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Google's (NASDAQ:GOOG) Fiber project is rightfully seen as a great challenger to the Wireline Operator business model, but will it make a massive dent in the communications industry? I doubt it. All Fiber To The Home (FTTH) operators are limited to just a few revenue-generating streams, Google too. There are severe shortcomings in Google's business model, which can be disastrous for the profitability of its project.

For investors and the likes, my analysis is a sanity-check; for those who are salivating on the prospect of getting Google Fiber in the very near term, this report is a reality check.

Background

Before we move on to the real work, please allow me to introduce myself. I am a so-called pioneer in the FTTH industry. Back in 1999 and 2000, my company started investigating a possible entry in the FTTH industry. Long story short, even Google's leadership recruiter knew where to seek advice on their upcoming Google's FTTH initiative.

On May 18, 2010, I received a very nice email from Google's Leadership Recruiters, stating:

Neal,

My name is _____________, and I am a Leadership Recruiter here at Google. I am heading a new project to identify an innovator to lead our new FTTH initiative. We believe this has the opportunity to be something quite special, but we need a true visionary to help us completely rethink the status quo of FTTH product architecture and network design (especially as it relates to current U.S. efforts).

Given your extensive international experience involving next generation broadband solutions, I would value 30 minutes of your time to get your thoughts and advice on how and where I should focus my efforts. Thank you very much for your time.

I was flattered, of course. I didn't get the job because I was only available part time (they were looking for full-timers), but needless to say that I shared my thoughts with this person and in his extension with the responsible people at Google's FTTH project.

My full time job is at a company (nowadays called Angie Communications) that is planning large-scale FTTH projects (in the Netherlands, the UK, and even the USA), but we are also including 4G Mobile and 5G wireless infrastructure in the mix. Angie is the latest reincarnation of a company that was founded by a group of Next Generation Communications experts, and I am proud to be their Global CEO. Our team (at Angie) consists of a 40-year veteran/pioneer in fiber optics technologies (Dr. El-Sherif, CTO), and a pioneer-builder (Elli Gudmundsson, CEO Europe) who has lead teams that rolled out FTTH and communications infrastructures for investors, worth approximately $1 billion. I have written numerous analyses and reports, and I even like to claim (tongue-in-cheek) that I have written "the book" on the NGC industry, back in 2007. Out of the many thousands experts who received my analysis (including "the book") I can't remember any (significant) criticisms on my (and my team's) findings. We are not a bunch of me-too/wannabe NGC hopefuls; I will go as far as to claim that my team and I have done seminal research and work in terms of business modeling and technological engineering (since early 2000) for this now-fledgling NGC industry.

Hoping to have established a reference to my relative authority in this field, let us now move on to the reason you are reading this document.

Introduction

After more than 12 years, our ambitious plans for the Next Generation Communications industry got validation by Google's announcement to launch its Fiber To The Home project.

It struck our team as remarkable how greatly similar the Google Fiber business model is with ours. And while there are lots of massive opportunities to be had, the FTTH industry is not for the faint at heart. Having been breathing and eating Fiber (no pun intended) for the last 12 years, I was curious to see how much sense Google's FTTH business proposition makes. This report is the outcome of my analysis, which consists of three segments:

  1. Analysis of Google Fiber business model;
  2. Market-size and opportunity analysis;
  3. Financial analysis.

Google is rightly so seen as a great challenger to the Wireline Operator business model, but will it make a massive dent in the communications industry? I doubt it. All FTTH operators are limited to just a few revenue-generating streams, Google too. There are severe shortcomings in Google's business model, which can be disastrous for the profitability of its project.

For investors and the likes, my analysis is a sanity-check; for those who are salivating on the prospect of getting Google Fiber in the very near term, this report is a reality check.

First of all, the size of the USA market is too large to be covered and thus disrupted by one single company, even if that company is Google.

If all households and commercial buildings would be connected to fiber, it would take:

  1. 5-7 (if not ten) years to complete;
  2. $150-500 billion (half a trillion dollars!) to build, own, operate this FTTH infrastructure over that period;
  3. An investment of $25-50 billion if financial engineering models can be implemented, conditional to successful modeling and project execution.

So, the probability that Google will built a FTTH infrastructure that connects millions of households and business is about 1%. The probability that it will be Google who brings FTTH nationwide is even slimmer.

Google Fiber Business model

The Free Model

The most troublesome aspect about Google Fiber is its promise to the media that its free service won't be loss-making. In one of her articles, GigaOm reporter Stacey Higginbotham notes a Google executives' remarks:

... the $300 initial connection fee will cover the costs associated with the deployments - it's not doing that at a loss either.

This is either a miraculous achievement or an omission of facts. The physical cost to make a home plug-and-play ready with fiber optic wires (the so-called Cost per Connection, CPC) to provide services is not going to be covered by a one-time $300 fee. I wish it could be, but reality shows it cannot be done (see section Financial Analysis, below). Plus, the free service is guaranteed for seven (7!) years, which implies that its operation costs (including help-desk etc., and -if you want- the price-per-megabit) is included in the one-time $300 payment.

Notwithstanding the profitability aspect, it is a genius strategic move by Google to offer the "common" speed on competitive systems for free at $300. It has at least a three-fold benefit:

  1. The equipment is basically subsidized by the customer (it gives them a psychological connection as to the value of this otherwise free service);
  2. The free service allows for a massive take-rate. People understand that their $300 investment boils down to just $3.50 per month (84 months/ $300) to get 5 Mbps;
  3. Customer loyalty: Google creates great goodwill, and when the customer is ready/willing to make the transition to the bundled Google Fiber service, they will become locked customers- a money-printing machine for Google for decades to come (if done correctly by Google).

Notwithstanding the seemingly fantastic offer (what can be better than free?), there are some potential downsides too.

  1. Google offers people to pay in installments of 12x $25, which on one side means that the connection fee can be paid over a full year, but on the other side it means that people are effectively paying $25 p/m for just a 5 Mbps connection;
  2. Google's decision making process in this affair must have been based on the hope that these people will migrate to their more expensive services.

Thus, if the competition is smart, they will beat Google to this with a similar offer, and throw in something in the mix for the other 6 years. If their lives depend on it, these competitors with deep pockets will not just roll over and die. Assuming so is just wishful thinking on the part of Google and its enthusiasts.

Also, as of yet, some residents of self-proclaimed poor areas of Kansas City are disillusioned. One commenter, Danny, writes on GigaOm:

I, unfortunately, live in one of the poor areas of Kansas City that is not even being offered the chance to pre-register for Google Fiber. But, let's be honest, there's no way enough people in my poor area of KCK would pre-register that I'd actually get service from Google anyhow.

Google promises to include other areas in its second pre-registration effort, but that would most likely mean the service won't be coming soon to those "poorer" areas. This, in effect, is cherry-picking, and regardless the great intentions of Google, it shows a massive flaw in business modeling and planning on their behalf.

The Paid Model

Google Fiber's paid model seems fantastic at first sight, but there are market risks lurking. Below is an overview taken from Wikipedia, which was sourced from Google's website.

Plan

TV + Internet

Internet

Cost

$120/mo

$70/mo

Installation

$300 construction fee (waived with 2 year contract)

$300 construction fee (waived with 1 year contract)

Internet Speed (Down / Up)

1Gbps / 1Gbps

1Gbps / 1Gbps

TV Access

Yes

No

Storage

2 TB DVR Storage (8 Shows can be recorded simultaneously)
1 TB Google Drive

1 TB Google Drive

Additional Hardware

Nexus 7 tablet

None

Let us first and foremost assume that Google Fiber's most appealing unique selling proposition is its 1 Gbps symmetric service. But if you don't care too much about speed and are happy with a lower speed (for the time being, until reality catches up with you), Google is in for some nasty surprises as it will face fierce competition.

In effect, the pricing strategy means:

1. A subscriber of the least expensive package will be paying approximately $840 for 1 year or $1,440 for 2 years (without TV);
2. At the two-year package, the overall expense/fee would be accruing to $2,880 in total (with TV);
3. Google does not provide phone services, thus is it not a triple-play / convergence provider.

If the competition is adamant to compete in terms of pricing by bundling TV, Internet and telephone, Google will have a hard time selling their (what then will be assumed as premium) 1Gbps service.

My conclusion is that when the dust settles, many enthusiasts will be poked from all sides by Google's competition, where the latter will focus on pricing, quality, and bundling (including the argument that it is much easier for the subscriber to have an all-including package).

It seems like Google Fiber has been put together with some very smart engineers, and with the help of some product managers, but providing these kind of services (which are basically primary needs today) is something else than search algorithms and answering the most difficult interview questions. This is people's business, and people will choose for what is best for them and their family and their wallets.

Google is hereby advised to devise a mechanism to a) include all people from all walks of lives, b) to differentiate their product offering even more, and c) to create a strategy to beat the competition on all fronts (for example/especially in terms of convergence and service bundling).

Market Size/Opportiunity

If deploying fiber wires to all homes and business would be an easy feat, the market size and opportunity would be massive, for everyone - not just for Google. The largest, most comparable project that involves large-scale rollouts (as we all hope Google would opt to do) is Verizon's (NYSE:VZ) amazing FiOS project. However, even the Big Red had to cough up billions of dollars - $23 billion ($23,000,000,000) as far as we know, and most likely somewhere near $30 billion in direct and indirect expenses/investments/costs. What did Verizon get for this massive investment? Here are the Q2'12 results:

Verizon FiOS

Total Homes Passed

14-17M

FiOS Internet Subscribers

5.1M

36% penetration

FiOS Video Subscribers

4.5M

32.6% penetration

Consumer ARPU

$100 p/m

Thus, no matter how fantastic the Verizon FiOS service offering was (including the fastest internet speeds in their markets), it has achieved to get a take-rate in the mid-30% range. That is achieved with a project on massive scale that offered bundles services. One could argue that price will make a difference, and I agree, but the rollout strategy is even more important.

When looking at the possibilities for Google to become a large-scale/multi-city/multi-state or even nationwide operator, we have to keep in mind the following:

  1. Scale of project;
  2. Service offering;
  3. Pricing.

The service offering and pricing has been briefly analyzed above, in the Business Model Analysis. The fact remains that the market is too large for one company to serve all USA households. The inherent aspect of building FTTH infra means that it is a labor-intense effort. Yes, Google has bought up tons of dark fiber, but that is no ordinary feat - everybody can do that, including Google's competitors. The opportunity of connecting each and every home/business with fiber optics is undeniably equal to its problem: every new entrant as well as the legacy (cable or DSL) operators is forced to build the last-mile/last-hundred-feet infrastructure - with fiber optic wiring.

According to the most recent Census data the USA overall market size is as following:

USA

Housing Units

131, 704,730

Commercial Units*

7,000,000

Total

138,704,730

Households

114, 235, 996

Commercial Units

7,000,000

Total

121,235,996

* Source: Commercial Building Inventory - Number is excluding apartments/dorms/etc.

Suppose Google wants to create a behemoth FTTH Next-Gen cable company that actually ends up with 15 million paid subscribers, it would probably take them approximately 5 years (if their builders work really hard), costing more than $24 billion, and at a loss (investment capital requirement) of almost $8 billion (i.e. if they actually serve 15 million subscribers - quite an ambitious feat when considering Verizon FiOS take rate of 32-36% at 17M homes passed). This is a truly bare-knuckles calculation, and does not include any form of operational cost (which is obviously highly unlikely at such a grand scale). An in-depth explanation of this cost structure will follow in the Financial Section.

As with many things, seizing upon an opportunity does not always equal a) successful execution, b) medium/long term business sense, and c) profits. It is true that Google Fiber is disruptive, and it will force the legacy operators (as well as newcomer FTTH operators) to review their business models and strategies. But it is equally true that the service provider business is a people's business; it is not easy to create a service-centric business that on top of all has to compete day-to-day with some of the world's largest companies, especially with companies who have decades of experience in providing physical services. As with any education, it will take years for Google and its executives to learn the ins and outs and the tricks and magic these otherwise sleepy and rusty giants can pull out of thin air when needed. And need they will, but it is going to be a money-intense and time-intense battle if Google Fiber reaches beyond Kansas.

Financial Challenges

When considering the feasibility and the profitability of a FTTH project, we usually take in consideration (and specify) several aspects of a project:

  • Cost Per Connection (NYSE:CPC) and Cost Per Home Passed - separately mentioned as part of total Capital Expenditure;
  • Average Revenue Per User (ARPU) - the monthly revenue generated per user per month;
  • Operational Expenditure over the stretch of the project's rollout time;
  • Capital Expenditure over the stretch of the project's rollout time;
  • Specific expenses and costs, separately mentioned as part of OpEx or CapEx.

In Google Fiber's case beyond Kansas City (KS and MO), we assumed the following:

  • In an oversimplified way, the average CPC would be between $850 to $1,250 - this could be much higher due a) equipment cost, b) geographic lay-out of market, c) disappointing take-rates that will drive the CPHP up;
  • ARPU of $100 (we assumed 50% would subscribe to the 1-year service and the other 50% would subscribe to the 2-year service);
  • Churn of just 1% (may be more, but it can be stabilized by additional sign-ups);
  • 20% Cost of Revenue (for example, apps/programming/3rd party services etc.);
  • 5% Franchise Fee paid to city (this may be waived in some places - but we assume this is going to be a real cost in larger projects sooner rather than later);
  • We assumed a promotional incentive/trial period (needed to attract subscribers);
  • We assumed no revenue-sharing with Real Estate owners;
  • We assumed no licensing costs or development costs;
  • We assumed absolutely NO operation cost (no employees, no marketing, no retail outlets etc. - if one wants to put a price on this [e.g. 10% of the project cost], just increase the Project Cost with 10%);

According to the calculations/projections as per our estimates, the above scenario is the best case. Readers must note that he industry average for the CPC and CPHP has been floating around substantially higher numbers. In the most comparable scenario, the FiOS project has resulted in a CPC of approximately $1,352, which is derived from $23B divided by 17M connections (we ignore the CPHP because that would totally skewer the calculation higher). Ignoring the fact that Verizon had an overbuild strategy (on their existing infra layer), we will assume that Google's genius engineers invented a way to establish a CPC at lower costs than Verizon.

In the analysis below, we have an overview of 12 scenarios, which reveals a dramatic outcome.

The 12 scenarios were derived from the following stand-alone projections:

  • CPC at $850
  • CPC at $1,000
  • CPC at $1,250

and

  • ARPU at $100 per month
  • ARPU at $70 per month

Overview range of scenarios

(based on 15 million paid subscribers)

Scenario

ARPU

CPC

Total Project Cost

Investment Requirement (at highest peak)

1

$70

$1,250

$25.8B

$12.5B

2

$70

$1,000

$20B

$8.9B

3

$70

$850

$19.8B

$6.9B

4

$100

$1,250

$28B

$9.7B

5

$100

$1,000

$24.2B

$6.8B

6

$100

$850

$22.4B

$5.3B

* Some amounts may result in lower overall project costs while the ARPU is lower. This is the result of the promotional discounts, which is weighted in ARPU levels. (Less discounts = lower expenses).

Seeing the above, and seeing Google's massive cash pile one would be quick to point out that Google can easily afford to invest $12.5B in the "worst case." However, this is not the worst case scenario. The worst case scenario would be that you add operational costs (let's say 25%) on top of that, which would result in $15B. And even then, things can take a turn for the worse.

Consider the total project cost of Verizon's FiOS, $23B, and then divide that not by the 17M homes passed (as I did), but with the actual subscribers (5,1M), This would result in a cost per subscriber of $23B/5.1M = $4,500. Applying FiOS business model in a nationwide extrapolation, the cost to pass (not subscribe) 100M households/homes with FTTH would be 5.8 (full market size at 100M) x $23B = $133B.

This is excluding operation expenses and other additional investments and costs that accompany such a massive project. Also, don't forget, Verizon had the massive benefit of an existing operating base and an existing service infrastructure. Google does not get to take advantage of that massive benefit.

I don't intend to say that Google cannot make money with the Kansas project; I think they can. However, the problem is when you go beyond a cushioned and championed area/region you will have to live and deal with the bureaucrats, the competitors and the discriminating public. Just speed will not cut it. Pricing and bundling are equally important (if not more for the time being) as the service offering, and in a larger project these aspects, along with the time and money intensity, challenges are of a greater magnitude than in the case of smaller projects.

The bottom line for investors/Seeking Alpha readers:

Is the FTTH project a big enough catalyst for readers to consider investing in Google? Should they take a wait-and-see approach? Well, I conclude by stating that investors will have to decide in due time how they perceive the chances of Google being successful in this very competitive and time-intense business. I'd consider a "Hold" if I were you.

Why? We should not forget that Google is one company that is spreading itself too thin nowadays. It competes (if it's not waging war outright) with some of the world's largest companies on not just one but several fronts. Microsoft (NASDAQ:MSFT) in terms of browser and OS, Yahoo (NASDAQ:YHOO) in terms of content and programming, Facebook (NASDAQ:FB) in terms of social media, Apple (NASDAQ:AAPL) in terms of mobile, these are just a few limited examples of what Google is up to. Now it has included Time Warner Cable (NYSE:TWC) and potentially Verizon and Comcast (NASDAQ:CMCSA) against it too.

Thus, with the eye on Google Fiber, the minute they announce to roll out beyond Kansas, start asking questions. I highly recommend comparing the feasibility of a larger roll out with the Verizon FiOS project. It doesn't make sense to invest in FTTH if you're not doing it for your bread and butter. If they announce (in let say 3 months) that they go beyond Kansas, I'd run for the exits. If they announce that this is it, then by all means do your own fundamental research, as you have been doing pre-Google Fiber.

In this analysis, I have highlighted the financial as well as business challenges of large-scale FTTH projects, but I also believe these risks can be minimized by implementing smart solutions on a large and full scale. While that is another discussion altogether, readers are welcome to challenge my findings.

Disclosure: I am long GOOG.

Source: Challenges And Opportunities For Google's Fiber Project: A Reality And Sanity Check