Wireless Outlook: Traveling the Back Roads to Carrier Growth
April 2004
Summary
The road to wireless growth lies less in next-generation technology, and more in taking the “back roads” to additional revenues, tuning and reusing existing assets rather than adding layers of net new cost. Simultaneously, new channels are needed to streamline distribution, reflecting 21st century practices rather than 19th century retailing.
- New Channels: renewed focus on exclusive (and expensive) store-front distribution is among the major elements driving increased cost-per-gross-ad (CPGA). Yet, by following other industries, wireless carriers have more options than ever for lower-cost distribution leading to substantial savings
- Wholesale: your new best friend — a large market for wholesaling “private label” wireless is emerging as unaffiliated local exchange carriers (LECs), cable operators (MSOs) seek incremental revenues, defending against triple-play wireless + wireline + broadband bundles
- Rifles not shotguns — segmented offers (whether “MVNO” or carrier-branded) remain an ineffectively
addressed, still-growing potential opportunity vs. mass market competition. Today’s lackluster “pre-paid” offers are largely about paying (the carrier), not about meeting different customer needs differently. - Untapped productivity — in the rush of network build-out, carriers neglected a wide range of efficiencies — combining declines in backhaul and special access circuit prices with changes to network topology can produce up to 25% savings in network operating costs. Innovative distribution channels (especially for wholesale and segmented offers) can lead to comparable customer care and marketing
Strengthening headwinds
Readers of either the general business or the telecom trade press are, in equal measure, likely to believe something along the following lines about the wireless industry:
- Global growth in wireless revenues will continue at near the current pace for some time — despite a slowdown in developed countries, emerging markets like China will continue to more than pick up the slack
- Deceleration of revenue growth in developed countries is temporary and, despite fierce competition, in the interim we can expect wireless carrier financial performance above telecom industry norms
- New technologies are finally “settling down”, most of the capital expenditures are behind us, leading to another ‘harvest season’ with data-related revenue growth more than compensating for eroding voice profitability
What if this turns out to be largely wrong?
- What if continued price declines mean the race to the bottom in voice revenue per subscriber is far from over?
- What if stand-alone wireless offers are marginalized by multi-product carriers (think LD)?
What if penetration levels of useful, diverse, and profitable data-related wireless applications with 20% or more top line contribution are reached not in three years, but ten? - What if renewed investment in exclusive distribution channels at premium prices succeeds only in further raising acquisition costs?
To put it another way, what if the truth and its operational consequences for wireless carriers are instead much more boring, much more urgent, and largely being ignored?
Truth and Consequences
We raise our contrarian wireless industry scenario not because we necessarily believe all, or even most, of it is likely but because wireless carriers largely behave as though none of this scenario is even a possibility. Consequently, we believe these carriers are missing large, bet-hedging opportunities for revenue increases in the interim, and stand-alone players (i.e. not affiliated with a LEC like Verizon, for example) are especially vulnerable to being shut out from further growth.
The competitive environment for developed country wireless carriers is in fact already quite unpleasant. The US market is a proxy illustrating the zero-sum game underway in most maturing markets — the battle for share gains vs. customer retention in an environment of flat growth.
- Demand curves confirm the market is maturing (Exhibit 1)
- The future outlook is more of the same or worse (Exhibit 2). “Price elasticity” hovers near 1.0 — in plain English this means there is relatively little demand for more minutes, even cheaper ones. Increases in minutes of use (MOU) will largely come at the expense of competitors, as overall consumption flattens.
- US MOU continues to increase by virtue of ever-fattening free-minute giveaways: nights and weekends, “rollover” minutes, and retention bonuses driven by the arrival of number portability
- Cost per gross ad (CPGA) is flat to increasing, driven by distribution costs, most notably massive advertising spending that is increasingly ineffective in generating net revenue gains (Exhibit 3)
Moving Distribution to Economy Class
Airlines around the world, starting in the US, have begun responding to economics of deregulation and competition. In the mid-’90s, sales and marketing costs for US airlines hovered around 12-14% of total operating expenses. Now they average closer to 8%, around the same percentage as aircraft leasing.
Like wireless minute prices, airlines have been dealing with rapidly declining revenue per seat mile (RPM) for some time. In this environment, reducing distribution costs has been among the key elements of changing the cost structure. Making distribution cheaper has been made possible by combining electronic ticketing and web-based ticket sales, both to business and leisure travelers. Ticket offices have been closed, and travel agency commissions have either been totally eliminated (as in the case of several ‘discount’ carriers) or set at very low, fixed levels (Exhibit 4)
Low-cost, web-based sales became the central part of the distribution mix — a ‘discounter’ like JetBlue sells approximately 75% of its tickets directly through its own website. Increasingly, airlines’ own web sites now “guarantee” lowest prices, further disintermediating already low-cost, third-party travel booking sites.
Taking the Back Roads to Get Ahead
The road to wireless growth in the near-term lies less in next-generation technology, and more in effectively levering existing assets to serve markets much closer at hand, at lower cost (especially distribution).
This means supplementing the core business by re-selling more voice minutes from the existing network, stripped of as much of the servicing and delivery cost structure as possible (marketing, distribution, billing, customer care). It means building a wholesale business around emerging wireless resale demand from both non-wireless carriers (smaller local phone companies, cable) and non-telecom retail brands (private label, discount chains, etc.).
Back road opportunities
The “back road” to growth is much less glamorous than the billion-dollars-or-nothing opportunity gambles to which large wireless carriers have become accustomed. Yet by taking another look, wireless carriers may be able to simultaneously defend against a near-term revenue downturn while strengthening their longer-term strategic position.
Without Wireless, A Bundle of Trouble
Among Verizon’s 50M consumer wireline customers, it is not unrealistic to expect 15% of them to subscribe to bundled local and wireless offers by the end of ‘04. For Verizon, aggressive bundling initiatives have helped slow access line erosion, significantly reduce wireless churn, and create opportunities to capture additional “wallet share” with broadband services and direct broadcast satellite resale.
The bundling trend deliberately leaves many smaller telecom providers out in the cold. Stand-alone wireless carriers, and hundreds of competitive rural, local exchange carriers, and cable companies are looking for ways to reach parity with multi-product carriers’ one-stop shopping value proposition.
Service providers lacking key bundle components create a market of mutual interest and immediate opportunity. National wireless carriers have the opportunity to wholesale a must-have bundle element throughdozens if not hundreds of non-wireless carriers, enabling these new resellers to bring their bundle of services to parity with larger, multi-product competitors.
Maturing, But Not Mature
Many potential subscribers still do not have cellular phones. In the US, this untapped market is perhaps as large as 30% of the existing subscriber base. The wireless industry hasn’t made much headway in expanding its addressable market to include the sizeable segment currently ineligible for, or declining to purchase today’s offers (reasons include: low income, sub-prime credit, product inconvenience, or lifestyle demographics)
Treating all these consumers as a single segment, the wireless industry has offered what are generically called “pre-paid” services. The label itself gives away carriers’ focus on their own need to minimize payment risk, rather than innovation for unmet needs of their potential customers.
US wireless carriers in particular have a very poor track record in this arena — their pre-paid offers are generally just watered-down versions of the real thing (cheaper phone, lower activation fee, cumbersome payment process, high per minute prices, etc.), often clumsily marketed with a “youth” focus.
Rifles, Not Shotguns
“MVNO” (mobile virtual network operator), one of the industry’s buzz-words for private label resale of wireless services holds some promise in fixing what’s wrong with the shotgun pre-paid approach. There are still few meaningful examples. The primary one is Virgin: successful in the UK, with the jury still out in the US. Using brand equity, retail and distribution know-how, and tailored offers, Virgin in the US sells Sprint’s wireless services under its own label.
A more interesting approach, if only for its simplicity, is MetroPCS. Operating in several major US metropolitan markets (such as Atlanta and Dallas) their streamlined, flat-rate, “unlimited” use offer appeals both to disenfranchised non-subscribers, as well as existing cellular users looking for greater simplicity at lower cost.
Assessing The Opportunities
Even a casual follower of the wireless industry will recognize that the opportunities we’ve sketched out are far from new — what is new, and newly urgent, is the size, clearer upside, and implementation feasibility of each.
Exhibit 5 compares the market characteristics, risks, and economics of three re-sale options— MVNO, Wholesale, and Tailored Offers. As a basis of comparison, we start with a fourth example that every wireless carrier already knows, because it is a structural part of their business — roaming.
- Inbound roaming is the original example of wholesale minute revenue, charged to provide service to visiting subscribers from other carriers. Despite below-retail pricing, these minutes are highly profitable as they generate little more than incremental network operations expense.
Because roaming is a reciprocal business, its ultimate profitability is driven by the “balance of trade” between carriers — primarily a result of geographic “luck” (ratio of inbound roaming to outbound). But because the incremental cost of an inbound roaming minute is stripped of typical high-cost elements (customer care, for example) it provides an economic “baseline” against which other, controllable, wholesale revenues can be compared
- MVNO: an attractive concept that has yet to take hold, the idea is that many brands can be in the wireless business (from Wal-Mart, to Best Buy, to Coca-Cola) by reselling network capacity from existing wireless carriers. In practice, however, there are two obstacles to wireless carriers profiting from this concept: (1) they are unlikely to be able to pro-actively create these opportunities on their own, (2) someone has to pay for the still-high marketing costs, and those costs are likely to be shared with the wireless carrier, diminishing the EBITDA margin
- Carrier Wholesale: As we’ve pointed out, multi-product bundling of telecom services is leaving hundreds of independent local carriers and cable companies out in the cold — they are missing the wireless piece of the puzzle.
This wholesale market is potentially the most attractive for three reasons: (1) strategically-driven demand — they need wireless to compete, (2) these non-wireless carriers already have the entire servicing infrastructure (provisioning, billing, customer care) and will want to use it as part of maintaining their richer, bundle-based customer relationships, and (3) wireless carriers are much more likely to be able to create these opportunities quickly and pro-actively.
- Tailored Offers: differentiated from core cellular offers by re-packaging minute bundles, feature sets, and handsets for unaddressed markets. Unlike “pre-paid”, payment and credit risk are only one potential dimension of the offer. As we mentioned, MetroPCS, which has recently registered for a public offering, suggests some of the potential direction here, combining both simplicity, lower prices, and low cost structure. As to credit risk, wireless carriers have made a mistake by going it alone, containing risk either through deposits or creating prepayment systems good only one thing — that carrier’s cellular bill.
EMI Financial is an example of a pioneer and potential class of payment partners that wireless carriers should actively cultivate. EMI’s Express-ATM™ product combines employer payroll deposits with national ATM network operators, essentially creating a debit card not tied to a checking account. Employees can withdraw cash at an ATM or use the card as a Visa/MasterCard equivalent when shopping.
Exhibit 6 compares the per minute cost structure of the three resale options we’ve introduced, comparing it against the roaming benchmark of today. Exhibit 7 shows illustrative economics of wholesaling to local carriers and cable companies for a US national, stand-alone wireless carrier with a nominal 50M covered POPs, reaching 10% resale penetration. The incremental $160M EBITDA is roughly equivalent to obtaining an additional ~1.2M retail subscribers
Timing is Everything
Along the back road, wholesale to carriers, tailored offers genuinely focused on consumer needs, and perhaps soon MVNO, represent three opportunities with material and near-term upside impact for wireless today.
But the window of opportunity is potentially short-lived. In the US market, one wireless carrier acting aggressively can potentially capture the lion’s share of these opportunities, making what is left over much less economically viable. And it doesn’t necessarily have to be a “stand-alone” wireless player. There is nothing stopping Verizon or Cingular/AT&T Wireless (i.e. BellSouth, SBC) from attacking the wholesale market, further isolating T-Mobile, Nextel, etc. from the bundling wave.
Minding the Store
If a low churn rate is the wireless industry’s Holy Grail, then Verizon is Indiana Jones. At 1.8%, Verizon enjoys an 80 basis point advantage over US industry norms.
Churn is the outcome of an extremely complex interaction between many causal drivers — operating decisions about network quality, customer care, billing accuracy, competitor promotions, cross-selling, etc. We believe more than half of Verizon’s advantage comes from superior coverage and its bundling strategy.
We will detail recent findings on wireless carrier productivity in a future report, but five general points should be considered when addressing “back road” wireless opportunities:
- “M-Commerce” anyone?: On Manhattan’s upper East Side, there is a cluster of more than a dozen storefront outlets, often immediately adjacent to each other, all selling the same thing — cellular phones. Not just the same phones but, often, the same brands and the same service for the same carriers. A visit to suburban malls, or even a single “category killer” consumer electronics outlet will be similarly revealing.
Storefront distribution of cellular service has long passed the point of diminishing returns. Within a single carrier there can be as much as a 30x difference in gross ad efficiency per “door”, even when normalized for population density and traffic. The time has come to aggressively triage poorly-operated, expensive retail outlets, low-value-added third-party agents, and begin substituting web-based, branded retailing and fulfillment, with over-the-air activation (Exhibit 8)
Alternatively, the UK’s mmO2/Tesco joint venture, applying real, exclusive distribution muscle with shared incentives is an innovative ‘bricks-and-mortar’ approach to retailing an alternative cellular offer.
- Manage drivers, not outcomes: The frustration of churn management is that it can only be addressed by programmatic attention to its many causes and their interactions. This is true for all components of wireless carrier productivity, from network operations through all elements of servicing (provisioning, billing, customer care). The EBITDA contribution from wholesale opportunities is partially dependent on continued progress in productivity improvements in the core business.
- Different business + same cost structure = failure: US airlines (Exhibit 9) are perhaps the best example — an extremely complex business with costs that “can’t” be removed, major airlines still struggle with incremental changes while profitable discounters enjoy unprecedented operating margin per available seat mile. The good news for wireless carriers is that as much as 50% of their cost structure (network operations) does not need much adaptation for wholesale opportunities, and wholesaling avoids most non-network costs altogether.
Benchmarks may not be what they seem: Churn is viewed as a fundamental measure of carrier efficiency. But is there an absolute level of goodness? Consider the wide dispersion in performance between MetroPCS’s 4.6% churn rate, and the norm.. Surely awful—or is it? What is an appropriate level of churn for a simplified product with lower credit risk addressing a new segment of first-time subscribers? - Don’t forget the network: in the rush of network buildout, wireless carriers neglected a range of cost efficiencies. The good news is that, despite slow uptake of data services, data-capable infrastructure (1X RTT, for example) have created as much as three times more voice capacity at significantly lower incremental capex per minute.
There is still money on the table. Major carrier report expectations of 25% savings from a collection of detailed network improvements ranging from LD trunking, to more aggressive bidding of backhaul circuits, to simplifying network topology, to RF optimization. Despite their high EBITDA margin, wholesale minutes will accelerate network cost pressures — these potentially large volumes must be handled at incremental minute costs at or below today’s levels.
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11 April 04
