Appendix E: Revisiting the Computer Industry
It would be favorable in extracting profits if wireline/wireless carriers could maintain control of the full vertical stack, from the data pipes to the content. The past decade has proven to be challenging for the traditional vertically integrated models in telecommunications. Carriers have recognized the complexities in various niches of the vertical and have divested assets like data centers and towers assets. Niches along the vertical have emerged such as IP Transit and Content Delivery Networks. Over-the-top offerings like Netflix continue to be a topic of concern.
Below we will look at the past, present, and future industry structure. We will question whether the wireline/wireless industry is horizontally- or vertically-integrated. We will look at the past and the present to propose what to expect in the near-future. We will consider if the environment will be more or less favorable for wireline carriers. We will also suggest that a pragmatic strategy for wireline firms is to align with the industry structure.
The state of the wireline/wireless industry has parallels to the computer industry. The computer industry went through a shift from a vertical structure to horizontal structure. In the early days, it made a lot of sense to be vertically integrated. Computer components required a high degree of technical integration and firms like IBM offered a lot of value by integrating the complexity. Today, the computer industry is very different. Most of the traditional computer companies have broken apart and have been sold off.
Professor Charles Fine describes the industry structure as something that does not remain constant, but rather gradually cycles between a vertical structure and a horizontal structure.
Source: Fine, C.H., “Clockspeed: Winning Industry Control in the Age of Temporary Advantage,” Revised ed., Perseus Books, (1999)
Over the past few decades, the telecom industry has matured and flattened. This movement from a vertical to horizontal structure is consistent with modular service-oriented software architecture which has been increasingly more relevant. In the prior vertical architecture, there were a number forces pushing it towards a horizontal and modular configuration. These included,
- The challenge of managing many different operating segments across the many dimensions of technology, required by an integral system. Traditional operators had to manage data centers, cell towers, manage hosted applications, facilitate wholesale access into their networks, and more.
- The challenge of fending off the entry of niche competitors hoping to pick off discrete industry segments. Niches such as Content Delivery Networks and IP Transit providers required a different distributed business model. This business model was in direct contrast to traditional telcos that built their moat around regional dominance.
- The bureaucratic and organizational rigidities that often settle upon large, established companies.
Although we believe the wireline industry and the larger telecom sector will continue to horizontally integrate, it is worth considering the driving forces for vertical integration which will eventually occur. These forces include,
- Technical advances in one subsystem can make that the scarce commodity in the chain, giving market power to its owner. At this present time, we don’t see such advances like this that exist.
- Market power in one subsystem encourages engineering integration with other subsystems to develop proprietary integral solutions. We also see little evidence of this in traditional wireline and wireless carriers.
- Market power in one subsystem encourages bundling with other subsystems to increase control and add more value. This perhaps is the most relevant factor that has some merits of truth. We believe wireline providers will be able to successfully deliver TV but not control the content itself.
Analysis of the industry structure helps to design and validate the business model. If an individual wireline carrier chooses to vertically integrate, is this consistent with the overall industry? If not, what is the method in which they plan to lower costs, facilitate scheduling and planning, facilitate investments in specialized assets? Conversely, if the wireline carrier chooses to horizontally integrate, there are a few key requirements for success. We will see these are consistent with the wireline thesis and favorable to Cincinnati Bell. They include,
- Reduction in Competitive Intensity
- In a consolidated industry, there is typically higher probability for high sustainable profitability.
- Oligopolistic industry structure allows the surviving firm to focus on non-price competition (ie. R&D spending, customer service, or advertising).
- Lower Costs through Economies of Scale
- Similar to pharmaceutical companies, wireline carriers have a shared sales, marketing, and support team which amount to a large fixed cost.
- On the operations side, regional economies of scale comes from the elimination of duplicate network infrastructure such as data centers, cross connections, and IP transit.
- Operating expenses are further minimized through having smaller network operation centers managing a larger number of network elements.
- Access to New Markets and Distribution Channels
- Kraft’s acquisition of Cadbury created access and distribution into India, Egypt, Thailand, and Latin America.
- Similarly, larger wireline carriers looking to expand into new markets will likely need to acquire regional providers as oppose to building out their own network.
In the next section, we will chronologically step through some key historical events in history of US Telecom. We believe it supports the strategy Cincinnati Bell is undertaking, which reflects a sound management team. We also think it supports the idea that Cincinnati Bell will eventually be purchased.
Appendix F: Past, Present, and Near-Future
- Late 1800s – Early 1990s (~50yrs): Many disjointed vertical phone companies
- During this period, people subscribed to multiple vertically integrated providers (represented by the vertical bars below). Technology at this time was relatively new and there was a need to reduce complexity for the average consumer.
- 1934 – 1982 (~50yrs) Communications Act: One big vertical
- Government gives AT&T monopolistic rights.
- 1982 – 1996 (~14yrs): DOJ splits up AT&T
- In 1984, AT&T was split to 7 x Regional Bell Operating Companies (RBOC) while AT&T retains control over Long Distance and Bell Labs.
- This new structure solved the complexity of connecting the many independent providers, while also relinquishing AT&T’s control.
- This was also the initial pressure to horizontally integrate (vertically disintegrate) although structure was still highly vertical and continued to be vertical till around 2000.
- 1996 – 2000 (~5yrs) 1996 Telecommunications Act: DOJ further splits up AT&T
- The industry is further deregulated
- AT&T’s R&D/manufacturing split from Long Lines
- AT&T Long Lines now allowed to offer local services
- The Act catalyzed a number of firms to further vertically integrate, however, the next decade would be focused on horizontal integration
- Until this point (~1996), companies were vertical. There was pressure to disintegrate and specialize in areas like wireless.
- Professor Charles Fine explains the reason for disintegration include: emergence of niche competitors, high dimensional complexity, organizational rigidities
- He visualizes this transition from a vertical to horizontal structure of the wireless carriers as such:
Source: Sharma C., Nakamura Y., “Wireless Data Services: Technologies, Business Models and Global Markets,” 1st ed., Cambridge University Press, 93, (2004).
- M&As prevalent in the next decade
- Wireless divisions spun off and joined together. PacTel, USWest, and Bell Atlantic became Verizon in 2000.
- Interexchange Carriers (IEXs) competed against AT&T’s long distance service, and integrated with Internet backbone providers to become the long-haul networks of the future. Late 1990’s gave rise to many new long-distance carriers such as Global Crossing, Qwest, Level-3, and Frontier. However, AT&T and MCI/Worldcom still controlled most of the market, combining for 82% (1999).
- 2000 – 2010: Niche Entries to Serve Discrete Industry Segments
- Firms like GTT selected a niche of providing back-bone services (IP Transit), then grew horizontally within this niche.
- Wireless carriers like T Mobile choose to sell off (and instead leases) its cell towers. It chose to take on one niche in the vertical (customer service) and horizontally growing from there.
- Firms like Digital Realty focus on the data center segment.
- 2010 – present and near future: Increasingly Horizontal Structure
- The near future should remain horizontal. This means,
- Continued M&A in horizontal lines of business
- Diversification of non-core assets
- Demand for modular architectures (ie. Elastic IP core, API integration, dynamic routing)