Google Fiber: An Optical Illusion

| About: Alphabet Inc. (GOOG)

In 2012, Google (NASDAQ:GOOG) took the wraps off a new internet and cable television service called Google Fiber. The fiber optic cabling used to provide this service is not the illusion. The illusion lies in whether Google is trying to disrupt the traditional cable television and internet delivery method. Conversely, is this just another Google project meant to create buzz around the company for technological innovations that do not necessarily translate into future profits. Some have claimed that every product created by Google is a whopping success. This claim could not be any further from the truth. The Google product development graveyard is littered with past failures. For every Gmail, there is a Google Wave that you may not even remember. Failed products will always exist for those pushing the envelope and pioneering new technology. Why Google Fiber deserves much more scrutiny, than Google Glass for example, is the sheer cost of this product should they decide to expand the offering. By the end of this article, you should know the pros and cons of this service being expanded in a significant way. Additionally, the profit potential and the capital required to finance such an expansion will also be outlined.

Brief Overview Of Google Fiber

The new service is called Google Fiber, and it was first offered in Kansas City after a unique selection process to determine where it would debut. The buzz around the service centers on the lighting fast internet provided by the fiber optic connection. Download and upload speeds utilizing the service are up to 1 Gigabit per second. According to Google, this connection speed is 100 times faster than the average current broadband service offered in your home today. In addition to the insanely fast internet offering, Google is also offering high definition television programming. For $120 a month with a two year contract, you get internet and high definition television with no upfront costs. They also throw in their Nexus 7 tablet which is supposed to be the remote control, for free. The service also comes with the other equipment such as a DVR type box.

Do You Need The Speed?

Consider a situation where you are offered a service that is 100 times faster than the alternative at the same price. For example, suppose you were told that the you could commute to work 100 times faster than you are currently able to. You were also given the option of browsing the internet 100 times faster. If you could only choose one of the two options which would you choose? This hypothetical question is meant to be thought provoking. It is difficult to reconcile why an internet service needs to be 100 times faster today than the current services available. Sure if someone is downloading 50 HD movies a day they might enjoy the extra speed. That example is the exception and not the norm. Ask yourself how often you watch videos on your smart phone, surf the internet, and in general use cellular connectivity to connect to the web. Is it slower than using the wireless connection at your home? Absolutely, but it does not stop you from using a mobile device on a cellular network.

Competing Perspectives On Google Fiber

A recent article on Seeking Alpha laid out the hypothesis that the Google Fiber service was a growth catalyst for Google. The article essentially makes the case that the service can be expanded significantly from the small test in Kansas City. At the same time the service is expanded it could eventually begin to produce material profits for Google.

An article written at the time the Google Fiber service debuted laid out an entirely different perception of the service. This article takes a much more unbiased view of the offering from Google and the costs associated with it. Instead of viewing the service through rose colored glasses, this article highlights the potential hurdles that Google would have to overcome to earn a profit on this product on a large scale basis.

I encourage readers to read both of these articles, in addition to this one, as they seek to discern for themselves the financial viability of Google Fiber.

What Does The Future Hold For Google Fiber?

There are competing views of what Google actually intends to do with this service. The company itself has hinted that their entry into this field is simply to provoke innovation by others such as Comcast (NASDAQ:CMCSA), Verizon (NYSE:VZ), and the other service providers. Others, however, think that Google intends to go full steam ahead into being an internet service provider (ISP) and cable television distributor. If all Google intends to do is spur innovation in the industry then they should be applauded for their effort. If they intend to expand the offering, investors in Google need to understand the risks that would be associated with such an expansion. This would not be a case of Google versus Microsoft and their Bing search offering. Google would be entering a field where they are at a clear disadvantage from an infrastructure standpoint. The company may very well have a better vision, better technology, and smarter engineers than their competitors. However, the established user base of the existing cable television and internet providers added to physical barriers to entry make this endeavor fraught with danger for Google.

Why Kansas City Is Not A Template For Expanding Google Fiber

Google admits publicly in a number of comments about exactly why they chose Kansas City to start their Google Fiber service. The over arching theme is that this location offered the least amount of red tape in launching the service. In other words, Google would have to spend less to launch the service in Kansas City than in other locations. This is a fundamental point to understand. The utility poles along your street that have power, cable, and internet lines are heavily regulated. Local authorities and the companies that use those utility poles incur costs to maintain them. In Kansas City, Google was essentially able to avoid the costs that a typical company would incur to gain access to those utility poles that are required to run the optical cabling. Expanding the service means gaining access to the infrastructure needed to bring the service to homes and businesses. Another item of note is that Google is choosing the cheaper and more prone to failure method of delivering their service. Today, cable and telecom companies are often burying their data lines compared to hanging them on utility poles. This is a more expensive method but over the long term involves less maintenance and outages from storms.

Profit Potential Of Google Fiber

In discussing the Google Fiber service, Google Chief Financial Officer Patrick Pichette said:

There is no sense selling a product at a loss

Those bullish on the prospects of Google Fiber picked up on that comment and now use it to justify how profitable the service may be. This does not seem to be a smart way to estimate the level of profitability the service might generate. It is estimated that Google might make $15 for every $199 Nexus tablet sold. While this technically is a profit it is not a reason an investor would run out to invest in Google. In fact if the estimates are correct, Google makes about a 7.5% operating profit before taxes for each tablet sold. This is significantly below the profitability level of Google on a company wide basis. As such, the CFO saying the Google Fiber service will be profitable should be taken with a grain of salt. Going one step further, the financial analysis below highlights how an operating profit could be achieved while still providing an unacceptable return on investment.

Financial Analysis

My skepticism surrounding the ability of Google to profit significantly from their Fiber offering is in large part based on a historical precedent. About 8 years ago Verizon launched their FIOS offering which consisted of digital television and internet delivered through fiber cabling. At the time, Verizon announced they would spend $23B to reach 17M homes. Note that this did not mean they would end up with 17M subscribers. It meant they would have 17M homes that would have access to the service. Using the cost Verizon provided, and the number of homes reached, a total of about $1,350 is derived as the cost to connect 1 home.

Google has plenty of cash on the balance sheet and mints more money every year. However, if I were a shareholder of the company I would be screaming for them to not seek to extend this service nationwide. The below images are quarterly reports from Verizon at various points in time after they rolled out their FIOS service. The reports show Q4 2008, Q4 2010, and Q4 2012. The images are snapshots of the "wireline" operating segment for Verizon which includes their FIOS service.

While viewing the financials shown for Verizon you should focus on the operating income margin in each quarter. In Q4 2008, it was over 6%, in Q4 2010 it had declined to about 2.5%, and by Q4 2012 the operating margin was negative.

Included in this operating segment are other product offerings besides FIOS. However, would you not expect to see the FIOS service if it is profitable, offset any profitability headwinds the wireline segment might face? The exact opposite happens as shown in the above financial results. Operating margins decline even as FIOS subscribers grow from about 4M at the end of 2010 to almost 6M at the end of 2012.

This example of Verizon is the most relevant example to use in considering why Google faces an uphill battle to earn material profits on their Fiber service.

Material Risk Of Expansion = Negative Cash Flows

Those who think Google can do no wrong also believe that Verizon and their apparent inability to monetize fiber delivered television and internet should not be used as an example of what Google might be able to achieve. This is said at the same time that Verizon has decided to stop expanding their service. Implicitly, this tells you that the profit potential is not what they expected it to be.

The financial analysis below provides an example of what a Google Fiber expansion might look like. The analysis starts with the premise that because Google is so potent they will be able to distribute their service for 30% less than the capital that Verizon required. Put another way, if it cost Verizon $1,350 per home to distribute FIOS, Google will be able to distribute their service 30% cheaper per home. This is a HUGE inference in favor of those bullish on Google Fiber and quite frankly probably is not possible. For the sake of argument, I am assuming it is. The other assumptions are shown in the table below:

I take the liberty of assuming that 75% of the customers will actually pay for the Google Fiber service. This is a pretty hefty liberty to take. For a onetime fee of $300, or $25 a month for a year, Google will provide those customers free internet service in the future. The last time I checked quite a few people like free things. It would be easy to see the 75% amount being on the high side. The other key assumption is the operating cash flow expectation of 30%. Essentially this is saying that of the $120 a month Google will receive for their service, 30% or $36 will go directly to the bottom line. Recall that Verizon currently has a negative operating margin. So again this is a pretty bold inference in favor of Google.

The below table uses the above assumptions and shows what would happen if Google expanded the service. The basic premise is that Google could expand the service from an initial subscriber count of 100,000 users by 50% annually. The analysis assumes that the capital cost is incurred in the same year as the subscriber growth. This would not actually be the case as the capital costs would be incurred in advance. Again we error on the side of assuming Google knows how to do things others do not. See below for an analysis of Google Fiber expanded to over 11M subscribers:

As you can see, Google would spend over $10.7B in capital to provide the service. They would spend at least another $1.7B in hardware costs to provide their tablet to each subscriber. In return, they would collect $10.6B in operating cash flow and about $.85B in one time set-up fees. After adding 11.4M subscribers, they would have spent $950M more than they were able to recapture in fees. You cannot generate a return analysis on the service because Google never generates positive cash flow in the above example.

The Risk Of Expanding Google Fiber

It should be quite obvious from the analysis above that Google will be extremely hard pressed to recover the capital it will cost to deploy this service on a large scale.

Every single assumption was made in favor of Google. The analysis does not take into account that cable programming costs on average increase by 10% annually, that Google has additional equipment to provide, or that the profit margin assumed is wildly higher than what competitors actually are earning today.

Taking this all into account it extremely difficult to understand why an investor can argue in favor of Google expanding this service. It sounds fantastic for a consumer who wants to reach the end of the internet in record time. As an investment, one of the attractive characteristics of Google is the fortress cash balance they have amassed. Google Executive Chairman Eric Schmidt recently hinted in an interview that the service would be expanded to more cities. He also noted specifically when referring to Google Fiber:

It's actually not an experiment; we're actually running it as a business

This comment provides further support to the view that Google has true ambitions to expand the service in a material way. Admittedly Mr. Schmidt is not tipping his hand as to just how broad the expansion may be. However, this make sense as it serves no purpose for them to telegraph to their competitors the true scope of their plans.

Why Google Fiber Is Important For Investors

At it's core Google is still a business that excels in delivering a web search platform that can be monetized by selling advertising. The company should be applauded when they seek out additional growth opportunities that are complementary to their core business.

Google Fiber is not an example of a bolt on offering to the core search business. Google may have plans to use this service to generate additional search and advertising revenues. But at what cost are they willing to chase these additional revenues?

Comcast serves about 20M subscribers today. Time Warner Cable serves around 11M subscribers today. These two companies have amassed debt balances of roughly $40B and $27B respectively. There is no example of a cable or telecom company that does not have a massive debt balance that was incurred to build out their infrastructure.

The ultimate question for a Google investor is whether or not the profit opportunity from this service is worth the cash, and most likely debt, that will be required to finance a large scale expansion of this service.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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