The Vertical Integration Downside: Lower Valuation

Singtel, Southeast Asia's largest telecoms operator, reported that annual net profit halved to S$554 million ($418 million), the lowest net profit in at least two decades. That performance by a leader in exploring additional lines of business illustrates three related strategic issues that eventually will be faced by every connectivity service provider serving the mass market.

The first issue is the exhaustion of legacy connectivity services markets. At some point, every customers that wants service will be buying it.

The second issue is the traditional difficulty or entering new markets, either in other parts of the ecosystem or in content or applications. Telcos have had a very-difficult time sustainably creating new roles for themselves elsewhere in the value system.

The third issue is the valuation penalty any successful “up the stack” asset (content, platform, application) has when buried within the telco organization. The same asset--inside a telco--earns a less robust valuation than that same asset, outside the telco organization.

That raises the issue of "how" a connectivity provider should "own" assets elsewhere in the value chain. Vertical integration actually seems to penalize the value of assets. Which suggests some strategy of ownership "outside" the connectivity organization.

Singtel has been trying to diversify for years, and has been a leader in exploring growth “up the stack” in the application layer, and beyond connectivity. So the inability to reap profit rewards is troubling. 

But some investments such as those in digital marketer Amobee and cyber-security firm Trustwave yielded weaker-than-expected returns, observers note. That is a recurring story for telcos who have tried for many decades to broaden their revenue bases in adjacent areas such as software or computing services. 

The next moves might pair infrastructure asset sales to fund investments in other growth areas such as financial services or gaming. 

At least part of the problem is valuation of telco infrastructure assets. Singtel notes that its infrastructure assets do not provide a valuation boost, compared to other suppliers that own fewer network assets. 

The other issue is that Singtel executives believe ownership of towers, satellites, subsea cables and data centers has not boosted Singtel’s valuation, compared to peers who own less of such assets. The expectation is that selling some of those infrastructure elements will free up capital to deploy in other growth areas. 

Weakness in mobile services revenue and market share is among the current issues. Mobile service revenue dropped 19 percent; blended average revenue per user fell 18.5 percent and subscriptions fell 3.6 percent over the last year, for example. 

That is not a unique problem. Globally, other service providers face low growth rates and falling ARPU. Saturation of mobile services--the industry growth driver for decades--is part of the problem. 

Beyond that, the typical telco must replace half of existing revenue every decade or so. We have seen that in fixed network voice services, mobile voice, long distance revenue and fixed network services generally. We have seen it in text messaging as well. 

source: IP Carrier

source: FCC  

That might seem hyperbole, but is a demonstrable fact. Globally, that means telcos have to generate about $400 billion in new revenue just to replace what they will lose over the next decade.  

Singtel’s issues really are the same issues every connectivity service provider eventually will face.

SD-WAN Gains, As Expected

SD-WAN is gaining traction in the digital business environment, a new survey conducted by Altman Solon for Masergy finds.  SD-WAN adoption is expected to rise to 92 percent of companies and 64 percent of sites by 2026 with most adopting it for efficiency (38 percent), cost savings (38 percent), and agility (34 percent).

source: Masergy

A majority of companies will use hybrid SD-WAN. Some 58 percent expect to use a hybrid access model (a mix of both public and private access) over the next five years. Both private-only access users (63 percent) and public-only access users (55 percent) are considering a shift to hybrid access. 

Among respondents using a public-only or internet-only approach to SD-WAN, 50 percent said they would incorporate more private access because performance is insufficient for their critical applications.

About 23 percent of respondents use a do-it-yourself solution, and 77 percent use a fully managed or co-managed solution.

Though "Just Another G," 5G Already Enables New Revenue Sources

Oddly enough, both challengers and incumbents in the U.S. mobile market make the same argument: they are monetizing 5G right now, irrespective of new use cases and revenue sources. 

In Verizon’s case the actual revenue driver is not 5G as such, but a shift by customers to higher-priced unlimited-usage plans. 

“Our service revenue is growing all the time because we have this migration going from limited to unlimited premium,” said Hans Vestberg, Verizon CEO. “So, we are going to have the majority of our customers unlimited.”

In a sense, 5G is being monetized as part of the shift to higher-priced service plans. “Sometimes people ask about when will you monetize 5G?” said Vestberg. “We're already doing it” in the form of higher average revenue per user, driven by the migration to unlimited-usage plans. 

Beyond that, some mobile service providers believe they are better positioned to capture market share, or have better assets in place, and can simply introduce 5G using normal or relatively normal capex spending they invest annually. 

"One of the questions I've gotten for years as we planned this midband-centric 5G mobile Internet pure-play is, 'how are you going to monetize 5G?' And I've always thought it was kind of a crazy question because 5G is just the next G," said Mike Sievert, T-Mobile CEO. 

source: Bloomberg 

T-Mobile's equity valuation, for example, has far exceeded that of AT&T and Verizon, both of which have been seen as no-growth assets by investors. The reason is simply that T-Mobile can continue to grow without necessarily finding or creating new revenue sources. It simply has to keep taking market share. Cable companies are in the same position. Invention is not required.  

T-Mobile’s  merger with Sprint gave it a trove of 5G spectrum and other assets that arguably mean it will enjoy at least a temporary lead in 5G coverage and, soon, speeds across its footprint. And T-Mobile has been taking 4G share for years. 

AT&T and Verizon, on the other hand, have had to spend heavily to acquire 5G spectrum, and also face market share losses to T-Mobile and cable operators. That being the case, they need new revenue sources to justify that spending. 

So though there are two different ways of looking at 5G, the immediate boost in revenue from 5G is coming either from higher market share (T-Mobile) or higher ARPU (Verizon). 

The first view is that 5G, by design, will support internet of things and other ultra-low-latency applications that 4G actually cannot. The foremost defenders of that view tend to be infrastructure suppliers, for the simple reason that this argument tends to spur purchasing by mobile service providers. That is a longer-term potential source of growth. 

The second view is simply that mobile networks get upgraded about every decade, to support higher bandwidths and lower costs per bit, so the immediate advantage is simply lower cost per bit.

Mobile service providers tend not to want to talk about that so much, for the simple reason that investors never are too excited about capital investment that essentially is “maintenance” spending, rather than investment to capture new revenue sources. 

But lower cost per bit enables the “unlimited” offer, which leads to higher ARPU. Lower cost per bit also enables home broadband using the mobile network. So 5G, by enabling lower cost per bit, also makes possible home broadband services using the mobile network. 

In that sense, 5G enables fixed wireless for home broadband, a new revenue source.

Vertical Integration or New Ecosystem Roles? Two Different Views

The prevailing wisdom about connectivity provider ownership of content assets always seems to be that bundling access to content with connectivity boosts revenue per account. The idea seems to be that vertical integration with content ownership benefits the connectivity provider primarily as it adds value to the connectivity product. 

The logic is sound enough, as far as it goes. But it might also miss another point. In the internet ecosystem, only so much value can be driven in any single segment of the value chain. An alternative idea is to participate in the revenue upside in multiple segments of the value chain--vertically integrated or not--as a way of growing total revenue, free cash flow or profits. 

In that view, while synergies are helpful, the larger issue is sustainability. To the extent that every connectivity product eventually becomes mature, and to the extent big new connectivity products are hard to discover or create, it is helpful if connectivity is not the only role within the ecosystem, or source of revenue.

Looking only at equity value, application providers vastly outproduce connectivity providers, looking at share price appreciation, for example. In the U.S. mobile market, only T-Mobile has been able to produce equity value growth at half the rate of firms such as Facebook, Amazon, Apple, Netflix and Google. 

AT&T and Verizon have experienced flat growth since 2016. The difference is that T-Mobile is able to grow by taking share in the core connectivity business, the same formula used by cable operators. 

source: Bloomberg 

Eventually that exhausts itself. Eventually, as has been the case since the advent of deregulation starting in the mid-1980s, big new product categories must be created beyond mobility, the current revenue driver. 

One sign of the looming exhaustion of mobility in advanced markets is steadily declining average revenue per user or account. 

source: Bloomberg 

The difficult, but obvious solution, is that connectivity providers have to participate more broadly in other segments of the value chain. This is different from “vertical integration.” Fundamentally, the additional roles need not directly contribute to core connectivity value or revenue. 

What those roles must do is create additional and sustainable revenue, allowing firms to diversify their value, roles and revenue sources away from a strict reliance on connectivity revenues and services, even if such roles remain crucial. 

Perhaps an analogy is the move by Apple from reliance on hardware sales with the addition of services, content and apps. 

Amazon’s move into logistics is more an example of vertical integration, a way to reduce operating costs. Netflix original content is a similar “internal” move, designed to create distinctiveness for its streaming service, and is essentially an example of vertical integration. 

Likewise, Facebook and Google own undersea capacity networks precisely because doing so reduces their operating costs. Amazon, Facebook and Google build their own servers and own their own hyperscale computing centers for similar internal reasons. Vertically integrating such functions reduces operating cost. 

That is not necessarily the value of connectivity provider movement into additional roles within the ecosystem. When they have been successful, connectivity moves into data center operations, content ownership, mobile banking or payments, app stores or cloud computing have less reduced internal operating costs and more increased value, roles and revenue within the ecosystem. 

if the core business keeps shrinking, new roles will have to be found. 

Ericsson offers a fairly simple argument for why big service providers have to consider moving into other areas of the information ecosystem: growth will not be found in the consumer connectivity business. 

Simply put, growth rates in the consumer communications business are forecast to grow only about 0.75 percent per year to 2030, while the broader information technology business grows at a compound annual growth rate of 12 percent per year.  

source: Ericsson

In the connectivity business, suppliers lose half of legacy revenue every decade, and have seen this happen virtually every decade since competition replaced monopoly as the industry structure. Do “nothing” and the core business is guaranteed to shrink. 

Just to keep revenues where they are, new sources of revenue, amounting to half current revenues, must be found every 10 years. 

The point is that connectivity  providers eventually will find new roles (larger or smaller) within the value ecosystem. Many firms will lack scale to do much other than supply local connectivity, and will be acquired or sold. Firms with scale will gain scale, but vertically within the stack, rather than simply horizontally.

If Bell Labs is correct, the key value proposition for the “communications” business will shift from “we connect you” to something else. It might seem quite ethereal. Someday it will be seen as eminently practical.

Is IoT Digital Transformation?

The global IoT market is projected to reach $1.5 trillion by 2030, says Ericsson. Presumably that includes the value of devices, software and services used to support IoT. Ericsson also links that growth to possibilities for “digital transformation.” 

Ericsson does not specifically define the term, but suggests it has to do, at least in part, with listening to customers; focusing on users; using data to generate insights and applying insights to create new products. 

It is that last suggestion--creating new products--that is the connection to “digital transformation.” One working definition of DX is that it is the application of technology to change current business models.

A business model is everything an organization does to make a profit, including customers, products, sales methods, fulfillment and monetization methods. To the extent that IoT creates new customers and products; uses different sales methods or fulfillment or new revenue sources, IoT is applied digital transformation.  

By 2026, there will be almost 27 billion connected devices, says Ericsson.

Telcos Have Stopped Losing Home Broadband Market Share to Cable

U.S. telcos have about 31 percent share of the installed base of U.S. home broadband connections, while cable operators continue to hold about 69 percent share, according to Leichtman Research data. 

Cable operators garnered about 92 percent of the net new additions in the first quarter of 2001, while telcos added about eight percent of the net new additions. 

That is modestly good news for telcos. For most of the last 20 years telcos have seen modest, if any, market share gains and almost continual shrinkage of the installed base. In some years past cable operators have gained more than 100 percent market share, as telco subscriber counts were negative. 

Over the past decade or so, cable has gained a bit more than 80 percent market share in every quarter, so one might argue that telco net additions have waned a bit, even if telcos have stopped losing market share every quarter in 2020.

Broadband Providers

Subscribers at end of 1Q 2021

Net Adds in 1Q 2021

Cable Companies
Comcast*	31,034,000	460,000
Charter	29,234,000	355,000
Cox**	5,435,000	55,000
Altice	4,370,800	11,600
Mediacom	1,454,000	16,000
Cable One	880,000	23,000
WOW (WideOpenWest)	823,800	10,000
Atlantic Broadband	511,004	6,383

Total Top Cable

73,742,604

936,983

Wireline Phone Companies
AT&T	15,435,000	51,000
Verizon	7,193,000	64,000
CenturyLink/Lumen^	4,728,000	(39,000)
Frontier	3,052,000	(17,000)
Windstream	1,122,300	13,000
Consolidated	794,224	2,024
TDS	501,700	8,400
Cincinnati Bell	437,600	1,500

Total Top Telco

33,263,824

83,924

Total Top Broadband

107,006,428

1,020,907

source: Leichtman Research 

While the turnabout does not necessarily mean telcos will challenge cable for the lead in installed base or market share, small gains are a vast improvement over installed base and share losses for two decades.

Can Tier-One Telcos Grow Enterprise Revenue?

Can Verizon Business grow revenue four percent per year? It might be able to do so. It is not so clear that more than a handful of tier-one service providers will be able to do so, though. 

One might ask the question in a broader way: can most tier-one service providers in mature markets do so?

Service providers in developing markets arguably can do better, but major service providers in developed markets have generally seen enterprise revenue contract in recent years.

U.S. fixed network business revenues are expected to keep falling. “The U.S. business wireline telecom services market will continue to slowly decline, shedding roughly $7 billion in revenue from 2019 to 2024,” said Amy Lind, IDC research manager, 

Globally, the GSMA says, “enterprise revenue is not growing significantly (at low single digit rates for many operators).

Many would argue T-Mobile is poised to grow far faster than that, based on the 10 percent share T-Mobile now has of enterprise customer spend in the mobile segment of the business. 

T-Mobile expects to grow its enterprise share (mobility) to more than 20 percent by 2025. That would require a growth rate of nearly 19 percent annually. Verizon has both fixed and mobile assets to leverage, and includes enterprise; wholesale; small and medium business and public sector customers in its domain. 

Other service providers lump small business customers into a mass market category primarily representing consumer revenues. 

T-Mobile also expects to grow its share of rural and suburban area customers from the low teens to nearly 20 percent in the same time frame. 

Challengers can grow by taking share, but market share leaders will likely have to look for new revenue sources, as the share leaders will be challenged to keep the share they presently have. 

That might come in a variety of ways. 

source: CapGemini 

source: CapGemini 

Verizon arguably already earns more IoT revenue than many other service providers. 

source: GSMA

And Verizon has a faster enterprise revenue growth rate than many other major providers. 

 

source: GSMA