700 MHz Auction: D Block Panic, Damping Expectations, And My Final Thoughts Before the Opening Bell.

After so much pre-game hype, it’s hard to believe we have actually gotten down to the 700 MHz Auction week. The fun and games will start January 24, although we won’t know (much) about the auction until it is all over sometime in late February or early March.

Not surprisingly, the news that Frontline Wireless , the company that did so much to shape the rulemaking around the “D Block” public/private partnership, went belly up before the auction even started has triggered a round of hand-wringing about the fate of D Block and finger-wagging by those who always thought it was a bad idea to impose any kind of conditions on licenses. As a result, we see a slew of stories questioning whether anyone will bid for D Block (or, at least, meet it’s $1.3 billion reserve price), with some spillover questioning about the future of the auction itself.

While I agree with GigaOm that wireless auctions aren’t for wimps, I do think the panic over Frontline’s failure to scrounge up capital to make the necessary up front payment (the “ante” required to buy “bidding credits” to participate in the auction) is exaggerated. Nor am I as pessimistic that the auction will produce some groundbreaking changes as others, although it could well happen that we get through this auction with no new “disruptive third-pipe providers.” I think we will certainly see the auction hit the $10 billion Congress estimated (and the FCC set as aggreagte reserve price), and we will see C Block meet its $4.6 billion reserve price.

On the other hand, if things start to go poorly in the auction, we may see some panic moves by the FCC, particularly with regard to D Block. The possibility that the FCC may retroactively drop the reserve price on D Block (possibly without holding a reauction) may introduce strategic behavior into the auction. Of course, since no one (including the FCC) can actually talk about this possibility makes the speculation even more insubstantial than usual. Still, since the possibility does exist, and because I think such a course would create real problems with the auction, I briefly discuss it below.

Analysis below . . . .

Folks have certainly sought to damp expectations for the upcoming FCC auction. This CNN story, for example, warns that incumbents will likely take the major licenses and the status will remain mostly quo. In this piece, FCC Chair Kevin Martin warns that the general tightening of financial markets may depress bidding — particularly by new entrants that need multi-billion dollar backers to even win the licenses, let alone subsequently build out the network. The failure of hedge fund/private equity firm Fortress Investors to qualify (presumably for chickening out on the up front payment) raises even further doubts about the willingness of big money investors to back an expensive and risky play against well positioned incumbents. And, of course, the conventional wisdom remains that Google won’t bid to win.

But what really has folks down on the auction is the collapse of Frontline and the future of D Block. The Wall St. Journal editorial page crows with delight that no one will bid for D Block. One may accuse them of ideological bias, but others have expressed similar concerns. Even Martin has difficulty keeping up his usual optimism, remaining “hopefull” someone will pick up D Block for the reserve price of $1.3 billion or more. In other words, the conventional wisdom is now as down on D Block (and by extension, the auction) as it was on the Clinton Campaign after the Iowa caucus, and with about as much justification.

In addition to all of these, we have a few outstanding wild cards that no one can talk about. We have a number of outstanding Petitions for Reconsideration (including one filed by yr hmbl obdn’t blogger) and the possibility that the FCC can take action during the course of the auction (although this would be a phenomenally bad idea).

Keep Perspective

I note at the outset that 214 bidders actually qualified, which still puts this auction well ahead of the “highly competitive” AWS auction in August ’06 (which had 168 qualified bidders). In addition, the absence of information about up front payments means that we have no idea how aggressively folks intend to bid, and no way to find out. Last time, there was a lot of excitement over the huge upfronts by the DBS guys and the cable guys. This time, all we have as a news item is who did or who didn’t qualify. So how can we debate if Google is totally pumped or not if we don’t know how many chips it opted to buy? Or whether AT&T will go for a huge play or just fill holes? We can’t.

Which, I remind folks, is a good thing. It keeps auction participants from formulating strategies based on this information and calculating whether to bid strategically based on participant’s resources in the auction. But it means we overweight the news we have. Nothing has substantively changed for Google since I made my Great Google Prophecy at the beginning of December. So I see no reason to alter my prediction that they have their game face on and want to win, although they may get outbid anyway. The presence of so many other national and regional bidders guarantees, to me at least, vigorous bidding for A & B blocks as well.

Of course, the incumbents still have the advantages that we warned about when we pushed for limitations on incumbent participation: notably the “incumbent discount” of already having a network and customers in place. Anonymous bidding has neutralized the “blocking premium,” that arises from an incumbent targeting a new entrant. But absent a new entrant credit or some kind of limit on participation by incumbents (like a spectrum cap that would keep folks with plenty of spectrum out of the auction), you are stuck with the incumbent discount giving incumbents an edge. But that’s why we at PISC asked for these things in our comments to the FCC.

Hopes For D Block?

D Block comes with a lot of baggage, particularly for new entrants. The public safety community is a large, diverse, and occasionally fractious bunch. The D Block winner will find itself in many ways constrained not only in its network architecture (which must support public safety needs) but also in its build out schedule (where it will need to work with public safety to satisfy its sensibilities) and business model (which must not present an undue security risk in the eyes of the public safety licensee). These risks are difficult to estimate, and the unfortunate example of the Sprint-Nextel/Public Safety rebanding/spectrum swap — that was supposed to be a windfall for Sprint and has now turned into a nightmare of delays, uncertainty, and disputes over reimbursement cost — highlights that even experienced carriers working with public safety support can run into real problems. Worse, any investor must worry that the FCC will invariably side with the public safety licensees due to the support for public safety (often characterized as a “third rail” in spectrum policy) and the risk of something going wrong and putting public safety at risk.

So without a bidder promising to take all that on, and with the one bidder that said it would dying for lack of capital because investors don’t appear to like these terms, what hope does D Block have? It depends on a number of factors. If C Block gets very competitive (which I think likely), D Block looks better and better — particularly for the right kind of bidder. The traditional carriers — particularly AT&T and Verizon — with experience working with public safety on a variety of issues from CALEA to E911 may find the prospect of working with public safety much less frightening than Silicon Valley VCs backing an unknown. Indeed, even the prospect of giving public safety licensees access to the D Block spectrum is familiar territory to wireless carriers, since they have worked with public safety on how to take capacity from commercial systems for priority uses since 9/11. Such carriers also understand how to play the FCC game, and may not feel themselves at such a disadvantage if it gets down-and-dirty at the FCC on implementation. Finally, carriers like AT&T and Verizon have networks that can easily support public safety for wireless broadband without causing a hiccup in their existing business model. If the carriers intend to build a wireless national broadband (which I think likely), it can happily act as a “dual use” network for public safety and a commercial carrier.

Google or Echostar (bidding as Frontier Wireless) may also give it a shot, for the right price. Google in particular may feint for C Block and capture a national license via D Block if it an do so for a trifling $1.3 billion. Recall my theory that Google wants to win so it can exert control, but not build a network and will therefore lease out the network construction to other carriers on terms that give Google access for its applications. Google could still purse such a scheme with D Block rather than C Block, provided it gets public safety to go along. It’s a worthwhile gamble that investors will swallow, given that Google has a track record of risky investments paying off. And if it doesn’t work out, Google can still sell the license to someone else — probably for three times as much.

So while I’m not saying it’s a slam dunk for D Block, I’m not writing the obit for D Block either.

Avoiding D Block Panic

The greater risk, in my opinion, is that the FCC might panic and do something stupid as a result of “D Block Panic.” In particular, I expect the FCC to get pressure (particularly from Republicans like Barton who never liked this plan in the first place) to drop the reserve price on D Block. At this stage, that would constitute a huge give away to the carriers, since parties that would have raised capital in a universe with a lower reserve price (like Frontline, which had argued for a lower reserve in its pending recon petition) have no opportunity to get financing and join.

Worse, under FCC auction rules, the Commission can simply decide to not reauction the block. Unlike the other blocks, where the FCC committed to reauction if the reserve prices were not met, the FCC merely stated that if the D Block did not meet the reserve price, “the license for D Block may be offered again.” (Here’s the Public Notice, the relevant language is in Par. 271). So the FCC can even wait until after the auction is over, see who won it, see how close they got to the reserve price, and then decide whether or not to reauction the D Block (and, if so, under what conditions). Alternatively, if the FCC wants to drop the reserve price earlier, it can act on the pending recon petition (by Frontline, ironically) to lower the reserve price in advance of the auction.

I’m not the only one to notice this possibility, of course. Silicon Valley Insider flagged it, as did the Wall St. Journal. It introduces some interesting prospects in bidder strategy. Further, with federal law requiring the FCC to deposit the revenues from the auction into the treasury by 2008, we can expect a push by a D Block winner to close the books on the auction once and for all and accept a below reserve price result. I see this as reasonably likely, especially if (a) the auction otherwise makes the $10 billion scored by the Congressional Budget Office, (b) the winning bid is at least plausible (close to $1 billion), and (c) the winner is either Verizon or AT&T.

The possibility of this sort of thing (and as I said, it was in the Wall St. J., so it’s not like no one else is thinking about it) is already enough to impact the strategic thinking of potential bidders. The key question, of course, is how? Will bidders try to drive up the price to avoid giving the unknown below-reserve-price bidder a potential bargain? Or will carriers stay away, hoping for a reauction? In general auction theory, the knowledge that the auctioneer may drop the reserve price is usually regarded as an incentive to drive down bidding. But parties must weigh the potential of giving competitors a bargain by failing to drive up the price, versus the possibility of a reauction with more favorable conditions.

The logical thing for the FCC to do would be to clarify what will happen if D Block doesn’t meet its reserve price. But I doubt there is consensus and the very fact of FCC debate or discussion on this also impacts bidder behavior. As with so many complex games, decisions not to act can have as much impact on the behavior of other players as decisions to act. If the FCC is seen as uncertain, it will create a whole different set of expectations and strategies (as well as attempts to influence the process without violating the silence imposed by the anti-collusion rules).

I sincerely hope that the FCC avoids “D Block Panic.” There is absolutely no reason for any kind of hasty decision, particularly when there are a number of scenarios under which the D Block minimum reserve price gets met. Above all else, it is imperative that the FCC keep an even greater clamp down on leaks, speculation, and gossip on the subject, since we will all be busy scrutinizing every time the staff in the auction division burp for possible clues. But apart form this, hasty action to lower the reserve price in advance of the auction wll almost certainly send a signal to bidders that the FCC is desperate to sell licenses at fire sale prices in all blocks. That will provide a tremendous incentive to all bidders to hang back, in the hopes of further concessions born of FCC desperation. Much better for the FCC to exude confidence and force bidders to fight as if the FCC means what it says and says what it means — at least this time.

Final Wild Card

Last, I point out that there are a number of Petitions for Recon pending. There is not exactly a lot of time to grant my request for reconsideration on spectrum caps. Or, perhaps a shade (but only a shade) more realistically, preventing anyone from winning both D Block and C Block licenses.

Last Prophecies Or Predictions?

Chairman Martin probably put it best at the Federal Communications Bar Association “Chairman’s Dinner” with a top 10 list of what the 700 MHz auction will show. Among these, to paraphrase: network neutrality opponents will say it shows that we don’t need NN, NN supporters will say it shows that we do need NN. Martin also observed that if anything goes wrong that consumer groups will blame the carriers, Martin will blame the subprime mortgage crisis, and everyone else will blame Martin.

There’s truth to that. Heck, we’ll blame him too, for failing to adopt our proposals on mandatory wholesale and exclusion of incumbents. That is part of the problem with something as massive and complex as this, and why every single analyst (including me) has hedged on predictions. (Or, as the folks at Stifel Nicolaus put it in their humorous end of year summary: “Whatever the result, we will say ‘As we predicted…’”.) As we roll up to the auction, it really can go any way imaginable — from an utter flop with the major carriers walking away with good spectrum cheap to a radical rearrangement of the wireless landscape as we know it. I’ve done my best to stack the odds for the outcome I think best serves the public interest by helping push for certain reforms. Signs so far look promising that at least some of those reforms will work as intended. But — especially with the financing crunch and the fact that half of our reforms didn’t get adopted — there’s no way to know what will happen until the curtain lifts off the auction when it’s over. (The one exception is whether or not the various blocks make their reserve prices. The FCC said in the Public Notice setting the rules that it will announce the fact that a reserve price was met when it happens.)

Damn frustrating, even if I did push for these very rules. Still, if it serves the public interest, I can live with frustration for the next few months.

Stay tuned . . . . .

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