CHAPTER 16

Data and Communications

The business model for U.S. telephony has undergone not one but a complex series of disruptions in the past 15 years. Technological innovation was certainly a factor, but demographics, regulation, and organizational dynamics both inside and around the carriers also played their parts in the drama. With anything so vast, old, and technologically complex, it is impossible to summarize without losing important facets that often are the subject of book-length monographs in and of themselves. One example was the carriers' yellow-pages publishing business. In many ways the forerunner to Google, commercial telephone directories were a $14 billion business in 1995, bigger than the entire recording industry. Furthermore, unlike newspapers (roughly $50 billion in 2000) or music, the telecommunications sector is a sprawling, regulated, but rapidly evolving complex that is particularly difficult to change. In addition to being complicated, telecommunications companies are big, representing about 3% of the global economy.

Evolution of the Incumbent Business Model, 1877–1996

From the founding of the Bell Telephone Company, the U.S. telecommunications sector has been characterized by a combination of technological innovation (much of it still relating to Alexander Graham Bell's master patent, #174465) and creative, intensive capital formation. Once Bell Telephone was bought by AT&T in 1899, it enjoyed essentially monopoly status. Indeed, a key feature of the history of American telephony is the ongoing role played by regulators concerned about anticompetitive behavior, consumer protection, pricing, and taxation. The operating assumption from the World War I period forward was that building multiple wireline networks was infeasible; AT&T and its successor companies were treated as a “natural monopoly” for decades.

Technological innovation was intertwined with the business model from the outset. In 1913, for example, AT&T acquired the patent rights to a new type of vacuum tube that exhibited superior performance in amplifying voice signals. The technology in turn enabled AT&T to strengthen the performance and lower the cost of long-distance carriage. In 1925, AT&T created Bell Labs to formalize its commitment to research and development.

The company was exceptionally good at research, having an important claim in the invention of the transistor,* radio astronomy,^† the photovoltaic cell, the laser, the UNIX operating system, and the C programming language; AT&T also commissioned the Telstar communications satellite. The record of commercialization of this research was far less distinguished, however.

The expenses for funding this prodigious lab derived from the regulated monopoly revenues: 50 state regulatory bodies and the Federal Communications Commission (FCC; for interstate commerce) set tariffs and tax rates that guaranteed the private company a comfortable return on the huge investment it had made in what eventually became nearly universal service to the vast majority of American households; U.S. wireline penetration was the highest of any major country in the world. As of 1970, for example, three times as many U.S. households had service compared to Ireland or France, measured by teledensity.

Not only was phone service universal, it was exceptionally reliable. Beginning with the leased phone and extending into the heart of the network, AT&T made its own equipment through its Western Electric subsidiary. Because competition was not an issue, there was no pressure to cut costs. Rather, equipment was engineered as an end-to-end closed system and built to higher standards than are typically available on an open market. As a result, wireline phone service in the United States had up to “six nines” availability: 99.9999% uptime means only about 30 seconds of outage per year.

Phone calls were billed on the basis of elapsed time, in minutes rounded up, and distance between calling parties, with lower prices available to consumers outside of business hours. Under circuit switching, the same technology pioneered by Bell, two calling parties hold a physical connection for the duration of a call in much the same way that a switch closes connecting the batteries and a bulb on a flashlight. (Actually, two circuits are occupied, one for the voice transmission and one for the call setup and billing system.) For both circuits, edge devices (telephones, typically) are “dumb,” and the intelligence to do things like call waiting or caller identification lies in the network. The extra value of a dedicated connection over greater distance was taken as article of faith, and since rates were set by governments and the service was a monopoly, customers could do little except complain about the power of “Ma Bell:” At its peak before the 1984 divestiture, AT&T was the biggest company on earth, employing more than one million people.

In 1974, the U.S. Department of Justice (DOJ) began antitrust proceedings against AT&T, which had only recently been forced to allow non-AT&T devices (such as early data modems) to connect to its network. In addition, and not part of the DOJ action, MCI was the first company apart from AT&T allowed by the FCC to sell point-to-point long-distance service to businesses. An agreement was reached in 1982 to break AT&T into seven Regional Bell Operating Companies (RBOCs, known shortly thereafter as R-Bocks) that provided local service, and a long-distance company retaining the AT&T name (along with the Western Electric manufacturing operation) that would compete with MCI and Sprint. The breakup occurred in 1984.

In the aftermath, AT&T reduced long distance rates by 40% over six years, though local carriers added access charges that prevented consumers from seeing all of the cost reduction. The local operating companies (led by Ameritech, beginning in the Chicago area that was home to Motorola, which helped develop the radio technology) also began offering mobile service in the 1980s after it had been developed by Bell Labs.

By 1990, packet switching (see Chapter 24) had begun to emerge as the Internet began its rapid scale-up: The data to be transmitted are broken up into packets, which are moved over a robust mesh of connections one packet at a time following different paths, and reassembled by a “smart” edge device (a computer rather than a phone) upon receipt. The transition to a “dumb” network ran completely counter to Bell engineering experience and doctrine. In addition, mobile telephony entered its modern phase in the early 1990s with so-called 2G (roughly, second generation wireless) networks. Nokia patented handset technology to sense signal strength and reduce transmission power accordingly, thereby improving battery life dramatically, which helped fuel cellular growth.

All of this helped set the stage for the Telecommunications Act of 1996. Local telecoms were ordered to supply access to their lines at a government-mandated price, enabling a vast number of upstart phone companies to compete with the RBOCs using, in many cases, Bell infrastructure, which was leased at attractive rates. The Competitive Local Exchange Carriers (CLECs, pronounced “See-Lex”) proliferated, numbering 30 in 1996 and growing to more than 700 in just four years.

Business Model Disruption, 1996–2010

But a funny thing happened in the aftermath of the Telecom Act: Millions of U.S. customers stopped wanting location-dependent copper-wire voice telephony. Untethered from physical wires, the notion of a “natural monopoly” based on the perceived inefficiency of multiple connections from competing carriers no longer obtained. The very asset that was regulated from natural monopoly to shared resource began to lose its attractiveness after more than a century of becoming essential. Beginning with cellular voice, expanding to Voice over Internet Protocol (VoIP), and then in the mobile smartphone/tablet boom of the late aughts, new ways of connecting to people and information made the old universal infrastructure a liability rather than an asset.

Think of the math in a simple illustration. In 1990, say, copper phone lines pass 100 houses, and maybe 95 of those households subscribe. The costs of maintaining the physical plant, repairing it after storms, and issuing and collecting bills are shared by 95 customers. Fast forward to 2010. The physical plant is 20 years older, municipalities are taxing phone companies' physical switching offices and sometimes even phone poles, and the costs of maintaining the infrastructure are now being borne by only 45 customers. Raising the monthly charges is scarcely an option for both competitive and regulatory reasons, so the wireline operations of the Bell operating companies (the rebranded AT&T, Verizon, and Qwest) are underperforming. Most of the CLECs have disappeared.

Despite (or perhaps because of) being some of the oldest tech firms on earth, telecoms had a tumultuous decade.

• Customers defected from landline service at staggering rates: according to the Telecommunications Industry Association, U.S. landline subscriptions declined by more than 20 million in the five years to 2005, and perhaps another 10 million since then, as Figure 16.1 illustrates.
• Technical developments, such as dense wave division multiplexing, made infrastructure investments in fiber optics stretch farther, and new revenue sources—particularly texting and ringtones for the carriers' mobile operations—helped offset the wireline decline.

  

  FIGURE 16.1 Alternatives to Wireline Telephony in the U.S., 2003–2009
  Source: Telecommunications Industry Association, World Bank.

• Furthermore, perhaps the most troubling competitor—Skype and its 200 million users of nearly free international calling— was itself a major headache to eBay, which failed to monetize its original $2.6 billion investment and therefore cost chief executive Meg Whitman her job.

Three external transitions hit the industry in parallel.

First, analog switched circuits over copper gave way to digital packet-switched data applications over networks connected through air or fiber optics. Analog data transmissions (faxes, particularly internationally) were a lucrative revenue source that digital e-mail helped decimate. Voice went from being the whole of the value proposition to being just another application, and one less appealing than text for the younger demographic. (See Figure 16.2.) Networks had to be redesigned and rebuilt: Verizon bet more than $20 billion on connecting individual premises to fiber optics, a far more expensive architecture than the cable operators' coaxial cabling or AT&T's fiber-to-the-neighborhood topology, but one with much greater capacity. In rural areas with low population density, meanwhile, sale of the wireline voice infrastructure is often an attractive option to RBOCs where buyers for voice networks can be found.

Second, mobile phones began as replications of their fixed-line counterparts but rapidly evolved, with texting in particular, but also with the personalization expressed by ringtones. Having a number associated with a person and not a location is a significant change. Even at the level of the country code, dialing 81 is no guarantee whatsoever that the person who answers will be in Japan. To the extent that the former monopolies had to make competitive claims after a century of regulated monopoly status, the advantages of Bell wireline service (reliability and ubiquity) were not claims that could be made for mobile service.

FIGURE 16.2 Text Messaging Is Dominant among the Young
Data Source: The Nielsen Company, April 2009–March 2010.

Finally, Bell companies went from being regulated to … still being regulated. On one hand, they face competition from cable operators and mobile service; at the same time, they must adhere to sometimes arbitrary decisions by state and federal regulators, using sometimes outdated logic or data, as to how to run their business. Put another way, the core competencies of being a successful regulated monopoly are not those of a battle-hardened competitive firm. Changing the organizational size, shape, and culture to be competitive, in several senses of the word, remains an ongoing challenge for AT&T and Verizon.

At the level of internal business strategy, voice telephony had both competitor businesses (particularly cable operators offering VoIP voice in a voice-video-Internet bundle as well as such providers as Vonage) and Skype, which, like Linux, could not be beaten by undercutting prices, litigation, or acquisition. Trying to preserve voice revenue, compete with Comcast and other cable operators, and deal with free as a viable price point (albeit one with some interconnect charges) made life especially difficult for the telecom firms and potential insurgents alike. To take only one example, eBay took on many attributes of a bank with the brilliant PayPal acquisition, but the connection of voice communications to off-price auctions is far less strategically obvious. Put another way, given the size, legacy, and regulatory constraints of telecoms compared to eBay, it's difficult to see a better path forward that these far less nimble and entrepreneurial companies should have followed.

Implications of “Stupid” Networks

David Isenberg, formerly a business innovation researcher at AT&T, helped identify what he called the “paradox of the best network” in the Internet age. He built on an insight from the astute investment analyst Roxane Googin, who noted in 2001 that “the perfect network is perfectly plain, and perfectly extensible. That means it is also the perfect capital repellant, [which] implies a guaranteed loss to network operators, but a boon to the services on the ‘ends.’”¹ This thinking that emerged from the success of the Internet ran counter to most everything that had worked for the Bell companies for a century:

• Intelligence at the edges, in computers or similar devices, relied on a “stupid” (Isenberg's famous word from his samizdat paper* of 1997) network in the middle that does only one thing: move bits.^† Bell networks had stupid edge devices connected by a smart network that could bill for a call, forward that call to a preprogrammed number, or connect relatively conveniently to various forms of government surveillance systems.
• Intelligence at the edge allowed for innovation to proliferate. The people running the network core, meanwhile, were very good at their jobs, but this excellence precluded them from changing anything at all dramatically. Unsurprisingly, Bell Labs engineers “knew” that the Internet would not work when they were first presented with its early theories and bypassed an opportunity to build it.²
• Stupid networks do not differentiate their traffic; smart networks know quite a lot about the two parties on the ends as well as what is passing between them.
• Moore's law³ meant an exponential pace of innovation in computer-related industries, including data networking: Dense wave division multiplexing, a technology for dividing light into component colors, each of which carries signal, allowed 16-fold improvements in the 1990s. The Bell system, in contrast, doubled in performance once a century, according to one industry wit.

Looking Ahead

Most critically for the Bell companies, losing the very things implied by a smart network—distance-based billing, or billing of any sort, for starters—challenged the business model at its essence. Recall our starting point: A business model is a cognitive commitment that makes a variety of behaviors possible in part by belief. With voice service, the legacy carriers face substantial dislocation as they confront the implications of a communications network that broke every rule that had helped build the best voice service, and the biggest company, on the planet.

Notes

1. Roxane Googin, High Tech Observer newsletter, September 2001, quoted at http://netparadox.com/.

2. Paul Baran interview, Wired 9, no. 3 (March 2001): “AT&T headquarters, with the old analog people, missed it. If a guy knew only analog, he could not comprehend what I was saying about the behavior of a digital circuit,” www.wired.com/wired/archive/9.03/baran_pr.html.

3. The long-term tendency of computing power (or price/performance) to double roughly every 18–24 months due to increased density of transistors on a microprocessor chip. The observation was originally attributed to Intel co-founder Gordon Moore.

*Bell Labs' John Bardeen, Walter Brattain, and William Shockley shared a Nobel Prize in physics for the discovery.

^†Bell Labs' Arno Penzias won a Nobel Prize in physics for helping discover what later was identified as the radio remnant of the Big Bang.

*Underground transmission of officially prohibited texts, from the Russian system of government under which transmission was common.

^†The Internet is not really as “stupid” as it might seem: Routing algorithms have grown quite sophisticated in analyzing optimal traffic patterns, particularly related to extreme variation in demand.