Is there a business case for telecom service provider IT infrastructure services?

Michael Kennedy

Kennedy

On the surface, cloud or IT infrastructure service initiatives appear to be attractive offerings for telecom service providers, but are they? Cloud or Infrastructure as a Service (IaaS) explicitly involves network services and hosting/IT infrastructure services. This combination of services holds the potential for higher margins and lower capital intensity than either network connectivity services or IT hosting services considered separately. These services provide higher value for subscribers than the traditional offerings because they delivery many management and support functions that subscribers would otherwise provide through internal resources, and they cost less to deliver because the cloud model improves asset utilization and reduces operating expenses.

This movement toward higher value-added service offerings also addresses strategic issues faced by both telecom and hosting service providers. For example, telecom service providers' broadband service offerings are facing increasing cost pressures, while OTT video services appear to be capturing the greater value share of broadband service usage. Similarly, hosting services are seeing others, especially content providers and systems integrators, capture the higher-value portion of the IT services market. Amazon (Nasdaq: AMZN) Web Services, an IaaS offering, has had notable success. The established hosting companies face financial challenges, much like those of wireline telephony businesses, including declining revenue from legacy services, low margins, big write-offs of impaired assets and high interest charges that offset the benefits of new higher value-added service offerings.

Cloud or IaaS capabilities are attractive to telecom service providers. They hold the potential to build new revenue streams as well as reduce cost and increase service velocity in the core business. Cloud-based service offerings are attractive sources of revenue because they can be sold to existing networking customers. This is easier than developing the market for both new services and new customers. For example, Verizon's (NYSE: VZ) Terremark offers colocation, enterprise cloud services, managed hosting, network and connectivity, advanced data solutions, application services and professional services. These services are sold to enterprises that also subscribe to Verizon networking services.

Cloud or IaaS capabilities also are needed to reduce the capital and operating costs, and increase service velocity in telecom service providers' traditional businesses. These capabilities are important building blocks for Software Defined Network (SDN). They employ technologies and architectural principles that can bring costs in line with revenues. First, underlying component technology favors x86-based microprocessors used in servers over ASIC-based network processors used in networking hardware. Microprocessors are following a technological progress curve that is twice as steep as that for network processors--costs are cut in half in half the time. Second, virtualization and abstraction principles that were pioneered in the data center are now being applied to networks. They hold the potential to increase network utilization by as much as 83 percent, according to one Tier 1 service provider. Also, my own analysis conducted for Brocade Networks shows a 7 to 1 increase in service velocity for several SDN use cases.

There are many internal initiatives that leverage cloud or IaaS capabilities. They produce lower cost and faster network service provisioning processes. The flexibility and low-cost cloud approach makes it possible to address individual network subscriber needs. This in turn enables the creation of differentiated services with associated incremental revenue benefits. A better and more uniquely customized network security solution is one example of differentiated services. One of the most fundamental and far-reaching initiatives is to build mobile networking's Evolved Packet Core (EPC) using cloud principles.

While I believe there is a consensus that cloud or IaaS capabilities should be core competencies for telecom service providers, there is no consensus on how to build them. CenturyLink (NYSE: CTL), Verizon and KPN in the Netherlands have acquired IT services firms to accelerate their internal efforts. CenturyLink cited a core goal of positioning itself to augment its legacy hosting offerings with an already developed cloud IT services suite as one motivation for its acquisition of SAVVIS in 2011. On the other hand, AT&T (NYSE: T), Telus (Toronto: T.TO) and France Telecom are strengthening their internal capabilities through data center consolidation and creating virtual IT platforms.

One reason there has not been a rush by telecom operators to acquire hosting companies is that both industries have similar weaknesses in that they are attempting to transition from markets with low margins, declining revenues and high capital intensity to new markets with better margins, higher growth and better asset utilization. Ideal merger acquisition candidates should complement rather than share the strengths and weaknesses of the acquiring company.

It will be challenging for telecom service providers to create new services and realign their internal cost structures. They none-the-less approach the challenge with many strengths. They have strong financials and operating scale that is comparable to Web services companies such as Amazon and Google (Nasdaq: GOOG). They have well-established distribution channels to enterprises and smaller businesses. Due to their scale and history of forming industry associations to achieve common objectives, they have substantial buying power versus their suppliers. They also possess substantial internal technological expertise. Service providers' prominent leadership positions in the Open Networking Forum (ONF) are just one example of this influence over suppliers. Telecom service providers, however, also have some significant weaknesses. Amazon Web Services' leadership position in IaaS is attributed to its innovation, agility and market responsiveness. Telecom operators are weak in all these areas. They also lack systems integration expertise, especially outside of the traditional networking space. Despite these weaknesses, it is critical that telecom service providers invest in developing these capabilities for their own businesses and to enter new markets.

Michael Kennedy is a regular FierceTelecom columnist. He can be reached at mkennedy@acgresearch.net.

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