Knowledge@Wharton Managing Technology Research Article

Verizon is betting billions of dollars on a new fiber-optic network that could transform it from a telephone company to a cutting-edge technology player. If Verizon's "build it and they will come" strategy works, the company could leapfrog over rivals, such as AT&T and Comcast, by offering faster Internet service and potentially richer video on demand. But if its fast network fails to entice consumers, the company will have created a multi-billion-dollar boondoggle.

Verizon's new network brings fiber optic lines directly to a customer's house. In theory, this network -- the equivalent of an Internet fire hose -- would give the company a platform to offer new services such as television and video games. Here's what makes the network faster: Typically, Internet speeds slow as they get closer to a home and hit a morass of telephone lines (think of a garden hose connected to a straw). To avoid this issue, Verizon is laying the groundwork for what is called a fiber to the premises (FTTP) network -- that is, fiber optic lines connected directly to a customer's residence -- that will result in speeds as fast as 50 megabits per second in selected areas. The typical cable broadband connection is about 6 megabits per second. AT&T has a similar fiber-optic network initiative but isn't running the fiber optic lines directly to homes.

Why the big bet? Verizon doesn't have a choice, according to experts at Wharton. Marketing professor David Reibstein says Verizon has to make a bold move given that television, voice communication and the Internet are converging just as the company's traditional phone business declines rapidly. "Could [Verizon] possibly survive without doing this?" asks Reibstein.

Other Wharton experts agree. "I don't think Verizon has a lot of choice in this. Faster Internet connections with combined telephone, Internet, TV and other digital content are going to happen whether [Verizon is] involved or not," says Wharton management professor Mary Benner.

Gerald Faulhaber, a business and public policy professor at Wharton, credits Verizon for reinventing the company instead of trying to protect its telephone business. "Verizon saw [its business prospects] and decided to do something. That's good," says Faulhaber.

Most observers agree that the risk of sticking with the status quo outweighs the possibility of failure. Traditional telephone service -- called wireline service in the telecommunications business -- is being replaced by wireless cellular phones and voice over Internet protocol services (VoIP) like Skype. And Verizon's current digital subscriber line (DSL) broadband service is usually slower than the Internet access offered by cable companies.

Verizon also said in its annual report that its new network will allow it to bundle video, Internet, telephone and wireless services to "help counter the effects of competition and technology substitution that have resulted in access line losses." But Verizon's reinvention raises questions. If you build a fast network, will customers necessarily come? How does the company balance long-term objectives with Wall Street's short-term focus? Can a large entrenched company function as an innovator in a competitive arena?

Wooing the Customer

Verizon's biggest challenge: It's unclear whether its fast network -- branded as FiOS -- will woo customers. For a one-year FiOS subscription running at 5 megabits per second, Verizon is charging $39.99 a month; $49.99 for 15 megabits per second, and $179.95 for 30 megabits per second.

In 2006, Verizon added 517,000 FiOS Internet data connections and 207,100 FiOS TV subscriptions. At the end of 2006, Verizon had obtained more than 600 video franchises covering 7.3 million households. Of those households, FiOS service is available to 2.4 million. Verizon has said it hopes to reach 18 million households by 2010.

But Verizon's expansion is pricey. In 2006, its capital spending was $17.1 billion, up from $14.9 billion in 2005, according to the company's annual report filed with the Securities and Exchange Commission. For 2007, Verizon projects capital spending of $17.5 billion to $17.9 billion. All of that spending is "in support of growth markets," the most prominent being FiOS and Verizon Wireless.

Verizon's spending on the FiOS network should peak in the quarter ending March 31. On Verizon's fourth quarter earnings conference call, Dennis F. Strigl, president and chief operating officer, said costs related to the FiOS rollout will peak in the fourth and first quarters. Strigl added that FiOS costs will dilute earnings by 11 cents a share in the first quarter. "Our view is that success-based dilution is good news in the long run." 

Nevertheless, those costs have Wall Street worried. Prudential Equities analyst Richard Klugman estimates that Verizon takes a pre-tax loss of $2,200 for each FiOS customer added, primarily due to installation costs. Including capital costs, Klugman estimates Verizon is losing more than $4,500 per new subscriber. Strigl said that Verizon is working to cut installation costs in the second half of 2007.

"Verizon is making a smart long-term bet on fiber to the home, but it's a risky bet. The capital costs are substantial and the payback scenarios are uncertain, but that doesn't make it the wrong thing to do," says Wharton legal studies and business ethics professor Kevin Werbach. "Bandwidth will be the lifeblood of any network operator, so Verizon is right to push the technology that gives them as much or more bandwidth than cable companies and other competitors. At the same time, just having the most bandwidth isn't enough to succeed; you need a good vision of how to use that bandwidth. That's where Verizon still hasn't convinced me, or Wall Street for that matter."

Many observers share Werbach's concerns. Verizon has a state-of-the-art network, but it's unclear what will make FiOS a "must have" service.

"Verizon's response to the challenges it is facing has been [to build out] the fiber network. In a way it makes sense because this is what Verizon is good at -- technology and laying networks. But the question is what will be done with these pipes," says Faulhaber. His biggest concern is that, to date, Verizon has argued that faster Internet service, television and video on demand will entice customers to use the FiOS network. "There has to be something else," says Faulhaber. "Attacking a mature video market as a newcomer almost never works unless you do deep discounting."

Indeed, Faulhaber wonders about Verizon's video value proposition. For instance, more channels may not entice consumers since they already have 500 channels and don't know what to do with them. In addition, Verizon may not be as deft as Comcast when it comes to managing content deals. "Verizon knows technology, but not the business side of video," says Faulhaber. "The business skills have to be there for video programming."

Werbach suggests that Verizon use its network to rethink how video is delivered. "TV as we know it will be transformed over the next 10 years. Conventional broadcast and cable channels will still exist, but new distribution mechanisms and content forms will be an increasingly large portion of the video universe. If I were Verizon, I would focus not on duplicating cable TV, or on small changes like a la carte channels, but on the radical potential of vast increases in video capacity. Verizon should position itself as the world's biggest, and most open, distributor, aggregator and originator of video content. It should invest in navigation and interface technologies to help users make sense of all that content. Otherwise, even with all the bandwidth, it will lose out to companies that can create better user experiences, like Apple, Cisco and whoever buys TiVo."

Reibstein agrees that television service won't be enough to make FiOS a hit. He says that how Verizon bundles services -- say, Verizon Wireless with Internet and TV service -- may win customers. However, Reibstein doesn't dismiss Verizon's argument that speed matters for broadband services. For instance, a fiber-optic network may mean it's easier to download video. That in turn could enable new services. "Adoption only happens when consumers see what you can do with those increased speeds. No one needed high definition video until we discovered it was better."

Meanwhile, Verizon is also looking toward on-demand video games to spur adoption of the FiOS network. On May 8, 2006, Verizon announced that it had purchased an equity stake in Super Computer International (SCI), a company that provides video game sites and related services. SCI is best known for a site called PlayLinc. Meanwhile, Verizon also has its own Verizon Game Network, which offers games on demand, and it sponsors video game leagues such as the Cyberathlete Professional League.

Experts at Wharton say gaming could spark FiOS use by early adopters. However, Verizon's best bet may be to open up the FiOS network to multiple content and software developers so that new services can be built, notes Faulhaber. In this model, Verizon would largely be a toll collector focusing on the FiOS network. "I would open the pipe up. At least a big chunk of that fiber should be opened to other players. These developers would then pay Verizon for access."

Balancing Long Term vs. Wall Street

Verizon's FiOS network and its insistence on spending heavily on new initiatives -- such as its high-speed wireless service -- have caused some consternation among investors. For instance, Verizon shares closed March 16 at $36.32, up 14.29% from $31.78 on the same date in 2006. AT&T closed March 16 at $36.98, up 42.72% from $25.91 on the same date in 2006. Comcast shares closed March 16 at $25.44, up 40% from $18.11 on the same date in 2006.

Benner says Verizon's stock price illustrates the tug of war between managers planning ahead for a decade and investors who want results now. To Verizon's credit, she adds, the company is trying to get out in front of technology changes, even though that creates tension with shareholders' preference for better earnings today. Generally speaking, shareholders of telecommunications and utilities tend to be more conservative and to invest in those firms for stable earnings and dividends. "Shareholders don't want Verizon to do major investments that may not pay off for a while," says Benner. "My research shows that shareholders often fail to realize that existing technologies will be obsolete in the future. Firms have no choice but to invest in new technologies, but to investors, it just looks like more cost."

Although there is conflict between Verizon's goals and Wall Street's focus on short-term results, Reibstein says there isn't much doubt among in-house managers. They know that the company's traditional telephone business has been on the decline since around 2001. In addition, executives remain upbeat about Verizon's new businesses. Regarding FiOS, Strigl notes that "we feel very good about our goals and growth opportunity in 2007. Everybody loves the service -- the speed, the ... quality, the reliability. Our view is that the market is ready for the upgrade that we can provide."

When will the tide turn for investors? When FiOS starts delivering returns, Benner says. Verizon Wireless, which is Verizon's most successful business, is now loved by investors due to its earnings and growth. However, there was consternation when that network was being built, too. "The challenge for managers is the uncertainty associated with new technologies," says Benner. "Verizon isn't sure consumers will want faster Internet service and TV combined. But if [FiOS] is successful, everyone will get behind it."

For now, Wall Street analysts are taking a "wait and see" approach. "The FiOS investment has driven capital expenditures to above 20% of revenues compared to the low to mid teens percentage for other wireline providers," wrote AG Edwards analyst Kent Custer in a recent research note. "While the FiOS initiative is expensive, we believe that bold action was required to combat the threat from wireless and cable."

Reibstein says Verizon will win investors over when it becomes clear whether FiOS gives the company a long-term competitive advantage. "The big question is: How long will that lead last? Is this a big expense with a temporary advantage? Or is it a long-term advantage?"

The Crowded Competitive Landscape

Verizon's investments in the FiOS network and other growth initiatives create a laundry list of rivals. Although Verizon is most often compared to AT&T, they only compete head to head for wireless and business customers. Verizon will primarily compete for turf with cable providers such as Comcast, which is increasingly entering the phone market.

While Comcast and AT&T are the most immediate rivals for Verizon, other competitors are likely to surface, according to Reibstein. Google with its YouTube site could become a Verizon competitor as could any number of startups currently off the radar. "Verizon needs to worry about the competitors that aren't known yet." 

According to Faulhaber, one thing is certain: Better technology isn't going to determine the real winner. Since telecommunications and cable companies will soon be competing for customers as equals, customer service will matter a lot more than bandwidth or new technology. The challenge for de facto regional monopolies like Verizon, AT&T and Comcast is clear: Make customer service a priority. "Someone has to figure out how to treat customers," he says. "They [cable and telecom companies] are in a different world with competition. Right now they are the ones everyone hates. The first company that [people] actually like to deal with, will win."

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