Telcos are Not Rewarded for Capex at the Same Level as Data Center Operators Making the Same, or Similar Investments

Connectivity service providers typically are not rewarded at the same level as are data center investors, which suggests more retail telcos will have to consider spinning off assets and becoming specialists of various types to be rewarded by financial markets for investing in assets such as data centers or cloud computing assets, according to Bill Barney, Asian Century Equity Chairman. 

In this illustration, where a telco might get a valuation lift of about six to seven times the amount of an investment, a data center operator making the same size investment, in the same sort of asset, might earn a valuation multiple of close to 14 times. 

The highest valuation multiple is earned by a telco for investing in mobile spectrum, at better than 14 times the amount of the investment. 

A data center investment in more capacity or its network gets a valuation multiple of about 13 times, while a cloud computing investment gets a whopping multiple of about 35 times. 

Source: Asian Century Equity 

That suggests a telco would be better served to spin off a data center business unit, for example. On the other hand, telcos get rewarded for optical fiber investments at a bit less than the rate a data center operator gets for making an equivalent networking capital outlay. 

Bouygues Telecom Tries to Disrupt the French Market

We may soon see a test of the rule of three and rule of four in the France telecom service provider market, as Bouygues Telecom tries to move up from the third spot to number two. The rule of three suggests a stable French telecom service provider market would be led by three firms. The rule of four suggests the market share structure will be 4:2:1 (40 percent, 20 percent, 10 percent) in terms of shares held by the top three firms.

That is quite different from today's structure.

According to Bouygues, its mobile market share (excluding M2M accounts) stood at 16.4 percent in 2020. At that point, the firm was in fourth place behind Iliad with 18 percent, SFR with 24 percent and Orange with 30 percent share. Adding the M2M or internet of things accounts, Bouygues already had reached the third position in market share. 

The more important part of the story is that Bouygues has been gaining market share for at least a decade. In 2010 it had about eight percent share. The conglomerate’s mobile business has the highest growth rate of Bouygue’s businesses. Average revenue per account also has been rising. 

The company had 12 million mobile customers (excluding M2M) in September 2020, an increase of 455,000 new customers since the end of 2019, of which 181,000 were in the third quarter.

Bouygues Telecom had 1.4 million fiber to the home customers in September 2020, with 378,000 new adds since the end of 2019. The FTTH penetration rate continued to rise to 34 percent  versus 22 percent a year earlier. 

source: Seeking Alpha 

The company had a total of 4.1 million fixed network customers in September 2020. The roll-out of Bouygues Telecom’s FTTH network is accelerating with 15.8 million FTTH premises marketed at end-September 2020 versus 11.8 million at the end of 2019. 

Bouygues has raised its target to 27 million premises marketed by end of 2022.

After an acquisition adding two million accounts, Bouygue should have reached about two percent, possibly three percent additional share points. So the assault on number two SFR, and supplanting that firm, means an overall shift of about four points: moving from 20 percent to 24 percent, ideally based on taking two points of share from SFR in the process. 

When Bouygues is able to take customers directly from SFR, it gains double: growing its own share and reducing SFR’s at the same time. 

The other issue is that, depending on how one wishes to count market share, fixed network revenue and accounts might prove important. In fact, some might argue that Bouygue’s ambitions are based on gains in fixed network customers and revenues more than mobile accounts and revenues. 

In principle, a jump into second place--by market share--is possible. The French mobile services market is not so stable that movement at the top of the market is largely impossible. It would be quite difficult indeed to make such a move if Orange had 40 percent share rather than 30 percent. 

Were that the case, One could then expect SFR share to be about 20 percent or so, with a third provider having 10 percent or perhaps a bit more. Under such conditions, it is next to impossible for number three to supplant number two, and virtually impossible to overtake the leader. 

So far, though, Bouygues Telecom has been able to steadily grow both mobile and fixed network accounts, gaining market share in the process.

Telecom Firms Have to Take What the Market Gives Them

Business strategy for leading and specialist firms in any full-service, multi-product business always is constrained, especially when markets have reached a stable configuration. The leading two firms by market share actually have disincentives to launch attacks aimed at gaining share, though the temptation for the number-three provider to launch attacks is higher, if risky. 

Smaller firms simply have to find sustainable niches, and cannot contemplate broad market leadership. 

“The financial performance of the three large players improves with increased market share-up to a point, typically 40 percent,” said professor Jagdesh Sheth. “Beyond that point, diseconomies of scale set in, along with the potential for regulatory problems related to heightened anti-monopoly scrutiny.”

That perhaps explains the stability of market share once the pattern is established. Once reached, it is no longer advantageous to push for additional market share: the leader because diseconomies set in; for the number-two provider because it does not have the resources to dislodge the leader. 

When the market leader has share of 70 percent or greater, there might not even be room for a second full-line generalist provider. “When IBM dominated the mainframe business many years ago, all of its competitors had to become niche players to survive,” Sheth said. 

When the market leader has a share of between 50 percent and 70 percent, there is often only room for two full-line generalists. When the market leader enjoys considerably less than a 40 percent share, there may--temporarily--be room for a fourth generalist player.

The minimum market share for a company to be viable as a full-line generalist is 10 percent. 

“A stable competitive market never has more than three significant competitors, the largest of which has no more than four times the market share of the smallest,” BCG founder Bruce Henderson said in 1976. Professor Jagdesh Sheth likewise has written about the Rule of Three. 

Notably, Sheth’s analysis parallels competitive market outcomes predicted by Henderson in 1976, though few telecom markets yet seem to have the idealized pattern, suggesting the markets are unstable, and will continue to change. 

Still, Sheth’s rule of three observations do seem to apply fairly well to changes in the telecom markets in the competitive era, allowing for the existence of big original monopolists that were disrupted by the switch from monopoly to competitive frameworks. 

Sheth’s analysis suggests that a “typical competitive market starts out in an unorganized way, with only small players serving it.” Consolidation happens, resulting in the emergence of a handful of “full-line generalists” surrounded by a number of “product specialists” and “market specialists.” 

In other words, a small handful of market share leaders is augmented by many specialist firms of smaller size that do not serve the full range of market segments. You might say that mimics the long tail structure many markets--including the connectivity business--assume as well. 

“With uncanny regularity, the number of full-line generalists that survive this transition is three,” Sheth said. “Typically, the market shares of the three eventually hover around 40, 20 and 10 per cent, respectively.”

“We have found that the extent of market share concentration among the big three depends on the extent to which fixed costs dominate the cost structure,” according to Sheth. 

There are implications for specialist providers, as well.

Given that specialists can only survive in niches, the performance of specialist companies deteriorates as they grow market share within the overall market, but improves as they grow their share of a specialty niche. In other words, “lead in a segment” works, while trying to compete with the giants fails. 

However, specialists sometimes can make the transition to successful full-line generalists when there are two or fewer incumbent generalists in the market. There the strategy is to try and become a new number three in the generalist market. 

Specialists thrive especially when markets are fragmented, as by geography. Many smaller firms avoid competing with others in the same market segments because they operate locally. 

Successful “super-niche” firms might be functional monopolists in their small niches.

Firms sometimes try to grow by acquiring many smaller firms in a segment. That “roll up” strategy of amalgamating assets can lead to leadership of a niche, emergence in a broader or different category, especially if there is no viable third-ranked supplier to block them.

The general rule is that, for most firms, sustainability in a settled market hinges on clear adherence to a niche or super-niche.

How Do Markets Get to Stable Rule of Three, Rule of Four Shape?

“A stable competitive market never has more than three significant competitors, the largest of which has no more than four times the market share of the smallest,” BCG founder Bruce Henderson said in 1976. 

Assuming the rule holds for connectivity businesses, it is the structure we should eventually see in the global telecom business, which was, until the latter 1980s, not subject to the rules. Formal monopoly businesses--by definition--have no competition.

But if asked to predict the eventual structure of the industry, at least for the tier-one suppliers selling at retail to consumers and businesses, the rule of three and rule of four would have made sense. 

In my own work, I have found the rule of four more important than the rule of three, though both rules are related. The reason is that the rule of four essentially provided guidance about questions many had around 1995 when the U.S. fixed telecom market, for example, was being nearly fully deregulated, in terms of telecom competition. 

In addition to questions about “who” would enter the market, “what” they would do, “how” they would compete, “when” the market would stabilize and “why” some attack vectors would be tried, many contestants would have wondered about the level of eventual success. 

How well would attackers fare? What would be the eventual fate of the incumbents? 

Business strategy in competitive markets largely free of regulatory constraints and major entry barriers tend to evolve towards a specific and stable market structure including the “rule of three” and the “rule of four,” Henderson argued. 

The rule of three states that a stable market is led by three firms. The rule of four refers to the expected market share in a stable market, where leader market share is twice that of provider number two, and where the number-two supplier has share double that of the number-three provider. 

That creates a stable market share structure of 4:2:1. It arguably is stable because there is little incentive for either number one or number two to disrupt the market by attacking to gain share. 

The number two supplier--with half the share and revenue of the leader--never has the ability to beat the leader in a long price war. The leader, on the other hand, generally is the most profitable of the top-three firms and risks that level of profitability if it provokes a market share battle that reduces profit margins. 

The leader might also trigger antitrust action were it to become significantly bigger. 

There are both strategy and tactical implications flowing from the rule of three and rule of four. 

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If telecom deregulation produced large numbers of new competitors, a contestant shakeout would be nearly inevitable. Surviving firms would need to produce revenue and customer growth rates above market averages, as the number of suppliers shrinks. 

The eventual losers would have increasingly large negative cash flows if they try to grow at all. Think about the experience of most competitive local exchange careers in the immediate aftermath of the Telecom Act of 1996 deregulation, the upstart digital subscriber line specialists of the same era, the legacy long distance providers, the bandwidth barons of international capacity, the fate of most independent mobile service providers from the earlier days of the mobile business or most independent cable TV providers. 

In all those cases, growth proved too difficult--in large part--because it was too capital intensive for firms that were not making profits. Sustainable profitability would be difficult for any firms aside from the leading and number-two firms. 

In competitive markets, share less than 30 percent of the relevant market--or at least half the share of the leader--would prove highly risky and likely unsustainable. 

In most deregulating markets, and especially when technology enables new ways to create and deliver products, at different price points and production costs, moats or defensive boundaries separating industries and roles become porous. It no longer is so easy to determine “who are our competitors?” 

The change in retail prices matters. Prices tend to fall in deregulating markets, and especially in those segments of the market where demand shifts rapidly. Voice, messaging and bandwidth costs are prime examples. 

Though arguably not the case in competitive telecom environments, if prices do not change,   competitor willingness to invest at rates higher than the sum of both physical market growth and the inflation rate will shift market share. That arguably has not been the case in the competitive telecom markets, as prices have continually fallen. 

Over-investment then becomes a hazard. If everyone is willing to invest at rates higher than revenue growth, then prices and margins will be forced down by overcapacity until firms stop investing.

In a competitive market, the low-cost provider tends to win. But if the low-cost leader holds prices too high, that provider will lose market share until the firm is no longer the market share leader. In markets where the top two providers have nearly the same share, all the other contestants tend to lose share over time. 

When the two top providers instead maintain higher prices, they both lose share to the other competitors. Market leaders can protect price at the risk of losing share. Paradoxically, when leaders cut prices, they hasten their dominance by creating the rule of three and rule of four market structures. 

The faster the industry growth, the faster consolidation occurs.

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Still, few mobile markets have the stable 4:2:1 market structure. Until recently, many observers would have argued that the U.S. mobile market was a structural duopoly. It is possible that will change in the wake of the T-Mobile merger with Sprint.

Sometimes Access Speed Does Not Differentiate in a Positive Way

Though U.S. industries get varying scores on the American Customer Satisfaction Index, there sometimes is more divergence within each category than between categories. Consider internet access service. 

In the ISP space, for example, Frontier Communications gets unusually low scores, compared to Verizon’s fiber to home service, likely because Frontier connections use slow digital subscriber line platforms, much of the time. 

It is harder to explain relatively poorer satisfaction with Altice or Mediacom services, as both seem to offer high broadband speeds. Presumably customer operations or prices are the issue there. 

Consider also that CenturyLink (now Lumen Technologies) scores the same as Charter Communications, though Lumen access speeds are decidedly lower than Charter’s speeds. Where Charter customers get an average of 95 Mbps, Lumen customers get about 35 Mbps. 

Access speed alone does not seem to explain very much. Something else in the experience seems to be operating. 

source: ACSI   

Customer satisfaction ratings for the linear video subscription business and internet service provider businesses historically have ranked at the very bottom of all industries measured by the American Customer Satisfaction Index. Mobile service has ranked higher in recent years, indeed scoring the highest of all telecommunications services. 

Since 1995, fixed network phone service has dropped significantly from fairly high levels of satisfaction. That might require some interpretation. Most U.S. consumers do not buy the product anymore, so the remaining customers seem to be showing modest satisfaction. Presumably the non-buyers consider the product to be unsatisfying. 

Video streaming services rank higher than linear video services, which might make sense given the growth of streaming services and the slow decline of linear services.

AI Will Mediate between IoT Devices and 5G Networks

In his talk at PTC’21 on Monday Jan. 18, 2021 (1 p.m. Honolulu time, 6 p.m. EST), Jefferson Wang, Accenture managing director for network and connected solutions, will explain how 5G, artificial intelligence and the internet of things are directly related. (register here)

Viewing all three technologies--5G, IoT and AI--are building a platform for enterprise digital transformation, Wang sees artificial intelligence and edge computing mediating the interactions between the connectivity network and the sensing devices. 

Basically, AI and edge computing orchestrate the interactions between networks, devices and analytics that provide the business value. 

source: Accenture

Perhaps more to the point, it is AI used by the controlling applications supervising the sensor networks and analytics that will do the mediation. As always, “value” is going to be differential. 

The highest value arguably will come when the analytics are able to adjust devices and processes in real time based on the analytics. The role of 5G and other communication networks will vary. When ultra-low latency is necessary, communications between sensors and analytic functions might take place directly on the premises. 

That might involve a private 5G network of some sort, without backhauling traffic to the public network. In such cases, the value produced by the public 5G network is lower. In other cases the edge computing functions will happen off premises someplace, in which case the 5G public network is more important. 

The 5G public network arguably has greatest value when a network slice is invoked, allowing all end points and processors on the private network to operate with the lowest possible latency and with some guaranteed level of throughput and performance.  

C-Band Spectrum Arguably is a Strategic Investment, Hurdle Rates be Damned

Typical investment hurdle rates exist in every business, but 5G might represent a challenging hurdle for most mobile operators. The hurdle rate is the rate of return above which an investment makes sense. 

In that regard, some argue that many telcos have failed to earn that rate of return on investments in fiber-to-home networks. Mobile operators arguably have done better than fixed network operators, as a rule.  

Some say telcos generally have failed to recover the cost of capital for perhaps a couple of decades. 

Still, there occasionally are big investment decisions that are not directly bound by that logic. Sometimes strategic investments are made, even when the normal payback models are stretched. Whatever the typical investment hurdle rate, strategic considerations sometimes compel investment even below the hurdle rate. 

Some of us remember roughly similar questions and answers asked about fiber to the home investments as well, back before the turn of the 21st century. 

One CEO, asked privately and off the record about the magnitude of FTTH investments, said the upside was “we get to keep our business.” Note: the argument was not “we will make more top-line revenue.” The justification was existential: “we get to stay in business.”

Similarly, one might argue that traditional rate of return considerations are not necessarily and directly driving the effort by mobile operators to acquire C-band spectrum to support 5G. As FTTH was viewed as a “do it or lose your business” investment, so might mid-band spectrum be viewed as the necessary price of competing in the U.S. 5G business. 

Strict hurdle rate considerations might be secondary to the necessity of acquiring mid-band spectrum, and lots of it, to remain competitive in the 5G era. There is risk in overbidding, but also risk in underbidding. 

It reminds me very much of the justification for FTTH deployment.