SMART Letter #65
Of Pachyderms and Visual Acuity
January 3, 2002

!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*() ------------------------------------------------------------ SMART Letter #65 -- January 3, 2002 Copyright 2002 by David S. Isenberg -- "it really is a rope" -- -- 1-888-isen-com ------------------------------------------------------------ !@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*()!@#$%^&*() CONTENTS > Of Pachyderms and Visual Acuity by David S. Isenberg with comments of various lengths and depths by SMART People David P. Reed Art Kleiner Howard Anderson Phil Neches Reuven Brenner Jeanne Schaaf > Copyright Notice, Administrivia ------- POLICY ON READER CONTRIBUTIONS: Write to me. I won't quote you without your explicit permission. So if you are writing to me for inclusion in the SMART Letter, *please* say so. I'll probably edit your writing for brevity and clarity. If you want your remarks published anonymously, no problem, just ask. And if you don't want your remarks published, that is default, dear Brutus. ------- OF PACHYDERMS AND VISUAL ACUITY -- ISENBERG AND FRIENDS FEEL UP THE NETWORK ECONOMY ELEPHANT, WARTS AND ALL If ideas were races, David P. Reed [] would be a three-minute miler. But since ideas have a 'time to come', Reed has a timing problem. Or maybe Reed is on time and everybody else has a timing problem. I wish. In the early 1980s (before the Intelligent Network was more than a dull gleam in the eye of the pocket-protected manager who would soon be assigned to invent AT&T Marketing) David Reed wrote the original Stupid Network paper (with Jerome Saltzer and David Clark) that laid out the argument that communications networks should be as non- specific as possible because network builders can't begin to guess what creative uses network users will put them to. Furthermore, argued Saltzer, Reed and Clark, they shouldn't. About the same time that some singer put the bop in the bop-she-bop-a-dop, Saltzer, Reed and Clark put the slash in TCP/IP. A couple of weeks ago, David Reed wrote to me to second Roxane Googin's message. Actually, he firsted it. In 1997 Reed came to the conclusion that bad accounting by the ILECs would lead to an S&L-like financial crisis. He wrote, " in mid 1997 . . . I calculated [that] 3/4 of a trillion dollars as the [ILEC's] accounting overhang at risk from getting depreciation wrong (it's essentially confusing 'useful life' with 'competitive life')." (Incidentally, Reed also mentioned another prediction he made in 1994, saying, "HFC plants, having been cost- effective for broadband access and cable distribution compared to DSL, will run into the end of their 'competive life' in 2002 or so, and the underlying junk bonds in the cable industry will not allow them to be refinanced." Watch out. He's standing by this one seven years later.) I suspect that much of the financial finagling by telcos and cablecos to forestall competition is aimed at extending the competitive life of their plants. If Reed is right permacession will continue. Reed's letter continues, "Moore's law is understood in the computer industry. They don't issue long-term bonds to finance their capital. But the telecom industry keeps doing it. As far as I can tell the only reason for this screwup is 'tradition'. Bond traders can't evaluate a competitive industry on a Moore's Law curve. But because people see wires as the asset, the opportunity to move the real assets to the edges, to the users or others who can finance them based on incremental value, is lost." Reed's article, "Accounting in the Age of Moore's Law", published in 1998, said: "The basic issue is that computing prices have been falling exponentially -- 50% every 18 months -- for the past 30 years and will probably stay on that curve for another couple of decades. Yet, for convenience, accounting treats the plunge as a steady, straight line. All assets, including computers, are depreciated as though they lose the same small fraction of their value each year. "Accounting inaccuracies, allowed to accumulate for years, can lead to spasms of disruptive activity . . . "To think about accounting, it's useful to return briefly to first principles. The value of an asset should be its ability to contribute to future earnings. Predicting that value is very hard, so companies generally try to use the replacement cost of, say, a computer as the asset's appropriate value. But even if companies did a better job of carrying computers on their books at replacement cost -- by shifting to exponential depreciation -- they'd still be missing extremely important issues. "Local phone companies show what can happen when values are badly wrong. Fundamentally, the local telecommunications industry is suffering from an accumulation of technological inefficiency that has been preserved and covered up by an accounting method that does not account for innovation. The industry may now suffer the consequences as competitors position themselves to make inroads into the local market. "Here's what has happened so far: For the past 30 years, Moore's Law has guaranteed that the switches that compute and process signals have plunged in price. Yet local phone companies have depreciated switches slowly, because their monopolistic positions and skill at regulatory politics gave them the freedom to defer the pain. As a result, when phone companies look at new ways of handling communications, they make their calculations based on balance sheets that assume signal processing is 1,000 times more expensive than it really is. If the computer industry operated in the same way as the telecommunications world, we'd all still be using, and depreciating, IBM 360-model mainframes, which were introduced more than 30 years ago and which have less processing power than the typical calculator of today. "At the same time as this depreciation disparity was developing, technology made it easier for new competitors with new, hyper-effective business models to enter the market. While the phone companies assume that they need to have switches that provide lots of intelligence at the core of their networks-to move calls, handle call waiting, and so on-a new style of communications has developed that assumes no intelligence in the network. Instead, this style -- which is the approach that drives the Internet -- assumes the intelligence on the ends of the network, in my phone and yours. One result is that users can finance new entrants into this kind of telecommunications market, by buying intelligent phone-like devices, in much the way they've financed the progress in the computer industry over the past two decades by buying personal computers. New phone companies don't need to raise risk capital and invest billions of dollars in central office switches to compete with AT&T. "The local telephone companies could well have to replace their old switching technology to keep up with newer competitors that have a more efficient approach. Such replacements, while cheap to buy, would entail huge write-offs, given that existing switches are almost worthless and yet are carried on the books at fantastic sums. The central office switches and line cards of the phone companies could become the nuclear power plants (the "stranded assets") of the telecommunications industry. We could wind up with a debacle on the order of the S&L problem that led to such an enormous federal bailout -- a bailout that some local phone companies are beginning to lobby for [remember this was written in 1997 -- David I] under the misguided notion that politicians will nostalgically support their monopoly position against new, more competitive entrants." David P. Reed's entire piece can be found at How (you might ask yourself) did what Reed and Googin are saying cause the current recession? Well, to me, it became obvious that the tele-giants were winning their war against competition and successfully crippling the emerging infrastructure of economic growth. It seemed like that to a lot of other people too. Then the RIAA kneecapped Napster, and the biggest short-term reason for bandwidth growth went down in the gutter. Why invest in competition if it is going to fail? Why invest in bandwidth if the bandwidth intensive apps are made illegal? Presto, change- o, disolve in legislation, add a pinch of litigation and stir in a pint of public relations. Blub, blub, blub. My AT&T office mate in 1994 said that if AT&T knew what was good for itself, it would kill the Internet. At the time, I thought he was right with regard to AT&T's interests -- indeed, I had just written a paper about how the Internet was threatening AT&T by changing people's communications patterns. Even though I agreed that if AT&T knew what was good for it, it would kill the Internet, my gut reaction was that this position was morally reprehensible. Besides I thought that killing the Internet would be impossible, that the Internet would route around attempts to kill it. Hah! I did not know it at the time, but today it is clear; the Internet only routes around what its owners want it to route around. Now it looks like the potential victims of the Internet have begun to understand what my office mate understood in 1994. It has taken some time -- a short time in Corporate Time -- for the vested interests threatened by the Internet to get their act together, but they have. As a result, today the re-verticalization scenario of SMART Letter #64 is a real possibility. ------- Art Kleiner [], who wrote the insightful (and for me, formative) history of corporate culture entitled _Age of Heretics_ (Doubleday, New York, 1996) -- a book that I wish Carver "technology solutions" Mead would read - - wrote that Avoiding Permacession -- SMART Letter #64, " . . . was probably the most significant and brilliant SMART letter you've ever done, in my opinion, including the two scenarios at the end, and it deserves broader distribution." Like I said, my friend Art Kleiner sure is perceptive. Wait a minute -- maybe he is dissing all my previous work. Art!!?? ------- Howard Anderson [] wrote to say that *he* caused the telecom recession. As he explained it to The Boston Globe (May 3, 2001): "Because of Y2K, every corporate technology executive in the late 1990s all of a sudden had extra money available to spend that was not charged to his regular account. If you give a 2-year-old a hammer, everything looks like a nail. So what did these executives do? They spent with abandon. They upgraded applications, they improved their infrastructure. The industry needed an enemy and Y2K was the enemy. "At the same time Amazon came on the scene. Every major corporation - John Hancock, Fleet - was afraid of being Amazoned. So they spent even more money to Webify their applications. But now, the Amazon threat is over. Y2K is over. Y3K is 999 years away. And corporations have gone back to 1996 technology budget levels, which feels like a recession after the growth rates of the past few years." Myself, I think this is part near-term-hype-recovery phase of Amara's Law. In other words, the threat of Amazon (and its descendents) is NOT over. By the way, if you ever get a chance to see Howard Anderson do a shtick, don't miss it. ------- Phil Neches [], weighs in: "If I get the gist of the Smart Letter #64, the telecommunications industry is leading the the world into a Japan-like permanent recession, for which the only ways out are to let the telcos put the world into their old- fashioned straight-jacket or have the government force a new-technology solution on a reluctant industry. Gee whiz, could it get any worse! [Government doesn't have to lead, but where infrastructure ('outside plant') is involved, government must be involved. What happens to telecom easements along city streets? There's no competitive, self-regulating marketplace there. Are easements private property? And if so, who gets paid? On what terms? Who enforces those terms? (Hint: begins with G.) -- David I] "Let me offer three perspectives on what's happening in telecom-land, that don't lead to quite such a dismal assessment of the future. "First, this could be a replay of the computer industry in 1984, although on a larger scale and with a slower time constant. Most of us over the age of 40 remember the 1980s as the decade in which the microprocessor rose from being an obscure toy to the main engine of all IT systems, pushing the mainframe with its 7-year depreciation schedules and huge costs aside. "But before the microprocessor outdid the mainframe, there was a nasty shakeout in microprocessor-based companies in 1983/4. This came about because VCs backed what turned out to be lousy business propositions in the early 1980s. Over 30 PC companies were funded "Fast-forward 16 years. Venture capital formation is up a factor of 20 or more ($2B/year then to $40-50B/year recently). We started a lot more companies, with a lot more capital each. But the percentage with winning business plans and the ability to execute them is probably about the same as ever. It's just that the dogs are Great Danes instead of Schnauzers, and there are 10 times more of them. [Unlike the computer industry, the dogs of infrastructure are on a leash, held by . . . government. -- David I] "It took the world 3 quarters to sort out the high-tech debacle of 1984. Some companies got additional funding, albeit on lower valuations. Some companies merged. Many closed. Sound familiar? "This [current] work-out period is now in its 7th quarter. Since it's always darkest just before dawn, I'll risk a prediction that the work-out will largely be finished sometime in the middle of 2002, after going on for 10 quarters. [Or longer, given G-forces :-) -- David I] "The companies that survive the work-out period will be smarter, better managed, more focused, and better targeted. With valuations out of the ionosphere, they should be able to attract capital to grow. With interest rates, including long-term rates, at 50-year lows, we may find companies using debt financing to a much greater extent than in the 1970s and 1980s. "Some of the old-line companies may make through. They won't be the same as before. Industry transformations usually unseat the broad-based incumbents, forcing them to also become more focused (or die). "The lessons for the big telecom companies are clear. They can go under by sticking to obsolete technology and business models. They can survive, and even prosper, by finding something valuable to do in the new world order, focusing on that niche, and abandon their earlier pretentions of universality. "It's clear that the many big US players (Lucent, and the remaining Baby Bells) haven't got this picture. But it's also not clear that they are entirely out of time. "The second perspective comes from relatively recent findings in mathematical economics relating to properties of competition in network markets. Some background is in order. "In an ordinary market, the marginal cost of a good goes up with volume. If you grow strawberries, you plant the most fertile land first, resulting in the lowest cost. As volume rises, you run out of the most productive land, and start planting less desirable acreage, with higher production costs. Good old Econ 101 stuff. "In a network market, the marginal cost either doesn't change or even goes down with volume. It cost Uncle Sam zillions of simoleans to the be first Internet user. It costs almost nothing to add the zillionth Internet user. Also, the utility (value) of the good to any user goes up with volume (more other users to talk to, more things to do, etc.). Adam Smith didn't imagine that this could happen. "It turns out that competition works doesn't work the same in ordinary markets and network markets. In ordinary markets, it can be shown (by math that I can't repeat here) that the market has four wonderful properties: + The market is efficient, meaning that over all, buyers and sellers get the best price possible; + The market is voluntary, meaning that buyers and sellers participate only to the extent that they want to, free of external compulsion to act against their own economic interests; + The market is balanced, meaning that supply equals demand, so that distorting surpluses or defecits do not accumulate, and + The market is strategy-proof, meaning that nobody has an incentive to buy or sell more than they strictly need (in other words, it doesn't pay to game the system). No wonder we like capitalism so much! "However, network markets don't quite work this way. Over the last 25 years, mathematical economists have shown that you can choose any 3 out of 4 desirable attributes for the market, but you simply cannot get all four at once. Bummer! [These are very strong, very specific claims to stand without the support of citations or, at least a high-level explanation of the math. I'd really like to be walked through the logic. Maybe we will hear further from Phil on this. -- David I] "Regulation of public utilities (water, electricity, telephones) began long before any of this math was understood. Historically, we gave up efficiency to keep the other three attributes (voluntary, balanced, strategy-proof). "Electricity deregulation as recently practiced in California gave up the strategy-proof property, in the hope of getting more efficiency. As each party madly tried to game the new system, prices spiked then cratered, leaving a mass of economic and political carnage in its wake. It isn't clear if anyone is getting more efficient along the way, at least not yet. "Microsoft uses its monopoly power to decide who stays or goes as a supplier, so the market is no longer voluntary. Critics of the government's effort to break up or tame Microsoft point out that if Microsoft is forced to live by rules which make the market voluntary, it may no longer be efficient. "My hypothesis is that in the telecom world, we've given up on balance of supply and demand, most prominently in wide-area (city-to-city and larger scale) backbone networks. Build it and they will come was the watchword. "We know what happens when the voluntary goal is relaxed (monopolies!). We also know what happens when the efficiency goal is relaxed (old fashioned public utility regulation, as practiced from around 1895 to 1995). We're finding out what happens when the strategy-proof and balance goals are relaxed, and I don't think we are enamored by the early returns. "The third perspective I can offer is that the SMART Letter takes too extreme a view of the change in economics of telecom. Directionally, the Smart Letter is right on, but pursuing the argument to an unrealistic extreme could be leading to some unwarranted conclusions. "To illustrate the point, consider the capital cost of residential and small business service. I'll argue that as the 50-year trend towards more and more employment in small versus large businesses continues, this is the telecom market which will matter most. "The table below presents the first cost, useful life, annual, and monthly depreciation for POTS (plain old telephone service). Conduit $1,000 40.00 $25.00 $2.08 Cable $200 40.00 $5.00 $0.42 Line Card $300 20.00 $15.00 $1.25 CPE $300 40.00 $7.50 $0.63 Upstream $200 20.00 $10.00 $0.83 Total $2,000 32.00 $62.50 $5.21 "It's easy to see how to make money on $20/month revenue with these very extended depreciation schedules. Now, let's see what happens when we decide that we need to take the depreciation schedules down to the point where we can see new technology enter the market in our lifetimes, and continue to do so. Conduit $1,000 30.00 $33.33 $2.78 Cable $200 5.00 $40.00 $3.33 Line Card $300 5.00 $60.00 $5.00 CPE $300 5.00 $60.00 $5.00 Upstream $200 3.00 $66.67 $5.56 Total $2,000 7.69 $260.00 $21.67 "It looks like it takes almost four times the cash flow, suggesting that an operator needs to charge about $80/month to have a viable business. The problem is, no single service can command that: Basic Extended Premium Telephone $20 $35 $50 Television $27 $40 $65 Internet $21 $40 --- [This is a neat picture that shows the effect of speeded depreciation, but it does not show the effect of Moore's Law, the collapsing of services into a single pipe, the effect of radical simplification of network infrastructure, the shift of costs to the edge, the decoupling of connectivity from service or any of the other things that are, per hypothesis, going on. -- David I] "But if I can combine any two extended services, or any premium service with either a basic or an extended service, I get there. "Funny thing: I have extended television service and cable modem internet service, and my bill just rose to pennies over $80. "So somebody gets it. "Further, this somebody is in a position to replace my cable with something all new by 2005. And this somebody is not a traditional telco. [But don't expect the purveyors of yesterday's video entertainment paradigm to clear the way for us to supercede them -- the cablecos will never bring us the Internet that today's off the shelf technology could afford, let alone tomorrow's. -- David I] "Postscript. The computer industry went on from the debacle of 1984 to create over a trillion dollars of new wealth. Once forced to do the right things, I have every reason to believe that the telecom industry will do the same or better. But I don't think that you would be very happy with a portfolio of 1980 computer industry leaders today. So why should you be happy with today's telecom portfolio in 2015?" [Phil, forgive me for interrupting so often. The above was fascinating, and great food for thought. I'd love to see your left hook in response to my jabs above.] ------- Economist Reuven Brenner [] writes: "I'd like to comment about the similarity you draw between the Savings and Loans and the telcos. + S&Ls were regulated about where they could invest, and there was also deposit insurance. + so this was a bureaucratic 'business' And managers self-selected. There were not many tough decisions to make. The not-so-competent managed the business. + when they were deregulated the deposit insurance stayed. But the same managers were suddenly allowed to invest anywhere - high yield, exotic securities - name it. The execs were not prepared to make such decisions. So, unsurprisingly, they made mistakes. + in the S&L case, government was the insurer of last resort, so had to pick up the bill. "Now where are exactly the similarities with the telecoms? + in the regulated telecom business, execs were self-selected too. + but by now the management has changed. Since MCI's success, you have the Malones, McCaws, Forstmans etc. allocating capital - so why are so many mistakes still made? [IMHO, Malone was an opportunist, a financial engineer. Give him flux, and he will figure out where the flux to make money. McCaw had one great success -- once again, he was an opportunist who saw a chance to aggregate vastly different cellular infrastructures -- his later attempts at technology coups have yet to succeed. (A cynic could think of McCaw and Malone as the two pirates who plundered the foundering AT&T.) Forstman was an investor who got the short end of the telecom stick when the ILECs defeated competition. -- David I] "+ is regulation that keeps telcos from making investments that would benefit them the problem? + or is it that nobody has yet figured out how to make money from all these technological innovations or how to build a lasting barrier to entry? "If the latter is the case then, may be, the best thing would be to give incentives to experiment, reallocate capital quickly -- and the best way to achieve that would be to eliminate capital gains tax. That frees up locked capital and is the best incentive that I can think of to experiment with." [Reuven knew that I'd be most heavily in favor of #4, technology change. But eliminating the capital gains tax seems too easy. Some economists (forgive me, Reuven if I tar you with this old brush -- if the brush doesn't fit, I'll acquit) . . . some economists see a budget surplus and say, "Eliminate the capital gains tax!" and then they see a recession and they say, "Eliminate the capital gains tax," and then there is a war and they say, "Eliminate the capital gains tax." Under what circumstances is the capital gains tax a good thing, if any? Why not eliminate the sales tax or the income tax, or the telephone tax? What about R&D credits? What about tax on static business models that don't spend at least 10% of their profits on R&D? What about a government funded institute of network economics, so we get more network economists who can think creatively about these problems? OK, OK, these are not necessarily genius ideas, but whadaya expect for three minutes of thinking by a failed biologist sitting in front of a keyboard? -- David I] ------- Forrester is the thin-report company, the company that tells executive suite-niks the 'so-what' about the 'so-what' and what to do about it. Jeanne Schaaf [], wrote asking what I thought of her new Forrester report on the X-Internet. The wha? The X-Internet is the Forrester story of how the Internet grows up, gets easier to use, has guaranteed reliability, thruput, and latency backed by service level agreements, runs smart SOAPy and XMLized applications that act on data themselves so we don't have to think about it. According to Forrester, the telcos are in the best position to build it. Why, why they MUST build it if it is to be built at all. Well, I can't see it. Guaranteed reliability, thruput, and latency is another way to say, "Intelligent Network." Once you start telling the telco how they should shape their pipes to your app, you've lost the nonspecificity that made the Internet great. And you quickly lose the ability to separate connectivity from service. Then there's the ease-of-use part. Seems to me that ease- of-use is for device or software manufacturers, not telephone companies. The last user-friendly device the telcos built was the Princess Phone. Did you ever try to use one of those monster business phones that come with a Definity PBX? It's like Windows without the GUI. Then there's the XML part -- smart applets and datalets twittering around the network in perfect harmony like so many birds foraging in a raspberry bush. Nice vision, but would the telephone company build XML apps? Would it know how? So I asked Schaaf why she thought the telcos were in such a MUST build position. She wrote back that the telcos were the only "service providers with the scale, scope, or financial viability" to do the job. Financial viability? I remember when AT&T had the best network, the best brand, the strongest balance sheet. Then it had the best brand and the strongest balance sheet. Then it had the strongest balance sheet. Then it had a strategy, which made $80 Billion in cable assets disappear. Ah, financial viability is an ephemeral thing. The most important telecom event in 2001 was that the Incumbent Local Exchange Carriers lost lines. For the first time, there were fewer active lines in the United States than the year before. This is in part because people use their cell phones as second lines, in part because more people are connecting to the Internet using persistent non-dial-up lines, mostly Cable Modems, and in part because fax is becoming obsolete and/or moving to the Internet. The walls of the ILEC are caving in -- history will record that Year 2001 was the turning point. The next Internet will not be built by any monolithic entity, not by the phone company, not by the U.S. Government. Instead it will be built by municipalities, by colleges, by small cable and telephone companies, by electric districts, by ISPs, by industrial development corporations, by garden clubs and boy scout troops. The telephone companies are history. Year 2001 was the turning point. You heard it here first. And maybe I'm wrong. (You heard *that* here first, too.) Happy New Year. May people be smarter and networks be stupider, and may 2002 be better than 2001 -- David I ------- COPYRIGHT NOTICE: Redistribution of this document, or any part of it, is permitted for non-commercial purposes, provided that the two lines below are reproduced with it: Copyright 2002 by David S. Isenberg -- -- 1-888-isen-com ------- [There are two ways to join the SMART List. The PREFERRED METHOD is to click on and fill in the form. But you can also send me email saying who you are, how you see your work connecting to mine, and why you want to join the SMART List.] [to quit the SMART List, send a brief "unsubscribe" message to] [for past SMART Letters, see] ** David S. Isenberg, inc. 888-isen-com 908-654-0772 ** -- The brains behind the Stupid Network -- **