Web Wars

China’s battle with Google (NSDQ: GOOG) over rules for the Internet is still raging in the headlines. But a battle royale for the web is also shaping up here in the US.

On one side are web content providers like Google, backed by the nation’s primary communications regulator, the Federal Communications Commission (FCC). On the other are companies who have spent and are spending hundreds of billions of dollars to build broadband networks capable of meeting Americans’ exploding demand for connectivity.

Not surprisingly, web content providers are deeply concerned about their ability to enjoy unfettered access to broadband networks for their ever-increasing applications and services. They want hard, fast and enforceable rules governing how broadband networks are run and prohibitions against network operators discriminating against content for any reason.

On the other side, operators and builders of broadband networks are focused on earning a return from the enormous investment they’ve made and continue to make. They want the ability to run their networks in the most efficient and profitable way possible, including the right to charge more for more intensive usage. This latter point is becoming increasingly important, as applications become more complex and existing bandwidth more stretched.

Enter the FCC. Under the Bush administration, Chairman Michael Powell and his successor Kevin Martin held a 3-to-2 Republican majority. The sitting president gets to appoint the majority, with the opposition party getting the other two commission seats.

Though with frequent dissents from the two Democrats, the commission took pretty much a hands off attitude on broadband Internet regulation, preferring instead to let the market sort out winning and losing companies and applications. The policy was enshrined in a 2002 ruling, which officially declared broadband communications a separate service, not subject to the same degree of regulation as traditional telephone service.

Under newly appointed Chairman Julius Genachowski, however, the now Democratic majority on the FCC has begun to take a far different line. The cause célèbre is “net neutrality”–the idea that government regulation should ensure that access to the Internet be completely unfettered.

The concept is hardly controversial. In fact, it’s been signed off on by all of the major broadband network operators, including AT&T (NYSE: T), Comcast Corp (NSDQ: CMCSA), Time Warner Cable (NYSE: TWC) and Verizon Communications (NYSE: VZ). All of these companies know that the key to growing profits from their networks is the successful launch of new applications. There’s a devil in the details, however, and it’s quite a potential deal breaker.

Mainly, just how much control should the FCC have over broadband network owners? Should it be akin to the commission’s power over the traditional telephone networks? Is broadband, as former Chairman Michael Powell stated this week, a unique new industry that government should continue to leave alone? Or is broadband something else entirely, where the FCC acts as enforcer only when the rules of fair play are broken? And what indeed are the optimum rules? What sort of punishment for breaking them should be enshrined in regulation?

If the system is run too much in favor of network owners, it could slow the launch of new applications that spur business opportunities. On the other hand, if the rules are skewed too much for content providers, there will be little incentive for companies to continue investing billions each year to increase bandwidth and speed needed to run those applications.

That means the government will have to plug the investment gap, which will only widen in coming years as demand for greater bandwidth accelerates. And that money is going to be harder and harder to come by in coming years, with Uncle Sam’s $1.5 trillion deficit.

In a very real sense, it’s hard to argue with the way things have been run so far. Verizon alone, for example, invests nearly $20 billion a year in its wireless and wireline broadband (FiOS) networks. The enormous success of smart phones like Apple’s (NSDQ: AAPL) iPhone and Research in Motion’s (TSX: RIM, NSDQ: RIMM) BlackBerrys is irrefutable evidence that consumers are receiving the benefits of an unprecedented number of applications and services, and the number continues to grow exponentially.

In short, dollars are being spent and invested at a record pace in the communications industry, which only a few years ago looked fairly moribund. According to some surveys, America ranks behind many other nations in terms of universal broadband connectivity. That was a major reason cited by Chairman Genachowski for greater broadband regulation when he first announced his plans earlier this year.

But it’s hard to argue that anyone who can pay their cell phone bill doesn’t now have the world at their fingertips, scores of different service options. In fact, it’s quite easy to construct your own bill based on demand for various services. And rates continue to come down for services across the board. Local and long-distance telephone service–once a major household item–has become basically an add-on with wireless, broadband and cable service for many.

As for competition, some rural areas still have only one communications provider, mainly the former local monopoly. That’s largely a consequence of a lack of scale inherent with a dispersed population, which has discouraged infrastructure development over the years. That’s what the Universal Service Fund has tried to address over the years, with urban areas essentially subsidizing service in rural ones for the sake of universal coverage.

Every urban area, however, has at least two wireline broadband competitors–a phone and a cable company–as well as several rival wireless networks. The largest population centers have more. And Sprint Nextel’s (NYSE: S) launch of its WiMax network in partnership with major cable companies promises to add a major wireless broadband competitor to AT&T and Verizon in many areas later this year, the first to achieve so-called 4G speeds and capacity.

In short, if you don’t like your provider, odds are you’ve got options.

Out on Appeal

All this, however, makes the FCC increasingly less relevant, as the network it does regulate (basic phone) continues to be phased out in favor of one it pretty much does not at this point (broadband)–which brings us to this week’s blockbuster: a unanimous decision by the US Court of Appeals for the DC Circuit that the FCC lacks the power to regulate broadband service.

The case before the nation’s second-highest court concerned a move by Comcast to slow network speeds for heavy bandwidth users, principally file-sharing services like BitTorrent. The then Republican-controlled FCC ruled that Comcast had over-stepped its bounds and was compelled to provide equal access to all, regardless of the effect on the rest of its network. It also required the company to release an unprecedented amount of information on its network management practices.

Comcast complied but quickly appealed the decision, arguing that it was the FCC that had over-stepped its boundaries. And this week it was vindicated by the court, dealing a heavy setback not only to the FCC’s ability to regulate networks in this instance but for its plans to enforce much stricter standards of network neutrality as well.

The question is what happens now. Some consumer advocates are urging the FCC to immediately reclassify broadband as a telecommunications service. That’s an action it could take simply with a majority vote, and Genachowski already apparently has the support of one of the Democrats, Michael Capps.

Reclassification, however, is something akin to using a sledgehammer to open a walnut. For one thing, traditional telecom service is subject to a library full of regulations that were devised well back in the last century, when universal connectivity meant a payphone that took your dime.

Suddenly imposing these rules on an industry that has basically operated on its own terms wouldn’t necessarily crash the system, or even immediately dry up investment. But it would spur a massive volume of litigation the likes of which few US industries have seen this side of Big Tobacco and asbestos manufacturers as governments, consumers, network owners and content providers all jockey for advantage.

Then there’s the political fallout. As I’ve said before, my talent is not to read minds. On a purely speculative basis, Mr. Genachowski may be willing to risk that kind of turmoil in one of the few industries in the US that’s created jobs. But with Congressional elections looming and the president already under fire for pursuing an expanding government agenda rather than creating jobs, he may get more push back from Democratic politicians than he bargains for. And Republicans are certain to register their opposition and cite this action as just one more example of big government overreach in the Obama era.

The cleanest solution, at least for the FCC, would be to pursue legislative change to give it the power to regulate broadband, but in a more seamless way that recognizes the changes in the communications industry. Senator John Kerry (D-MA) has already expressed his support for a new law governing broadband, charging that it’s necessary for the Internet to remain a job creator. He already has a lot of company in both houses of Congress as well as the Obama administration. And the content providers are certain to push hard for others to join their ranks.

On the other hand, legislative efforts to regulate carbon dioxide emissions and the financial system still languish in Congress, despite the strong support of most Democrats. Unless the FCC can bring along some Republican support–which looks doubtful, at bet–it’s highly unlikely it will get an omnibus bill through to regulate broadband communications. And the odds of anything passing this year grow increasingly dim as the November election approaches.

There is a third way the FCC can get what it wants: Use what it does control to wring concessions from network providers. One of Chairman Genachowski’s initial broadband proposals, for example, was to auction off to wireless companies an unprecedented amount of federally owned spectrum now used by broadcasters. The announcement was immediately popular and, if the auction is carried out, could no doubt be used to get companies to agree to a new compact on net neutrality rules.

There’s also Comcast’s attempt to buy NBC Universal, which must win the approval of the FCC. The FCC has traditionally used merger proceedings as a negotiation on a range of other issues, and it’s likely it would be able to in this case, as Comcast has long pursued the content assets. In this case, that means convincing the cable giant to basically agree to at least most of what the FCC couldn’t win in court this week.

We probably won’t have to wait long to see how the FCC will respond to its setback in the courts, which could conceivably include an appeal to the US Supreme Court. Whatever they do, however, major US communications providers–including Comcast–continue to price in very low expectations, despite continuing to grow rapidly from expanding connectivity.

Yields remain at high levels, ranging from 6 to 7 percent for giant telecoms to as much as 10 percent for rural phone companies. Even cable companies are paying out more than ever. Cash flows are solid, with rural companies like Windstream Corp (NYSE: WIN) covering fourth-quarter distributions by a 2-to-1 margin. And balance sheets are strong and getting stronger, thanks in part to companies’ ability to issue new bonds at very low interest rates.

Frontier Communications (NYSE: FTR), for example, has been able to basically complete its financing for its purchase of 4.8 million lines from Verizon. Not only were they able to issue bonds last week at rates that investment grade companies have traditionally paid. But their plans for a $2 billion bond auction quickly became over-subscribed and expanded to a $3.2 billion offering. That’s despite the fact that the company is still waiting on regulatory approval in three states and from the FCC to complete the deal.

There was a time when the communications industry was fragmented and rife with failing businesses. This is not such a time; the weaklings have fallen, and the strong have gained unprecedented reach and balance-sheet strength, even as demand for connectivity has accelerated. Even the phase-out of traditional copper phone networks is becoming ever-less of a drag on results, as broadband and wireless increasingly dominate the revenue mix.

Regulatory uncertainty continues to hold these stocks back. And the FCC’s net neutrality quest will no doubt keep things that way for at least a while longer. But low expectations mean low risk at current prices, as well as yields that rank among the most generous on the planet–even as these companies continue to grow with one of the surest trends on the planet, surging global demand for connectivity.

That’s the classic formula for a strong buy, at least for anyone who considers themselves remotely contrarian, i.e. willing to bet against the crowd.

Question of the Week

Every week, I answer a frequent query from readers in this space. This week, I’m at the Vancouver MoneyShow, where the questions were heavy on the emergent Northern Tiger. Send your question to utilityandincome@kci-com.com.

• My broker says dividends paid by my Canadian stocks aren’t considered qualified for tax purposes in the US. I’ve tried to convince him otherwise, but instead he insists on sending out a Form 1099 listing my dividends as ordinary income. Is this right?

No, but it is understandable why he won’t listen to you. Wall Street is still licking its wounds from the debacle of late 2008 and is terrified of being sued. In fact, I’ve heard some major houses now have more litigators on staff than broker/advisors. That’s a sorry state of affairs.

But we do have an activist government with populist leanings–as well as a mountain of well-meaning but ultimately ineffective and cumbersome regulations on the book to “protect” investors in the form of Sarbanes-Oxley. It’s not hard to see why they would want to protect themselves.

That’s as far as I’ll defend these guys, however. Basically, what they’ve chosen to do is treat the Ernst & Young report on qualified dividends as their gospel. This, they believe, will limit their legal risk to being sued.

On the other hand, they’re leaving aside the fact that this report was issued some years ago and that even the author admitted it was incomplete. By the way, the E&Y report was never officially sanctioned by the Internal Revenue Service, which explicitly warns investors not to trust 1099s but to instead make a good faith filing of how various income should be classified. Equities, including foreign equities like Canadian stocks, are considered to pay qualified dividends. That much is clear to everyone.

What’s been in dispute is just what exactly qualifies as an “equity” holding, and that’s where the real confusion has been. E&Y’s report, for example, doesn’t list every security on the planet. But anyone taking their report on its face would have to conclude that what isn’t listed isn’t qualified. That’s the reason why some Canadian income trusts show up on your 1099 as paying qualified dividends, while others with the same structure and in the same business do not.

That’s why for the past several years, we’ve advised investors to follow the lead of the IRS itself. Rather than rely on the obviously faulty 1099s, use the information provided by the companies and trusts themselves on their websites, which will include statements about how counsel views the taxability of the dividend. Don’t try to get your broker to change the 1099, an effort bound to end in frustration. Instead, simply file the dividends as qualified and use the information provided by the companies as your backup.

The good news is we appear to at last be reaching some kind of clarity on qualified dividends in the US, as the Obama administration attempts to make preferential rates on dividends permanent at a higher rate of 20 percent. We all need to hope they succeed, as the alternative is a reversion back to ordinary income tax rates for dividends. In fact, I continue to advise investors to visit www.DefendMyDividend.org and register their support of extending preferential rates.

As for Canadian trusts, 60 of them have already either converted to corporations or announced such moves, including what their post-conversion dividends will be. The good news is more than half have either held or increased their payout since announcing conversion and even the rest have rallied from pre-conversion trading ranges.

The other good news is that by converting, they’ll clear up any remaining questions about whether they should be taxed as qualified in the US. And IRA investors will no longer be withheld the standard 15 percent at the border after conversion, resulting in an effective dividend increase to boot.

You Cruise, You Win

Roger Conrad and his KCI Investing colleagues have been combing the globe for their next luxury investment cruise: Any ports of call must be ripe with investment potential, of course, but they must provide a rich slice of the world’s treasures and unique insights into human luxury. And after the brutal year we just finished, who couldn’t use some luxuriant down time learning how to prepare their portfolios for what this next decade has in store.

Save the dates: Thursday, October 21, through Monday, November 1, 2010. Explore the wonders of Turkey and the Greek Isles while learning about the newest investment strategies from Roger, Elliott Gue, Yiannis Mostrous and GS Early.

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For those of you lucky enough to have sailed with this keen crew in the past, you know you are in for a meticulously planned journey into the business, investment and cultural offerings of the region. KCI in partnership with Joseph H. Conlin Travel Management is offering this journey solely to KCI subscribers and their friends.

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