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Has net neutrality decision impacted trading in the telecom sector?

Today the United States Court of Appeals-District of Columbia gave the Federal Communications Commission a victory, holding that the agency has the statutory authority to reclassify broadband providers as telecommunications companies as opposed to the industry favored status of information service providers. Broadband providers and their supporters have vowed that the fight is not over, telegraphing the probability of obtaining a ruling from the full bench of the appellate court or, going all the way to the United States Supreme Court.

The telecommunications services sector seemed to have shrugged off the ruling. The Thomson Reuters G7 Telecoms Sector Index registered a .06% decline at the end of the trading day. The sectors biggest players, AT&T and Verizon, saw their stock values increase .47% and .80% respectively. The response is not surprising since broadband operators such as AT&T, Verizon, and Comcast have been providing their high-speed access services pursuant to an open internet philosophy for decades. Their primary argument has been that broadband regulation should be conducted with a light touch and that throttling access speeds or discriminating against certain content or websites would be bad for business given the level of competition that they face.

Wall Street, unlike the Commission, has not been afraid to declare how competitive the telecommunications sector is. Charles Schwab analyst Brad Sorensen had this to say in a recent report about the telecommunications services sector:

“The telecom sector is certainly not what it was a couple of decades ago, although some investors may not realize it yet. The days of near-monopolistic control of landlines are long gone. These days the sector is driven by fierce competition, with new ways of communicating continually entering the market, and consistent—and expensive—upgrade cycles. To us, this reduces the traditional defensive appeal of the telecom sector.”

The court avoided the question of market power and deferred to the Commission’s predictive judgment on telecommunications companies willingness to invest in broadband network deployment. Although the sector has long left the monopoly environment existing prior to the passage of the Telecommunications Act of 1996, should traders consider not only a throwback to the regulatory world of the 1990s that the court’s ruling has cemented but reorganization of the sector that resembles the Ma Bell days?

The 1990s were the pre-convergence days. Carriers followed a silo model separating, in the case of larger local exchange companies, their long distance operations from their local exchange operations. In order to avoid the disruption that may ensure from increased complaints regarding perceived throttling, suspected paid prioritization, and misunderstood network management techniques, what if larger carriers like AT&T and Verizon decided to spin off their newly created “utility” pieces and focused on providing backbone, mid-mile, advertising, content delivery, and special access services? State public utility commissions, long shut out of the broadband regulatory game, may now view the courts ruling as permission to re-enter the regulatory fray.

Spinning off the telecommunications component and leaving them subject to state and federal regulation may allow AT&T, Comcast, and Verizon to focus on the content and data business and go head to head with Google or Facebook, edge providers, who, though subject to the Federal Trade Commission’s privacy regulation, don’t have to suffer the FCC’s Title II regulation.

A spin off may be good for traders especially if the utility components are subject to rate-of-return regulation thus providing the certainty of fixed-income behavior while the unregulated portions, while subject to the volatility of competition, may generate higher rewards that come with the greater risk.

It’s still early and in the immediate term broadband providers will be focused on continued appellate court action. The long term potential restructure stemming from this action is something traders should keep in mind.


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Broadband: Why would an edge provider let FCC see its business model

Technocrat’s Anne L. Kim blogged on comments Consumer Electronics Association CEO and president Gary Shapiro made at a recent Brookings Institution event.  Here is an excerpt from her post:

On net neutrality, Shapiro wants more of a hands-off approach from the government. He wants to see government allow industry and nongovernmental organizations establish principals. “And if the principals are violated, then act,” he said.

“I personally am fearful of all of a sudden sending those companies into a new area of regulation like utilities,” referring to the FCC considering using Title II of the 1996 Communications Act to rewrite net neutrality rules.

He said he likes things the “way they are” and that he’s rather not see them changed, adding that “good intentions scare me.”

Take a look at Title II, something more edge providers need to do, and you can appreciate some of Mr. Shapiro’s fear.  For example, section 211 of the Communications Act requires that common carriers (a classification that net neutrality advocates want applied to broadband providers) file copies of all contracts that they have with other common carriers.  So, if Google, a broadband wannabe, has peering or transit contracts with Comcast, Google will have to file its contracts with the Federal Communications Commission, and probably with state public utility commissions as well.  If these contracts contain information regarding traffic from certain edge providers a la Netflix, Netflix wouldn’t be happy that some aspect of its business model may be on public display with the FCC.

This type of transparency may bring joy to net neutrality proponents but not to the edge providers they purportedly are so concerned about.  In my opinion, letting the government have a copy of a contract entered into autonomously is the same as the government regulating your free speech.  Unless there is a dispute to be resolved between two parties to a contract, I see no reason to let the government have access to its contents.  If edge providers want to see a slippery slope created that takes regulation right to their doorsteps, Title II will lay the bricks for that driveway.

My walk down the Yellow Brick Road of regulation gets scarier when I take a look at section 215.  Section 215 allows the FCC to examine transactions involving the furnishing of services, supplies, equipment, personnel, etc., to a carrier.  Also, the FCC, pursuant to this section, may examine transactions that impact charges a common carrier assesses for provision of wire or wireless services.  Section 215 also allows the FCC to determine how reasonable these charges are.  Also, the FCC may report its recommendations to Congress as to whether charges are invalid and should be modified and prohibited.

Now, not to knock on Google, but since they are the Internet flavor of the week given the disclosure of their perceived wretched diversity in hiring practices, disclosing matters regarding personnel much less on their services should make the company and its investors think twice about supporting net neutrality brought to you via Title II classification.

All of Title II should be scary to venture capitalists, private equity, and their investor clients, but section 218 should bring great pause. This section allows the FCC to inquire into the management of all common carriers.  The FCC may obtain management information not just from the carriers, but from entities that directly or indirectly control them.  That, in my mind, includes private equity firms or venture capitalists that may have a controlling interest in some little regional or rural broadband provider.  With the SEC stepping up its scrutiny of private equity via the Dodd Frank Act, does private equity want another alphabet soup agency knocking on its door?

Here is one more, especially for the app developers.  Section 231 speaks to app developers, or more definitively access software providers.  This section prohibits the use of the World Wide Web to transmit material harmful to minors.  I wonder how many apps fall under this category.

When you look behind the curtain of good open network intentions, you can find some scary stuff.

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Net neutrality will not encourage capital flow to edge providers

Capital flows to an activity that provides the highest returns.  That activity may involve a high level of risk but the premium paid out by entrepreneurs to their investors hopefully compensates for uncertainty.  Policy making by government regulators is a source of uncertainty for entrepreneurs in the Internet space.  Levels of uncertainty increased after the U.S. Court of Appeals-District of Columbia’s ruling in Verizon v. FCC where the court held that the Federal Communications Commission’s authority to regulate access to broadband is based on its duty to promote the deployment of advanced services.

Underlying the philosophy of net neutrality is an argument that the consumer, the end-user, should be responsible for paying all the costs associated with the transmission of data from an edge provider.  This would include costs associated with data traveling down a path that goes from the edge provider through a backbone provider onward to the end-user’s Internet access provider.  For example, Netflix, a company that distributes videos over the Internet, would not be responsible for paying fees to Cisco, a backbone provider, or, should Netflix interconnect directly with it, Comcast, an Internet access provider.

What the net neutrality argument ignores is the multi-sided market that Internet access providers operate in.  The argument also ignores costs generated at interconnection points through the Internet and fails to address the proper costs recovery mechanism at each interconnection point.  The net neutrality argument concludes that cost causation is one-way, from the end-user to and through the Internet and the fees the end-user pays to his Internet access provider should recover this cost.

In actuality, the Internet is what I term, “multi-way.”  The self-healing and permanent virtual circuit characteristics of Internet protocol requires constant communications between nodes, routers, servers, and other devices on the Internet regardless of whether an end-user’s laptop is on or not.  Information requests are constantly being exchanged between backbone providers, edge providers, and Internet access providers.  The end-user is not the only cost causer.  If entrepreneurs cannot explain to investors why costs are not being recovered from all cost causers on the network, capital will flow to the next best generator of returns.

Work by Larry F. Darby and Joseph P. Fuhr appears to bare out this conclusion.  In a 2007 study on the impact of net neutrality on capital flows, Messrs Darby and Fuhr concluded that requiring end-users to pay for next generation networks:

  • Is inconsistent with practice in other multi-sided markets;
  • Will increase investor risk, suppress investment, and slow construction of next generation broadband networks;
  • Will increase rates to consumers; and
  • Will reduce the present value of consumer surplus

Network providers are challenged with coming up with pricing schemes that optimize the scale of their networks while maximizing the networks’ values.  The prospect that investors will recover their investment in networks has a dark cloud hovering over it; a cloud generated by the 2000 dot-com bubble burst.  Wall Street tends to see reductions in short and middle term returns as a result of large infrastructure investment.  Investors are also see growing threats to broadband network deployment from satellite and municipal-provided broadband networks.

According to Messrs Darby and Fuhr, “Specifically, investors have a big stake in the resolution of net neutrality issues and particularly in the outcome of the debate over who can be charged, by what principles and by whom–that is, in resolution of a set of network access pricing issues.”

If the FCC truly wants to promote deployment of advanced services, it should talk more about the importance of not only spectrum as natural capital, but the financial capital necessary for deploying the networks on which advanced services are expected to run.


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Capital needs to keep flowing to broadband providers

This morning Georgetown University sponsored a panel on regulation and the transition to Internet Protocol networks. The panel zeroed in on the role an all IP network can play in economic development. What I found of interest was how the capital markets were digesting all the policy talk; the regulatory environment in the broadband space and how it may impact the flow of capital.

There may be an opportunity to educate investors on how the policy initiatives at the Federal Communications Commission may impact their returns to capital. At least that is the impression I got from remarks made by Jennifer Fritzsche, a managing director and top flight telecommunications analyst for Wells Fargo Securities. According to Ms. Fritzsche regulatory changes are restrictive and could result in declines in broadband business. Not a good sign for investors.

Wall Street is bottom line minded, I gathered from Ms. Fritzsche. Traders and investors want to know if AT&T, for example, is going to hit their numbers. Concepts like net neutrality can result in that eyes glazed over look. It would take a real savvy telecommunications investor to be able to digest policy concepts like net neutrality and special access.

The FCC should take note of one thing, especially if they want to be true to their word about fostering economic growth, innovation, and employment: equity investors look at IP investment as a positive and are surprised that AT&T has not invested more especially at the low rates in the market. (And Ben Bernanke and friends at the Federal Reserve are still keeping rates low.)

Again, the take away for the FCC: the greater the level of regulation, the less the incentive to invest.