Vertical Integration is Risky, But Might be Imperative

Vertical integration now is becoming an important strategic issue in the applications and communications industries, welcome trend or not.

Whether or not most mobile and fixed communications operators are able to move up the stack,  Google is clearly moving down the stack into devices, retail internet access, undersea capacity and new access platforms. It is not alone.

Amazon’s purchase of Whole Foods, the grocery store, moves Amazon elsewhere in the distribution chain.

Amazon’s creation of its own air freight operation, and now its moves into retail package delivery provide other examples of app layer integrating backwards into the value chain.

source: wikiwand.com

And Amazon long ago got into the devices business (KIndles, Echos, phones, tablets).

In the video entertainment business, content networks and owners are moving to integrate content distribution platforms to go direct to consumers as well.

Apple designs its own integrated circuits.

As always, the point of such vertical integration is to capture business benefit. "Vertical integration is simply a means of coordinating the different stages of an industry chain when bilateral trading is not beneficial,” say McKinsey consultants.

Generally speaking, value chains that feature adjacencies where there are few sellers and few buyers create business risk.

Reliance on a single, or a few customers, is a source of business risk because of the implications of losing those few customers, or having them significantly reduce buying volume. Likewise, reliance on a single, or just a few products, creates similar risk.

For Google, internalizing undersea capacity assets simply saves it money, while providing better quality control and flexibility. Amazon finds the same motivations drive its creation of air freight and local delivery services.

For Google, creating its own devices supplies the same value as does Apple in tightly integrating software and hardware. On the other hand, intervening in the internet access markets causes all the traditional suppliers to upgrade the existing access infrastructure.

Few firms arguably succeed at vertical integration. But successful moves can create barriers to market entry by other firms. And that is why vertical integration matters.

AT&T believes it can, and likely must, vertically integrate. At the moment, its moves to become a content producer and owner are the most-obvious example. In the future, moves to integrate various internet of things applications, services and platforms are likely to be equally important.

Simply put, the mobile services business model has reached saturation in the U.S. market, and firms such as AT&T must find entirely new services to sell to its customers.

You would be correct in arguing that such vertical integration is highly risky, and that horizontal acquisitions make more sense for most firms, when possible. The problem is that horizontal growth sometimes is difficult to impossible.

In its home market, horizontal expansion is not possible for AT&T, for regulatory reasons. Horizontal expansion is possible internationally, but will not help decline in its core market, absent some significant vertical movement.  

For other firms, such horizontal acquisitions take lots of capital, and that generally means additional debt. That can be difficult in a business that normally requires fairly high levels of debt, in any case.

Winner Take All

Winner take all is major trend in the application business.  In the 2010 to 2014 period, the top 20 percent of companies in the telecom, media and technology industries captured 85 percent of the economic profit in TMT industries.

The top five percent of companies—including tech giants such as Apple, Microsoft, and Alphabet (Google’s parent)—generated 60 percent. You might note that scale plays a role. In most of these businesses, there are network effects: the more users, the more valuable the network; the higher the revenue potential; the greater the profit margin and equity valuation premium.

Telecom providers are not in comparable position to "take all," simply because their ability to reach huge scale is limited: regulatory barriers and capital requirements being the chief obstacles. For that reason, the access services business will remain more fragmented than the applications business.

source: McKinsey

How AI Can Help Telecom

McKinsey analysts believe a range of new technologies, including artificial intelligence (augmented intelligence) can help service providers reduce capital investment up to 40 percent and network-related operating expenses by 30 percent to 40 percent.

“We estimate that just 20 to 30 processes generate 45 percent of the average operator’s operating costs. Using advanced technologies, such as machine learning, to simplify and digitize those processes can cut costs by as much as one-third,” McKinsey consultants estimate.

“Our analysis suggests that a cost reduction of 30 to 40 percent and increasing cash-flow margins from 25 to nearly 40 percent is possible,” they said.

source: McKinsey

“One company we know had 600 IT systems; another had 3,000 prepaid plans,” the consultants said. “Self help” systems also can help.

“A mobile operator we know reduced the number of support calls it fields by 90 percent after it set up sophisticated systems to track and anticipate the problems of its customers and to give them resources to solve those problems on their own,” McKinsey consultants say. “Providing self-service guides and automatic tips about possible problems can help customers solve 75 percent of the issues themselves. Customers can solve an additional 15 percent of problems by using advice from instant-messaging chats (with employees or artificial-intelligence agents) or from online discussion groups. This leaves just 10 percent of problems to be handled at the costliest level of support: a phone call with a customer-service agent.”

“With predictive models fed by customer information, mobile operators can develop cross-selling offers that appeal to individual customers and determine how best to reach them, down to the time of day,” McKinsey said. “This approach, we believe, can add as much as two percentage points to a wireless operator’s EBITDA margins.”

“One company increased its sales from cross-selling campaigns by 25 percent once it started using analytics to plan those efforts,” they add.

By running massive sets of customer data through machine-learning models, a service provider can identify people who appear likely to cancel their service. Then it can woo them with offers aimed at the causes of their dissatisfaction.

“Research by one mobile operator determined that two percent of its customers had a 48 percent likelihood of canceling their service in the next three months, a rate much higher than the five percent likelihood among its other customers, McKInsey found.

So the company divided the “likely churners” into segments based on the reasons they might cancel. Offers that sought to address churn drivers reduced cancellations by 15 percent, McKinsey found. Also, the mobile operator spent 40 percent less than it usually did to carry out such programs, the consultants said.

As Mobile Goes, So Goes Telecom

In the past five years, the telecom business has entered a period of slow decline, with revenue growth down from 4.5 percent to four percent, EBITDA margins down from 25 percent to 17 percent, and cash-flow margins down from 15.6 percent to 8 percent, according to McKinsey consultants.

Competitive boundaries are shifting as core voice and messaging businesses continue to shrink, partly under regulatory pressures, but also because social media is opening up new communications channels.

Among U.S. telecom companies, for instance, landline and mobile voice now account for less than a third of total access, down from 55 percent in 2010, while data revenue has risen from 25 percent of total revenues in 2010 to 65 percent today.

The issue is what to do. In the near term, horizontal mergers to increase scale are the most likely move by most firms.

In at least some cases, service providers will try to move into other segments of the value chain, either “up the stack” in the direction of applications, in some other cases perhaps “down the stack” (or backwards into the value chain), if one considers devices to be “down the stack” (I would put devices up the stack, but that is a matter of preference).

A third of the 104 respondents to a McKinsey survey were preparing to move into adjacent businesses such as financial services, IT services, media that are “up the stack” moves into parts of the ecosystem other than access and communications services.

To be sure, many of those planned initiatives will fail to be launched, in the end. The point is that one long-term solution to industry revenue shrinkage is to get into adjacent businesses elsewhere in the same value chain.

source: McKinsey

What Takes Place of Mobile Revenues Within a Decade?

It might seem fanciful in the extreme to predict that mobile services will not be the industry growth engine, much less the lead revenue driver, in a decade. But history suggests that will happen.

About every decade since 1997,  the U.S. telecom business has had to adjust to a fundamental change in revenue drivers. In 1997, about half of total revenue was driven by long distance services. A decade later, such revenues had shrunk to less than a quarter, and mobile service revenues had grown to about half of total revenues.

After another decade, internet access arguably grew to support half of total revenues. Likewise, over about a two-decade period, Verizon mobile revenues displace fixed network revenues. In 1999, Verizon earned 82 percent of total revenue from the fixed network. By 2013, 68 percent of revenue was generated by the mobile network. The cash flow picture was even more stark.

In 1999, the fixed network produced 82 percent of cash flow. By 2013, mobility was producing 89 percent of cash flow. The fixed network was creating only 11 percent of cash flow.

The picture at AT&T was similar. In 2000, AT&T earned 81 percent of revenue from fixed network services. By 2013, AT&T was earning 54 percent of total revenue from mobility services.

Also, consider CenturyLink. In 2017 (assuming the acquisition of Level 3 Communications is approved), CenturyLink will earn at least 76 percent of revenue from business customers. In the past, CenturyLink, like other rural carriers, earned most of its money from consumer accounts.

The point is that several shifts have occurred:

• Long distance to mobility
• Fixed to mobile
• Voice to internet access

Another big shift is inevitable, as revenues that can be generate by services for humans and their smartphones has reached saturation.

As hard as it may presently be to conceive of a different future, in a decade, the revenue drivers will have changed again, and mobile subscriptions for human users will have ceased to be the big revenue driver. For at least a few tier-one service providers, content and other apps are likely to be part of the story.

source: Business Insider

Smart Cities Business Model is the Issue

The business case for most “smart cities” initiatives is likely to be poor to negative, in most cases, one can argue. The reasons are simply that incremental revenues to sustain the services are going to be slim to non-existent in a direct sense, even in cases where a positive societal outcome is possible.

In many cases, sustainable operation will only be possible by supporting the apps with tax or user revenues; and some potential savings in energy use. To the extent there are perceived benefits, most will be hard to quantify, as they create a “more livable” city environment, with indirect value in ability to attract and retain business entities and support economic growth.

source: Nokia

On the other hand, some “smart city” use cases, such as connected vehicles, might well be underpinned by sustainable revenue models. Some believe it will be possible to create new subscription services, however, for parking or traffic information and other information services.  

source: ericsson

Coverage "Donuts" Could Connect 99% of Humans

How to connect the unconnected remains a key issue in most markets, for the simple reason that rural areas are difficult places to build infrastructure that can cover its own costs, much less support a sustainable business model.

And the challenge might be more focused than we have thought in the past. In fact, if new research by Facebook continues to follow the present model, it might be possible to connect up to 99 percent of human beings by extending the edge networks around cities just 39 miles (63 kilometers).

In other words, creating a new 39-km coverage "donut" around cities would allow internet access to reach 99 percent of humans.

New “pseudo satellite” platforms should play a role.

According to Stratistics MRC, the Global High-Altitude Pseudo Satellites (HAPS) Market is expected to grow at a CAGR of 15.2 percent between 2017 and 2023. The HAPS market includes unmanned aerial vehicles, balloons or other airships. UAVs will lead the category, though.

HAPS are aircraft positioned above 20 km altitude, in the stratosphere, for very-long-duration flights counted in months and years, and essentially are substitutes for satellite coverage or other terrestrial infrastructure such as mobile networks.

The growth of HAPS is part of a larger trend, notably the replacement of bandwidth and spectrum scarcity by bandwidth and spectrum abundance as a fundamental condition in the communications business.

But here is why HAPS could be hugely significant: according to new studies by Facebook, 99 percent of the population (of 23 countries it has studied so far) live within 63 kilometers (39 miles) of the nearest city.

Facebook therefore believes that if it can “develop communication technologies that can bridge 63 km with sufficiently high data rates, we should be able to connect 99 percent of the population in these 23 countries.”

For such “edge of city” coverage, UAVs and other HAPS platforms might well be feasible as substitutes for satellite or terrestrial mobile coverage.

Up to this point, there has essentially been no way to create sustainable models, which is why subsidies (universal service support) have been essential. But much is changing in the area of communications platforms.

We are developing lower-cost connectivity solutions, releasing much more spectrum, enabling spectrum sharing and finding new ways to aggregate licensed and unlicensed assets to create much more capacity. The result is that the cost of connecting people and locations in very-rural areas should fall, in coming years.