As I discuss in an article published Tuesday, FiOS is a monumental bet by Verizon on the future. It will cost $23 billion to run fiber past 18 million homes, roughly half of those served by Verizon.þMy article focuses mostly on how Verizon has been more successful than expected with the new service. But one prominent skeptic, Craig Moffett of Sanford C. Bernstein, has a far more bearish take on both the traditional wireline phone business and on Verizon’s FiOS effort. It’s worth hearing him out — he was the top-ranked cable analyst in Institutional Investor’s annual survey and he started covering telephone companies as well last year.þFiOS has been very popular with consumers because it offers faster Internet service, more high-definition video channels and more bells and whistles than most cable systems. But Mr. Moffett’s argument is that what is good for customers is not good for investors.þ“If I were an auto dealer and I wanted to give people a Maserati for the price of a Volkswagen, I’d have some seriously happy customers,” Mr. Moffett said. “My problem would be whether I could earn a decent return doing it.”þMr. Moffett has tried to figure out all the money Verizon will spend building and selling FiOS, the interest it pays on the money it borrowed to pay for it, the savings because the new system is cheaper to maintain and all the fees its customers will pay. He compares this to what he figures Verizon would have earned had it not built FiOS. Add up all the figures and discount it to present value and Mr. Moffett figures that FiOS puts Verizon some $6 billion behind.þVerizon, not surprisingly, objects rather strongly to Mr. Moffett’s analysis. The company doesn’t disclose its version of all the numbers he uses, however. It does say that the cost of wiring neighborhoods is coming down faster than he estimates and that the revenue potential from video, data and other services may be higher than he is counting on. þ“This is not a case of ‘We will build it and we hope they will come,’” said Peter W. Thonis, the company’s chief communications officer. “This is real innovation, which as always requires some element of risk. But the customer has already voted in favor of FIiOS wherever we’ve deployed it. We’re out of the risk phase and into the growth phase.”þHere are the main tenets of Mr. Moffett’s critique:þTraditional telephone service is doomed to extinction.þþMr. Moffett starts with the premise that the 130-year-old phone network based on copper wire will become extinct.þ“It is an obsolete technology,” he said. “It’s not like horses lost share of the transportation market until they stabilized at 40 percent market share.” þCable systems are the natural replacement for phone companiesþþOnce the technology was developed in the 1990s to use the existing coaxial cables used for television signals for Internet service and voice calls as well, the writing was on the wall for phone companies, he argued.þ“In 1996, as soon as you saw that the technology existed for a cable network with vastly higher capacity and vastly lower margin cost to be able to do voice calls over the same network, you would have said the end game is obvious: Cable will win and the telcos will go into bankruptcy. The only question is how long it will take.” þLest he be criticized for having a soft spot in his heart for cable companies, Mr. Moffitt argues that the cable industry collectively wasted the $100 billion it spent on upgrading its networks.þ“Cable built a plant that was more expensive than they ever should have built,” he said. But now that the cable companies have spent that money, their network is in place to deliver phone service more cheaply than any other alternative, he argues. þFiOS is phenomenally expensiveþþHere is how Mr. Moffett looks at the costs of the plan that Verizon has announced for FiOS. Through 2010 the company will pay an average of $817 to run the fiber past the 19 million homes, on poles or under the ground. It will also incur $172 per home passed in other costs related to the video infrastructure. He assumes that 40 percent of the customers passed will buy at least one FiOS service. If you allocate the cost of running the fiber past the homes that don’t buy FiOS to those that do, that makes the cost of building the network $2,473 per home. (That cost would be less if more than 40 percent of the potential customers sign up. Or it could be higher, if sales don’t achieve the 40 percent level.) þBut the costs don’t end there. Once someone decides to buy FiOS, Verizon will spend another $718, as Mr. Moffett calculates it, for equipment in the home and the labor to connect it to the network. There is another $130 in marketing expenses, and $576 for interest on money spent to build the network before it is completed. þAll this adds up to $3,897 in capital cost for every FiOS customer.þAs one comparison, the total enterprise value of Comcast (that is its stock market capitalization plus the value of its debt) comes to only $1,500 per connected home, he said.þThe returns from FiOS aren’t enough to pay for the high costsþþThe second half of Mr. Moffett’s calculation tallies how much Verizon can be expected to earn from FiOS. He estimates the operating profit Verizon will each service will earn over 15 years and calculated the present value — a way to discount money received in the future — of those profits. On that basis, the cumulative profits for each FiOS video customer will be $556. Each Internet customer will earn Verizon $813, Mr. Moffett estimates. For telephone service, he only adds in the fees from 30 percent of telephone customers, the portion he estimates would have otherwise dropped Verizon service and switched to cable or cellphones. This comes to an average of $564 per customer.þ(If you are comparing those numbers in your head to the prices charged for these services, you might wonder why video, which often can cost much more than data, has lower profits. The reason is that video is a much lower margin business because of all the payments to cable networks. Internet service and telephone service are much more profitable.)þDeduct from these amounts, however, the cost of promotions and sales commissions needed to lure customers. Verizon has recently given away televisions and camcorders, so Mr. Moffett estimates these costs to be $100 for each data customers and $390 for each video customers.þMr. Moffett also tallies other benefits Verizon will receive from FiOS. It will save $572 per subscriber in maintenance because the digital network can be modified without sending a technician in a truck. It will avoid $390 in investments it would otherwise have to make in the old copper network. Uncle Sam will help out, too, with $827 in tax savings.þAdd that all up and the operating profit, in present value terms, that Verizon will earn from FiOS customers will be $2,520 for those that buy video and phone service, 3,068 for Internet and phone service, and 3,334 for customers that buy the so-called triple play. None of those are above the $3,897 per-customer cost of building the network. þThe bottom line, after assuming how many customers will buy each type of service, is that Verizon will lose $769 on each FiOS customer, according to Mr. Moffett’s vast spreadsheet.þFiOS will be a huge hit with customersþþHidden in all those assumptions is that that Verizon will wind up selling video to 25 percent of the homes passed. That would give it market share that rivals cable. By contrast, Mr. Moffett said, DirectTV took 13 years to gather a 15 percent penetration. Similarly, he projects that FiOS will wind up with 30 percent of the data market, reversing the losses for the phone company’s DSL service.þAT&Ts approach isn’t much betterþþAT&T decided that a full fiber network was much too expensive. Instead, it is wiring neighborhoods with fiber, but connecting homes through existing copper wires. This technology is a variation on the DSL service phone companies have used to offer high-speed data service.þBy Mr. Moffett’s calculation, AT&T’s approach costs only $2,200 for each customer to build. But that’s not enough to make a profit, because the revenue is less, too. The service, called U-Verse, is less attractive than FiOS so it is not getting as many customers, he said. So Mr. Moffett gives this a thumbs-down, too.þQwest, which doesn’t have a cellphone business to fund any capital expenditures, is the only phone company that has come up with what Mr. Moffett defines as the right answer: do nothing.þ“Qwest decided there is no return to any of this stuff, so let’s run the business for cash,” he said.þVerizon won’t go bankrupt, and will even start to look goodþþAn added benefit for Verizon, as Mr. Moffett describes it, is that the nature of FiOS makes its financial statements more attractive to investors who are not so concerned with the return on investment.þVerizon is replacing expenses, which show up on its quarterly profit and loss statements, with capital spending, which appears on its balance sheet. þ“Instead of rolling a truck for a routine add-and-drop-service call and expensing $400, they are rolling a FiOS truck and capitalizing $4,000,” he said.þTo be sure, Mr. Moffett says that FiOS is not a “bet the company” move by Verizon. Because the company has a vibrant wireless business, it has the money to absorb the cost of building FiOS and the inevitable decline of the rest of its wireline network, Mr. Moffett said. þMoreover, investors are going to start to look kindly on Verizon as it moves forward. They will see the money spent to build the network as “sunk costs” and focus instead on the profits that will come from signing up video and data customers. þ“The question isn’t whether it is profitable,” Mr. Moffett said. “The question is whether it will be sufficiently profitable to make it worth spending $23 billion.”þ
Source: NY Times
