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War of the Worlds - Part II: Telecom's Uphill Battle
Turning the Corner – Telecom is threatened again…
From Apologist to Strategist
Speaking to investors in 2004, Sprint (NYSE: S) CEO Gary Forsee observed: “I think I’ve used the term ‘Perfect Storm’ … more times than a meteorologist, and I felt more like an apologist than a strategist. But that was yesterday. Today I believe we’ve turned the corner.”
“I think I’ve used the term ‘Perfect Storm’ … more times than a meteorologist, and I felt more like an apologist than a strategist”
What’s around the corner is a new assault on telecom, placing the industry on the precipice of another downturn. Developed-world telcos, now refocused on wireless and broadband, have yet to convincingly demonstrate they can outrace the secular decline of their still highly-profitable legacy franchise. And they are about to collide with unfamiliar new competitors threatening to disrupt the very broadband future that telecom only recently, and often grudgingly, embraced.
The near-term worries for telecom strategists include another round of sharp decline in the legacy wireline business, and wireless’ and broadband’s shaky ability to shoulder the load of growth expectations.
First, “managed decline” of legacy voice services is becoming increasingly untenable, and the clock is just about running out. Conventional wisdom, especially concerning US incumbent local exchange carriers (ILECs), is that “the worst is over.” This is an apparent extrapolation of significant (and we believe, temporary) improvement in access line disconnect rates into a strategic conclusion.
Yet, cable and independent-provider Voice over IP (VoIP) services have barely even begun their challenge. When they do, incumbent telcos’ “soft landing” may well be jeopardized by an access line disconnect problem at least as large, but possibly even greater and more damaging than what they have undergone in the last three years.
Second, though telcos are repositioning themselves as “multi-service carriers”, rebuilding their core business around wireless and broadband connectivity, this transition may not sustain growth, or even stability in the medium term. Both wireless and broadband are destined for significant unit price declines and flattening subscriber growth. When coupled with diminished free cash flow from legacy businesses in (faster) decline, telcos may find themselves shrinking instead of growing. Cost savings from recent mega deal post-merger integration may be fully captured as early as year-end 2006 – any shortfalls in wireless/broadband top-line growth could very well require additional, material cost structure improvements.
In short, some telcos may be compelled to at least temporarily reposition themselves as low-cost utilities, in contradiction to today’s telecom industry message to capital markets: “bear with us, we’re on a path to restoring growth in exciting new markets.”
War of the Worlds
More serious still is the long-run threat of non-telecom competitors diverting expected telecom profits by changing the rules of the game
More serious still is the long-run threat of non-telecom competitors diverting expected telecom profits by changing the rules of the game1.
The next round of broadband competition for wired and wireless alike includes application value, not just connectivity. Media (i.e. content), consumer electronics (i.e. devices, including software), big-box retailing (i.e. distribution and support), and consumer packaged goods (i.e. brands), collectively have the potential to carve out significant portions of broadband-related wallet share.
Telecom (i.e. connectivity) is in the middle of a multi-industry broadband contest which potentially marginalizes, and surely alters, telcos’ relative position in broadband-related profit streams. The shift to competing over more “customer-visible” value (vs., say, infrastructure speed or reliability) can change telcos’ supplier and partner relationships into competitive ones, and disrupt telcos direct-to-subscriber relationships.
As a concrete, miniature illustration of what’s at stake in a “War of the Worlds” future, let’s apply some imagination to the recently-announced iTunes®-enabled cellphone.
The telecom industry controversy leading up to the Motorola (NYSE: MOT), Apple (Nasdaq: AAPL) announcement centered largely on whether this device would interfere with wireless carriers’ own music download offers (which, other than ringtones, are largely in the aspirational phase). These envisioned carrier music services, which depend on still-emerging 3G broadband networks to deliver fairly large music files, would be backstopped by a third-party aggregator and music library licensor. Carriers would then resell music downloads to their subscribers, presumably hoping to engineer a wholesale deal as advantageous as today’s ring tone resale (roughly 50/50 split with music provider).
Nevertheless, Cingular broke the telecom industry mold and obtained some period of exclusivity in selling a GSM version of this hybrid device. The actual handset is simply a physical combination of a music player and a phone, allowing one hundred songs to be downloaded by wired connection from a PC or Mac to an onboard memory card.
No “War of the Worlds” here – Apple’s iTunes service, Motorola as a device manufacturer, and Cingular as a wireless carrier (including device sales and handset subsidies) each benefit in proportion to the popularity of the device, business models intact.
Roll the scenario forward to make it interesting. It’s 2008. Apple and Target (NYSE: TGT), a major US retailer, have partnered around their compatible brand demographics to broaden the still-burgeoning iPod ® franchise. Motorola is out of the picture. Apple has contracted with Taiwanese electronics designer and manufacturer BenQ (Taiwan: 2352.TW) to create multiple new iPhones with twice the functionality at two-thirds the wholesale cost of Motorola’s 2005 original.
Apple is now an “MVNO” (mobile virtual network operator), stamping its brand on wholesale capacity from Verizon Wireless (NYSE: VZ), co-marketing and retailing with Target. The offer spans the device, voice service, 3G broadband access, and music downloads, all in the palm of your hand.
It is fair to say that this hypothetical scenario is not what Verizon or its peers have in mind for their future. It is but one, perhaps extreme, example foreshadowing how long-standing industry relationships, both competitive and complementary, can be restructured in telecom’s “value network”1.
Migrating Profits
Broadband profits are beginning a long-term migration away from connectivity towards content, applications, and services
Broadband profits, whether wired or wireless, are beginning a long-term migration away from connectivity and infrastructure generally towards content, applications, and services.
This shift is analogous to a well-established trend in information technology – as that sector has matured, the industry’s technology component layer (e.g. processors, memory, etc.) and systems infrastructure layer (e.g. servers, operating systems, middleware, etc.) have been increasingly commoditized, and profits have migrated upwards toward “business value” suppliers (e.g. outsourcing, systems integration, etc.)[2].
Redistribution of broadband-related value is a natural outcome of broadband connectivity’s growing market success. The effects of mass adoption, predicted but not delivered during the dotcom/telecom bubble, are now arriving as household penetration of high-speed internet access in many developed countries passes critical mass (US – 35%, UK – 50%, Asian countries with subsidized infrastructure – 70%+). Among these effects are:
- lower-priced connectivity with continuous price-performance improvement (Megabits per second per dollar, more symmetric upstream and downstream bandwidth). Offer segmentation (slower, cheaper vs. faster, more expensive) will add to pricing pressure – latecomers to broadband are more likely to purchase increasingly adequate, lower-priced offers.
- enabling new applications, devices, and their distribution channels, made economically viable by enough broadband-connected subscribers – Apple’s iPod/iTunes double-play, for example. Like iTunes, many innovations can be expected to reinforce telecom’s infrastructure-only role, creating incremental value in which telcos do not participate. And demand for such non-telecom broadband innovations will be further fueled by transferring subscriber savings from cheaper connectivity to higher value, “life-style relevant” services.
- disrupting existing business models, especially those that involve bandwidth-rich digital media such as music retailing, DVD and videogame rentals, training and education, etc., and, of course, telephony as well.
Unchanged, or at least unexamined, telcos’ historical business models are likely to consign them to a proportionally smaller, and diminishingly profitable slice of the growing broadband pie. Being a telecom strategist now requires understanding the business models and economics of the surrounding industry sectors, and the threats and opportunities they create for telcos.■
1 For a discussion of value networks and a practical understanding of strategies which redefine industry boundaries, see Co-opetition , Barry J. Nalebuff and Adam M. Brandenburger, Currency/Doubleday, 1996
2 For a concise discussion of this trend, see “Why IT Never Did Matter – Now More Than Ever”, a presentation by Bruce Harreld, IBM’s senior vice president of strategy. Its title is a play on, and rebuttal of, Nicholas Carr’s controversial May 2003 Harvard Business Review article, “IT Doesn’t Matter”
Bad Connection – Telecom’s old playbook needs to be replaced
Hold the Line, Please
Telcos’ focus today – harvesting mature assets while migrating to broadband-based revenues, (both wired and wireless) – is not competitive strategy, but an industry-wide recognition of technological and economic reality. Capital-intensive, next-generation “converged” networks may be rolling out, but few carriers are actively focused on building broadband business models that could sustain further material increases in profitability pressures, or on creating serious alternatives to service commoditization.
harvesting mature assets while migrating to broadband-based revenues is not competitive strategy but an industry-wide recognition of technological and economic reality
Put more bluntly, if telcos aspire to be growth companies again they will have to do more than consolidate themselves, using eroding 35-45% EBITDA legacy businesses to finance the transition to lower-margin connectivity. But the same strategic instabilities threatening telecom also provide it with an opportunity to change the game, starting with a fundamental rethinking of the industry’s future.
Each element of incumbent telcos’ amazingly durable strategic playbook has, in varying degrees, reached the point of diminishing returns and limited competitive effectiveness:
- Manage regulation – obtain regulatory preferences, and/or stop competitors from obtaining them (example issue: wholesale pricing of circuits for resale by competitors, access charges for VoIP carriers, etc.) In general, developed-world telecom regulation is in retreat or has reached accommodation. Newer business such as wireless, broadband, and cable are regulated comparatively lightly. While one should never underestimate the potential for policy and regulatory skirmishes, even large incumbent carriers would probably concede the major regulatory battles are now behind them.
- “Grow” through consolidation – increase scale economies, and improve price stability. Consolidation, with US carriers and Vodafone (NYSE: VOD) topping the M&A league tables, is largely over. There isn’t much left to consolidate, and cross-border acquisition opportunities, other than in emerging markets, are relatively scarce (though recent deals such as France Télécom’s acquisition of Spanish wireless carrier Amena may be proving this wrong).
- Assemble the (connectivity) pieces – augment declining businesses (e.g. local access or long-distance) by adding missing pieces (e.g. local access or long-distance) or acquiring businesses perceived to be in growth segments (e.g. cellular, emerging markets).Adding more types of connectivity has been one of the principal rationales of consolidation itself (buy wireless growth to offset declining wireline, for example) and, as noted above, incumbents have largely accomplished this
- Increase wallet share – bundle multiple connectivity services to increase revenue per subscriber, combining margin-maximizing prices (e.g. wireline calling features) and share-maximizing prices (e.g. cellular), in an effort to stem EBITDA decline and reduce subscriber churn. Virtually everyone is on the multi-service bundling bandwagon – one-stop shopping is no longer a differentiator – thus shifting the battle back to “more subscribers” from “more money from fewer subscribers”
Looking backward, the four-part strategy has been a success. It guided major incumbents through the ‘Perfect Storm’, allocated their capital responsibly (in sharp contrast to new entrants that arrived, imploded, and in some cases defrauded, during the bubble), buying time to find a bridge from declining businesses to growing ones.
Looking forward, however, how to compete remains a question still unanswered even as secular trends erode profits not just in legacy telecom, but in the “safe havens” of broadband and wireless as well.
Lost and gone forever
Access line disconnects are eroding the wireline business – loss rates have been as low as ~2-3% year in the UK, to as much as 10% annually at the peak in the US. A good deal of the “first wave” of access line disconnects has been second lines displaced by broadband, often cable. The second, more threatening, wave of access line disconnects about to start is the replacement of primary line voice service by adding Voice-over-IP (VoIP) service to broadband connections.
In North America, DSL net additions (the ‘next-generation’ wire) have not replaced legacy access line losses, as illustrated by an SBC (NYSE: SBC) example (Exhibit 1). The gap between the rate of DSL lines added and traditional access lines being disconnected is in no small measure because of the cable industry’s success with broadband. Replacement of primary line telephone service with broadband-based VoIP is likely to make this worse.
So for telcos the interim burden of financial performance falls heavily on their wireless businesses and the enterprise market segment. In the US, the burden on wireless business performance has increased sharply – for example, capital markets expect fully 80% of BellSouth’s (NYSE: BLS) EBITDA growth to be derived from its minority interest in Cingular, despite accelerating DSL net additions.
Flattening wireless
Despite substantial wireless substitution (i.e. consumer shifts to wireless at wireline’s expense), paid Minutes of Use (MOU) per subscriber are saturating (Exhibits 2,3), even as substantial minute give-aways continue unabated (free nights and weekends, family minute pools, rollover minutes, free in-network calling, etc., etc.).
In Europe, where SMS frequently substitutes for comparatively expensive talk time, message volumes per subscriber are flattening and price competition for both SMS and voice minutes is accelerating as interconnection charges are phased out and, like the US, a growing range of discount competitors come to market.
3G (third-generation) wireless looks less and less likely to provide the wireless salvation telecom once expected and which telcos’ often still imply to their shareholders. 3G suffers from three strategic disadvantages:
- High costs both from overpaying for spectrum licenses and economically-disadvantaged network performance for broadband applications
- Competing with itself – all major carriers have 3G – resulting in margin-destroying share wars early on in the product lifecycle
- Competing with more efficient substitutes in a fragmenting market (wired broadband may be adequate for most, other wireless broadband will proliferate, and application-specific wireless such as satellite radio may take away much of the profitable application revenue)
Broadband connectivity won’t replace legacy EBITDA
As broadband penetration continues, with corresponding increases in competition, prices are falling. A good deal of what drives broadband adoption is the simple convenience of always-on access at adequate speed, not absolute bandwidth.
In North America and Europe, subscriber adoption will center on a ≤$35 offer with peak downstream speeds likely to be in the 6+ Mbps range, with as much as a third of the market taking slower, value-priced service in the ≤$20 range, and a small fraction adopting premium connectivity (Exhibit 4)
With voice-over-IP about to make sharp inroads in telephony, the economics of voice and broadband combinations have significant downside, driving blended EBITDA towards broadband connectivity margins (Exhibit 5).
In countries with strong cable competition, ILECs’ laggard broadband deployment has already cost them enormous subscriber share. Telcos are in the process of trying to regain share just as broadband begins significant price declines. While the game is far from over, and the incumbents’ regulatory explanations are many, it is hard to view this huge market share deficit as anything other than a major strategic misstep adding to telecom’s growth challenges.
Toe the Line, Please
Telecom innovation traces its roots to the era of government or de facto monopolies in which the public switched telephone network (PSTN) was entirely closed to outside innovations and not particularly responsive to external demands.
Improvements, at whatever level, could come from only one source – the vertically-integrated telco. The AT&T model, widely emulated in other countries, at one time spanned operations, maintenance, engineering, and manufacture of virtually every element of the phone system for the vast majority of Americans.
For the better part of a century, the innovation chapter of telecom’s playbook has had three interlocking elements:
- supplier-driven innovation: a very limited number (in the original model, one captive supplier) of like-thinking network equipment vendors drive feature and service innovations (e.g. voicemail, “vertical” services in Class 5 switches, replication of those services in softswitches, etc.)
- technology-centric innovation: most recently, network digitalization of the ‘80s, cellular network technologies of the ‘80s (analog), ‘90s (PCS/digital), and last several years (3G/broadband)
- closed system: the telecom network was the original “ walled garden” – only telco-provided services were available. Outside entrepreneurial innovations were not permitted, unwelcome improvements were rebuffed3. The closed model persisted despite a new PSTN architecture implanted in the 1980’s enabling rudimentary separation of call control and value-added services.
Put more crudely, telecom’s historical approach to innovation contains a strong strain of what a General Electric head of R&D years ago christened the ‘chuck wagon’ approach to research strategy: cook it up, ring the bell, and yell “come and get it!” Worldwide, there remain very few exceptions to this model despite generational changes in technology. France Télécom’s (NYSE ADS: FT) pre-internet Minitel service enabled hundreds of outside service suppliers to offer text-based information services, with total revenues almost equaling France Télécom’s connectivity charges. In Japan, NTT DoCoMo’s (NYSE ADS: DCM) i-mode service levered simplified web access to enable tens of thousands of independent suppliers to offer services and share revenues with DoCoMo.
Broadband, or more precisely IP-based network architecture, has already made telecom’s historical approach to innovation obsolete – content and value-added service providers no longer need carriers’ consent to offer their services directly to subscribers, and equipment providers have multiplied and diversified.
Yet most telcos continue with selective, largely reactive, and connectivity-specific adoption of innovations (e.g. ring tones). Few are yet systematically building business development and service management capabilities to meet long-term challenges of connectivity’s revenue erosion. ■
3 In an emblematic case fifty years ago, AT&T enforced its perceived right to exclusively control innovation by obtaining an FCC order (later reversed in court) to ban “Hush-a-Phone”, a molded plastic mouthpiece to increase privacy and shield the handset from outside noise. Similarly, in the late ‘60s the Bell System challenged the “Carterfone”, an acoustically-connected device for bridging communications between a mobile radio and the phone system. Both challenges were based on the foreign attachment doctrine, prohibiting “harmful” connections to the network.
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12 October 05
