Verizon Rolls Dice, Invests $23 Billion on FiOS

Called FiOS, short for fiber-optic service, the expanding network is Verizon's best line of defense against cable operators poaching its phone customers with their bundled services. Once fully deployed by 2010, FiOS will enable Verizon to offer its own "triple play" packages to consumers that include high-speed Internet, TV and phone services across its nationwide network. The big selling point: FiOS operates on a robust network that offers data downloads that blow away those currently available through the coaxial cable used by cable operators and the copper wiring used by telephone companies.

While a highly strategic move on Verizon's part, FiOS is an extremely costly proposition that could take a while to gain traction. It requires a massive overhaul of Verizon's network that entails replacing its copper phone lines with fiber optics and gaining permission from municipalities to dig up the streets to lay the fiber. Verizon also needs to secure approvals to offer television services in each neighborhood. Installation of FiOS in customers' homes has proven time consuming and costly as well, and the company will need to spend a healthy chunk of change on marketing to get the word out to consumers.

Those costs, Verizon says, will dilute its earnings per share in the "mid-thirty cents" range this year, with dilution peaking during the current first quarter and then improving throughout the year. The company has told analysts that it expects FiOS to turn an operating profit in 2009, but, according to Stifel Nicolaus analyst Christopher King, it could take as long as a decade for Verizon to completely recoup its investment.

"From a business standpoint, FiOS does give Verizon a long-term competitive advantage in the consumer marketplace," says King. "However, it's certainly expensive from [a return on investment] perspective."

Verizon is placing a huge bet that consumers will become increasingly bandwidth hungry. By installing fiber all the way to customers' doorsteps, Verizon is planning to offer exceptionally fast data download rates that could eventually reach 100 megabits per second (Mbps). AT&T (T), on the other hand, is spending $4.6 billion — about one fifth of what Verizon is spending — to upgrade its networks with fiber optics and to offer a TV, Internet and voice service called U-verse. However, AT&T is stopping short of taking fiber directly to consumers' homes. Instead, U-verse will rely on traditional copper wiring to deliver the last leg of data traffic into the home, thus offering slower download speeds than Verizon's all-fiber network.

"Is this going to be a 100-megabit world in the future? Will consumers demand that type ofbandwidthh going forward? AT&T is betting 'no' and Verizon is betting 'yes,'" says King.

"It's doubtful that consumers will be opening their wallets to pay for that type of broadband connection," says JupiterResearch broadband analyst Doug Williams.

The belief is that prices will eventually come down as the network gains scale, allowing Verizon to lower its prices for FiOS Internet, TV and phone services. That could help it better compete against the cable operators in the future. However, conventional wisdom doesn't always rule in this market. Williams notes that the cable providers have been able to raise their prices without losing many subscribers to the satellite TV providers.

Nevertheless, cable operators should keep a watchful eye on the telcos like AT&T and Verizon. In-Stat, an independent communications market research firm, estimates that the telcos will be able to sign on six million subscribers to their television services by 2010. That's up from less than a million subscribers in 2006, says In-Stat's principal analyst Michelle Abraham.

Verizon ended 2006 with a total of 207,000 FiOS TV subscribers. For Internet access, Verizon signed on half a million customers — getting about 14% of the six million households that have access to FiOS to sign on. Verizon plans to increase FiOS's availability by three million households per year until 2010. (AT&T expects to reach the same amount of households with its U-verse service by the end of 2008.)

"There's a lot of skepticism on Wall Street as far as the amount of money that [Verizon is] spending on the project and whether it's worth the investment," says In-Stat's Abraham. To that end, Verizon's shares have been more or less stuck in the mud.

Stifel's King, who has a Hold rating on the company's shares, notes that those concerns have caused Verizon to trade at a valuation that is cheaper than AT&T. Should FiOS-related dilution of the company's earnings start to diminish after the first quarter as the company projects, he believes the stock should gain some ground.

Without a doubt investors will be watching to see if Verizon meets other goals as well, including whether or not it can keep its expenses in check and gain the attentions of consumers. With all of the uncertainty surrounding the FiOS launch, I think betting on near-term lifts in Verizon stock may prove foolish. Those looking to ride out Verizon's fiber-optic bet long-term, however, may find the gamble worthwhile.