Internet Service Providers in Canada
Catherine PETERS <firstname.lastname@example.org>
This paper, using newly collected statistics, examines the Internet service provider (ISP) industry in Canada. The paper explores the range of products and services offered by the different firms to determine whether ISPs are profitable and what their financial records look like and to identify the characteristics of successful firms and some of the important issues for the future growth and development of the sector.
Internet service providers, or ISPs, are a relatively new part of the rapidly developing information technology (IT) industry. Nonexistent only a few years ago, this dynamic class of companies emerged because of the innovative and entrepreneurial spirit of the Internet's early pioneers. True to their roots in many of the country's research and education institutions, ISPs are creative, experimental, and highly adaptive enterprises. They continue to grow in ways never imagined by the Internet's original creators. To expand and succeed, ISPs develop new business models, create new products and services, and continuously deal with a myriad of challenges. Because of the wide range of services and products they offer and would like to offer, ISPs are an integral part of the information revolution facing Canada's economy and society.
Despite the important role they play in Canada's growing information economy and industry, very little is actually known about how ISPs operate, what characterizes successful firms, and what unique issues and concerns face their sector. The Canadian government supports the development of the Internet and the applications and services it offers, be they electronic commerce, health and education applications, community networking, or government services. The government has begun dialogues with individual companies and associations to learn more about the ISP sector.
The first step of the project was guided by several key questions. These included the following: Are ISPs profitable? What do their financial records look like? What are the characteristics of successful firms? What is the range of products and services offered? Finally, what are some of the important issues for the future growth and development of the sector?
As this was the government's first effort to gather statistical information on the Internet service provider industry sector, the authors began by compiling a list of ISP companies in Canada. This list was developed through a variety of sources, mostly online. Of the 360 companies surveyed, 102 responded, giving a response rate of 30 percent. As a result, the survey is not a comprehensive census of the industry, nor should it be considered a truly representative sample. The paper will not, therefore, report many of the absolute values of the survey, such as the total number of subscribers or the total revenue of ISP firms. These numbers would give a misleading and incomplete picture of the ISP sector.
The survey and this paper, however, do provide a rich source of information on ISP practices, and this paper will discuss the characteristics of the highest revenue-generating firms and the most profitable firms. The authors recognize a potential bias in the results, a hazard of empirical work. The rest of the paper will go through these findings and others in greater detail.
Firms within the ISP sector differ greatly from each other. There are a few large firms, several medium-sized, and many small. The firms also differ in the range of products and services they offer and in their strategies for success. To effectively analyze all these companies and their strategies, the data were examined using several different approaches. The results were looked at in aggregate for Canada and by revenue and profitability tertiles. Examining the data by tertiles yielded more detailed information about economies of scale and scope, the characteristics of successful firms, and the differing barriers to growth for companies of differing sizes. The tertiles, in short, helped develop a more detailed picture of the ISP sector in Canada.
To form the tertiles, the companies were first ranked from highest to lowest according to their reported revenue and profitability status. These two ranked lists were then each divided into three approximately equal parts. The average features of each group -- high, medium, and low -- can then be compared with each other. This method of analysis helps determine whether the strategies and characteristics that determine revenue status are also the same ones that determine profitability status. The tertiles also helped isolate the skewing effect of the eight largest companies on the aggregate data.
ISPs were asked to report the number of their subscribers, business and residential, in each Canadian province. When grouped by the revenue and profitability tertiles, the information reveals a positive relationship between revenue and total subscribers. Figure 1 shows that the upper revenue tertile has more subscribers than the middle, which subsequently has more subscribers than the lower. When the eight largest companies are removed from the upper tertile, however, this conclusion no longer holds. Thus, the hypothesis that revenues are related to number of subscribers is rejected by this sample. Several possible explanations for this exist. First, companies with lower numbers of subscribers may provide a number of value-added services that justify a premium price. Second, smaller companies may be targeting more lucrative niche markets. Third, the number of customers might be over-reported, particularly if there is a high degree of subscriber turnover. Finally, this may be the result of a deliberate marketing strategy where Internet access itself is a loss leader, and the company makes money by providing other services.
Figure 1. Average number of subscriptions by revenue and profitability tertiles
With regard to profitability tertiles, the bottom tertile (the least profitable third of ISPs) had the most subscribers, accounting for 67% of the total. This suggests that the biggest companies are not profitable. Furthermore, this suggests that the more profitable companies specialize and/or provide value-added services in areas where margins are higher. The bottom line is that simply providing access -- and only pursuing a strategy of getting more customers -- is inferior to a strategy based on provision of value-added services.
ISPs were asked to provide information on the price of their most commonly sold monthly subscription packages, for both residential and business customers, and the services included for that fee. Average package costs for the entire sample were $23.05 for residential customers and $70.69 for business customers. However, the business average price falls to $57.71 when one outlier is removed (that had a price of $1200 per month!). These and all other dollar amounts throughout the paper are in Canadian dollars.
For residential customers, 16% of the ISPs provided an unlimited amount of Internet access as part of the package, while the remaining 84% of ISPs included an average of 65 hours in the monthly subscription price. Price levels are fairly consistent across both revenue and profitability tertiles. Additional services provided by ISPs as part of the package are as follows:
Other options cited by ISPs in an "other" category include domain registration service; virtual Web or domain park service; shareware; access to newsgroups; and free setup.
Figure 2. Average cost of most common monthly residential subscription package
When examined by revenue tertiles, the number of hours included in the subscription price increases with revenues, suggesting that offering more hours attracts more customers and thus provides more revenues (Figure 2). Interestingly, when profitability tertiles are examined, the opposite relationship turns up: the least profitable companies provided the most number of free hours. Thus, this may not indeed be a successful strategy, which accords with the previous section's conclusion that providing access is not where the money is to be made in this industry.
Figure 3. Average cost of most common monthly business subscription package
Significantly more ISPs provided unlimited access to the Internet for business customers than for residential customers. This in part explains the price premium for a business subscription package as shown by Figure 3. For business customers, 40% of the ISPs provided an unlimited number of hours of Internet access. The remaining ISPs provided an average of 71.8 hours as part of the subscription package. By tertiles, the high revenue tertile charged a much higher average price of $131.96 for an average of 67.2 hours of access, with 50% providing unlimited access. Middle and lower tertiles charged $41 and $46, with 30% and 37%, respectively, providing unlimited access.
Additional services provided by ISPs as part of the business package:
A number of other services -- including free setup; directory listing; firewall services; Web site creation; and online hours tracking -- were written in an "other" category. This demonstrates a market segmentation approach by ISPs, where different classes of customers are offered different prices and packages for services.
ISPs also provide additional services on a pay-per-use basis. Across Canada,
Fifteen percent of the ISPs surveyed offer a range of other services on a pay-per-use basis, including application development; customized names and e-mail addresses; dedicated connections; e-mail paging services; firewalls; hard disk space for Web pages; database services; network design and installation; on-site technical support; programming services; and training.
The variety of additional services offered demonstrates the degree of economies of scope in the ISP industry. That is, average costs fall as ISPs provide additional, related services. This includes those services bundled together as part of a package, as well as those offered à la carte.
ISPs were asked to estimate the percentage of their revenues derived from various sources. The results, given in Figure 4, show that the dominant revenue source was residential subscriptions, accounting for an average of 50% of the total. This was followed by business subscriptions at 31%. Thus, according to this sample of companies, combined business and residential subscriptions account for over 80% of the ISP industry's revenue. This highlights the relative importance for ISPs of properly bundling services so that they are able to offer packages that meet consumer needs.
Figure 4. Sources of ISP revenue (percent)
Installation charges amounted to 6% of revenues, a relatively small but not insignificant part of the total, as this is a one-time-only charge. Fees for additional Internet access amounted to 3% of revenues. This can be partly explained by the high costs of incremental, pay-per-minute access. Aware of these high rates, consumers may be limiting their Internet usage to what is included in their subscription package (price elasticity information would be required to fully assess this explanation). Another factor may be that consumers prefer to have a flat rate for access.
Advertising amounted to a mere 3% of revenues, a surprisingly small figure. While advertising is becoming more and more prominent on the Internet, this figure suggests it has not penetrated down to the ISP level in a substantial way and remains in the domain of Web sites. Advertising will likely become more prominent in the future, as local producers use the Internet to reach local customers and as ISPs at all levels tap advertising as a source of revenue. A very small number of ISPs have attempted a business model that provides free (or very low cost) access to the Internet. In exchange, advertising is sent to the user's browser when he or she logs in. This type of service may account in part for the 3% figure.
Fee services to nonsubscribers account for 3% of revenues. Other sources, including consulting, donations, Web page design, licensing, government funding, training, and other services mentioned in the previous section, account for 6% of revenues.
When broken down by tertiles, there is a negative relationship between the proportion of total revenues that comes from residential subscriptions and each of revenue and profitability tertile, as shown in Figure 5. That is, the high revenue and high profit ISPs tend to derive a smaller proportion of their revenues from the residential market and more from the business market. This suggests that the smaller players in the market rely more on the residential market, and that the business market, while more difficult to access, is more lucrative.
Figure 5. Share of revenue from residential subscriptions
Internet penetration rates into both residential and consumer markets are low relative to the total population. Thus, there is much room for growth in the ISP market. Competitive tactics of ISPs regarding value-added services will play a major role as this market evolves.
ISPs were asked to estimate revenue growth rates for this year and for next year. Among the 32 respondents (this represents about a third of the sample -- many companies were seemingly uncomfortable providing this information), average growth this year was about 210%, with average growth projected to be approximately 460% next year. Clearly, these ISPs are optimistic about the future of the Internet. Figure 6 shows these projections broken down by revenue tertile. Interestingly, the companies in the lowest revenue tertile estimated revenue growth of 340% this year and just under 700% next year. Similar results appear for the lowest profitability tertile, suggesting a discontinuity between optimism and ability to produce profits.
Figure 6: Revenue tertile -- average revenue growth
The survey asked ISPs to estimate operating expenditures. Of the major expenditures, salaries and wages accounted for 42%, advertising 12%, and leased line charges 33%. Figure 7 breaks down these expenditures by profitability tertiles.
Salaries and wages were positively related to profitability, i.e., they accounted for a relatively larger proportion of expenditures as profitability increased. The most profitable tertile averaged 52% of expenditures on salaries and wages, compared to 41% for the middle tertile and 27% for the bottom tertile. This may be a result of the need for skilled (and relatively expensive) labor to produce high quality Web content or to manage a complex network.
Figure 7. Distribution of operating expenditures -- profitability tertiles
The proportion of expenditures on advertising was negatively related to profitability, with the lowest tertile averaging 21% of expenditures on advertising, compared to 8% of the middle tertile and 8% of the highest tertile.
Figure 8: Distribution of operating expenditures -- revenue tertiles
Figure 8 shows operating expenditures broken down by revenue tertiles. Notably, high revenue companies and high profitability companies paid proportionately less for their leased line charges. The lowest revenue tertile paid 57% of expenditures to leased line charges, while the middle tertile paid 23% and the upper tertile 13%. The cost of leased lines is clearly an important factor in the ISP business. These numbers suggest economies of scale in the provision of access due to the relative discounts available for leasing large amounts of bandwidth. Thus, leased line charges are a potentially large barrier to entry in the ISP business, particularly as the industry overall grows in scale.
Overall, expenditure figures suggest that as higher revenue companies pay significantly less for leased line charges, they are able to put this savings toward hiring skilled labor to provide technical support and value-added services to customers.
Figure 9: Average total operating expenditures -- revenue and profitability tertiles
Figure 9 shows total operating expenditures broken down by both revenue and profitability tertiles. The upper revenue tertile had average operating expenditures of $1,615,900, compared to the middle tertile average of $121,700 and the lowest tertile average of $44,500. This is indicative of the range of ISP operations across Canada, which go from the very small to the very large. These numbers are roughly reversed for the profitability tertile, with the upper tertile having average operating expenditures of $1,669,100, the middle $229,300, and the bottom $153,200. Comparing these numbers to the revenue tertiles suggests that the biggest companies are also the least profitable, and thus there may be plenty of room for small but profitable niche operators.
Comparing operating revenues to operating expenses, the high revenue tertile is losing money, with average expenditures of $1,615,900, compared to average revenues of $828,900. (Note that these are averages and do not mean that all high-revenue ISPs are losing money.) The middle and low revenue tertiles are roughly breaking even, with average expenditures of $121,700, compared to average revenues of $129,100, for the middle tertile, and average operating expenditures of $44,500, compared to average revenues of $35,800, for the lower tertile. The net values for all these tertiles are shown in Figure 10. The latter numbers suggest that small companies are making a living, but not a killing.
Figure 10: Average net revenues by revenue and profitability tertiles
Data on capital expenditures was also requested in the survey, but was unavailable at the time of printing.
ISPs were asked to what extent various factors impeded the growth of their Internet services. These were marked on a scale of 1 to 5, with 1 being the lowest and 5 the highest. Generally, there was little difference in the results across the revenue or profitability tertiles. However, as might be expected, the bottom revenue tertile was slightly more concerned than the overall averages for every category (except "cost of dial-up lines"). The summary results are given in Table 1.
Of the five options provided, the factor causing the most concern was "cost of leased lines." The average score for this factor was 4.21, and 64.1% of the respondents answered 4 or 5. At the time of the survey, the issue of whether ISPs would be required to pay contribution charges (which would increase the cost of leased lines) had not yet been resolved, so this may be reflected in the responses. Importantly, as noted above, a large proportion of ISP expenditures revolves around this cost, and given the profitability status of most ISPs, a rise in this input cost could be very damaging, particularly for smaller ISPs.
Table 1. Barriers to growth
*Note: These numbers reflect the overall averages from the 'Other' category. No more detailed information is available.
The second highest factor was the "cost of dial-up lines." This factor had an average score of 3.86, with 56.9% of respondents indicating this as 4 or 5. Thus, the two largest areas of concern for ISPs revolve around costs at both ends of the ISP business: their links to consumers and their links to the Internet. Notably, with some degree of variation, there is limited or no competition in these markets, and although prices are regulated, ISPs are somewhat captive. This indicates that government policy should ensure that it helps create a level playing field that allows a diverse range of companies to offer Internet services. This increases consumer choice and may help foster the future growth of the ISP industry in Canada.
The factor "regulatory environment" refers to general uncertainties regarding how a changing regulatory framework, or decisions made therein, could affect the ISP business. This factor received an average score of 3.28, with 36.5% giving an answer of 4 or 5. This indicates that ISPs were concerned about this factor, but not overly so, at the time of this survey. As the regulatory environment affects the prices of upstream providers, however, ISPs would certainly be concerned, as noted above. This goes to the core of the ISP business: providing a value-added service that is largely dependent on the infrastructure offered by bigger telecommunications companies, who may indeed be competitors in the Internet access market.
The factor "lack of qualified staff" received an average score of 2.87, with 27.1% of the respondents marking a 4 or 5. The ability to draw highly skilled personnel at reasonable cost is a major issue in the information and communications technologies (ICT) industry generally, though these results indicate that ISPs are concerned but not overly worried about this factor. Looking back at the results of the previous section, presence of skilled personnel does seem to be a factor in providing the value-added services that lead to profitability, so the extent that this is a problem for smaller ISPs will affect their growth.
The factor "threat of litigation" refers to fears that the company could be taken to court for possessing or providing access to materials that are considered illegal under either the Criminal Code (e.g., child pornography, hate literature) or the Copyright Act (intellectual property, trademarks, copyright). The average response was 1.85, with 5.8% indicating a 4 or 5 response, both surprisingly low figures that indicate a general lack of concern on the part of ISPs. As noted in the Industry Canada publication, The Cyberspace is not a No-law Land [Racicot, Michel, et al., The Cyberspace is not a no-law land, Industry Canada, 1996, http://strategis.ic.gc.ca/SSG/it03117e.html], there is a lack of case law on such matters, but there are instances where ISPs could be held liable. Actions by trade associations, such as the Canadian Association of Internet Providers, to adopt a model code of conduct for its members, express industry concerns about this issue. Several factors may explain the low results: ignorance about potential liability regarding illegal materials; a feeling of confidence that since these matters have not been tested in Canadian courts as they have in the US, they will not be prosecuted; and/or a reflection of the libertarian, frontier mentality of Internet culture.
The category "other" received an average score of 4.78, indicating that items written in here were of major concern. Thirty-six respondents coalesced around four additional factors that can be drawn out. The biggest of these factors was "competition," cited by 12 of the 36. This refers to the arrival of the large telecommunications companies into the market for Internet access and services. This reflects a fear that, while smaller ISPs are more nimble and able to provide a more customized service, pricing practices of the big players could drive smaller ISPs out of the market. In addition, 8 respondents each cited "access to capital" and "business management," and 3 respondents cited "user issues."
As part of the general survey, respondents were asked to rate the ability of their company to compete in ten areas related to the production and marketing of IT products and services. Self-ratings, from highest to lowest, are presented in Table 2 below.
Table 2. Competitiveness
ISPs generally rated themselves favorably in each of the ten areas.
Internet service providers are a diverse group of companies. While providing Internet access is still a core activity and residential customers are still the largest overall source of revenue, other activities are more profitable. This paper concludes that simply providing access and only pursuing a strategy of getting more customers is inferior to a strategy based on providing value-added services.
One successful strategy appears to be one that segments the residential and business market by providing different classes of service. Classes of service are distinguished by the hours of access offered and the bundle of value-added services offered. If customers are placed in the appropriate class of service, ISPs are able to capture as much of the Internet population as possible -- from light to heavy users. This helps generate as much revenue as possible for the companies while best meeting customer needs.
The variety of service classes and the range of products offered -- from database services to training -- demonstrate the degree of economies of scope in the ISP industry. ISPs are willing to expand into new service areas as long as average costs fall with each additional or complementary service. ISPs continue to introduce new services and products, showing that the full economies of scope may not yet be fully realized.
Many of the small players have not yet realized the benefits of economies of scope. The study of revenues indicates that the smaller players rely more heavily on the residential market and that the business market, while more difficult to access, is more lucrative. Smaller firms may have difficulty accessing the more lucrative business market. Nevertheless, given that the penetration rates of the Internet into both residential and consumer markets are low relative to the population, there is much room for growth in the ISP market.
In addition to economies of scope, economies of scale play an important role in the profitability status of Canada's ISPs. The above analysis suggests that economies of scale in the provision of Internet access exist due to the relative discounts available to companies leasing large amounts of bandwidth. As a result, leased line charges are a potentially large barrier to entry in the ISP business, particularly as the industry overall grows in scale. The expenditure figures obtained from the survey suggest that as higher revenue companies pay significantly less for leased line charges, they are able to put this savings toward hiring skilled labor to provide technical support and value-added services to customers.
The expenditure figures, when examined by revenue tertiles, also suggest that the biggest companies are also the least profitable. This result does not support the commonly discussed scenario that the ISP market will collapse into an oligopoly where only a few large companies will exist. The survey results suggest that there may be plenty of room for small but profitable niche operators.
Small companies, however, may be very sensitive to the price of their factors of production -- items such as leased lines, dial-up lines, and personnel issues. As noted in the analysis above, a large proportion of ISP expenditures revolves around the cost of leased lines. Given the profitability status of most ISPs, a rise in this input cost could be very damaging, particularly for smaller ISPs. Dial-up lines are another source of cost concern, though these services are, to a certain extent, regulated.
Competition ranks as one of the chief concerns of many of the ISPs, particularly competition resulting from the arrival of the large telecommunications companies into the ISP market. This reflects the fear that, while smaller ISPs are often more nimble and able to provide a more customized service, the pricing practices of the big players could drive the smaller ISPs out of the market. The concern about competition issues is much greater than concern about other potential threats to the ISP industry, such as the threat of litigation. Although government policy is to increase the amount of competition in this area, policy should ensure a level playing field with a diversity of companies offering Internet services to maximize consumer choice. An outcome that allows for significant increases in the cost of lines will pose a danger to the growth and success of smaller ISPs.
This study has been able to draw out the characteristics of ISP industry in Canada. By examining the details of the responding ISPs, the paper has shown that the ISP industry is robust and offers a spectrum of services often bundled to capture market segments. As the competition for Internet access drove down the profits in that area, firms developed a wide variety of business strategies, company structures and, most importantly, value-added products and services to better compete along other margins. While the large companies are able to realize economies of scale, smaller companies are more nimble and profitable. The success of these smaller firms, however, is often fragile and is potentially very sensitive to competitive threats, such as the price of lines.
Ultimately, this study is a snapshot of a dynamic, evolving industry that is at the core of an economy based on information, knowledge, and networks. Policy should continue to foster the growth of innovative new companies offering an increasing variety of new services to Canadians. In doing so, Canada will keep its lead as the knowledge economy unfolds.