The Austrian economist Joseph Schumpeter was fond of saying a good recession is like a “cold shower for the economy”. It weeds out the weak and paves the way for radical innovators. It’s a pity, then, that this isn’t looking like a good recession. As Bedlam Asset Management pointed out recently, with governments propping up industries at whim and titans clubbing together (American car-maker style) to avoid extinction, we’re returning to “the almost forgotten and corrupt world of national cartels”. However, that’s music to some ears, such as US cable and telecom firms. Companies that control cable TV and internet access have been sitting pretty in recent years. Unlike Europe, where 27 firms battle it out to offer internet and broadband, Americans effectively choose between just four providers who control 70% of the market. And as Jack Goldsmith and Tim Wu point out in Who Controls the Internet, despite the falling price of internet services, on average Americans still spend as much on cell phones, cable TV and internet connections as they do on energy. Why?
Many attribute US providers’ pricing power to control over bandwidth. When you watch a video on YouTube, say, a huge chunk of data is sent along a fibre-optic cable to Google’s data centre and then relayed to your computer. The speed at which all of this happens is partly constrained by the cable’s capacity, or bandwidth. And, here’s the rub, with the explosion in the popularity of videos, Youtube alone generated more internet traffic in 2006 than the entire internet in 2000. According to market research firm Nemertes, user demand will outpace capacity by 2010.
Grant van Rooyen of communications group Level 3, quoted in The Economist, isn’t so sure this is a lasting problem. A lot of the cable laid during the tech bubble still isn’t being used. And while internet traffic might be growing at a rate of 50% a year, that’s down from 100% a year five years ago. So there’s no reason why infrastructure can’t be scaled up to keep pace with demand.
But internet traffic volume isn’t the key for cable and telecoms firms, says Andrew Schmitt of Nyquist Capital. “What matters is revenue.” Text messages take up next to no bandwidth – 600 text messages require less than a minute-long phone call – yet the largest carriers have been able repeatedly to lift the price of texting in recent years. Telecoms firms will always conspire to keep the supply of band-width low anyway, say Goldsmith and Wu. It’s like Opec with oil. Scarce bandwidth means higher phone, TV and internet bills and more profit for providers.
So what will solve the problem of high bandwidth cost? More competition would help. Obama has signalled his interest. But that will be tough, say Goldsmith and Wu. “Most of the much-hyped competitors from earlier this decade are dead or moribund.” The big telecoms firms already exercise formidable power – lifting prices or imposing caps on consumer bandwidth almost at will. The more likely solution, says Penny Sleuth’s Greg Guenthner, is improving the efficiency with which consumers use their existing bandwidth. In principle, it’s like swapping your SUV for a more efficient hybrid once oil prices take off. We look at one firm leading the charge below.
The best bet in the telecoms sector
A company at the forefront of driving the move to cut bandwidth costs is Soapstone Networks (Nasdaq:SOAP), according to Penny Sleuth. Soapstone develops software to simplify and streamline the networks used to handle internet traffic. For example, its new Provider Network Controller (PNC) allows governments and businesses to lower bandwidth costs and increase the reliability of their networks. “The technology is revolutionary for the industry, and has garnered quite a bit of acclaim.”
This is a critical time for Soapstone. Investors fled the stock as it abandoned its manufacture and sale of router products in the face of fierce competition to concentrate on the more specialist PNC business. As a result, Soapstone now trades at $2.50, on a p/e of 2.4. But with the disappearance of the router business effectively priced in and their pioneering PNC system now ready to go to market, “SOAP looks a steal right now”. The company will start reaping the benefits of its transition in early 2009, when it is expected to secure licensing contracts and maintenance fees. Industry analysts expect this network control business to reach $31bn by 2012. The company’s financials are also strong – it holds $6.50 per share in cash. So “buy shares of Soapstone for $3 per share or less”.