Shaking Hands With Devil in Smart Paradigm

by: Keith Woolcock

Over the last couple of weeks, Deutsche Telecom (DT), France Telecom (FTE) and Telefonica (NYSE:TEF) have announced that Google (NASDAQ:GOOG), Yahoo (YHOO) and Microsoft (NASDAQ:MSFT) should pay to use their telecom networks. This echoes the decision by a US Court, which found that the US telecom regulator – the FCC – had no legal authority to impose ‘Net Neutrality’ obligations upon Comcast (NASDAQ:CMCSA), a US cable broadband operator.

Network neutrality is a regulatory principle that states that a telecom operator must treat all internet traffic equally. If regulators around the world drop their insistence on net neutrality, telecom operators in those jurisdictions will see their earnings rise dramatically, as Internet companies are charged billions of dollars for Internet bandwidth usage.

As expected, Neelie Kroes, EU Communications Commissioner, made a statement on net neutrality quell the uncertainty. Much of the press grabbed headlines by reporting that she slapped down the telecom operators for talking too soon, stating that net neutrality was not negotiable.

Having read her statement in full, however, we have a different interpretation. Our view is that Ms Kroes has not yet made up her mind on net neutrality. In her statement, she said:

I do not make the assumption that one side or another should prevail in this debate, or even that further Commission intervention is required.

Given that the amounts involved are large, and strong arguments can be made on both sides of the net neutrality debate, this issue will not go away.

Political pressure has been building up in Europe and the US to raise broadband speeds, which are slow relative to Japan, Korea and Singapore – harming the West’s economic competitiveness. One way to get broadband speeds up is to subsidise broadband infrastructure. Yet in these times of austerity, that option may be jettisoned.

Indeed, we got a clear sign that this option was off the cards when the British Government threw out the idea of a broadband tax a few weeks ago, as the UK passed its UK Digital Economy Bill through Parliament. Another way to encourage investment in broadband is to scrap the net neutrality rule. That would allow telecom operators to build new high speed networks secure in the knowledge that they could charge commercial rates to all those who used them.

I believe this latter option will ultimately prevail. We are shaking hands with the devil: the internet will become less open but easier to use and so more profitable for some content companies, for Apple (NASDAQ:AAPL) and for some broadband suppliers.

Recently, it was revealed that Google is developing a device to rival Apple’s IPad and, in a yet another shift of strategy, Microsoft is about to launch own branded mobile phones. Meanwhile, back at No 1 Infinity Loop, Palo Alto, Apple has announced that it is to launch iAd, its very own mobile advertising network. Net neutrality, mobile advertising and own branded devices, are each linked to the rise of the mobile Internet. Within two years there will be 500m smartphones sold each year, which will outstrip PC sales.

Smartphones and tablet computers make it easier for Apple and others to act as gatekeepers who control the content and applications that run on these devices. No surprise then that Google, Microsoft and others are tweaking their business models and beginning to offer own branded devices. The nature of the internet is changing; it will become less open but more profitable for content companies, some device makers like Apple and, if net neutrality rules change, some telecom operators too.

Embedded vs. Open

An embedded device is closed to the user and in essence remains tethered to its maker, or the phone operator. Therefore, the content and applications that run on such a device can be controlled more easily than they can on a PC. Apple’s Apps Store, which is now being copied by other device makers, is the best example of this shift. Only Apple approved content and applications are available, which makes it easier.

By contrast, personal computers are open devices that can be easily programmed by the user, or any third party. In contrast to iPads and smart phones, no one controls what applications or content users are able to run on their PCs. The open regime has dominated the Internet since its birth.

Over time, the influence of the open Internet will subside as mobile users become dominant. Mobile users have demonstrated that they are more likely to pay for content if it is easy to do so and saves them the time and bother of hunting for free applications and content. This is the lesson of iTunes: music is freely available but for a small fee iTunes is makes finding what you are looking for more convenient.

iTunes and the smartphone are emblematic of what can be called the Smart Paradigm. In the Smart Paradigm, a great deal more thought has to go into the design of devices and the content and applications that run on them than ever occurred in the PC era. The reason for this is that phones and tablet computers are used while we are mobile. We therefore have less patience and time to surf the web, instead we need content delivered in an easy to use form. In return for convenience we are more likely to pay.

No Romance Without Finance

Besides boosting the power of smart device makers like Apple, the mobile Internet increases the importance of telecoms. The reason for this is that the mobile Internet has less available bandwidth than the fixed line internet, so the investment in quality of service becomes more important. At the same time, the mobile Internet offers content providers and device makers the opportunity to extract more value from their customers, because it knows their geographic location. In addition, the mobile network knows what time we are in a certain position and it even knows who we are with. All of this information is highly valuable for advertisers.

To borrow an old advertising slogan, first coined by Sun in the 1990s, The Network is the Computer. If the network is the computer, then it can add value to the data flowing over it and, if value is added, then payment is more likely to be extracted. The shift in the balance of power is best summarised by Cesar Aierta, the CEO of Telefonica, who said:

Google, Yahoo and Microsoft use the phone network without paying us anything, which is fortunate for them and a disgrace for us. We do customer care, after sales, installation; we do it all. I mean, they only have algorithms and content, nothing else.

Media Outperforms

Mr Rupert Murdoch, the head of News Corporation (NASDAQ:NWSA), would – like every other media boss – dispute that last statement. In the Smart Paradigm content becomes more valuable because it too can have more value added to it. As we have pointed out on several previous occasions, a device like the iPad can enable newspaper and magazine publishers to produce dynamic content that makes use of rich graphics and so can be tailored for access while we are fully mobile. The shift in the balance of power is beginning to be recognised by the market.

Since 11th February when we first argued the case for News Corp and media in general, the shares have risen 20% to $15.03. Likewise, Disney’s (NYSE:DIS) shares have risen 21% over the same period. Over this period the Powershares Dynamic Media ETF (NYSEARCA:PBS), has risen 17%. By comparison, the XLK technology ETF (NYSEARCA:XLK) has risen just 9% in that time.

Disclosure: No positions