ISP Business Case
Business Case Overview
There are many dimensions that materially affect the business case for broadband service providers. This overview summarizes the major considerations for most service providers.
A market of sufficient size will attract ISPs to build networks and offer services. The extent to which any ISP will invest in a network fundamentally comes down to decisions based on the business case. How does an ISP typically consider how to invest in a broadband network and what may cause them to provide less than full coverage for a municipality?
Typically, an ISP will estimate a number of key factors to determine the viability of their business case in terms of return on investment (ROI). These factors include:
| FACTORS | MEASURES | IMPLICATIONS |
| Market Size and Growth Rate | How many residents, businesses, and other organization exist in the target area – now and in the foreseeable future? | Larger markets enable greater economies of scale for revenues to offset network capital costs |
| Population Density | Where is the greatest concentration of potential customers? Are there areas that may be difficult or costly to reach based on the technology used? | Lower density areas involve higher costs per customer. Some pockets of customers may be difficult to reach depending on the technology with topology issues. |
| Addressable Market | What is the size of the market to which the ISP intends to offer services? Generally, this will be determined by iteration through the business case based on optimizing the revenue/cost ratios. | Services may not be offered to all potential customers in order to optimize the business case ROI. |
| Market Demand and Take Rates | How many customers can be expected to subscribe for each service offering over time? This is generally a forecast based on experience and is affected by how much competition is present in the area. | Estimates of take rates by service offering (different price levels) for the addressable market generates a multi-year revenue forecast. There will be an expected maximum take rate over time based on capturing market share. |
| Network Costs and Timing | What are the capital costs required for network builds to offer services to the target market? The costs depend on a number of factors, including technology, topology, population density, etc. Deployment may be phased over a period of time to better manage cash flow. | Capital costs require a reasonable payback period, typically less than 5 years. Phasing network deployments allows revenue generation to start before network build is fully completed. Future network upgrade costs should also be considered. |
| Operating Costs | What are the ongoing costs for operating the network and providing customer support? This includes, maintenance, installation, technical support, customer service, etc. | There will be fixed costs to set up operations for the new area, although there may be some cost efficiencies by integrating with nearby or centralized operations. There will also be incremental costs based on forecast subscriptions. |
| Sales and Marketing Costs | What are the costs for acquiring customers and for achieving the forecast take rates? | There will be incremental costs for local marketing and sales, possibly including local dedicated sales staff. |
These factors are estimated on a year by year basis to develop a pro forma business case over a period of time, usually five years as a minimum. Risk analysis would also be applied to evaluate best case, worst case, and expected outcomes for things such as subscription rate forecasts.
Definition: Pro Forma
A pro forma financial statement is a collection of financial statements that are based on certain assumptions and projections. An organization prepares pro forma financial statements in an effort to provide a “big picture” view of its overall financial situation.
Generally, the prepared statements include projected balance sheet, income statement and cash-flow statement; collectively, these projected financial statements are referred to as “pro formas.” Pro formas do not follow Generally Accepted Accounting Principles (GAAP) and there are no guidelines for the assumptions used in pro forma statements and projections; therefore, organizations must define the assumptions they use in preparing these statements and provide the assumptions as part of the pro forma package.
A pro forma business case is essentially an estimated set of financial statements that allow the ISP to evaluate profitability, cash flow, payback, and ROI over a period of time. There will be an Income Statement (profit and loss), Balance Sheet, and Statement of Cash Flows, each broken out by year.
Income Statement
The Income Statement provides a breakdown of revenues and expenses, and estimates Net Income by year. Capital costs are not included directly, but are accounted for in the Income Statement using factors for depreciation and amortization. A key metric for evaluating operating sustainability is called Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), which is essentially what is left from total revenues once ongoing operating expenses are deducted. EBITDA should be expected to grow year over year as take rates grow, and with incremental revenues growing faster than incremental operating expenses. Net income may be low or even negative in early years, however, when capital cost depreciation and amortization are factored in.
Balance Sheet
The Balance Sheet estimates the yearly position of assets, such as the value of network equipment in service, and liabilities, such as debt obligations for financing the network build. The difference between the value of total assets and total liabilities is the owner equity, which includes retained earnings. Ideally the owner equity should increase over time, or at least not decrease, but it may vary depending on the timing of phased investments in network builds.
The Statement of Cash Flows shows the change in the Net Cash position year over year and should increase each year.
In terms of evaluating the business case financials, the ISP will want to be confident that they can achieve proftability within a reasonable amount of time, typcally within the five-year timeframe, when the cumulative net profit from ongoing operations is positive. There are many different ways that service providers may evaluate potential ROI. One example is provided below.
Evaluating Return on Investment
For evalutaing the return on investment many telecom companies use a composite charge factor[1] that includes:
- Annual depreciation charge, for example, 10% for an average service life of 10 years.
- A “cost of money” to reflect the funds tied up in network investments that could be earning interest (or the interest that has to be paid on the borrowed funds for the network investments), e.g. 10%.
- Annual income tax expenses, e.g. 4%.
- Annual operating expenses and allocated overhead, e.g. 16%.
For example if the charge factor (sometime referred to as carrying charges) totals 40% then for every additional $1 of network investment cost, the ISP would need to increase its annual revenue (immediately in the first year and every year thereafter) by $0.40 to recover its original capital investment. If the network capital cost averages $1,000 per customer then the ISP would need to start collecting $400 per year per subcriber just to recover the original investment costs.
Service subscription rates take time to grow while network investments usually require significant upfront costs, so the effective capital cost per subscriber will be higher in earlier years. In addition, the capital costs per premises “passed” will vary depending on the technology used and the incremental costs of needing to serve more difficult to reach customers.
The ISP must also consider the ROI relative to other investments, whether this be building networks in other, more profitable locations, or even doing nothing. They will compare the rates of return on potential investment choices to ensure they are putting their finite time, effort, and dollars in the right place.
[1] Charge factors will vary from provider to provider and can change over time, but they will typically have some “standard” factors to use for evaluating their business case.
Implications for Communities
It is a combination of these factors that frequently stop ISPs from entering small markets or from limiting the extent of their network builds, as well as upgrading existing networks. This is at the core of issues many communities must face when considering how to improve the availability of broadband.
The primary factor limiting ISP interest in building, extending, or upgrading broadband networks is the incremental capital cost relative to the incremental revenue they can expect to gain. Communities need to consider one or more strategies to overcome this limitation in a service provider business case.
If the market is too small (i.e. there is just not enough additional revenue potential to justify the additional capital cost investment) then it may be possible to create better economies of scale by collaborating with neighboring communities. This can expand the market size while reducing the capital cost per subscriber.
Where this is not possible or feasible, communities should consider means of offsetting some of the capital costs through direct financial investment and through offering useful in-kind services and assets. If the required ISP investment in capital costs is sufficiently reduced, then their business case may improve to the point of being attractive. The municipal investment should not be considered a form of subsidy for helping the ISP but rather an investment in improving the economic and social well-being of the municipality. The ISP may recognize these benefits and become a valued partner, even if these benefits do not show up in their business case financials.