[McKinsey] Has broadband finally arrived?

I Find Karma (adam@cs.caltech.edu)
Mon, 21 Dec 1998 12:32:03 -0800 (PST)

I really think that while I was sleeping these last 3 months, broadband
stepped up its time horizon considerably. Talk about your growth
industry for 1999-2000... I include below the McKinsey report I found at


The amazing part is, whether cable modems win, or whether xDSL wins, or
whether they split the market, it looks like chipmaker Broadcom (NSDQ:
BRCM) is going to be a *big* winner (and this says nothing of Broadcom's
satellite and 10-Gig ethernet plays). Smaller companies like @Home
(NSDQ: ATHM) and Com 21 (NSDQ: CMTO) and Aware (NSDQ: AWRE) are riskier,
but have the potential for fantastic returns, too. And satellite really
has its work cut out for it.

On the other hand, it looks like America Online, Worldcom, Microsoft,
and Yahoo! all stand to do very well from increased broadband access,
too. (And, as a result, companies like CSCO, DELL, and EMC look good
as well.) Wow, what a GREAT time to be following technology...

> The last mile to the Internet: Has broadband finally arrived?
> Cable companies have the lead, but RBOC technology may have better
> economics
> What now for the narrowband winners?
> The McKinsey Quarterly, 1998 Number 4, pp. 0617
> Internet access is big business. It commands more than double the
> revenues of the flashier Internet portal and content companies that
> grab most of the headlines. So far, however, providing Internet
> access to residential customers in the United States has been a
> money-losing proposition.
> Players are competing in two battlegrounds defined by the
> fundamental economics of Internet access. Over the past year,
> winners have emerged in each.
> First, there is a battle for customer relationships, in which
> Internet access is only one element in the broad array of content,
> products, and services that players deliver to consumers. America
> Online is the clear leader in the customer relationship battle: its
> 13 million subscribers account for more than 50 percent of all
> Internet traffic. Exploiting its early entry into the online
> marketplace and its ownership of both backbone network and content,
> AOL built a unique stronghold in narrowband Internet services,
> combining a critical mass of subscribers with a depth of
> relationship that will be difficult for others to emulate. It has
> since sold its backbone network to WorldCom and outsourced backbone
> services to GTE and WorldCom, and now focuses exclusively on
> managing content.
> Internet gateways such as Yahoo! and Excite, delivering a range of
> services that attract a substantial fraction of Internet traffic,
> are also strong contenders in the relationship arena. Internet
> service providers (ISPs), on the other hand, will have difficulty
> developing broad and deep customer relationships because they lack
> the skills to deliver multiple services and are late starters in the
> race to build customer relationships.
> The second battleground is to be the owner, operator, and wholesaler
> of the least expensive and highest-quality network access and
> backbone infrastructure. In this battle, WorldCom is the clear
> leader: it carries over 40 percent of all backbone traffic and owns
> the biggest worldwide network of points of presence (POPs). Although
> its Internet business does not report separately, it is likely that
> it already shows a profit.
> These winners aside, however, the thousands of companies that make
> up the Internet access market collectively lost a total of almost
> $400 million in 1997 as they sank money into building out their
> infrastructure and acquiring customers. Among the hardest hit have
> been the US local telephone companies known as RBOCs (regional Bell
> operating companies). They have invested hundreds of millions of
> dollars in building ISP businesses, but have neither profits nor
> much in the way of market share to show for it.
> Luckily for the RBOCs and the thousands of other access providers
> that have lost out to AOL and a handful of other profitable ISPs
> such as EarthLink and MindSpring a long-awaited technological
> discontinuity known as broadband is about to rewrite the rules of
> the Internet access game. Broadband is the name for a range of
> technologies that enable users to access the Internet at speeds of
> up to several megabytes per second (Mbps): in other words, up to a
> thousand times faster than with today's typical modems. Downloading
> Web pages with narrowband technology has been likened to sucking
> jello through a straw; broadband technologies, on the other hand,
> promise to deliver crisp text, video, and sound as quickly as if the
> user were watching television.
> Having overcome their initial reluctance to join the fray, cable,
> telephone, and satellite companies are now competing in a quickening
> race to deliver broadband service to personal computers in
> consumers' homes. This race is set to transform the users, the
> technology, and the economics of Internet access. In particular, the
> new technology is able to create a broadband "last mile" to the home
> that can be used by cable and other companies to attack the
> narrowband local loop in which the RBOCs have long held monopoly
> privileges. Since AOL and other ISPs have no automatic or guaranteed
> access to customers who use broadband technology to get onto the
> Internet, broadband may have the power to determine who wins and who
> loses in the Internet access industry.
> So-called broadband access to the Internet has been waiting in the
> wings for years, but local telephone companies have been reluctant
> to invest in it for fear of cannibalizing their lucrative 1.5 Mbps
> (T1) leased lines, for which business customers need a special line
> and are charged a premium price. Cable television companies, for
> their part, have often boasted about building out cable modems
> through which high-speed Internet access could be delivered, but the
> cost of their ambitions frequently came up against a chronic lack of
> cash.
> So why is broadband suddenly becoming viable? The turning point came
> when satellite operators began delivering 500 channels of crisp
> digital video and audio to cable customers. (Note that this is
> essentially a one-way pipe; satellite technology isn't capable
> except in conjunction with another pathway of providing the
> two-way interactivity necessary for broadband access to the Web.)
> This incursion into cable companies' core customers has startled
> them into accelerating the upgrade of their cable systems in order
> to stay competitive an upgrade that has incidentally given them
> the ability to offer high-speed two-way Internet access with a
> proportionately less expensive buildout.
> Broadband comes in many flavors, each supported by a different
> industry group. Telecom companies are moving to deploy digital
> subscriber line (xDSL) technologies; cable companies are pushing
> cable modems; and wireless competitors are betting on local
> multipoint distribution systems (LMDS), multichannel multipoint
> distribution systems (MMDS), and satellite technologies.
> Of these technologies, cable modems and xDSL are the most viable in
> the next three to five years. Satellite's infrastructure costs make
> it too expensive for the consumer segment. Wireless technologies
> that might challenge cable modems and xDSL are still in their
> infancy. Meanwhile, the cost of cable and xDSL access is falling
> fast, bringing them into the price range of $30 to $50 per
> subscriber per month.
> Early results show that the adoption rates for cable and xDSL in the
> areas where they are available are higher than those for comparable
> new technologies in the past. Analysts' projections put broadband
> penetration at 12.5 million in 2002 (up from 100,000 today), with
> consumers enjoying faster access to richer content and spending up
> to three times more time on line every day than the typical
> narrowband user.
> Broadband represents a major discontinuity in the Internet access
> business. First, it has the power to change the nature and value of
> Internet subscribers. Initially, it is likely to skim off the most
> attractive consumers and extract disproportionate revenues from
> them. The premium service it offers, accompanied of course by
> premium prices, will ensure that broadband subscribers are more
> financially attractive than other Internet users.
> Broadband delivery should also boost Internet businesses' ability to
> generate high-margin advertising and transaction revenues. Given
> these conditions, broadband will come to account for 10 percent of
> users and 30 percent of high-margin revenues by 2001, according to
> analysts' estimates. Over the longer term, as prices fall and its
> capabilities are exploited by more applications, broadband may
> attract a much wider audience than narrowband has to date, making
> the Internet a truly mass medium.
> Second, broadband involves a big shift in technology that will
> undermine the advantage held by narrowband incumbents. Multiple
> technologies are vying to deliver broadband content over the "last
> mile" to consumers' homes. No matter which technologies succeed
> wireless, cable TV, or traditional telephone lines they will need
> a new infrastructure, starting with new equipment at both the
> consumer premise and the upstream end. In addition, new server
> technology will have to be deployed to deliver the richer content
> that will be feasible once the bandwidth bottleneck has been broken.
> All these new investments serve to level the playing field between
> current narrowband leaders like AOL and new entrants using broadband
> technology.
> Third, players delivering broadband access will have entirely
> different economics because of increased fixed costs over the last
> mile to the home. As we shall see, the heavy fixed costs of
> providing broadband access to a local community make the economics
> highly sensitive to penetration. Unlike narrowband, which uses
> conventional telephone connections and requires only modest
> investment to build out a POP, broadband incurs the substantial
> costs of upgrading cable system headends (the place where the local
> signal originates in cable TV networks) or phone company central
> offices. Until economies of scale are reached, the cost of consumer
> equipment is also considerable. All in all, these higher fixed costs
> per POP change the game of managing local assets.
> Were it not for the broadband discontinuity, new entrants and the
> losers of the narrowband battle would be doomed to play catch-up in
> the battlegrounds of customer relationships and network
> infrastructure. But because of the sensitivity of its economics to
> subscriber penetration in a local area, broadband opens up a new
> battleground in the Internet access market where such players can
> enjoy at least a level playing field and perhaps even an advantage
> over narrowband incumbents. Once they have established themselves in
> this new arena, broadband players may then be able to use it as a
> platform to attack the other Internet access battlegrounds.
> The new opportunity afforded by broadband is to achieve scale in
> operating the local access infrastructure. Because broadband access
> will initially be a high-end service targeted at the most attractive
> Internet subscribers, its penetration (the percentage of homes in a
> given area subscribing to it) will be small in comparison with that
> of narrowband access. But as we have seen, the fixed costs of
> building a broadband POP or upgrading a cable headend are
> substantial, and the servers that are needed locally to store
> replicas of the most frequently requested data (thus ensuring
> faster, higher-quality service without clogging the network) also
> add to the upfront costs. As a result, it will be uneconomic in the
> near term for multiple providers to cover the same area. One player,
> on the other hand, could achieve attractive economics by building
> out broadband POPs in a region and allowing multiple players to
> resell the service.
> In principle, this local infrastructure opportunity also provides a
> platform for competing in the two battlegrounds where narrowband
> leaders have emerged: namely, the portal (customer relationship)
> business and the backbone (infrastructure management) business.
> @Home, for example, is leveraging its exclusive ability to deliver
> local broadband access in order to provide an integrated offering,
> analogous to AOL's original narrowband service, that includes
> portal/directory services and proprietary broadband content. At the
> same time, it is using the traffic from its growing customer base to
> fill its new backbone infrastructure.
> Cable companies appear to have an early lead in the race to deliver
> broadband access. As we noted, this is the happy result of a threat
> to their core business from direct broadcast satellite (DBS), which
> prompted them to accelerate their deployment of hybrid fiber coax
> (HFC). In doing so, they have already spent between 60 and 80
> percent of the sum they need to invest to upgrade to broadband
> capability. By the end of 1997, cable systems had completed HFC
> upgrades to cover approximately 45 percent of US homes; coverage is
> expected to increase to 60 percent by the end of 1998, and 75
> percent by the end of 1999. As well as increasing the number of
> channels that cable systems can carry, these upgrades will allow
> cable companies to tap into Internet access revenues at relatively
> low incremental cost.
> Cable players have two main advantages over RBOCs in delivering
> broadband Internet access to consumers:
> No conflict over goals. Broadband access represents a source of
> genuinely incremental revenue for cable providers. Unlike RBOCs,
> which have to worry about cannibalizing existing T1 revenues that
> amounted to some $1.5 billion in 1997, cable companies can afford to
> price low to build penetration and establish leadership. Some
> analysts estimate that broadband access could double cable
> companies' revenues per subscriber.
> Better execution. Cable companies have executed their broadband
> strategies more effectively than RBOCs, perhaps because of their
> familiarity with the access and content business model. By setting
> up focused subsidiaries such as @Home (owned by TCI and allies) and
> Roadrunner (owned by Time Warner and allies) to deploy, market, and
> operate their broadband services, they have overcome skill gaps in
> data service and improved their marketing. They have also speeded up
> consumer adoption by forming partnerships with content players to
> ensure the availability of engaging broadband content.
> As a result, cable operators have deployed cable modem services much
> faster than RBOCs have deployed xDSL -- so much so, in fact, that
> they account for a full 90 percent of today's broadband subscribers.
> The baby Bells may have been slow in rolling out xDSL, but they are
> far from out of the race. Indeed, xDSL has certain advantages should
> the RBOCs pursue it strenuously:
> Familiarity and flexibility. Because it uses telephone lines, xDSL
> means that migrating narrowband customers will need less education.
> It will hook up to existing phone outlets anywhere in the home
> instead of having to be close to a TV, and with new technologies
> such as DSL-Lite -- championed by technology heavyweights Intel,
> Microsoft, and Compaq -- installation can be "plug and play," with no
> need for a visit from a technician, unlike cable.
> Better economics at low penetration. After teething troubles with
> high equipment costs and such installation problems as interference
> with nearby T1 lines, the installation costs of xDSL are now
> approaching those of cable modems. In addition, since a larger
> portion of the costs varies with the number of households
> subscribing, telephone line delivery has considerably better
> economics at low penetration than cable, allowing an xDSL provider
> to reach profitability earlier.
> These advantages aside, RBOCs also have a solid brand advantage over
> cable companies. Despite these rivals' efforts to shed their
> reputation for unreliability and poor customer service by using the
> @Home and Roadrunner brands, they still lag on this critical
> dimension for the consumer market.
> Both cable companies and RBOCs are well positioned to take the lead
> in the battle to build local scale in broadband access
> infrastructure. Though cable currently enjoys a clear edge, RBOCs
> have the power to close the gap. Whether or not they make the effort
> to do so and introduce an alternative to cable in local broadband
> access infrastructure will determine the competitive shape of the
> Internet access business. For their part, AOL and narrowband winners
> should do whatever they can to gain access to broadband customers,
> whether through cable modems or xDSL.
> Below, we evaluate the broadband opportunity from the perspective of
> cable systems (and the consortia of investors they lead), narrowband
> access providers, and RBOCs.
> Because RBOCs have been reluctant to deploy broadband technology or
> price it attractively, the cable providers @Home and Roadrunner have
> established an effective monopoly on broadband access for the
> consumer. Their cable company parents (and the broad consortia of
> computer and media industry players that have also invested in them)
> clearly harbor aspirations that extend beyond the local broadband
> access infrastructure, and they are positioning their broadband
> capability to compete directly with the narrowband winners in the
> battles for customer relationships and backbone infrastructure. If
> this strategy is successful, their customer relationships could
> eventually rival those of AOL, and their backbone that of WorldCom
> or GTE (which provide backbone access to AOL).
> But the broad three-battleground strategy that @Home for one is
> mounting is high in risk as well as return. @Home is betting that
> it can not only establish a local loop broadband infrastructure, but
> leverage it to become a "broadband AOL" -- in other words, a company
> that controls customer relationships with millions of Internet users
> as well as a backbone provider. By competing across the board,
> however, @Home is reducing its chances of winning where it commands
> an advantage, namely in the battleground for local broadband access
> infrastructure.
> Its integrated strategy is both slowing its growth and encouraging
> competition for local broadband access. First, by not wholesaling
> broadband access through customer relationship winners like AOL or
> Yahoo!, @Home is limiting its growth. Since most of its subscribers
> are already Internet users before they sign up, AOL and Yahoo! could
> be powerful sales channels.
> Second, by competing directly with the current Internet powers,
> @Home is increasing the likelihood that an alternative local
> broadband infrastructure will be created. Seeing the potential
> threat, AOL and other Internet leaders will be motivated to seek
> out, encourage, and perhaps even develop an alternative broadband
> route to consumers. And once an alternative exists, @Home will have
> little hope of maintaining its integrated strategy in head-to-head
> competition with a host of hardened narrowband competitors. Instead,
> it will have to resort to being merely a local broadband access
> wholesaler, competing on price and desperate to fill its fixed-cost
> pipes.
> Despite these risks, @Home's strategy may succeed if others, most
> notably the RBOCs, do not provide an alternative to cable's current
> broadband access monopoly. The fact that the market values @Home at
> more than $6 billion, despite 1997 revenues of only $7 million,
> suggests that investors are not convinced RBOCs will rise to the
> challenge.
> Despite the discontinuity introduced by the deployment of broadband
> technologies, the winners of the narrowband battles possess
> substantial advantages in their respective battlegrounds. If given
> the opportunity to resell broadband access, portals like AOL and
> Yahoo! will have a head start in signing up and serving new users
> thanks to their established relationships with millions of users and
> the time-tested quality of their narrowband offerings. Similarly,
> the scale and geographic coverage of the large Internet backbone
> providers make them attractive partners in the provision of the
> upgraded backbone needed to support broadband offerings.
> The threat for narrowband winners is that they will be locked out of
> broadband when a single integrated player like @Home uses its
> dominance of the local infrastructure to attack them in their
> strongholds. To protect themselves, the narrowband winners must do
> whatever they can to encourage the development of competing
> alternatives for local broadband access by partnering with the RBOCs
> to push the deployment of xDSL, or perhaps by helping promote a
> wireless or satellite technology.
> At the same time, the narrowband gateway winners should strive to
> convince @Home to let them resell broadband access. When AT&T's
> acquisition of TCI was announced, AOL quickly reiterated its
> interest in forming a partnership to resell high-bandwidth access.
> And even if @Home does not cooperate, narrowband portals should
> develop exclusive services for broadband users to compete for
> customers' share of mind. Today's narrowband backbone providers
> should try to develop relationships with local broadband providers,
> and take steps to upgrade their offerings to enhance broadband
> performance on their networks.
> Luckily for the narrowband winners, RBOCs have every reason to
> deploy xDSL, even without being pressured. Their earlier reluctance
> to cannibalize their highly profitable T1 leased line business has
> been a key factor in slowing their deployment of broadband access
> alternatives. Today, the decline of that business appears
> inevitable, whether or not the RBOCs act.
> Regulatory requirements, combined with the compelling economics of
> xDSL, already allow competitive local exchange carriers (CLECs) such
> as Covad to offer businesses xDSL-based T1 connections for just $199
> per month (as opposed to $1,500 per month or more for a standard
> leased line). Given this sharp cut in costs, the real question for
> RBOCs is whether they are going to cannibalize their leased line
> business themselves or let someone else do it. Selling xDSL to their
> business customers is probably necessary if they are to maintain
> their existing relationships. From there, it is but a small step to
> leverage the same infrastructure to serve consumers. The challenge
> will be to design a differentiated pricing scheme that segments the
> market on the basis of capacity requirements and minimizes the
> impact of cannibalization.
> This means that the RBOCs have compelling reasons to compete in the
> local infrastructure battleground. Unlike @Home, however, they
> should concentrate on building an efficient wholesale broadband
> access business. By focusing on the opportunity in local
> infrastructure, RBOCs can leverage their ownership of the local loop
> while fully exploiting the customer acquisition capabilities of
> today's narrowband leaders to grow rapidly, build local scale, and
> overcome cable's current lead.
> It will be tempting for RBOCs to set their aspirations beyond the
> wholesale opportunity. After all, they have millions of customer
> relationships and can offer a wide array of telecommunications
> services in conjunction with broadband access. And there is probably
> no harm in having a retail business in addition to wholesale. But
> while an exclusively retail strategy that strives to capture and
> hold customers by bundling telecom services could be successful in
> theory, in practice it recreates an approach that has failed for
> RBOCs in narrowband. Instead of competing head on against the
> strongest players in the Internet, RBOCs should leverage the power
> of the narrowband leaders to build a sustainable position operating
> local network assets of which they are the natural owners.
> As the dust begins to settle on the narrowband access battlegrounds,
> winners are emerging that have established powerful positions either
> in national infrastructure scale or in customer relationship scope.
> The emergence of broadband access represents a major discontinuity
> that is creating a third battleground in local broadband access
> infrastructure. Cable has the early lead in this new arena, and may
> be able to use its success to attack the narrowband winners. For
> their part, the narrowband players enjoy considerable advantages,
> but depend on RBOCs to act decisively in building an alternative
> broadband infrastructure. The choices that the RBOCs make will not
> only shape their own fate in round two of the access battle, but
> also determine the future structure of the Internet access industry
> as a whole.
> The basic components of the business system that
> delivers Internet access to consumers are the
> national transportation backbone; the local
> point-of-presence (POP) infrastructure with
> access lines, servers, routers, and modem banks;
> and customer service and support. Many players
> interact and compete in complex ways in this
> space, and the relationships between them are
> evolving rapidly. Four key roles can be
> identified:
> - Backbone providers (notably UUNET and Sprint)
> own the backbone infrastructure and act
> primarily as wholesalers, but also sell directly
> to end users, particularly medium-sized and
> large corporations.
> - Large Internet service providers (ISPs) (both
> national players such as EarthLink, MindSpring,
> and MCI, and regional and local players such as
> Erol's, FlashNet, and the RBOCs) have
> relationships with 100,000 or more end users,
> and either purchase capacity from others or own
> local or regional infrastructure (in which case
> they often also act as wholesalers to smaller
> ISPs).
> - Small Internet service providers are local
> "mom and pop" operations that typically provide
> dial-up access to a few thousand customers.
> - Online service providers (such as America
> Online or MSN) provide an integrated offering of
> Internet access and exclusive and proprietary
> content.
> The Internet access industry as a whole has lost
> money ever since its inception. In 1997, the
> losses amounted to some $400 million on revenues
> of roughly $6 billion. Although AOL, the leading
> online service provider, reached profitability
> in 1997, and small ISPs were profitable on
> average, backbone providers, and in particular
> large ISPs, posted heavy losses. There were five
> main reasons for this:
> - The limited penetration of the Internet. In
> 1997, penetration stood at about 23 percent of
> US households too small a number of users to
> pay for fixed infrastructure and G&A costs.
> - The rapidity of growth. This pushes up
> acquisition costs to $60 to $100 per customer
> (sums that are put down to expenses rather than
> capitalized), and makes for the inefficient use
> of network capacity, with additions coming in
> lumpy increments that force players to spend
> ahead of demand.
> - The competitive pricing pressures and the
> resulting ubiquity of the "all you can eat"
> flat-price model, which allows a small number of
> customers to abuse the system and consume a huge
> chunk of capacity without bearing the cost.
> Among AT&T WorldNet's subscribers, the 3 percent
> of heaviest users consumed over a third of the
> total capacity until restrictions in the form of
> usage-based fees were introduced in late 1997.
> - The immaturity of revenue sources, with
> transaction and advertising revenues per online
> household lagging far behind the levels achieved
> by media such as cable TV and TV home shopping.
> This is despite superior demographics, better
> targetability, and continuing increases in time
> spent on line (AOL's customers spent up to 48
> minutes per day on line in 1997 compared with
> under 20 minutes in 1996).
> - The high customer churn, with well over 40
> percent of subscribers switching provider in the
> course of a year. By contrast, even the highly
> competitive world of long-distance telephony
> experiences churn rates of only 20 to 30
> percent.
> Over the next two to three years, improvement
> can be expected in all five of these problem
> areas. By 2000, Internet penetration may have
> reached 33 percent of US households, while
> growth is likely to have slowed considerably.
> Pricing pressures have started to ease, with AOL
> increasing its rate from $19.95 to $21.95 per
> month and AT&T WorldNet limiting "all you can
> eat" to 150 hours per month to stop abuse.
> Non-subscription revenues have started to
> increase (advertising revenues per online
> household rose from $17 in 1996 to $39 in 1997),
> and churn rates are falling as competition
> stabilizes and providers invest in customer
> support.
> When taken together, such changes could make the
> average player profitable by 2000. But industry
> structure will be critical, with a few players
> capturing scale and scope economies and pricing
> levels being determined by the extent of
> fragmentation or consolidation in the industry.


We call things we don't understand complex, but that means we haven't
found a good way of thinking about them.
-- Tsutomu Shimomura, _Takedown_