The Boring Telecom— Are the glorious days gone forever? (III)
Part 3 — on value erosion and Telco unbundling
This is the third piece of a longer story. There is no need to read them in sequence, but its the way I was writing it up. In Part 1 and 2, I gave some historic retrospective, a mix of history and dynamics. In this part its all about value lost
Recipe for value erosion
Telecom industry is the backbone of modern economy. It has carried the 3rd industrial revolution, brought people and continents closer together. Its essentiality and the basic need was well reflected by a customer survey I ran back in my operators days. When asked how important a mobile phone was, a (young) respondent replied: “more than bread and water”.
Everybody needs it, no one can live without it. Yet the striking part is that this industry has severely underperformed.
Past decade was particularly disappointing for Telecom shareholders. While there are shining stars like Jio or T-Mobile US, that delivered significant upside, their cases fall under ”exceptio probat regulam”. Only the energy sector performed worse than telecom (but that was due to several uncontrollable factors, including the growing “green” sentiment). The worse situation in Europe is attributable to fragmented market with many more market players than in US and aggressive regulatory policy of EU.
Revenue growth stalled or is stagnant, while capital is investment inefficiently (ROIC being close to WACC). The relative stability of Capex/Revenue should not mislead — there is simply a financial limit to capital investment, not that all needs are satisfied just fine. As I wrote in my article on network sharing:
Between 2010 and 2018 industry revenues were down $27 billion, while telcos invested $250 billion in the network. Over 2019–2025, another $1.4 trillion would be spend by the industry, 70% of which would be on deploying 5G.
The erosion of value is a cumulative act between inability to grow the top line and monetizing costs efficiently. Regulation has its stake in hindering growth to some extend, but foremost it were the industry players, the operators, themselves that have failed to monetize beyond core and protect their investments. Innovation and venturing was sacrificed to standardization of everything, risk taking and agility fell victims to the “safe approach”. Ironically enough, while telecom connected the global world, the business orientation remains highly local, usually bound to a single country. The only moves “beyond the pond” were M&A deals of scale — essentially just buying revenue and cash flow, with hopes to synergize on costs. But barely any deals went on acquiring a globally operating company.
More reasons are certainly there, geography and lifecycle matters too, hence why I would like to focus the most common ones.
Prioritizing acquisition over loyalty far too long
I recall my marketing professor saying that among the 4Ps (product, price, place, promotion), price is the last instrument to be touched when no other means to stimulate sales are left. In telecom, it seems to be the first and foremost tool of revenue management.
In the early years telecom operators were able to skim on high prices. To attract more customer pricing had to be democratized. That played a bad trick to the providers — once you lower the prices there is no going back up. As long the number of customers grew faster than decline in unit price, no one cared. Once the markets saturated competition became dog-eat-dog and acquisition costs grew. Given that there was no real product differentiation after all, direct and hidden discounts were the major marketing instrument.
At some point decline of unit price was no longer sustainable and so the focus shifted on bundles — a package of minutes, SMS and (later on) GB of internet for a fixed sum. Tactically, additional discounts were given such as vouchers for reduced fee against a commitment to contractual binding for a certain period (e.g 24 month contract). Logical end of the ever-growing bundles were the unlimited tariffs. These came first in the wireline internet and later in mobile. But for the latter this was a disastrous end — there was not much else to differentiate on. Philosophy was “more for less” and mobile operators started adding subsidized devices into the tariff plans, essentially sacrificing own margin at benefit of OEMs.
Aggressive pricing led to the situation where new customers were paying less than existing customers, all to disdain of the latter. One of the reasons this risk was only discussed on aggregate was the silly orientation on APRU as a metric of success in business. The problems with ARPU as KPI is that it does not showing the marginal effect of adding a new customer, ignores acquisition costs (promotions, commissions, subsidies). In short, ARPU of a new customer can the same as with existing customer, but margin substantially lower! This seems to be trivial to readers, but in fact only few carriers in 2000s were technically able to track margin on individual customer level. Today, still many marketing and sales decision involve ARPU as a KPI.
Being constantly exposed to commercials promising heavy discounts meant existing customers quit to re-join and decrease costs. Regulatory obligations such as Mobile Number Portability decreased friction costs and killed of loyalty along with relentless acquisition strategy. Carriers started to realize the importance of retention and customer base management techniques, especially as markets reached saturation and competition became cannibalizing.
All of a sudden industry turned obsessed with keeping the client happy and non-churning. Campaigning became annoying with SMS and Email ads spamming inboxes, agents calls distracting. The peak of that were campaigns and activities aimed at optimizing customer’s tariff proactively attacking its main secret sauce:
Telcos are able to generate high margins, because ~40% are overpaying without being aware of that. This is the true cash cow factor
Industry quickly learned and optimized campaign management. CRM tools got more flexible, pricing schemes were optimized to more P&L subtle structures. All too late. Loyalty was a byproduct of discounting mechanisms. The only way to reduce churn was to lock-in customers in a broadly bundled deals: converged offers amalgamed wireless with wireline product. The industry essentially went from dual-play to triple play and quad-play — bundling converged mobile and fixed world offerings. This evolution is heralded and promoted as churn prevention panacea is essentially a hoax and self-deceit (and most proponents still operate in terms of ARPU and not in TCO terms). Particularly amusing was the bundling of landline (wireline telephony) service in a “Quad-play bundle”. Who needs landline anyways? But that helped to show success in stopping fixed line decline.
Telco have sacrificed long term relationship for a “quick buck”. Focus on acquisition created “a cult of ARPU”, a useful but misleading KPI
Unrealized value from M&A
M&A is quite common in telco, originally in scale deals, later extending to scope deals. Consolidation particularly in fragmented markets was a common way to increase coverage and economies of scale, especially for wireless providers. In order to increase portfolio depth, M&A focus shifted to wireless acquiring wireline operators, particularly those with triple play offerings (cableCos) and strong backbone and B2x client base. M&A deals were done in- and cross-country, intra-industry and in adjacent. My colleagues at Detecon regularly release a spotlight review of M&A in TMT.
The bold statement I’d like to make here is that takeovers, while bringing short-term value (especially for shareholders of takeover company) did not create long-term value for shareholders of the acquiring company. I am not alone with my views. The reasons for failure are quite common, out of top10 list here, I’d pick “overestimating synergies” and “lack of strategy”.
Particularly mobile-fixed deals had “convergence” as key synergy driver. Intuitively it made sense: wireless network needs a fixed network as backbone and access infrastructure. Duplicating structures are to be dismantled, sold-off and joint operational costs decreased. Turned out to be harder to deliver than promised as transformation costs were underestimates just like the scale of network “overlap”.
In overly simplified logic: as main cost is the last mile it seemed obvious to use fixed line to customer premise also to connect Radio Towers. It turned out that its “not the same last mile”, as radio towers while hosted on residential buildings (rooftops) are not easy connectable to home fixed line infrastructure. While telco’s were able to synergize somehow on backbone (partially at least), last mile synergies mostly failed. On the revenue side, convergence synergies delivered value as in ability to offer quadruple play products, but the broken logic is that convergence is more of a retention product than acquisition.
Adjacency deals are more difficult to judge, as there is far broader universe of different industries in deal scope. But for example Content sector (payTV foremost) deals were less value creating. The 2016 mega-deal of AT&T to buy Time Warner arguable failed, for various reasons, but in my own view it just lacked any strategy or synergy underlying (I wrote on that in Part 2). In 2021 Verizon sold of its “content” package, including Yahoo.
Back in 2011, McKinsey was wondering about the future of Telecom M&A correctly identifying the strive to go beyond Core and compete against new boys on the block, IT giants like Google, as main drivers along with classical scale. Now, 10 years later, Large Telco groups are divesting (Telenor, TeliaSonera, Deutsche Telekom, etc.) and losing the game to Google and Co in the battle for Home and Cloud.
Second major reason, the “lack of strategy”, is usually understood as rationally justified acquisition focus. But actually some crazy bets like wireless industry itself emerged from are just as important (that doesn’t imply a rush, but rather unconventional thinking). The questions I ask myself is: why did Telco not buy Google in early 2000s? Or Facebook in 2008? or Skype in 2011?
Telcos spend much more than couple of billions on acquisitions that extend scope and give synergies. True, intuitively there is little synergy in buying Skype, the company which actually eroded most of international voice revenues. But buying Facebook would be brilliant as a financial investment alone — check out Naspers. Take on the other hand what WhatsApp acquisition did to SMS pricing. True story is, Telco thinks locally and thinks late stage not VC style. Only for the last 5–6 years there is some movement in Telco CVC (corporate venture capital). I find that part particularly interesting as a maverick model.
Bottom line is that while poor understanding and execution can be blamed in parts for unrealized value, in my view a simple reason is Telco’s unwillingness to move away from core or think beyond own geography. But worst outcome is that ultimately, by diverting cash to M&A Telcos less remained to other value driving investments.
Defocusing on inhouse innovation
I wrote about failure of wireless to bring up new products in Part 1. Not to repeat myself I’d let numbers tell the factual story. First, the chart of R&D spend at Deutsche Telekom, which declined by 90% over the years.
Second, a comparison of Capex and R&D spend between Telco and those “new boys from the block”. All Telco’s follow the same path of Zero R&D.
Quite funny to see Apple being put in nirvana, but broader picture shows radical differences with a sad conclusion that Telco’s stopped innovating long time ago. Then look at the last chart below
Telco’s are not only not innovating, but actually helping monetizing others R&D, foremost their vendors (Huawei, Ericsson, Cisco, Nokia, ZTE…). Just compare vendor revenue growth with Telco revenue growth the chart in the beginning.
Cost cutting to the bone
To start-off, cost efficiency is important and Telcos have to act. But an while an act is something reasonable, overreaction is a sign of helpless hysteria. In most cases saving should cover the investments for network expansion in most cases. Given the argument, that Telco pay for vendors revenue growth, this appears as a cut in own flesh. There is a limit to reduction of 3rd party Opex and Capex, depending on the bargaining power and cost cutting gets particularly emotional when it comes to workforce reduction.
There are healthy methods to efficiency: automation has improved productivity in-house, while outsourcing at least promised some economies of scale efficiencies. Managed services is a great operational model as long as contract is not binding 3rd party exclusively. Yet in most of the large scale cost cutting problems, savings were overestimated and cost of transformation underestimated. Rational choice dictates to stop bleeding, i.e. if total benefit goes negative. But, and this is not unique to Telco, swallowing sunk cost is unbearable for most.
Timeframe is another big hindrance: savings must be realized within 2–3 years. This is a reason why network sharing is barely used, albeit being one of the few cost-decreasing strategies (more on that in my other article)
Divesting assets is a healthy “de-grossing” which helps reduce overhead costs. Selling off stakes and units (especially cross-border) which do not hurt core business is reasonable. How far should divesture go? Telcos are selling off towers and fiber only to lease them back from the buyer is a big trend — the colloquial term is “Light Asset Model”. But check my simple math again: valuation of a “full-metal” Telco is between 5–8 EBITDA, whereas TowerCo’s multiples grow over >25! Arithmetically, a tower-less Telco would be worth far less.
Without Towers and Fiber how much is Telco worth in market capitalization terms? While short-term motivation for getting cash injection is clear, that cash is being invested mostly in something (equipment) which has a far lower value!
Value chain unbundling
“A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable” — Warren Buffett
In the early days Telco was a strong, vertically integrated business. Cost of entry (moat, or barriers to entry) are still very high, especially in wireless where newcomer would require coverage first in order to operate commercially. It is the reason why there are barely any newcomers, albeit some were successful, like Jio (and time will tell if Rakuten or Dish make the case)
From outside it may appear as a strong moat, where Telcos are in control. Only that it is not the case if we look at elements of the value chain. Below is my own vision of the current telco value chain based on a version my colleagues have designed.
Looking at classical chain (“NetCo-ServCo”) won’t reveal the true impact, hence we transformed it, from perspective of a digital service platform.
While no players aims to replicate the whole chain, what happens is that parts of it are being disrupted. As a result, the whole value chain is fragmented and telcos fight many battles! Right hand side (closer to customers) was first populated by MVNOs (operators without own network) and then by OTT and have pressured the top line (ARPU side) cannibalizing core revenues. Digital transformation lead to value chain insertion — by then a a crowded space by Hyperscalers (colloquial industry term for global DC/cloud operators like #AMZN, #GOOG or #MSFT). Left side (network) has long remained a well protected moat due to huge investment requirements. With emergence of private mobile networks even that moat is under siege.
The most protected moat — the network infrastructure, is something Telcos are giving up themselves by selling passive infrastructure to TowerCos, FiberCos and DataCenter operators. What these do in return is expanding their business operations in wider areas, evolving into Neutral Host operator.
Value Unbundling is driven by class of competitors which do not compete with Telco as a integrated model, but rather disrupting parts of the value chain. While aforementioned errors are rather due to Telcos internal actions, Value Unbundling is an external threat to which Telco has yet to find an answer.
