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CROSSING WIRES
by Roger Conrad
Editor, Utility &
Income
June 30, 2006
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In the 1990s,
incumbent communications companies were usually guilty until proved
innocent in the eyes of US regulators. Officials went to great lengths
to coddle small rivals of Big Tel and Big Cable, with the idea that this
would create real competition and lower prices for consumers. Several hundred billion dollars of market losses later, most of the small rivals are gone. Other zombies survive, but in severely downsized form. Big Tel and Big Cable, however, are offering more products than ever before, mainly in competition with each other. Prices to consumers have fallen and the companies continue to rake in the cash, as upcoming second quarter earnings reports will once again show. As for regulation, both the Federal Communications Commission (FCC) and Congress are rapidly dismantling what's left of the subsidies and operating restrictions designed to guarantee survival of Big Tel/Big Cable rivals. Congress has also rejected attempts to impose new network neutrality regulation, which would essentially limit what owners of networks can do, including forbidding billing Web companies for upgrading systems. This very complicated issue may be revisited at some point, particularly if network owners wind up abusing their freedom. But the message from US regulation of communications is clear: less is better. As with the debate over CO2 regulation the US position is in stark contrast to those of most other, countries. This spring, for example, New Zealand regulators decided to impose very tough sanctions against TELECOM NEW ZEALAND (NYSE: NZT), unless that company immediately opened its network to rivals on very favorable terms. There's even talk of forcing the company to break itself up, to ensure it won't give its affiliates preferential treatment over its network. Neighboring Australia has also begun riding herd on its communications companies, particularly TELSTRA (NYSE: TLS). The government plans to sell off more of its remaining stake in a $17.59 billion privatization later this year. But despite the state's obvious interest in a successful auction, regulators in the country have created a highly uncertain environment that's undermining the stock. Telstra shares are less than half where they were at the last sale of government shares, as investors have doubted the worth of its market-leading position in the face of hostile regulation. Not surprisingly, the biggest contrast with the US is in the European Union. The EU's new chief regulator Viviane Reding is definitely on the warpath against the continent's major telecoms. Her goal is to create by government fiat the kind of competition for broadband that currently exists between US Big Tel and Big Cable. Reding's efforts are already running into head-on opposition in several major countries. In Germany, for example, the government has granted DEUTSCHE TELEKOM (NYSE: DT) the right to keep rivals off the high-speed network it's now building, as an incentive to plough in more capital. Spain and France are also known for being very territorial with their national phone companies, in large part because they continue to employ heavily. So is Italy, though new Prime Minister Romano Prodi has tried to be accommodative to his neighbors. THE AMERICAN WAY As I wrote last week, the debate on CO2 regulation in the US appears to be shifting to the European position in favor of a cap-and-trade system--and away from that taken by the Bush administration, which is that global warming is a myth and no action need be taken. This week, for example, the president himself stated that the country needs to move away from fossil fuels, though he again affirmed opposition to CO2 regulation. The primary catalyst for action on CO2 regulation by Republican Washington may wind up being the courts, where a case involving some eight state attorneys general continues to advance. Action by Congress to enact a benign cap-and-trade system--in which CO2 emitters will buy credits from those who are reducing CO2 emissions--would head off what could be a confusing and damaging court-ordered plan. The controversy over broadband communications, in stark contrast, is likely to be resolved globally on a US model. That's because attempts by the EU, New Zealand and other countries to impose competition by government mandate are almost certain to fail. The primary goal of Reding and others is to increase broadband penetration rates in their countries. The top 15 countries in the EU, for example, had broadband connections of less than 15 percent of their populations at the end of 2005, according to a study by the Organization for Economic Cooperation and Development. That was well below that of the rate in the US, which is rapidly approaching 20 percent. And it's even further below broadband penetration rates in Iceland, the Netherlands and Denmark, which rank among the world's best-connected countries. Reding's idea is that by creating and sustaining competitors by government mandate, she will be able to ultimately increase broadband penetration by bringing down prices. She may succeed in doing that if network owners are forced to rent their lines cheaply enough. The example of UNE-P (network elements platform pricing) in the US shows that government-sponsored competitors will survive as long as subsidies and mandates remain in place. But once those go, so will the competitors. Where her plan is certain to fail is on the investment side--i.e., ensuring that enough capital is attracted to the business to create the capacity needed for a thriving Internet. The best historic example is what happened with UNE-P, which spectacularly proved that promoting the existence of competitors does not increase investment, and in fact discourages it. Basically, UNE-P companies had no incentive whatsoever to build competing local phone infrastructure. Even giants like the former long distance kings AT&T (NYSE: T) and MCI did no building whatsoever. Rather, when the courts overturned UNE-P and the FCC was forced to follow suit, they waved the white flag. Within a few months, they were merging with their erstwhile largest competitors, network owners SBC and VERIZON (NYSE: VZ), respectively. The shift in US regulation since the '90s has been in part due to the realization that the key to greater broadband penetration is investment, not simply the existence of subsidized competitors. Countries like Japan, for example, are not wanting for competitors. But NTT (NYSE: NTT) has built out its high speed network in large part because the government--which still owns a big stake in the company--has generally given the company a free hand to keep using its ample cash flow to build and to run the network as it sees fit. Verizon is now engaged in the biggest network upgrade in US history, since Theodore Vail's AT&T began stringing wires coast-to-coast in the last century. It's no secret that Vail was able to hook up the country because he had the exclusive franchise to do so, granted by none other than legendary trustbuster Theodore Roosevelt. The FCC's decision to leave Verizon and other network owners alone has given the company similar confidence to run high capacity fiber optic cable directly to homes and businesses, creating the fastest broadband network on the planet. Broadband subscriber growth rates continue to accelerate for both Big Tel and Big Cable, which is also making major upgrades. And with WiFi, WiMAX and other wireless broadband networks and investment also growing, the US' broadband penetration rate should continue to grow rapid in coming years as it's been doing in recent ones. In contrast, tighter regulation in Europe, New Zealand and elsewhere may already be threatening to choke off investment. Telecom New Zealand has already hinted as much. US broadband spending already outstrips that of its European rivals. The gap could widen considerably if Reding goes through with her plans to regulate EU-based telecoms by early next year. BANKING ON BROADBAND For investors, favorable regulation is essential to the success of any regulated company. That includes communications, despite the fact that it's a partially deregulated and competitive industry. US communications companies appear to be increasingly in the sweet spot. We may not see new fees imposed on Web companies like GOOGLE (NSDQ: GOOG). In fact, the success of Web companies is absolutely essential to network owners. But Big Tel and Big Cable at a minimum now enjoy more leverage in this relationship. And that should work to the benefit of shareholders going forward. The most obvious winners are the Big Tel and Big Cable companies. Rural wireline and wireless companies--provided they own networks--are also winners. And these groups remain cheap. Turning overseas, the tilt toward more regulation in many countries will be a net negative as long as it lasts. And we may not have seen the worst of it either. This weekend's elections in Mexico will offer some crucial clues in how Latin America is evolving, and whether we'll see the continued ascendancy of a pro-development, pro-trade Latin American left--as now rules Brazil and Chile--or another populist victory, with dangerous consequences for the entire region. At least one Mexican legislator has called for the nationalization of Carlos Slim's TELMEX (NYSE: TMX) and AMERICAS MOVIL (NYSE: AMX). Should that point of view prevail, it would be hugely negative for Mexican wireless and wireline communications. Ironically, Mr. Slim has already transcended the situation by building a continent-wide empire and demonstrating skill at hooking up the region's consumers. For the most part, other big telecoms should also be able to transcend any backsliding in regulation. Spain-based TELEFONICA (NYSE: TEF) is a truly global company, with operations all over Europe as well as Latin America. Even Deutsche Telekom has global operations. In any case, without the participation of telecom giants around the world, there won't be a real buildout of broadband capacity. Governments may succeed in constructing WiFi or other broadband networks in some areas, particularly wealthier ones that can avoid the diversion of tax dollars. But in the end, the best networks will all be privately owned. The only alternative governments have if they're serious about hooking more people up, is to encourage investment by private capital, while monitoring to ensure all Web companies and others who rely on the Internet have the ability to access it. Anything else will only delay needed investment, and therefore the speed and capacity needed to keep moving forward.
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