Virtually all equity analysts subscribe to a particular view of how tier-one telcos should run their businesses. Basically, they should stick to their connectivity knitting and not attempt to diversify into other areas of the application, computing, content, financial services areas.
In that view, even if the telecom industry has low revenue growth, it should be able to wring cash flow margins (30 percent to 40 percent), with modest capex except when going through episodic technology upgrades about every decade, with recurring revenue sustaining their business models, argues Cestrian Capital Research.
Pre-tax free cash flow then could remain in the 20-percent range, and the ability to pay dividends in the five percent range.
The issue is whether that is sustainable long term.
And there are historical reasons for skepticism about moves into market adjacencies: telcos rarely have succeeded. In 1991, AT&T acquired computing firm NCR, then spun it back out in 1996 after discovering it could not create the expected synergies between computing and communications. In 1998 AT&T acquired Tele-Communications Inc., the largest U.S. cable TV operator, along with other assets intended to transform the legacy long distance voice provider into a broader business. AT&T, struggling with high debt, later sold the TCI assets to Comcast.
British Telecom BT and Deutsche Telekom have gotten into the content business, as have AT&T and Verizon. Some will point to financial underperformance by many leading telcos that have diversified, and argue the diversification failed.
Others might argue the issue is that the legacy revenue drivers simply are eroding faster than the new lines of business can be built. Traditionally, enterprise customers drove the bulk of profits for tier-one telcos. That has changed in the competitive era. Much the same trend can be seen even in the mobile data business that has over the past decade driven revenue growth in the mobile business, even as mobility has driven revenue growth for the global telecom business.
“We believe that telcos should reduce reliance on communication revenues by extending their reach across the telecom value chain,” say analysts at DBS Group. Nokia Bell Labs also believes the value proposition must shift from connectivity, as well.
Fundamentally, the telco problem is that prices for its core connectivity products are trending towards zero. And even with scale, near-zero prices will not sustain today’s business model.
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