A merger of necessity [Commentary]

Companies that use broadband connectivity are far better off than those supplying it

March 04, 2014|By Ev Ehrlich

The proposed merger between Comcast and Time Warner highlights the vast gap between the imagined world the broadband industry's critics and the real world in which these companies must compete.

For years, the critics have advocated forcing companies such as Verizon and Comcast to share their infrastructure with their competitors or mandating that the broadband market only offer one level of service. Their argument is that America's broadband is gripped by a "cable/telco duopoly" that uses its market power to slow innovation and gouge the consumer. And the Comcast-Time Warner combination is their new monster under the bed.

In fact, the substance of these criticisms is simply wrong. The latest rankings from Akamai show the U.S. eighth and rising in global Internet connection speeds, and a new report from the International Telecommunications Union depicts U.S. wireline broadband as being the most affordable among our trading partners as well.

But even more dissonant are the data on profitability. In a new study set to be released next week by the Progressive Policy Institute, I examine the rates of profit of two subgroups of the Fortune 500 — companies that provide the Internet (from ATT and Verizon down to Level 3 and Frontier) versus companies who reside on it (from Apple and Microsoft to Facebook and Yahoo). The (average weighted) rate of profit on sales for the "providers" is 3.7 percent, versus 24.4 percent for the "residers." Calculated on assets, the rates are 2.1 percent versus 17.7 percent, respectively.

So the companies that use the broadband Internet are making six to eight times the margins of the allegedly monopolistic companies who provide it — the exact opposite of what you'd see if the price gouging accusation was real.

The problem is that advocates for regulation simply don't get the competitive dynamics of the broadband industry. And if we don't have that understanding, we can't understand the Comcast/Time Warner merger.

In the rotary phone world, "connectivity" — dial tone — created all the system's value, once you had a phone. But the Internet is different. Rather than a "dumb" signal, Internet connectivity is part of a multi-part parlay with devices, services, applications and other components that deliver value to the consumer. All of these components compete for a larger slice of the integrated customer value pie.

Consider the iPhone. Its vaunted voice recognition technology, for example, has been around for a long time. It's only been offered in phones now because mobile broadband is powerful enough to let the cloud deliver the service to the user in real time.

So the innovation that makes the iPhone and its applications more valuable to consumers was really the faster speeds offered by mobile service providers. And this is the competitive reality today. The device, website, app and content companies are capturing most of the benefits created by the connectivity "providers," hence their lusher margins. Yet the providers must continually innovate and improve their service so their customers will bring those devices and applications to the providers' platforms. In essence, the "providers" are caught in a loop in which they innovate, the downstream device and service providers capture the value created by those innovations, and the providers must then innovate all over again. No wonder the residers make money far outstripping providers.

And it's not just the mobile market. Watch bandwidth-munching UltraHD TV — so-called "K4" — as it enters the consumer market, now that there's enough bandwidth to support it. Will the set-makers make the margin, or the broadband providers who made the new sets possible?

So, unlike their caricature as duopolists, provider market power is extremely limited. They are essentially high fixed-cost systems that must continually attract new customers to spread their fixed costs over a larger base, even as other companies garner most of the benefits of their innovation.

And they have little power over content as well. If Comcast were to block, say, YouTube, would you keep their service, or switch to Verizon, ATT, Sprint, Dish, DirectTV or any of several other provides to get what you want to see? And which is the danger — that Comcast will charge you to reach YouTube, or that YouTube will one day charge Comcast to be on its system? In the real world, content, not connectivity, has the muscle.

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