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"High expectations, low profitability” – Arthur D. Little’s global broadband report

By Andreas Hürlimann, Director, Arthur D. Little

Delivery of high-speed Internet access and services over high-bandwidth infrastructure (broadband) has rapidly become a defining feature of the communications landscape, and it represents the main engine of growth for telephone and cable operators across the world.

Its growth has been phenomenal: from the earliest deployments of the technology in the mid 1990s, total consumer expenditure on broadband is expected to have exceeded USD 30 billion in 2003. Yet the industry is complex and players face significant challenges in both getting the product and business model right and coping with such high growth. Given significant investments in technology, services and customer acquisition, the industry to date has been characterised by low profitability.

Arthur D. Little set out to address three principal questions:

  • How will the market for broadband develop over the next five years?
  • What are today’s prevailing and expected future revenue models?
  • How can current and/or new industry players become profitable?

The study incorporated perspectives from companies most actively shaping the broadband industry:
  • Content Providers
  • (Access) Service Providers
  • Equipment Providers
  • Government and Regulators

The current broadband market
Currently expanding at double-digit rates, the broadband market is set for sustained growth in the future. As Exhibit 1 illustrates, penetration (as measured by the percentage of households with broadband access) is highest in the Asia-Pacific region, and worldwide we can see a classic "S-curve" market growth profile emerging:

The global market can be characterised as High Growth, with only Korea and possibly Hong Kong having reached “Maturity”. On the current trajectory, many markets could also see penetration approaching or exceeding 50 percent within five years. The United States, Korea and Japan combined today account for 50 percent of total worldwide subscribers. For most customers, access speeds are around 500kbits/s, with higher speeds (up to 8Mbits/s) becoming more widespread in the most developed markets.

DSL (which uses copper telephone lines) is the most prevalent technology for delivering broadband, although in certain markets (notably the UK, US, Korea, Austria, Switzerland, Netherlands, and the emerging markets of Malaysia, Venezuela, Columbia and Brazil), cable has established an early lead. Cable operators have been more innovative than their telephony competitors in building up their networks faster and in bundling broadband with cable TV or telephone products. But the availability of DSL – the technology is usually almost ubiquitous compared to the limited cable footprint – will increase and ultimately outpace cable access.

Challenges faced by industry players
Despite the substantial broadband penetration growth achieved, the industry continues to face considerable challenges.

Strategic challenge 1 (for NSPs and ISPs) - maintaining ARPU and margins
Today, Average Revenue Per User (ARPU) in broadband is based largely on access fees for a basic broadband subscription. In 2003, access fees are expected to account for about 85 percent of total revenues earned from broadband users. This figure is slightly down on previous years as the share of revenues earned from premium content (seven percent in 2003, from three percent in 2002) and equipment purchases/rental (eight percent in 2003, up from seven percent in 2002) increases. However, access still accounts for the overwhelming share of user-generated revenues.

This presents a significant problem for the industry since, as markets develop, access fees have typically trended downward. The strong correlation between declining access prices and increasing penetration confronts operators in three areas:

  • Declining ARPU makes it more difficult for operators to recoup the heavy costs of customer acquisition, which typically total USD 150 per customer with modem and set up.
  • Operators (NSPs or ISPs) are not generating significant revenues outside access and despite high customer usage, broadband is yet to attract significant revenue from 3rd party sources (e.g. from advertisers).
  • And since customers with broadband have a greater propensity to use high-bandwidth applications (e.g. video, games and music), operators face the need to continue to invest to upgrade their networks to maintain service levels.

Exhibit 2 confirms the trend towards lower ARPU at higher penetration, and the dilemma facing operators investing in additional bandwidth. ARPU is generally lower (adjusted for purchasing power) in higher penetration markets. And although some Asia-Pacific markets appear “above trend”, this is primarily a reflection of the greater access speeds on offer (with the average price per kilobit continuing downward).

Faced with this profile, operators must wonder whether the potential returns justify the substantial investment required.

NSPs and ISPs are increasingly looking to supplement revenues from basic access with additional services, in partnership with content and application providers (discussed under challenge 3 below). Currently, ISPs are "buying market share" in many markets by aggressively pricing broadband access in the expectation that the large customer base will eventually pay back their initial acquisition costs. We believe there is also scope to amend the prevailing "flat-rate" pricing model, including charging heavy users a premium reflecting the additional requirements generated for the network, or to reflect a guaranteed "quality of service" (e.g. successful connections and minimum access speeds). And a greater focus on costs is required to improve margins, with operators needing to sweat assets harder to achieve profitability.

Strategic challenge 2 (for regulators and alternative providers) - ensuring a basis for effective competition in the access market
Incumbent telephone operators dominate the broadband access market, especially in Europe. The UK provides a good example of this. We estimate that by the end of 2003 British Telecom (BT) will have a market share of just below 15 percent of narrowband customers, a market in which all players are considered to have an equal chance. BT’s share of broadband will be much greater - 30 percent of the overall broadband market including cable and 55 percent of the market for DSL access. Its share continues to rise, and BT is not alone among incumbent operators. Elsewhere (e.g. Telefonica in Spain and France Telecom through its Wanadoo subsidiary) incumbents account for over 50 percent of their home broadband market.

Without strict regulatory controls, dominance by the incumbents is not surprising since they determine both timing and extent of network upgrades required to support broadband services. They also set the wholesale price and hence to a significant extent can determine their competitors’ margin (wholesale access can account for over 50 percent of the retail price charged by most ISPs). Since costs of customer acquisition, set up and service are typically higher for broadband, independent ISPs find it extremely difficult to make an overall margin, but they have few, if any, alternatives for wholesale access. This stems from a failure in many markets to fully implement an “unbundling” of the local loop (LLU), bit-stream access or to establish an infrastructure competition with the corresponding wholesale offer. There are clear correlations between competition among infrastructure providers, high broadband penetration and relative low access prices. In the most highly penetrated market Korea, Hanaro Telecom, Thrunet, Dacom, Onse and Dreamline all compete with KoreaTelecom via cable, DSL, LAN and wireless networks.

European regulators face an important challenge with broadband to ensure that competition is maintained long-term. They must push for lower wholesale prices as demanded by independent ISPs. However, the ISPs themselves also need to demonstrate greater discipline on pricing. To date, where wholesale prices have been reduced, ISPs have also looked to reduce retail prices, maintaining low margins.

Strategic challenge 3 (for content providers) - extract more value from a rapidly expanding new distribution channel
As we described above, premium content or other value added services account for only a small proportion (about seven percent) of total customer spending on broadband.

Content providers report significantly increased usage as customers migrate from narrowband to broadband. Usage levels in broadband households are typically about two hours a day - more than twice narrowband usage levels, and approaching TV viewing levels (typically about three and a half hours a day). The "always on" and flat rate pricing features of broadband are undoubtedly key drivers of usage, but the customer experience while online is also strongly enhanced by the higher access speeds.

Broadband represents one of the fastest growing new markets for content providers, but translating usage into revenue has proved challenging. We expect content providers to overcome their initial hesitation and embrace broadband alongside other media. We also expect content providers increasingly to distribute content directly to end users, without going through an intermediary or partner. Some content providers initially sought to offer services mainly in partnership with ISPs (e.g. with T-Online in Germany) that offer managed links and streaming services, and in so doing reducing their investment in hosting and delivery infrastructure and securing some marketing support. However, as the market builds, providers will offer and bill their services direct to the customer (e.g. BSkyB in the UK, with its skysports.com subscription service), excluding the ISP or NSP from any share of revenues. In such circumstances, we believe broadband represents an important and viable new market for content providers, with significant benefits likely for early movers.

Strategic challenge 4: For CPE providers, how to build added value as the market matures?
Competition among providers of customer premises equipment (CPE) for broadband access has been fierce. The proportion of customer spend on CPE that we highlighted earlier (eight percent of total ARPU) is relatively low, for two reasons:

  • Part of the total CPE costs are absorbed by operator subsidies and hence reflected in their costs of customer acquisition. They range from 50 percent up to full absorption of CPE costs.
  • Furthermore, CPE prices have been falling, driven down by competition for market share among providers, and by the strong purchasing power of ISPs and NSPs who place large orders for equipment to offer them to their end-customers.

Falling prices, ease of use and standardisation of CPE have been important drivers of the broadband market. CPE manufacturers are now increasingly looking to increase the functionality offered, enabling greater value-added functionality for the "smart" home of the future.

Can the industry deliver profitability and build value?
Despite the rapid growth of customers, broadband presents risks as well as opportunities for value creation for all players, as illustrated above in exhibit 3.
Broadband also presents a challenge for investors, with few "pure play" opportunities to invest in broadband businesses, since providers of broadband access, services or equipment are often part of much larger organisations. In the absence of reliable benchmarks, valuing broadband is very difficult. Investors have in the past attributed the highest price/earnings multiples to content and equipment providers, with NSPs trading on less aggressive multiples. However, it seems that for their purely broadband operations, it may be the NSPs that are closest of all players to achieving profitability.

Insights for the executive
We conclude this summary by offering some perspectives on the evolution towards profitable broadband and potential courses of action for industry players:

  • We believe telco-based NSPs are likely to realise profitability in their broadband operations. We consider this group most likely to maintain profitable operations, on account of their high retail market share and dominance of wholesale access provision. The principal risk would appear to come from the regulators, through mandating lower wholesale rates or LLU. NSPs must develop a business-led investment strategy for future infrastructure upgrades as customer demand for access bandwidth continues to increase. At the same time, future revenue opportunities, such as providing business support services to partners, must be assessed while maintaining low-cost broadband operations.
  • For content players, the ball is very much in their own court. They have a very strong position and are presented with a rapidly expanding new digital distribution channel. We believe a viable premium content market can be developed as the market continues to expand, aided by better encryption and rights management systems. But providers need to be clever in promoting broadband as a complementary rather than alternative distribution channel.
  • Leading CPE manufacturers need to extend functionality of devices to protect against commoditisation in a highly competitive market. Higher specification devices present an opportunity, potentially connecting multiple devices around the “smart” home, and offering a wider range of services for the user. Today CPE manufacturers earn low margins on modems and PC peripherals and the products are largely “plug & play” and interoperable. In absence of a product/functionality-led strategy, manufacturers strive for cost leadership. Interoperability and ease-of-use are imperative in designing new devices.
  • For government and regulators, the job of facilitating and policing a viable industry is only half done. Most express satisfaction with the high rates of growth currently being achieved combined with falling prices. However, the continued robustness of the industry is undermined by the current low profitability. Governments and regulators need in particular to remain vigilant for dominance by incumbent telco-backed NSPs and ensure the conditions exist for all players to compete on a fair and equal footing.
  • Non-telco-aligned ISPs seem unlikely to achieve profitable broadband operations under the current market conditions. At present, their product range and pricing is heavily influenced by NSPs, and in general they have struggled to capture customers in sufficient volumes to build critical mass. They need to push national and international regulators strongly for wider or cheaper wholesale access and maintain discipline on retail prices to ensure the benefits are not simply passed on to customers. They must develop smart pricing strategies to further expand broadband usage and orientate their advertising and marketing messages away from product features and towards consumer needs. They have the greatest need to exploit new revenue sources, in particular variable access pricing or quality of service premiums. We expect some smaller local ISPs to fail; surviving ISPs need to build scale and expand revenue streams.

Andreas Hürlimann is a Director of Arthur D. Little's Zurich office. He is the leader of the global Telecommunications, IT, Media and Electronics (TIME) practice of Arthur D. Little. His main areas of interest are strategic, organisational and operational questions relating to broadband and mobile operators. Andreas Hürlimann holds an MSc EE from the Swiss Federal Institute of Technology, Zurich, and has been with the telecommunications and electronics industry for more than 15 years.


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