Watch Out for Irrational Exuberance

Veterans of the telecom industry have lived through financial bubbles before. That is what happens when greed overcomes rational fears about over-investment.

As much as internet service, data transport providers and, in some cases, data center operators, must grapple with ever-increasing demand, those industries also have seen bouts of over-investment in capacity. Think about long-haul fiber transport in the late 1990s or excessive prices paid to acquire 3G spectrum in Europe. 

Excessive optimism led to mispricing of assets, over-investment, questionable growth metrics and outright fraud. Not to mention use of leverage. 

Asset-backed bonds played a role in the telecom collapse of 2001. During the late 1990s, there was a frenzy of investment in the telecommunications industry. Many telecom companies borrowed heavily to finance their expansion, and they often used asset-backed bonds to do so. These bonds were backed by the future revenue streams of the telecom companies, but when the telecom bubble burst in 2000, the value of these bonds plummeted. This led to a number of telecom companies defaulting on their debt, which in turn caused the collapse of the industry.

Merchant banking and excessive use of “junk bonds” also played a role. Telecom companies used merchant banking to finance their expansion by issuing high-yield debt securities, also known as junk bonds. These bonds were often sold to unsophisticated investors who were attracted by the high yields.

Synthetic securitization also increased risk., Synthetic securitization is a type of securitization that involves creating a security that is linked to the performance of another security. Telecom companies used synthetic securitization to transfer their debt to other investors. This allowed them to reduce their debt burden, but it also made them more vulnerable to default if the underlying assets declined in value, which they did. 

Off-balance sheet financing also minimized the actual amount of debt firms were taking on. 

Even debt-equity swaps increased risk. Telecom companies used debt-equity swaps to reduce their debt burden, but it also made them more vulnerable to default if their stock price declined.

Aggressive accounting practices also used aggressive accounting practices to inflate their profits. In some cases, such practices drifted into fraud. Think Worldcom and Enron. 

These risky financing schemes allowed telecom companies to borrow more money than they could afford.

It is the sort of “irrational exuberance” one often has to watch out for.

Mobile Operator Questions About 5G Payback Model Reflect 4G Experiences

Many in the mobile ecosystem ask the question “how will we make money from 5G? Fixed network operators have been asking themselves similar questions--"how do we get a payback from fiber-to-the-home?"--for several decades.

For mobile or fixed network operators, competition and changing demand make payback models uncertain and challenging. Where facilities-based competiton exists, the infrastructure cost per customer account always rises.

Stranded assets are the reason, though more an issue for fixed networks. In a monopoly market, the single provider might hope to get close to 98 percent take rates. In a competitive market with two equally-capable providers, each provider might hope to get 50 percent share of the installed base.

That effectively doubles the network cost per customer, as revenue is earned from about half of locations passed. In markets with three or more facilities-based competitors, cost-per-account increases more.

Demand changes also effect payback models. Fiber to the home once was underpinned by the assumption that there would be high demand for up to three services (voice, video and internet access).

As demand for fixed network voice and linear video subscriptions declines, the business model increasingly is built on home broadband. Voice and linear video help, but both are expected to keep declining.

But that has key revenue implications. Where a home location might have been expected to generate revenue of $80 to $200, the growing reality is that a location is expected to generate perhaps $50 in home broadband revenue, and then some amount of voice or other revenue from some locations.

Basically, revenue expectations--average revenue per customer or location--are effectively cut in half. That forces changes to the payback model on the cost side. Basically, costs must drop.

Those savings can come from intrastructure cost declines; operating cost drops; higher subsidies; lower maintenance costs; lower headcount and overhead or any combination.

The key point is that revenue assumptions for fixed networks increasingly are founded on lower gross revenue assumptions; revenue from additional sources; shared costs between mobile and fixed networks and more importance attached to defending market share or taking market share.

The parallel question asked by mobile operators--"how do we make money from 5G?--embeds some of the same issues faced by fixed network operators.

What the question likely means is less an uncertainty about revenue drivers and more a concern about the distribution of value within the ecosystem: will mobile operators reap a fair share of 5G benefits (higher revenue, higher profits, higher market share, lower operating costs)?

Looking only at consumer retail costs--exclusive of experience advantages such as higher speed; lower latency; new services or capabilities--it is not yet completely clear that average revenue per 5G account is higher than 4G ARPA.

5G has proven to generate higher ARPA in some markets, however.

It is a virtual certainty that 4G and older connections will be replaced by 5G. So the baseline for 5G revenue is 4G revenue. Beyond that, there is expected upside from private networks, network slicing (virtual private networks), edge computing and new enterprise connections to support internet of things use cases. 

To be sure, many wonder whether “we can charge more for 4G?” The long-term answer is not yet knowable, but the practical answer might well be “yes.” 

And that can be true even when direct tariffs for 5G are not that different, if different at all, from 4G tariffs. Some mobile operators do not charge a premium for 5G, but expect to gain market share, which drives higher 5G revenue.

Other service providers provide incentives for customers to use 5G but with a price increase coming in the form of unlimited usage. The actual driver of higher revenue per account is the shift to a higher-priced “unlimited usage” tier, not 5G as such, though such plans include 5G access at no extra charge. 

And though we have not seen it much, if at all, some mobile operators might decide to institute speed tiers for mobile service that mimic the ways access is sold on fixed networks. Customers might be offered lowest prices for lowest speeds; mid-tier pricing for mid-tier speeds and premium prices for the higher speed tiers. 

But there is another sense in which the question of “how will we make money from 5G?” can be understood.

Customers got value in terms of higher speeds when 4G was introduced. Mobile operators expected to sell more data, which would generate more revenues, and also create new services that would further increase revenues. 

But tough competition in many markets meant that mobile operators were not able to charge a price premium for 4G access. So the benefits went largely to consumers, according to ING analysts. “They got more data, better speeds and often paid less,” ING says. 

Governments also raised billions in revenue from spectrum auctions.

So one way of understanding the question about 5G revenues is the distribution of value and revenue for mobile operators within the 5G ecosystem. The downside for mobile operators is lower recurring revenues from 5G, compared to 4G. 

“Operators do not want to repeat these mistakes” seen in the transition from 3G to 4G, ING notes. But some might argue that the long-term trend will be difficult to break. 

source: Statista 

source: Strategy Analytics

source: Researchgate  

Taking market share, shifting customers to pricier accounts and increased usage charges are the immediate ways mobile operators have boosted 5G revenues over 4G levels. 

Longer-term pricing trends, though, might be difficult to change, as prices have been declining since 1996. 

On the other hand, the whole reason we see a next-generation mobile network about every 10 years, since 3G, is that capacity demand by customers keeps climbing. And while mobile operators can increase effective capacity using small cells and better radios, at some point an increase in spectrum is required. 

Also, as modulation and coding gets better with each successive generation, the cost to deliver a bit drops, allowing mobile operators to supply data consumption demand at lower costs. 

So another way to look at the payback model is to ask “what happens to your business if you do not upgrade to 5G?” Defending existing market share is a legitimate business outcome. 

Creating a more-efficient data network that supplies demand affordably also is an important business outcome. And to the extent 5G network capabilities are required to support dense internet of things networks, edge computing networks and network slicing, not investing in 5G forsakes any revenue opportunities in those areas. 

In many ways, that is akin to the value of fiber-to-home networks. In many cases, higher revenue per account is not expected. The business value instead comes from consumer market share gains, market share defense and the ability to compete in those markets. 

There is incremental value in terms of backhaul support for mobile small cell networks or business-grade services for smaller businesses. There is value in reduced operating expenses and possibly headcount. 

In other words, there are lots of ways 5G contributes to overall business value for mobile operators that go beyond direct tariff increases.

The "5G Race" Storyline is Wrong, As Are So Many Others

The “5G race” story framework seemingly is irresistible: there will be winners and losers, with the winners moving fastest to deploy the networks. The only problem with the storyline is that it likely will prove to be false. 

Does anybody really believe being “first” with analog mobile services, or any of the past digital generations (2G, 3G, 4G) has mattered? Has it changed the economic positions of nations, or industries, beyond what we would expect for other reasons?

In other words, does early or late adoption actually matter? A fair assessment might be that it could matter for industry suppliers, in terms of market share. Some might argue Huawei gained from early supply of some 5G infrastructure, while Nokia suffered. 

On the other hand, the new emphasis on open and virtual networks opens the door for new suppliers, which might make early victories by incumbents irrelevant over the longer term, as new firms enter the supply chain. 

“Early or late” might temporarily provide advantage or disadvantage for particular mobile operators in some markets. But making sense of the advantage also must include the momentum and growth profiles of each firm before 5G. Maybe a firm gains or loses share in 5G because it already had been gaining share in 4G, for reasons unrelated to 5G deployment. 

Among the historical examples of the irrelevance of the early-late paradigm is the development of several technologies in the U.S. market, where adoption always has been “late.” That is said to be true now of U.S. 5G speeds. It is true for the moment, but ultimately the relevant gap will disappear. 

That does not mean U.S. speeds, on average, will be among the top 10 globally, for example. U.S. mobile speeds are slow, and have been relatively slow, for 4G services, compared to many other markets. The point is that it will not matter, in user experience or other expected benefits (for industry, firms, economic growth, innovation). 

But the “U.S. is behind” storyline has been used often over the last several decades. Indeed, where it comes to plain old voice service, the U.S. is falling behind meme never went away.

In the past, it has been argued that the United States was behind, or falling behind, for use of mobile phones, smartphones, text messaging, broadband coverage, fiber to home, broadband speed or broadband price. 

In the case of mobile phone usage, smartphone usage, text message usage, broadband coverage or speed, as well as broadband prices, the “behind” storyline has proven incorrect, over time. 

Some even have argued the United States was falling behind in spectrum auctions. That clearly also has proven wrong. What such observations often miss is a highly dynamic environment, where apparently lagging U.S. metrics quickly are closed.

To be sure, adoption rates have sometimes lagged other regions. Some storylines are repeated so often they seem true, and lagging statistics often are “true,” early on. The story which never seems to be written is that there is a pattern here: early slowness is overcome; performance metrics eventually climb; availability, price and performance gaps are closed over time. 

The early storylines often are correct, as far as they go. That U.S. internet access is slow and expensive, or that internet service providers have not managed to make gigabit speeds available on a widespread basis, can be correct for a time. Those storylines rarely--if ever--hold up long term. U.S. gigabit coverage now is about 80 percent, for example. 

Other statements, such as the claim that U.S. internet access prices or mobile prices are high, are not made in context, or qualified and adjusted for currency, local prices and incomes or other relevant inputs, including the comparison methodology itself. 

Both U.S. fixed network internet prices and U.S. mobile costs have dropped since 2000, for example. 

The point is that the “U.S. is behind” storyline seems irresistible. But it also ultimately is meaningless. All the relevant gaps were eventually overcome. One possible explanation is that U.S. service providers, who earn high profit margins compared to most other countries, upgrade deliberately, to maintain margins, rather than necessarily rushing to “be first.”

Consumer demand also is an issue. It can be argued that U.S. consumers wait to see value before adopting new technology, instead of rushing to buy the latest technology “just to be early adopters.”

The point is that the “5G is a race” is an irresistible storyline. But it arguably will be proven false. Countries, firms and consumers will adopt 5G when it makes sense, when it offers value, or simply as a byproduct of buying some other product, such as a desired phone model. 

That is, in substantial part, related to another problem journalists face, namely the “next big thing” storyline that becomes news because that is why proponents and vendors are pushing. Many journalists would probably agree that they tire of writing stories about the next big thing, or the present big thing, over and over again. It seems to be an occupational hazard. 

But the point is that easy storylines are irresistible for possibly lazy journalists. To be sure, deadlines create the need for story construction tools, including the venerable “two sides” framework (he said, she said). We all use such tools. 

That is why elections are characterized as horse races, or why verification matters. Still, some might argue that a bit of  laziness is why verification is sorely lacking, or why more original stories are not routinely created. It is not easy to do so routinely. It is harder work. But sometimes it leads to “better” storytelling.

Telco Stranded Assets for Voice, Internet Access as High as 75%

Facilities-based competition radically changes the economics of any fixed network access market because it radically disrupts the ability to reap financial returns from any network investment. The math is pretty simple. All monopoly-era mass market networks assumed the customer or user base was nearly “all” households or consumers. 

So “network cost per customer” or “per user” was nearly identical with “cost per location.” Likewise, “revenue per location” was nearly identical with “location.” 

That all changes with facilities-based competition. Assume two equally-skilled facilities-based competitors operating ubiquitously in any area, one the legacy monopoly provider, the other a challenger. 

Assume that, over a period of perhaps a decade, a former monopolist loses 50 percent market share to the new competitor. By definition, the revenue per location drops in half, while the cost per location doubles. 

Telco losses in the U.S. market have been far worse than that. Taking all voice lines into consideration, fixed network share of voice lines (all suppliers) now is about 35 percent. Mobile has 65 percent share of accounts. 

source: US Telecom

Looking only at fixed network accounts, U.S. telcos have about 36 million accounts, while competitors (cable providers and independent VoIP providers) have 62 million accounts. If there are roughly 146 million household locations, telco sales of voice reach only about 25 percent of locations. So voice stranded assets are as high as 75 percent. 

source: US Telecom

In the increasingly core internet access business, telcos have about 38 million accounts, or about 26 percent of locations. So stranded internet access assets are as high as 74 percent. You might make roughly the same argument for video entertainment accounts. 

All of that arguably translates to low profit margins. 

source: US Telecom

It gets worse. Assume that for some services, there actually are three, possibly four facilities-based suppliers (satellite video providers, for example). Assume those competitors are competent as well. Assume those other competitors have a combined 20 percent market share.

Then the two fixed network providers have a theoretical 40-percent market share. That reduces revenue per location further, and raises cost per location. So 60 percent of the network investment is stranded. 

Further assume customer demand changes that steadily reduce revenue to be earned on the network. You can see this in voice take rates and now linear video take rates. That further raises cost per location and reduces revenue per location. 

To be sure, scale matters in the telecom industry, as it does in many capital-intensive industries, because heavy capital investment means financial returns are boosted by intensive use of those assets. 

Perhaps another way of saying “scale matters” is to note that market share matters for profitability. 

So network utilization--the ability to load revenue-generating traffic and services onto the network--has been a key issue for at least two decades, especially where facilities-based competition is possible. 

Typically, in any market, the supplier with the largest market share also is the most profitable. In the mobile phone business, it has been true for some years that most actual profits in the handset supplier portion of the ecosystem have been reaped by just two firms, Apple and Samsung. 

One salient feature of the internet ecosystem is that it tends toward “winner take all” market structures, whether one looks at the application, operating system, device or access parts of the ecosystem.

In the application space, advertising revenue is dominated by Google and Facebook, which claim 63 percent of U.S. digital ad revenue in 2017. In the operating system market, Android and Apple iOS were the leaders, with 99-percent market share. The device portion of the market is the least concentrated, although Apple and Samsung have earned most of the profits.  

Mobile and fixed network access markets likewise are oligopolies, in virtually every market. Fixed markets in many cases remain virtual monopolies, while mobile markets tend to be oligopolies.

source: MTN Consulting

But scale alone is proving to be an elusive way of assuring profits. 

Business strategies in the global telecom business have changed over the past four to five decades. Five decades ago, profits were driven by long distance calling and the base business was selling monopoly voice to everyone. 

Sometime in the 1980s the revenue and profit growth shifted from fixed network long distance to mobility. Fixed network operators facing stiff competition switched to a multi-product consumer services strategy. 

By the 2000s subscription growth drove mobile revenues. By the 2010s internet access began to be the revenue driver for fixed and mobile operators, not voice or subscriptions. 

It might be a matter of debate how much internal industry decisions and external forces have shaped strategy. 

As we enter the 5G era, it is possible to say that the fortunes of some mobile operators were determined early in the 3G era. Though it is reasonable to suggest that issues ranging from addressable internal market to regulatory policy have mattered, some argue that excessive spending on spectrum licenses for 3G created debt problems that hobbled mobile operator ability to foster growth.

But business strategy might also have played a role. When organic growth is quite slow, one obvious solution is to expand geographically, buying market share out of region, in other words. Many European firms, for example, went on a huge global expansion spree in the 3G and 4G eras. 

It also is impossible to ignore the impact of the internet and IP generally. Those trends essentially opened up the communications networks, ending the walled gardens that historically characterized telecom business models.

At the same time, the end of walled gardens, and the ease of competing “over the top” also mean that any telco-owned apps often must compete with third-party apps. And telcos never have been known for their prowess at creating big and popular new apps. 

Historically, there has been a simple solution for telcos wanting to enter new lines of business: acquisition. 

The new problem is that app provider market valuations and multiples make acquisitions of such firms expensive for telcos. In other words, telcos contemplating big app asset acquisitions encounter the price of expensive-currency assets to be bought with cheap currency. 

That has restricted the historically-important acquisition method telcos have used to enter new markets. In the past, most telcos have gotten entry into new and faster-growing markets by acquiring, rather than building, the new businesses. 

That is much harder when the would-be acquisitions are of high-multiple application suppliers, using low-multiple telco stock or borrowed money. Most telco free cash flow typically must be deployed to pay dividends and reduce past borrowings. 

Taken together, all those trends now suggest that decades-old geographic expansion plans conducted by some mobile operators now are unwinding, as the contribution to revenue growth has not often been matched by increases in profits. 

And that poses new strategy issues: where is revenue growth to be found if geographic expansion, once a logical path to growing revenue, is unavailable? The other logical answer--acquisitions of fast-growing firms in new markets--often is impossible because the market multiples of such firms are high, while telco valuations are low. 

In other words, acquisitions big enough to move the revenue needle cannot be made. Smaller acquisitions are possible, but often, because of small size, cannot move the revenue needle. And, in any market where scale matters, organic growth might never be fast enough to gain leadership. 

Most telcos, in most markets, have learned from their experiences with overpriced spectrum bids. Seldom, anymore, do spectrum prices seem unreasonable. On the other hand, the core telecom business is in slow growth mode in most markets, if still relatively higher in some emerging markets. 

Among the big new questions--if geographic expansion is not generally feasible--is how to reignite growth, especially in promising new markets. 

Compounding those questions is the growing need to look at revenue growth from outside the legacy domains based on connectivity services. Almost everyone assumes that will be quite difficult.

The traditional fear is that telcos really are not good at running businesses outside their core. And there are good reasons for that opinion. But with growth so slow in the core business, and competition not abating, while geographic expansion often is unpromising, telcos may ultimately have no choice. 

Of course, there are other paths. It might well be that most telcos will be unable to sustain themselves over the next few decades, as they are unable or unwilling to expand beyond connectivity. In that case, bankruptcy lies ahead, with potential restructuring of much of the business. 

Precisely how advanced connectivity still can be provided, if today’s business models fail, is not clear. It long has been the conventional wisdom that, in any competitive market, the low cost provider wins. Who those low-cost providers might be then is the issue. 

The other path, which only the biggest telcos might contemplate, aer risky, expensive acquisitions--exposing themselves to harsh criticism--to create new business models not so exclusively dependent on connectivity revenues. 

We already can see some illustrations of the stark choices. When big and small cable operators alike start to say their future is internet access, not video or voice, one must ask whether such a single product strategy will work, long term. The major reason why telcos and cable operators in the U.S. market have survived competition is a switch from single-product to multi-product strategies.

Essentially, they sell more things to a smaller number of customers. That might not work if the new model is one product sold to many customers, especially if the main competitors in those markets are competent. 

Cable operators clearly dominate market share in the U.S. fixed network internet access business. The issue is whether the business model works without other customer segments and products. If the answer is no, then the multi-product strategy will still have to be pursued.

The big shift might be from multi-product consumer bundles to multi-product operations based on consumer fixed network internet access, consumer mobility and business capacity services.

How Will Telco Strategy Change Next?

Business strategies in the global telecom business have changed over the past four to five decades. Five decades ago, profits were driven by long distance calling and the base business was selling monopoly voice to everyone. 

Sometime in the 1980s the revenue and profit growth shifted from fixed network long distance to mobility. Fixed network operators facing stiff competition switched to a multi-product consumer services strategy. 

By the 2000s subscription growth drove mobile revenues. By the 2010s internet access began to be the revenue driver for fixed and mobile operators, not voice or subscriptions. 

It might be a matter of debate how much internal industry decisions and external forces have shaped strategy. 

As we enter the 5G era, it is possible to say that the fortunes of some mobile operators were determined early in the 3G era. Though it is reasonable to suggest that issues ranging from addressable internal market to regulatory policy have mattered, some argue that excessive spending on spectrum licenses for 3G created debt problems that hobbled mobile operator ability to foster growth.

But business strategy might also have played a role. When organic growth is quite slow, one obvious solution is to expand geographically, buying market share out of region, in other words. Many European firms, for example, went on a huge global expansion spree in the 3G and 4G eras. 

It also is impossible to ignore the impact of the internet and IP generally. Those trends essentially opened up the communications networks, ending the walled gardens that historically characterized telecom business models.

At the same time, the end of walled gardens, and the ease of competing “over the top” also mean that any telco-owned apps often must compete with third-party apps. And telcos never have been known for their prowess at creating big and popular new apps. 

Historically, there has been a simple solution for telcos wanting to enter new lines of business: acquisition. 

The new problem is that app provider market valuations and multiples make acquisitions of such firms expensive for telcos. In other words, telcos contemplating big app asset acquisitions encounter the price of expensive-currency assets to be bought with cheap currency. 

That has restricted the historically-important acquisition method telcos have used to enter new markets. In the past, most telcos have gotten entry into new and faster-growing markets by acquiring, rather than building, the new businesses. 

That is much harder when the would-be acquisitions are of high-multiple application suppliers, using low-multiple telco stock or borrowed money. Most telco free cash flow typically must be deployed to pay dividends and reduce past borrowings. 

Taken together, all those trends now suggest that decades-old geographic expansion plans conducted by some mobile operators now are unwinding, as the contribution to revenue growth has not often been matched by increases in profits. 

And that poses new strategy issues: where is revenue growth to be found if geographic expansion, once a logical path to growing revenue, is unavailable? The other logical answer--acquisitions of fast-growing firms in new markets--often is impossible because the market multiples of such firms are high, while telco valuations are low. 

In other words, acquisitions big enough to move the revenue needle cannot be made. Smaller acquisitions are possible, but often, because of small size, cannot move the revenue needle. And, in any market where scale matters, organic growth might never be fast enough to gain leadership. 

Most telcos, in most markets, have learned from their experiences with overpriced spectrum bids. Seldom, anymore, do spectrum prices seem unreasonable. On the other hand, the core telecom business is in slow growth mode in most markets, if still relatively higher in some emerging markets. 

Among the big new questions--if geographic expansion is not generally feasible--is how to reignite growth, especially in promising new markets. 

Compounding those questions is the growing need to look at revenue growth from outside the legacy domains based on connectivity services. Almost everyone assumes that will be quite difficult.

The traditional fear is that telcos really are not good at running businesses outside their core. And there are good reasons for that opinion. But with growth so slow in the core business, and competition not abating, while geographic expansion often is unpromising, telcos may ultimately have no choice. 

Of course, there are other paths. It might well be that most telcos will be unable to sustain themselves over the next few decades, as they are unable or unwilling to expand beyond connectivity. In that case, bankruptcy lies ahead, with potential restructuring of much of the business. 

Precisely how advanced connectivity still can be provided, if today’s business models fail, is not clear. It long has been the conventional wisdom that, in any competitive market, the low cost provider wins. Who those low-cost providers might be then is the issue. 

The other path, which only the biggest telcos might contemplate, aer risky, expensive acquisitions--exposing themselves to harsh criticism--to create new business models not so exclusively dependent on connectivity revenues. 

We already can see some illustrations of the stark choices. When big and small cable operators alike start to say their future is internet access, not video or voice, one must ask whether such a single product strategy will work, long term. The major reason why telcos and cable operators in the U.S. market have survived competition is a switch from single-product to multi-product strategies.

Essentially, they sell more things to a smaller number of customers. That might not work if the new model is one product sold to many customers, especially if the main competitors in those markets are competent. 

Cable operators clearly dominate market share in the U.S. fixed network internet access business. The issue is whether the business model works without other customer segments and products. If the answer is no, then the multi-product strategy will still have to be pursued.

The big shift might be from multi-product consumer bundles to multi-product operations based on consumer fixed network internet access, consumer mobility and business capacity services.