Verizon's big bet on fiber optics

The phone giant is spending billions of dollars on cutting-edge technology. But any payoff is years away, says Fortune's Stephanie Mehta.

By Stephanie N. Mehta, Fortune senior writer

(Fortune Magazine) -- Verizon isn't going to take it anymore. After years of ceding ground in the broadband wars to cable operators Comcast (Charts), Cablevision (Charts) and Time Warner Cable (owned by the parent of Fortune's publisher), the New York City-based telco is making an audacious - and very expensive - bet on a new Internet connection that is faster than anything the U.S. has ever seen.

The technology, called FiOS (for fiber-optic service), will cost consumers from $40 to $200 a month. The pricetag for Verizon to wire 18 million homes - just over half its market - by the end of 2010: a whopping $23 billion.

The fiber-optic play is the most dramatic example of CEO Ivan Seidenberg's efforts to remake Verizon, a vast company with $88 billion in sales last year. Seidenberg is spinning off some rural phone lines and old-line businesses like phone books and investing in boosting the capacity of Verizon's wireless and wireline networks to serve up movies, games, software and even new kinds of search engines.

In thousands of cities and towns in its territory, Verizon has crews tearing out the copper lines - the so-called twisted pair of wires - used to transport phone calls for more than 100 years and replacing them with hair-thin strands of fiber-optic glass that will download data at up to 50 megabits per second and upload files at 10 megabits per second. (According to Verizon, a typical customer with FiOS would be able to download a 90-minute movie in about five minutes, vs. 30 to 60 minutes over a standard cable modem service.)

For Seidenberg, the rollout is a triumph. When he announced the plan in May 2004, some analysts didn't believe he'd actually go through with it: They doubted that conservative, dividend-paying blue-chip Verizon would ever pony up the money for such an ambitious project. Technology types questioned whether a stodgy utility would be capable of offering such a cutting-edge service. Now Seidenberg is delivering on his promise. But the question for investors remains: Will the daring gamble pay off?

Wall Street remains skeptical. Verizon (Charts) shares have had a nice run-up in the past year, climbing about 20 percent and outpacing the broader market. But AT&T (Charts), another telco facing stiff competition from cable operators, is up almost 40 percent in the same period.

There are several reasons AT&T is in favor right now, including expected cost savings from its recent acquisition of BellSouth. Its wireless unit may get a boost from Apple's iPhone, due in June. And investors seem to prefer Ma Bell's cheaper approach to selling faster Internet and TV services. Instead of connecting fiber directly to homes, in most cases AT&T is pushing fiber deep into neighborhoods, using its existing copper network to handle the last bit of transport.

There's growing concern among investors that FiOS is going to hurt Verizon's earnings even more than analysts initially anticipated. The company recently told analysts that costs associated with the fiber project will dilute earnings per share in the "mid 30 cents" range, up from previous guidance of about 31 to 32 cents. But some analysts believe Verizon will have to spend still more to market and install FiOS.

"We view this as a multiyear issue," says Citigroup telecom analyst Michael Rollins, who predicts that the pain will carry into 2008. "The market needs to be braced for a longer period of dilution and higher-than-expected costs from this FiOS build." He thinks the impact this year will be about 43 cents a share, and he has a sell rating on the stock.

FiOS is divided into fixed and variable capital expenditures. Verizon has told analysts it expects to spend about $850 per home this year on fixed items such as marketing costs, network gear needed to deliver data and video, and the thick cables of fiber that snake in and around neighborhoods. Then, each time it signs up a customer, the phone company says it will spend an additional $880 on items like pulling fiber directly to the user's house and installing special equipment.

Some analysts believe that Verizon will have trouble keeping those costs down; FiOS is, after all, a new and complex service that can't be switched on remotely the way phone service is: The carrier, for example, tells customers to reserve four to six hours for installation, but the process can take much longer.

Francis McInerney, a business strategist who has done consulting for Verizon, says it took three technicians two days to install his connection. (He was part of a field trial, to be sure.) "FiOS is a good service, better than anything you're going to find in this country today," he says. "But the cost of customer acquisition is very, very high."

A Verizon spokesman says that over time the company's costs will continue to go down, not up, and that FiOS will generate positive cash flow in 2008 and be profitable in 2009. To become a growth story, though, Verizon will have to use FiOS for more than Internet connections. It will have to develop and sell applications for the FiOS network, much the way it made scads of money selling high-margin features like caller ID and call waiting to its traditional phone customers. One such add-on is a $20-a-month service that records shows and then allows them to be viewed on any of a home's TVs.

But Verizon has more limited experience developing and marketing online fare. Its Verizon Central portal for DSL users, for example, is clunky and a bit confusing. And FiOS's awesome speed presents a potential long-term challenge: It may encourage consumers to download movies, TV shows, and other interactive services directly from the Web, bypassing Verizon's video offerings entirely.

For all the risks associated with FiOS, it is clear that Verizon had to do something dramatic to retain and win back customers wooed by the cable guys, who now offer phone service as well as fast Internet and TV.

Though it will take years for Verizon to recoup the cost of deploying FiOS to customers' homes, the alternative would have been even less appealing: "They now get $95 a month from me, up from $60," says Daniel Berninger, a telecommunications analyst with Tier1 Research, who has both FiOS and Comcast broadband in his Annapolis home. "Without FiOS, I would have gone to Comcast exclusively - and Verizon would have gotten zero from me."

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.