Frame 1: Investment Thesis of a Level 3 (NYSE:LVLT) Shareholder
My post on Level 3 generated a significant response from the investor and telecom communities. A number of people who contacted me were bullish on the future of Level 3. One shareholder allowed me to reprint a portion of their investment rational anonymously. Here is a condensed version of their investment rational:
“CroweBonics is Silicon Economics applied to our communications business. It’s a fun reference to the phenomenon which Crowe has opined so often. It’s nothing more unless we get into the more complex Mini Max Model. I have never used their model due to the simplicity of my mindset when looking to apply investment thesis-when the company started, and some believe, will factually kick in with the tsunami of video traffic hitting all “networks.” It’s the price elasticity of demand concept. We are comfortable with 3:1 ratios where bit demand is growing three times price compression. If demand is growing at 75 percent and prices are dropping at 25 percent; we have a 32 percent GROWTH rate. The hangover in telecom killed the formula, as you know. Even traffic growth doubling each year would be revenue neutral to the top line while fifty percent year over year price degradation might occur. At last check, IP & Data traffic was growing at 40 percent according to my research. I believe we have begun and are heading into the HYPER GROWTH portion of the S curve...So William, we have a “healthy business” it appears again (CroweBonics), and a best of breed management team!”
Breaking some code words in this email, the term “CroweBonics” was this investor’s play on words with a historical reference to a network model called Mini-Max I that Level 3 asserted back in the 1999-2003 time frame.
Frame 2: Level 3 Investor Presentation and the Silicon Economics Mini-Max Model
Back in 1999, Level 3 promoted network thesis and model that lower cost and network capacity would be driving factors in the evolution of the internet, the New Economy, the Digital Revolution and the telecom revolution that was fueling much of the underlying investment thesis of the 1990s. The concept was summarized in a November 3, 1999 issue of Converge! News Digest:
“Level 3 Communications is betting its business on the premise that bandwidth is strongly price elastic. Speaking at NGN 99, James Crowe, Level 3 President and CEO, said the tremendous bandwidth capacity of new fiber networks will stimulate the same hyper-elastic cost-demand phenomenon seen in the microprocessing field. The cheaper it becomes, the more you use. Crowe said Level 3 Communications will be built with a fully upgradeable design. Because new generations of networking equipment are up to 8 times more cost efficient to operate than preceding infrastructures, Level 3 anticipates a continuous cycle of rebuilding, including switches and routers, the optics of its transport network and even the fiber in its trans-continental conduits. Unlike other mega-carriers, Level 3 will pursue a horizontal business model, focusing on switching/transport service, not content aggregation. Crowe believes in technologies that demonstrate the best price/performance improvement ratios, namely, IP as the convergence layer and DWDM as the transport. Voice revenues dominate in the short term, so Level 3 will implement Lucent’s IP softswitch architecture along with VoIP gateways. The PSTN will provide overflow capacity. Looking ahead, Crowe envisions virtual “tele-presence” conferencing approximating the information gathering potential of the human optical nerve – a rough guess of 15 Tbps uncompressed for a simple, two-way tele-presence exchange. That’s enough data to fill one-sixth of the aggregate capacity of entire first generation Level 3 network, if every fiber in every conduit were lit with today’s optics.”
Using the benefit of hindsight, it is interesting to note that in 1999 Level 3 was “…focusing on switching/transport service, not content aggregation.” Seven years later, L3 is all about content delivery via Vyvx and the CDN network they acquired from Savvis. Level 3 does not promote the Mini-Max I model as they did they past, but they clearly believe that video traffic is or will be a major driver of network capacity and video plays to their strength as company with their network cost metrics and fiber capacities. Below I included a image of slide 7 of Kevin O’Hara’s, COO of Level 3, presentation at the Merrill Lynch Communications Forum on February 27, 2007:
I did download a version of the Mini-Max I model from the Internet Archive. You can search for it on the IA site or download the PC version of the Excel spreadsheet here: Download minimax.xls. Here is a link to a fun interview that James Crowe did with Wired Magazine in 1998.
Frame 3: Venture Capital Investments Thesis
When VCs read the Infinera (NASDAQ:INFN) S-1 is their reaction positive or negative to the funding model? I am not critiquing the business plan or the company, I strictly discussing the funding model divorced from the company. Do VCs think $300M or $400M funding plans are an investment thesis that works? Speaking with several VCs, I think the answer is no.
My observation is that $200-400M funding plans do not work over the long term. How many companies in the networking space could be supported by venture capital if they all required $300M and six years to achieve an IPO exit? Ciena (NYSE:CIEN) raised ~$40M before their IPO. Cisco (NASDAQ:CSCO) raised $2.5M of venture capital from Sequoia in 1988. Eighteen months later, Cisco went public. Nineteen years later, system level networking companies are filing for IPOs after funding plans of $100 to $400M. I recently have been talking to VCs about startups in the networking space. Where are they? Why are so few? I think problem is the funding plans required to make these companies successful are enormous and the barriers to a successful IPO are daunting.
If there is or will be an explosion of video, a video tsunami on internet, I would expect to see a number of startups in the video or internet infrastructure space. Where are they? Where is the next optical switch company? Where is the next Infinera 2? Where is the next long-haul or metro WDM startup? How about another router or switching company building products with the next level of integration, density and cost improvements? Here is a link to a collaborative story on whether New England ever have a Cisco Systems. My point is that venture capitalists are paid to make risk investments and they are either (1) asleep while the video tsunami is approaching or (2) they do not see the approaching wave because the funding investment level does correlate with the external market hype.
Frame 4: Mary Meeker / Morgan-Stanley Research Reports
In the process of looking for collaborative data points regarding the impact of video on the internet infrastructure, I reviewed the recent presentations from Mary Meeker’s team at Morgan-Stanley. You find an index to their technical presentations here. I find value in the material from Mary and her team because of their consistent effort over a long period of time. The research material starts with The Internet Report from 1995 and spans the entire time period to today. Few analysts and technical people have such a long historical record available for comparison, review and critique. It is a point of quality in her team’s favor to make available a vast amount of material to frame historical perspectives. Here are three slides from their recent report on the state of the internet presented at the Web 2.0 Conference in San Francisco in November 2006.
The first slide graphically illustrates the emergence of P2P traffic on the web, which Meeker cites in slide 20 as 62% video. The third slide is the question slide and I do not think we have a definitive answer. Clearly the companies that own long-haul fiber backbones (e.g. L3, AT&T, Verizon, Sprint) would like to see high value commercial video as a business driver. The P2P video traffic is a significant driver of bandwidth, but it is similar to the Napster event of the late 1990s – it is under monetized. P2P traffic that is non-monetized is the killer application for service provider in negative manner. The whole net neutrality debate is centered on paying for use of bandwidth. It is the toll road analogy. If I am running a P2P service and it is traveling over someone’s backbone that I accessed through a different local broadband provider, the backbone provider is not gaining income from the packets I sending which are a stream inside a fix service contract between the local bandwidth provider and the backbone provider.
This is the challenge presented by the uncoupling of pipes and services in the service provider model. Technical evolution now allows services to exist separate from the connectivity pipes, or in other terms services can exist outside of the network. When this uncoupling occurs, service providers are not monetizing the services running inside the pipes (i.e. circuits, wavelengths, etc). This is the challenge of P2P video. Who is gaining what percentage of the video revenue in a P2P service? There are monetization challenges in the current market construct for commercial video and P2P video. The chain of commerce for the monetization of video is not as simple as growth rates will drive top line revenues. The video chain of commerce must be considered in terms of the uncoupling of services and pipes. This is the heart of the new neutrality debate and the basis for the assumption that service providers might evolve towards being only connectivity providers.
Frame 5: Infinera S-1 and Internet Bandwidth Consumption as the Macro Event Driver
Infinera is not the only company to recently file for S-1 that is leveraging video as a business driver as well as challenging funding model. BigBand Networks filed for an IPO having raised $100M in venture capital and acquiring the CMTS business from ADC to fuel the revenue engine a few years ago. Here are some excerpts from the Infinera S-1 that illustrate the use of video and overall internet bandwidth consumption as the primary supporting element of the investment thesis:
Infinera S-1 pages 51-52: “Increased Demand for Network Capacity: The global market for optical communications equipment is estimated by Ovum-RHK, a third party industry analyst, to be nearly $12 billion in 2006. Our DTN System currently competes in the WDM segments of this market, which we estimate to be $3.7 billion in 2006. Drivers of Increases in Demand for Network Capacity: We believe that a number of trends in the communications industry are driving growth in demand for network capacity and ultimately will increase demand for optical communications systems, including our DTN System. These trends include: Growth of Internet usage and IP traffic: Internet protocol, or IP, network traffic continues to grow significantly as bandwidth consumed per Internet user and the total number of Internet users increases; Increasing broadband penetration and high capacity services: Communications service providers are offering broadband internet access to an increasing number of subscribers to support voice, video and high speed data offerings. In addition, rapid adoption of new consumer applications such as video and music downloads and business applications such as videoconferencing necessitates an increase in network capacity to accommodate high-quality delivery of these bandwidth-intensive services; and Availability of more affordable bandwidth capacity: Competition among cable, satellite and telecommunications service providers in providing bundled services such as the “Triple Play” (voice, video and data) has caused a decline in consumer pricing for such offerings, which is encouraging greater consumption of bandwidth.”
Frame 6: The Quest for the Holy Grail: The Killer App!
In their famed Internet Report, Mary Meeker and Chris DePuy of Morgan-Stanley declared that “at a minimum, e-mail should become pervasive. So should Internet/Web access: Email is the “killer application of the Internet today, and browsing through information services the “killer app” of tomorrow,” [see, the Internet Report, Mary Meeker and Chris DuPuy, February 1996, page 1-2]. Now that we have transitioned enough of the Web 1.0 (i.e. dialup) infrastructure to the Web 2.0 (i.e. broadband) infrastructure, is video the killer application, the Holy Grail or the next great hope that the internet has been waiting for?
Anecdotally it appears that video and the affect that video is having on the internet is being used too loosely. It is almost taking on a life like that of the Worldcom fable that the internet is doubling every 100 days, which was a story that found itself in many a business plan presented to a venture capitalist back in the 1990s. Here is a link to an excellent paper on the history of the internet doubling every 100 days, myth and legend. The question is whether video is indeed the application that changes the infrastructure of the internet or is this a variation of the second derivative of growth applied to the internet using video? Here is another reference to the coming data tsunami and how the data overload assumption becomes propagated. I am not disputing that it can or will happen, I am stating that we are missing metrics to support the assertion.
I did some channel checking with people who sell optical networks. If there was a massive video tsunami on the way, I think the service providers who own long-haul optical networks are also missing the warning. People on the front lines of the optical wars tell me that metro networks are hot and growing, but the long-haul networks are just adding capacity. Qwest is in the midst of a rebuild of their first generation long-haul gear acquired from Nortel (which started the whole 10G bang, as in it was the first 10G gear deployed) and AT&T (NYSE:T), Sprint (NYSE:S) and Verizon (NYSE:VZ) are fixing portions of their networks and adding capacity. What is not happen is there are no new overbuild backbones occurring. No service provider is pulling new fiber. The optical market is far healthier then it was two years ago, but we are not back in the days of the late 1990s when service providers were ordering optical equipment at $100M to $500M per purchase order every quarter.
Google (NASDAQ:GOOG) purchased YouTube.com because they believed they could monetize the video streams and/or monetize the advertising business that could be developed from the YouTube.com daily user base. If the video traffic in terms of transmission bits was the most valuable asset, then I would have expected Google to buy the pipes, but they bought the content and the users instead of the pipes. How much traffic will Slingbox and DVRs produce in the network? Can service providers monetize this traffic greater than the connectivity of the pipe that connects to the box? If video is indeed the explosive, killer application that internet has been waiting for, where are all the startups that are going to provide the next generation of infrastructure? Have we reached a point in the service provider model to conclude that the horizontal integration model won over the vertical integration model? This is the inverse of the assertion Level 3 extolled back in the 1999-2001 time period that “Silicon Economics was Disrupting the Vertical Integration Model” of the service provider industry. Today, the service provider market looks more like fully integrated vertical market structure then a set of disparate horizontally focused entities. Andrew Schmitt at Nyquist Capital introduced me to the Invisible Hand Services' Metro New York Liquid Bandwidth Exchange. If I look at the flattening of the price curve, should I conclude that companies that can own more of the end to end (i.e. fully vertically integrated) distribution chain of commerce for data (i.e. video, VoIP, etc) will realize higher profits? Or should I assume that bandwidth consumption with increase significantly that cost of the replacing the capacity will result in scarcity and drive bandwidth costs higher?
I chose the title of this post because I can see either a market discontinuity or investment discontinuity in the effect that video is having on the internet. As always, thoughts and comments welcome, whether private or public.
Full Disclosure: I do not own shares of any of the companies mentioned in this post.