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Verizon's AOL Buy Is an Expensive Gambit at Trying to Be More Than a Dumb Pipe

With T-Mobile and Sprint aggressively going after the smartphone business, both AT&T and Verizon are trying to use their significantly larger scale to change the game.

iStockPhoto / Jason Doiy

Is the wireless business really so competitive that Verizon needs to become a video provider, too?

In short, the answer may well be yes.

Given the high fixed costs of running a wireless network, carriers around the globe are looking for ways to avoid being just a “dumb pipe.” With a hyper-aggressive T-Mobile and a reinvigorated Sprint, both AT&T and Verizon are seeing pressure on the core business of delivering bits and bytes to mobile devices.

The U.S. market is largely saturated with smartphones at this point, and while customers are adding additional devices, such as tablets, those aren’t game-changers and also tend to be less profitable than the phone business. Meanwhile, both AT&T and Verizon lost core smartphone customers amid the intense push, especially from T-Mobile.

What AT&T and Verizon do have is a scale that Sprint and T-Mobile lack. That allows them to get into businesses its smaller rivals can’t afford. If it plays its cards right, it can offer a bigger collection of services than either Sprint or T-Mobile and, in doing so, make it much tougher to compete.

AT&T, for its part, has already made its move to acquire DirecTV as well as a pair of Mexican cellphone companies. In addition, AT&T has struck key deals to equip a number of carmakers’ vehicles with LTE connections, ensuring that it can offer a bigger bundle of wireless connections than a company just offering phones and tablets.

Verizon has indicated it plans to get into the mobile video service business, but needs both the content and advertising to make such a service pay off. That’s where AOL comes in. It’s still hard to believe Verizon needs to buy all this advertising technology since so many companies are in the business of selling both content and advertising technology.

But Verizon does need to make the economics of its forthcoming video efforts pay off. Delivering video to mobile devices is inevitably trickier and costlier than sending similar services to home Internet connections. Yet the costs of licensing content are likely to be similarly high.

Watching mobile TV is commonplace in some countries, such as Korea, but has not gotten much traction in the U.S. despite past efforts such as Qualcomm’s FloTV and, more recently, a little-known project called Dyle.

The key is being able to profitably offer a collection of services that customers want, at a price they are willing to pay. Verizon just bet $4.4 billion that AOL holds that key.

“We really like the technology a lot and we think of it as a key enabler for us as we begin to generate revenue and value above the network layer,” Verizon Executive Vice President John Stratton said at a Jefferies technology conference earlier Tuesday. “So we’ve talked a lot about our over-the-top video ambitions and this is for us a very important cornerstone enabler as part of that broader strategy.”

Verizon already has a home video service, known as FiOS, that it spent billions to establish along the Eastern seaboard; however, the company says that is different from what it needs to do in mobile video.

“Obviously, from a technology platforms perspective, there are capabilities that we will look to leverage across both the linear business in FiOS, as well as the new business,” Stratton said. “But when you think about the service proposition itself, the actual content that will be delivered, the nature of how it will be consumed, they are very different and so we don’t really look at those as a single development effort… And so this is a service that if you think about over-the-top service, the primary target for us is the millennial generation that has very different ideas about what they want to consume — how, where, when. So that’s a bit of a different platform than the linear stuff we do on FiOS.”

Verizon has promised the mobile service will debut later this year, but hasn’t gone into much detail. The company has already made moves to bolster its digital video know-how, including last year’s purchase of Intel’s OnCue video service technology.

What’s unclear is how the service will be delivered. Sending high-quality video to mobile phones consumes gigabytes of data, which costs around $10 per gigabyte at the current rate. One technology coming down the pipe is known as LTE-Broadcast and essentially sends the same video signal to all the phones in a particular area. That could make distributing video far cheaper, but also make it more like linear television than the on-demand model that Stratton is talking about.

The AOL purchase could be of even broader benefit if Verizon is able to create a world in which advertising, rather than just customer fees, helps offset part of the wireless bill.

“Verizon, like peer AT&T, has seen usage explode but, at least up until now, there has been little success in translating rising usage into rising revenue,” analyst MoffettNathanson said in a research note. In just the past year, for example, wireless usage has doubled while service revenues have remained flat. “By acquiring AOL, Verizon is pointing to a future where advertisers, rather than users, carry a heavier burden. The strategy speaks to disruption.”

This article originally appeared on Recode.net.

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