves little benefit for them or us, and further erodes their reputation with the so far largely complacent majority of their customers. However, they are not stupid and so they know they will lose this fight eventually. What they are trying to do is set the agenda by attempting to dictate what their customers can do, but only for the present and the immediate future, until their strategists can figure out a way to successfully (and acceptably) lever them up the value chain.

I suspect they'll fail even though I can sympathize with why they are trying. Now even Google is sufficiently annoyed that they are pushing back by offering to create an open-access fibre network for some lucky community. By blatantly showing what is possible with true open access, the restraints of the incumbents become transparent to many more people. So long as most people believed that what they were being offered in the way of broadband service was normal, the incumbents' negative tactics worked.

Google's experiment is fascinating since they can show the way a utility can in fact move up the value chain. Except that the value isn't in the network but in the content to which Google will attach its advertising. This means there is little of value in this lesson for the broadband providers since they are not in that space, they have little prospects of getting there, and they have little appetite to try. They prefer to make the money come to them rather than go to where the money will be. I think they'd better get used to the idea of being a utility again because that's exactly where they're headed with their current strategies while others innovate.