Original URL: http://www.theregister.co.uk/2007/05/17/the_economics_of_fibre/

BT: we need fibre, not share buybacks

The short-term thinking that's holding back UK plc

By Keith McMahon

Posted in Networks, 17th May 2007 15:04 GMT

Analysis Fibre to every home and business (FTTH) in the UK is desperately needed if the UK is to keep its long-term economic competitiveness.

It's extremely disappointing that BT today announced a £2.5bn share buy back programme. We'd all be better off in the long-term - BT shareholders included - if BT invested that in deploying fibre, rather than a short-term cash giveaway.

Guaranteed profit

BT manages the UK local loop through its Openreach subsidiary, and Ofcom allows BT a regulated 10 per cent return on its investments, therefore contrary to some beliefs there is little or no risk to BT shareholders on a FTTH deployment - just a regulated return at the Openreach level and potential upside at the operating unit levels (Retail, Wholesale and Services) with the sale of additional services, improving margins or market shares.

For a practical example: if it costs Openreach £10bn to deploy FTTH, and the cost of borrowing is six per cent, then Ofcom will guarantee Openreach an additional £400m of pre-tax profits per annum (£10bn multiplied by (10 per cent minus six per cent). This is also a big tax benefit for BT, as an investment of this level will reduce its tax bill for many years to come. Even with a full 20 per cent tax charge, £320m of additional earnings for BT with its current PE Ratio of 17.5 adds around £5.6bn of market capitalisation for shareholders.

There is a big debate going on throughout the world about open access and regulation of fibre projects. Most of these debates are irrelevant in the UK, because there is already a separation of the network and service divisions of BT. For instance, Openreach can provide three distinct network services at the exchange for all other service providers: a voice, data, and broadcast video pipe with an associated tariff menu.

Saving money by spending it

In the 12 months to March, Openreach had operating costs of £3,289m. It's seriously doubtful that FTTH would add more costs to this figure because BT's copper network, which in some parts of the UK is over 70 years old, is so expensive to maintain. Many of the distribution frames in the exchanges are also extremely old, and we know from LLU statistics that maintenance costs are extremely high.

In the United States, Verizon claims that operating costs have been dramatically reduced by replacing copper with fibre, and the investment almost pays for itself. However, the weather in the UK is nowhere near as extreme as parts of the US. Also, Iliad in France claims that margins are higher for fibre than LLU, which also implies a cost advantage.

In the UK's regulated environment, Ofcom assumes that operating costs are reduced by 1.5 per cent per annum for regulated prices. This efficiency gain could almost certainly be increased if FTTH replaced the Copper Local Loop.

Triple Play opportunities

The Openreach products would effectively be a voice, data, and video "pipe". Effectively, the situation could be quite similar to the existing LLU setup with a standalone data pipe, a combined voice and data pipe, and an extra product for broadcast video. This broadcast video product would be similar to the current proposal at Ebbsfleet which bundles the Freeview channels, DAB channels, and the Sky "satellite" channels.

Obviously, the video pipe is an additional revenue stream for Openreach. I would guess that the appeal of Freeview and DAB channels alone is limited to customers where reception of Freeview is poor or multi-dwelling units where aerials are not permitted.

However, the bundling of pay TV channels would add up to a viable end-user service. It would also provide a third distribution channel, and would probably win some market share from both Sky Satellite and Virgin Media Cable networks. Also, because Openreach is effectively a network provider with BT as its biggest customer, it would provide opportunities for a whole variety of entrants into the UK pay TV market.

The speed of the data pipe would also be increased as the current flavour of FTTH meets the GPON specification (ITU-T G.984). GPON offers a 2.4Gbits/s downstream and 1.2Gbit/s upstream shared pipe for 32 connections. This easily allows a 100Mbit/s down and 10Mbit/s up service - with a 200/20 service. The speed guarantee would not be distance related as is the current case with ADSL. This could command a higher price.

However, the biggest element of increased revenue is for Openreach to win lines back from the competition, or avoid the loss of lines. According to its Q1 results, Virgin Media had around 4.8 million customers with various services for Openreach to win back and gain additional revenue. This is excluding the business market, where alternative networks such as C&W have been directly connecting companies for years.

I would expect Openreach rolling out a FTTH project to cause serious competitive damage to both Virgin Media and C&W in the UK. For me, this is a not serious concern in either economic or competition terms as long as the Openreach network is truly open and BT Retail does not have special advantages over other service providers.

Digging up the road

For a greenfield site, the cost of deployment for fibre is estimated to be similar to that of copper. The equipment and cable costs are similar and the expensive labour intensive tasks of digging trenches to lay the cable and internal home and exchange cabling have to done for either fibre or copper. For reasonable sized new housing developments, there is no reason why Openreach wouldn't lay fibre rather copper in the future.

To replace the legacy copper network, digging and internal cabling have to be repeated, and this is not only expensive but disruptive to the neighbourhood. Costs can be minimised by using exiting ducts and telephone poles for overhead drops where available. These costs are normally grouped together as "cost to pass home" which are fixed whether one house or the entire street sign-up to the fibre network.

The other component is the "cost to connect", which is lighting the fibre and installing the electronics at the home and activating the fibre at the exchange. This is obviously success based.

In terms of actual costs, Verizon currently provides the benchmark with $800 per home passed and $842 per home connected quoted in its latest earnings call. There is also a recent paper by the Broadband Stakeholder Group which quotes a study by the Enders Group that 90 per cent of UK homes could be fibred for €14bn.

Given this, a nice round figure of £10bn won't be too far away from the mark for the UK FTTH project.

How much will fibre cost us per line?

An additional £10bn of RAV (regulated asset value) for Openreach would imply an additional £1bn per annum of earnings for Openreach (before interest and tax).

The additional fibre assets would generate an additional depreciation charge of £500m per annum to Openreach assuming a 20 year write-off. However, these charges need to be offset against the current copper network depreciation because, of course, the copper network won't be replaced. This is another big number: I estimated that the depreciation charge is around £250m per annum. The basis for this assumption is because the current £11.3bn of RAV will include quite a few items outside of copper plant, such as the actual exchanges - and I'm trying to be conservative. This leads to total additional earnings required at Openreach of approximately £1,250m per annum.

We also have to look at the cost savings from operating the fibre rather than the old copper. With Openreach's annual operating costs running at around £3,289m per annum, it would not be beyond the realms of possibility to expect £150m of annual savings.

This leaves the net regulated increased revenue at Openreach at approximately £1,100m. Of course, this is before the incremental revenue from video services, increased bandwidth, and increased market share. The £1,100m revenue across the 22 million lines in the UK equates to around £50 per line per annum or £4 per month charge.

Obviously, there would be a big debate with Ofcom on how much of the regulated return should be borne by lines on the existing copper network as opposed to new fibre homes. My own thought is that the whole of the UK network should bear as much cost as is politically possible and therefore the costs are spread over as many lines as possible. If a huge differential in price between services delivered over copper and over fibre exists then there is less incentive to people to swap and a big reduction in the possibility of ever sunsetting the copper network.

In my opinion, one way this problem could be solved would be to have a price list for a raw data and voice pipe whether delivered over fibre or copper as under the current WLR and LLU regime. There would be an incremental price for high speed broadband over fibre and another price for broadcast video. These incremental prices should be calculated to cover the success based element of the fibre network, in other words the cost to connect over the estimated life of the customer electronics, which would be around five years. This would work out with costs to connect of around £500 to £8.33 per month for the network charges for both high speed fibre data and broadcast video, which I think is reasonable. This would also mean around 50 per cent of the costs would be in cost to pass or an additional £2 per month to everyone's line rental.

The bottom line

The recent decisions by the French operators and by Verizon in the US to roll out FTTH without large scale government subsidies prove that the economics can be made to work. The special situation in the UK where Openreach prices are regulated, actually means the project is less risky for BT shareholders. BT just requires approval on how the costs are to be apportioned.

The big question in my mind is why BT is not pushing ahead presenting a FTTH project. I can see that BT would want to minimise changes, and therefore risk, while it is upgrading the core network with 21CN. Realistically, I can see how a big project like FTTH would absorb Ofcom for around a year, navel gazing and negotiation, before approval was granted. By which time there will be large areas of the country where 21CN is implemented.

The only reason I can think of is that BT does not think there is currently enough political and end-user support for such a project. But this support will build over time as more and more cities and homes within Europe are connected with fibre and the UK falls further and further behind. Support will also build as more and more consumers become frustrated by the UK speeds and find that services such as video streaming over the internet only work at low quality.

With an increase in line rental of just £2 per month, OpenReach gets a fair mechanism to pay for the investment. FTTH is not only vital to UK plc, but affordable. It's frustrating to have to sit and wait while BT decides to make the case. ®

This article appears today on the Telebusillis blog.