Subject: Empowering the Customer or Empowering the Telco - State of the Internet 2002 (abridged) Published annually to the IETF list

From: Gordon Cook <[email-masked]>
Date: Sun, 6 Jan 2002 16:24:17 -0500

Empowering the Customer or
                            Empowering the Telco

State of the Internet 2002:  Assessing the Technical, Economic and 
Policy Consequences Behind the Collapse of 2001

In its examination of the impact of Internet technology on global 
telecommunications during 2001, this report will bring into focus 
changes that are reshaping one of the world's largest and most 
critical industries in ways unforeseen only a year ago.  Neither the 
Internet nor the phone companies are going away.  However, while 
technology continues to reshape possibilities for industry markets, 
it is having economic impacts in 2002 that will increase the risks 
and opportunities for informed managers, financial planners and 
policy makers.

As the reverberations from the collision of the tectonic plates of 
Internet and "telco" seek to establish some new equilibrium, the 
architecture of the Internet is shifting and becoming more complex. 
Issues of control seem more and more important.  To the extent that a 
nethead versus bellhead philosophy is still meaningful the difference 
between the two is reflected less in the technology being used and 
more in ideas about where control is to be located.

Trends:  Technology and Economics

The most significant technology trend that we see is one that will 
present managers, investors and policy makers with a choice pointed 
out by the title of this report.  Empower the user.  Or empower the 
telco.  Choices are being made.  The technologists are driving 
control of lambdas into the hands of end users.  Peer-to-peer, as 
software and infrastructure, is enabling the formation of communities 
of users at the network's edges.  Here the goal is generally to make 
the center and anything associated with it disappear.  Huge fortunes 
are being wagered on the web based client server model.  The bell 
heads and walled garden guardians may find out too late that their 
centralized content control model is not the only way to do business. 
The impact of technology on network architecture will be the most 
important trend to watch in 2002.

But, as many have found out to their dismay, we can no longer make 
intelligent decisions in telecommunications absent a thorough 
understanding of the industry's economic picture.  Indeed analysis of 
technology trends done without understand of their economic impact, 
are, in this climate, of limited use.  Therefore, the remainder of 
this summary will turn to economic issues.

The COOK Report started publication a decade ago as the Internet was 
in its early stages of commercialization. Ten years and a trillion 
dollars in global investment later we have witnessed dramatic changes 
in global telecommunications.  But what we have now is not what any 
reasonable person would call "success."  The old technology did not 
collapse under the onslaught of a triumphant new global packet 
network bringing vast amounts of inexpensive bandwidth to every home 
and business.

One reason it did not was that the technologists were so certain of 
the superiority of their product and were so good at driving the hype 
that got them their early stage capital investment they were able to 
sail forward without a long term viable business model for what they 
were doing.  Build it and you will be saved - somehow.  The 
provisioning of vast amounts of cheap bandwidth was seen as a 
sustainable business model for the Internet.

The problem is that ten years on the bandwidth business model has not 
proven to be a viable one.  The question is whether bandwidth is 
something on which a business model can be built?  Or is bandwidth, 
like a highway, just an enabler?  We started out a decade ago talking 
about the information super highway and then proceeded to try to 
build multiple global privatized versions.  Imagine if Ford had spent 
tens of billions building a global interstate for its cars.  While 
GM. Daimler-Chrysler and Honda and Toyota had each done the same 
thing.  What has been built are highways with largely identical 
performance and capable of huge indiscriminate through-put of 
"vehicles" or packets.  They have lead to an unsustainable business 
model.  "Become a customer of my commodity system."  "No.  Not his. 
Mine.  I just doubled the speed and I will sell you access for 20% 
less.  I only had to borrow another billion dollars against my non 
existent profits." Yes we have a train wreck.  Any wonder?

But remember after all the investors were being sold a product that 
moved at 'Internet speed' and hyped as a global, winner-take-all, 
economy-of-scale, build out where one year in Internet time was said 
to equal seven ordinary years and where there would be a 'winner" 
with first mover advantage.  The new Internet world was hyped as one 
where regulation was unneeded because it would slow the rate of 
adoption of the new technology.

Consequently, all the big players operated in their own informational 
vacuums.  Through an informal old boy-girl network, they 
interconnected where necessary and as fast as they could spend their 
capital.  They built global commodity systems frosted with a whiff of 
secret sauce that alleged that one system was better than another. 
"Trust us," they said as they continued to run full tilt ahead.  The 
trust that was granted is coming back to haunt us.

Just within the past week we are seeing evidence of a new and 
potentially very disturbing basket of problems generated by the all 
the hype about the technology that applied Moore's Law to 
telecommunications for the first time.  We have been spending much of 
the past month talking with folk from the financial analyst 
community.  We heard concerns expressed about sales of 20 year IRUs 
on dark fiber among Enron and the other large new global Greenfield 
fiber network players.  It was asserted that it looked as though 
income from the IRU was booked up front at the time of the sale with 
the IRU on the same fiber then being resold by the purchaser to 
another party so that income from the resale could again be booked as 
profit.  We asked where we could find some documentation on this and 
were told that there wasn't much.  That the information had been 
gleaned primarily from listening to quarterly phone briefings of 
analysts by management.

But suddenly the situation changed.  On January 1, 2002 the 
Washington Post published a confirming story by Peter Behr.  The 
headline:  Broadband strategy plunged Enron into trouble.  Behr 
wrote: "Enron's recent financial disclosures show that its claims of 
success in broadband included large gains from trades with private 
partnerships it had set up itself. And using aggressive accounting 
practices, it assigned exaggerated values to the broadband contracts 
it traded with others in the industry, greatly inflating its actual 
revenue and profit, Enron insiders and analysts say." [Snip]

"The [profit] margins were whatever they decided,'' said a former 
Enron vice president familiar with the broadband trading, who spoke 
on the condition of anonymity. In many instances ''they were trading 
with themselves,'' he said. As prices for fiber-optic circuits 
plummeted, Enron tried and failed to lure telecom giants that used 
broadband - such as MCI WorldCom Inc. and Verizon Communications Inc. 
- to trade with it and create a true market. Carol Coale, an analyst 
at Prudential Securities who heard Enron's repeated claims that its 
trading operations were growing rapidly, said: ''These guys were 
great spin doctors. They had the answers. The answers were lies.'' 
http://www.washingtonpost.com/wp-dyn/articles/A46876-2001Dec31.html 
The entire article is well worth reading.  As the self regulated 
industry had been saying:   "trust us."

So What Were We Trusting?

The "stupid network," taken as a concept, captured important 
differences in the operation of the new Internet companies while it 
ignored the huge revenues and deeper pockets of the old line telcos. 
It was propelled by a reality defying arrogance that allowed a Bill 
Schraeder to build a global company with a billion dollars a year in 
revenues in a matter of months and then bankrupt it in a matter of a 
few more months. Remarkably, we are now - a year after the train 
wreck began - watching a growing string of bankrupt or soon to be 
bankrupt global super highway builders.  The fall out has left the 
infrastructure industries that they depend on paralyzed, seen the 
loss of trillions in market value, hundreds of thousands unemployed 
in the midst of a global recession and left policy makers with no 
creative idea of what to do. We are marching toward a denouement 
designed to allow the ILECs to try to be the last ones standing by 
allowing them to use their control over the "last mile" to 
re-monopolize service.  This after all, is what the "free market" has 
given us.  We owe the great boom of the last 20 years to our faith in 
the free market so if we just hang on a while longer someone or 
something will save us.  Indications that the new technology may also 
bankrupt the ILECs are not yet on the radar screens of most analysts.

This leaves us in a strange situation.  One where we are so smart 
that we can shove billions more photons down the same thread of glass 
this year than we could last year.  But it is also one where we are 
also so ideologically blinded that we remain wedded to the building 
and maintenance of multiple privately owned systems when experience 
now shows us that there is no business model that can pay for 
multiple competing privately owned commodity systems.

A dozen years ago we created a Federal corporation to clean up the 
savings and loan fiasco.  But in 2002, with a critical global 
industry on edge, no one can see a large enough picture to understand 
what to do.  If local and national governments are a public good, and 
if a freely accessible global commons of locally built highway 
systems maintained from business and user taxes is also a public 
good, perhaps the only feasible foundation on which to restructure 
telecommunications is a nationally maintained blanket of 
publicly-owned glass threads.

Asking about the Internet's business model is like asking about the 
Interstate Highway System's business model.  Who owns it?  Who 
controls it?  And to whose advantage is it used?  How are Ford's 
interstates better than those of GM?

[Two paragraphs SNIPPED]

Roxane Googin, Editor of the High Tech Observer, in a short essay in 
David Isenberg's Smart Letter 64 has captured the essential problem: 
"But even though the attackers are starving, they are forcing 
marginal bandwidth prices below the ILEC's cost of provisioning -- 
not only replacement but also provisioning.  So the ILECs are going 
to get squeezed because they have this complex, labor-intensive 
infrastructure that is no longer supported by a viable economic base."

"In this kind of nightmare scenario, nobody wins. It is just a big 
mess because the attackers are [also] going under. Meanwhile, they 
have crippled the incumbents. We are witnessing the perfectly 
predictable outcome of this process: no equipment sales, and no more 
progress."  [Snip] "So we have to fix the problem. This means 
restructuring the debt and owning up to what the real issues are. 
This owning-up hasn't been done yet."

"Then we have to reallocate the assets to the right parties. 
Unfortunately some markets don't behave in a traditional market way. 
Typically common-good markets, like transportation systems, tend to 
be regulated markets, because the capital outlay upfront is 
associated with an unknown return in the future. This regulation is 
rather contentious, whether it is the old telecom, the airlines, or 
even trucking. There are just some markets that don't behave well, 
and I'm afraid that this is one of them. So we have a lot to think 
about."

"Time is of the essence. The reason that we are in this downward 
spiral is because telecom is draining the vitality of the entire 
economy. On the margin, this is where our last decade of growth came 
from, and now it has stopped. It would be helpful if policy-makers 
knew the problem from this perspective."

We think Googin's analysis is correct and we will soon publish a 
detailed interview with her showing why.  Interviewing her has led us 
to wonder if the technology analysts ever talk with the financial 
analysts?  For years, from the technology side of the fence, we have 
pointed out what others have said about how the decreasing costs of 
the Internet Protocol and fiber based technologies mean the "end" of 
the traditional telco.  The conventional wisdom was that the next 
generation telco's would succeed and absorb the old circuit-switched 
incumbent local exchange carriers.  It is beginning to look like the 
opposite is true.  Furthermore, if Roxane Googin is correct, the 
carnage won't stop with the bankruptcy of the next gen companies but 
will spread to the incumbent local carriers themselves.  This is what 
we mean when we suggest that the Internet has yet to find a 
successful business model where it can deliver to our homes and 
businesses low cost bandwidth as an enabling technology without 
destroying the global telecommunications industry on which it depends.

In our coverage in 2002 we shall look in detail at what Roxane Googin 
is saying about the phone companies.  Here is a summary of her 
analysis.

Why the ILECs Are in Trouble as Data Grows and Voice Shrinks

While the general perception is that an over supply of dark fiber is 
driving bandwidth prices down to the detriment of everyone, reality 
is a little bit more complex.  The costs of lighting that fiber are 
very large.  Considering the ILEC investment in SONET, the costs for 
them to light new fiber are so significant that a recent article in 
Light Reading pointed out that it is becoming cheaper for them to buy 
a lightwave from another carrier's lit fiber than to light their own. 
The point is that all the way up and down the circuit switched telco 
food chain carriers without the expenses of the first generation 
SONET infrastructures are able to sell bandwidth at less than the 
ILEC's cost of production.

A major problem of the ILEC is its huge investment in SONET based 
networks that bit-for-bit are not as competitive with what can be 
delivered by the newer players that have built IP based networks that 
rely on newer, cheaper SONET or on gigabit Ethernet and coarse wave 
division multiplexing.  But the ILECs are locked in with several 
hundreds of billions of dollars worth of OSMINE compliant SONET 
equipment that their balance sheets say they are amortizing at 25 
plus years.  As a result they have, and will have long into the 
future, huge interest payments to meet.  (Of course the new TCP/IP, 
fiber based greenfield players are also heavily invested in SONET and 
have themselves large interest payments due.)

The ILEC's ability to meet those payments is contingent on their 
ability to continue to deliver profitable voice minutes.  Given their 
enormous investment in local plant and in the people needed to 
maintain that plant, they need to protect, at any cost, their 
installed base of voice traffic.  For many years voice traffic has 
been growing at a few percent a year and data traffic growing two to 
three times as rapidly.  While data traffic is now a majority on all 
their networks, voice traffic still accounts for 80% of their income. 
According to RHK revenue per megabit of voice is seven times that for 
a T-1 (1.5 megabit) Internet connection.  Clearly efficiencies in the 
cost of production are to be found on the data side of the equation, 
given the impact of both dense wave division multiplexing and the 
efficiency of IP.

The voice minutes on which the ILECs and older carriers depend to pay 
the costs of running their infrastructure on a month-to-month basis 
are being siphoned away from the telco's SONET based networks.  The 
Internet has caused digital to be perceived as "cool."  The ILECs 
brag about their new digital infrastructures in their quarterly 
reports.  For example on November 5th 2001 BellSouth bragged that 
over the preceding decade it had invested in "749 broadband 
(ATM/Frame Relay) switches and 20,000 SONET rings in service in its 
network."  BellSouth "expects to end 2001 with approximately $4.5 
billion in data revenues."  It "projects to end 2002 with 22-25% 
growth in network data revenues."  But note that there is not a word 
that we have been able to find in this ILEC statement or in any other 
that data is profitable for them.

As Googin explains it:  "while they tell us they get 80% of their 
revenues from voice, they never say they get 80% of their profits 
from voice.  They simply do not tell us this information.  Given that 
data represents over 50% of their network traffic and about 20% of 
their revenues, it is probably not profitable for them at all.  They 
therefore do get 80% of their revenues on under 50% of their traffic. 
Since their network is monolithic, and largely of fixed cost, one can 
assume that data runs at a loss."

The Data Voice Mix Begins to Change

In 2001 the trends in data growth that had long been forecast finally 
began to hit home.  Softswitch services pioneered by next gen 
carriers like Level Three digitized vast amounts of voice traffic and 
sent them over IP networks as data.  Sky rocketing phone card sales 
at less than two cents for a voice minute siphoned voice data from 
ILEC networks.  On December 14 in a promotional announcement from 
Singapore for Cisco's voice-over-IP products Andrew Vlachiotis, 
Director of New Technologies Group of Cisco quoted a study that 
stated that for the first time since 1993, the Private Branch 
Exchange (PBX) market has declined 16.2 percent in the second quarter 
of 2000 from the same period in 1999. This is remarkable when 
compared with 10-15 percent growth rates for the previous five years 
according to Vlachiotis.  [Editor:  the fact that the timing of the 
change may be Y2K related adds another lever of uncertainty into the 
process of figuring out what these numbers really mean.] Furthermore, 
as we have documented in the lead article of our November 2001 issue, 
the release of Windows XP and the maturation of a whole family of SIP 
based proxy servers has come together with Softswitch technologies to 
enable the corporate PC to become a desktop voice phone.  We are 
beginning to witness what will become a flood of circuit switched 
voice minutes exiting the ILEC's expensive networks.  But these voice 
minutes don't evaporate.  What they do is become encapsulated inside 
inexpensive IP data packets.

Sure enough, examination of ILEC quarterly reports shows that ILEC 
voice minutes delivered starting with the June 2001 quarter have not 
only turned flat but have actually started to DECLINE.  Now if each 
data minute brings in about one cent, each voice minute brings 7 to 
ten cents in revenues.  Since 80% of their income is from voice under 
these conditions a 5% decrease in voice minutes could mean a 20% 
decrease in revenues.  The technology changes being brought on by IP 
ALTERNATIVES to ILEC circuit switched SONET services are going to 
deprive the ILECs of the income needed to operate their networks, 
repay bondholders, and make a profit.

[Ten paragraphs SNIPPED]

Michael Powell utterly misses the point.  Not only about size 
enabling price reductions for, as the market consolidates into larger 
players, the players are raising their prices. Powell also has no 
clue about the technology cost changes that are now building.  A year 
from now his pronouncements on Internet broadband may seem like a 
minor blip before the on-set of the whirlwind.  Still, absent major 
complaints from an educated public and from sectors of the telecom 
industry that understand there will be no role for them if we allow 
government to turn voice and data communication over to cash rich 
Microsoft to charge whatever prices they can extort, we are headed 
for ugly day of reckoning.  As the current telcos fold what is not 
yet clear is whether even Microsoft's $35 billion in cash will be 
enough to pick up the pieces.  Certainly it and Cisco (19 billion in 
cash) can pick up a lot of the carnage.  Others will no doubt step in 
as well.  Of course it is possible that the Feds may act in time to 
"save" the ILECs.

What is clear is that our  free market blinders, especially under 
this Republican administration,  will prolong the impact of the 
collapse by destroying the last vestages of the public commons on 
which the Internet was built.  In doing so, it will ensure that the 
ability of small companies to innovate instead of having to beg for 
niche roles in the delivery of monopoly services is destroyed.

The COOK Report's On-Going Mission

Whatever happens, we shall follow, as they progress, the continuing 
technology developments that are reshaping the global telecom 
industry.  By observing changes in the ability of users to implement 
their own networks and architectures, we shall help readers identify 
trends in the changing locus of power during a time of upheaval.  By 
watching the cash rich players develop new strategies and following 
varied attempts to build alternative infrastructures, we identify 
those who will likely be able to pick up the pieces.  Finally, we 
shall advocate a public policy that sees the Internet as a family of 
enabling technologies rather that a means of more efficient 
monopolies for distribution of content. In doing this, we hope to be 
able to influence an increasing awareness that the quickest end to 
the troubles of the industry will be found in a path that uses the 
financial power of the government to create a new foundation that 
will be open to innovators and not run solely to benefit a new set of 
would be monopolists.

[ Final Three paragraphs SNIPPED]

Postscript: One fascinating and intuitively obvious solution was just 
raised by Peter Cochrane, the former CTO of British Telecom in an 
article Broadband Won't Happen by Accident.  See the Canarie list on 
12/30/:
http://www.canarie.ca/MLISTS/news2001/0228.html.  Here Cochrane 
suggests that as the ILECs collapse those who step into to pick up 
the pieces could affordably run fiber to neighborhood POPs where 
802.11b nodes could enable a wireless local loop.

For complete table of contents and ordering information for this 458 
page report, point your browser at 
http://cookreport.com/empowering.shtml

Gordon Cook, Editor and Publisher
January 6, 2002

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