The telecoms business model
Penetration and ARPU
Telecommunications is a very simple business complicated by regulation and politics. The standard business model relies on a trade off between pricing, penetration and capital intensity. Almost all elements of the telecoms industry follow the standard “S” growth curve in penetration as depicted in Figure 1.
Figure 1: Penetration “S” curves in UK telephony
0%
20%
40%
60%
80%
100%
120%
140%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006E
Wireless Broadand
Wireless penetration inflexion - mass market
Penetration slows - start of a market share battle
Premium product - business focus
Source: Deutsche Bank
Four key drivers
In Figure 2 we have attempted to describe, simplistically, the effects on what we believe are the four key drivers (business model clarity, competitive environment, pricing and capex) of telecoms profitability at different stages in the product life cycle. Although there are clearly some business models that do not conform to these characteristics, we believe most of them do.
As we show later in our BCG matrix analysis (Figure 76) and as we also show in Figure 6, much of the European telecoms sector is approaching the maturity stage in the product life cycle, with broadband penetration offering a hope of growth, but with significant price deflation and an increasing risk of substitution with the technologies that it has enabled (VoIP, IPTV etc).
Figure 2: Key drivers of the product life cycle
Phase of the life cycle Business model clarity Competitive environment Pricing Capex
Early stage Uncertain Limited Premium product Capital intensive
Growth Certain Focused on growth Aggressive deflation to drive
penetration Customer/demand driven
Maturity Commoditization Market share battle Commoditization Replacement/maintenance
Telecom cycles
The telecom industry work in cycles (earning, revenue growth etc) and they tend to range from 3 to 7 years. In Europe over the past 15 years there have been several cycles, such as:
Market related:
Mobile penetration and revenue growth: 1998 to 2004
Broadband penetration growth: 2004 to ?
EU regulatory focus on unbundling, mobile termination and mobile roaming tariffs:
2004 to ?
Financial related
TMT bubble: 1998 to 2000
European earnings downgrades: 2004 to ?
European deleveraging: 2001 to 2004
The most important consideration currently is where is the growth driver for the European industry? Historically the telecom industry has found ways to invent growth drivers but currently the outlook is void. As such, rather than the industry growing at its historical rate (at greater than nominal GDP) expectations are that it grows at rates below nominal GDP in the coming years. This is shown in Figure 3 and in Figure 4 we proffer a view on where European and US telecom industries are in their current cycle. The outlook for the US operators appears to be more positive as the regulatory cycle has subsided and operators are more aggressively roll-out fibre and IPTV services.
Figure 3: Re-inventing growth Figure 4: Cycles in telecom trends
Today
Fixed Mobile What is the next technology?
Historic growth
Future growth
+ ve
-ve
Time 3-7 years?
US telecoms ?
EU telecoms ?
Source: Deutsche Bank Source: Deutsche Bank
Evolving value chain
One of the major drivers of the current change in the cycle is the revolution in the structure of the European telecom value chain. In the past, operators focused on networks, where there was an exclusivity of supply, and outsourced industry R&D to equipment manufacturers (i.e.
Nokia, Ericsson etc), and distribution to third parties (such as Carphone Warehouse in the UK) and this meant that the consumer relationship was minimal.
In the modern world network exclusivity is disappearing as the equipment manufactures increasingly look to manage, and even own infrastructure, and other media operators and upstarts, such as Google, are entering the distribution place. In order to respond telecom operators are investing more in R&D to deliver new products and are seeking to take control of distribution channels, both on-line and on the high street, and finally are investing in brand and market segmentation to more appropriately target the consumer.
Figure 5: The evolving telecom value chain
Networks Equipment Distribution Consumer
BSkyB Google
R&D
New focus of operator servicesSource: Deutsche Bank
Usage drivers: New product innovation
Average revenue per user (ARPU) is one of the most common measures of customer value in the telecoms world, especially in the mobile environment. It is most often driven by usage, either with an incremental pricing-based model (i.e. a charge is incurred for every call made) or through a bundle (i.e. a flat rate package with specified or unlimited usage).
With growth slowing and many markets in the maturity phase of development new product innovations, which could be additional services and products that either exploit existing infrastructure or open up new market environments, are required. In Figure 6 we flag where we believe different products/services currently are in the product life cycle and we highlight the maturity of the leading revenue streams (mobile voice and traditional wireline). There are however new services and products that offer hope for the future, such as telecoms operators offering TV services.
Figure 6: European telecoms product life cycle
Introduction Growth Maturity Decline
Traditional wireline – voice
ATM, X25, leased lines Mobile voice
Mobile SMS
Broadband Instant messaging
Mobile data VoIP
Mobile TV, IPTV, video telephony
Introduction Growth Maturity Decline
Traditional wireline – voice
ATM, X25, leased lines Mobile voice
Mobile SMS
Broadband Instant messaging
Mobile data VoIP
Mobile TV, IPTV, video telephony
Source: Deutsche Bank
which products and services are substitutionary to existing offers and which are revolutionary products. For those that are substitutionary, we have listed which other business areas have they affected.
Figure 7: Classifying new products and services
Product/Service Categorization Affected business
Mobile voice Revolutionary Mobile SMS Revolutionary
Mobile data ?
Broadband Substitutionary Traditional wireline access (PTSN and ISDN)
VoIP Substitutionary Wireline and mobile voice
Instant messaging Substitutionary Email, SMS, voice
Mobile TV Revolutionary
IPTV Substitutionary Traditional TV (terrestrial, cable, satellite)
Video telephony Substitutionary Wireline and mobile voice
Source: Deutsche Bank
Wireline – all about access and traffic
Access – growth and then substitution
A wireline business model (either incumbent or new entrant) is fundamentally about securing the consumer access and then charging for incremental services. Unfortunately, in most cases the premium charged for incremental services trends to be zero and as such the wireline business model is increasingly focused on access revenues. As can be seen in Figure 8, access line growth in OECD countries was consistent throughout the 1990s but more recently has started to decline as wireless competes as another form of access technology and broadband has reduced the demand for multiple access to single premises -- broadband has replaced ISDN and increasingly the convergence with media is such that consumers require only a single TV/telephony access pipe rather than one for each service.
Figure 8: Access lines (m) and growth (%) in OECD countries
0 100 200 300 400 500 600 700
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 -2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
Access channels* Growth
Source: OECD
In many counties access line penetration has stalled at around 50% to 60% of the population reflecting the fact that the average house has over 2 residents that can share and access. In certain countries, such as Mexico, access penetration remains lower and we doubt there will be huge long-term growth, as wireless is picking up the incremental demand for access technologies, and is considerably more cost effective to deploy – the civil works in constructing wireline infrastructure can be excessive. There may, however, be incremental demand if broadband penetration picks up, but again there is an affordability issue in many of these under-developed countries.
Figure 9: Access lines penetration in OECD – 2004
Luxembourg Sweden Switzerland Norway Germany Denmark Iceland United States Canada Netherlands Finland Korea Greece United Kingdom Japan Australia OECD average Italy Ireland France Austria Belgium New Zealand Spain Portugal Hungary Czech Republic Poland Turkey Slovak Republic Mexico
0
% of population OECD average
Source: OECD
In Europe, the pressure on access lines is explicit. Using Deutsche Telekom as an example below (Figure 11), the company grew ISDN access volumes in the 1990s as if offered higher basic internet dial-up speeds and was not regulated (only PSTN access fees and traffic tariff were regulated). This ISDN growth replaced existing PSTN accesses, which were also starting to suffer the effects of the growth in mobile penetration. However, with the launch of broadband, ISDN has become more redundant and since 2005 DT has experienced access line erosion due to unbundling.
Figure 10: Deutsche Telekom PSTN and ISDN access lines (000)
Figure 11: Deutsche Telekom PSTN and ISDN access lines changes (000)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
PSTN ISDN
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
PSTN ISDN
Source: Company data Source: Company data
Traffic – up, down and down
Over the past decade it is has been difficult to construct a view on the underlying trends in tariff as there have been many material one-off events. Liberalization of the European telecoms markets and consequential tariff deflation led to increased volumes, but this was combined with huge growth in ISP dial-up accesses, which stimulated a dramatic increase in local call volumes. This has subsequently been impacted by the growth in broadband which has reduced dial-up ISP minutes and increased mobile substitution, especially in markets where mobile is the dominant traffic device (such as Portugal and Finland as shown in Figure 12). Increasingly VoIP substitution is also depressing traditional traffic volumes.
Figure 12: Share of outgoing mobile minutes (%) – 2005
16.2 19.9
21.7 25.6
29.4 30.3
31.4
40.0 40.6
42.3
48.8 49.2
55.7
10 15 20 25 30 35 40 45 50 55 60
Germany Sweden Netherlands Greece Italy Denmark UK Ireland Spain France Austria Finland Portugal
Source: Analysys
In Figure 13 we show how the German fixed-line voice market grew between 1997 and 2002 due to liberalization and the growth in dial-up ISP traffic. But due to mobile, broadband VoIP, volumes in the industry have rolled over. Figure 13 also highlights how Deutsche Telekom has lost 50% market share in wireline traffic (since liberalisation in 1998).
Figure 13: German market traffic growth (bn of minutes)
0 50 100 150 200 250 300 350 400
1997 1998 1999 2000 2001 2002 2003 2004 2005
Other DT AG
Liberalisation and ISP growth
Broadband, VoIP and mobile substitution and ISP growth
Source: Bundesnetzagentur
This shift in traffic revenue has led to a substantial cut in the importance of wireless traffic revenue in an operators revenue mix. Indeed at Deutsche Telekom, access revenue, due to price increases and DSL growth, has increased by 32% but traffic revenue has declined by 71% since 1998. This also reflects a huge rebalancing of tariff that has been undertaken in Europe over the past decade. Historically, and for philanthropic reasons, access fees were kept to a minimum in order to stimulate penetration, but traffic fees were high. In this scenario, heavy users (i.e. corporates) subsidised domestic telephony. However, with the charges in EV model to more accurately reflect the cost of provision, access charges have increased and traffic fees have declined.
Figure 14: Access and traffic revenue at Deutsche Telekom’s domestic wireline business (Euro m)
-5,000 10,000 15,000 20,000 25,000
1997 1998 1999 2000 2001 2002 2003 2004 2005
Access revenue Traffic revenue
Source: Company data
Mobile – penetration is the king
Universally the mobile technology has been accepted by the consumer, once the price point of entry has been lowered (with advances in handset development, infrastructure costs have declined for the benefit of the consumer) and in many emerging markets the wireless device has become the pre-eminent access technology (i.e., stimulating wireline penetration). Key to this business model is penetration (access or SIM), and the industry growth becomes challenging when penetration growth slows down (as we depicted in Figure 1) and a market share battle materialises.
The scale of industry growth since the turn of the century across the globe has been outstanding. The technology has grown such that penetration is now over 40%, up from low single digits a decade ago. This growth has predominantly been driven by the near universal acceptance of GSM technology (other than in Korea and Japan) which has led to a consequential reduction in both capex and handset costs as shown in Figure 16.
The combination of competition in the infrastructure market, (especially with the entrance of Chinese vendors such as Huawei) and the belief that 2G technology will soon be replaced by 3G, has led to infrastructure price deflation. This has allowed mobile technology to be rolled out into emerging markets where ARPUs are low, and advances in handset technology are such that ASPs (average selling prices) have declined as the cost of low-end handsets has reduced to $30 and below. This has materially enhanced the attractiveness of the emerging market mobile business model (hence the huge growth in markets such as China and India)
Figure 15: Global digital mobile customers (m) Figure 16: Technology spread of mobile customers
0 500 1,000 1,500 2,000 2,500 3,000
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 H1 2006
GSM 81%
3 GSM 3%
CDMA 2%
CDMA 1x 9%
TDMA 1%
CDMA 1x EV-DO 1%
PDC 2%
iDEN 1%
Analog 0%
Source: EMC and Wireless Intelligence Source: Wireless Intelligence
Europe was the main driver of GSM growth (as the EV adopted it as a single technology in the early 1990s) as penetration is over 100%. The US has grown on a more steady trajectory, helped by consolidation, and growth in GSM technology over the past three years (the USA also has CDMA technology), but the growth in LatAm has been the most marked, due to handset price deflation and severe competition in Brazil as the market has consolidated. In total volume terms, the Chinese market is driving the huge absolute, even if relative growth is less discernable.
Figure 17: Penetration of mobile by continent Figure 18: Geographic spread of digital mobile customers (2006E)
0%
20%
40%
60%
80%
100%
120%
2003 2004 2005 2006E 2007E
Europe Middle East + Africa China
Asia Pacific North America LatAm
Africa 9%
Asia Pacific 41%
Europe: Eastern
17% Europe: Western
22%
Middle East 6%
USA/Canada 5%
Source: Deutsche Bank estimates and company data Source: Wireless Intelligence
However, across continents the mobile business model varies significantly, primarily due to stages in competition, development and regulatory pressures. In Figure 19 we attempt to show how the European mobile business model is changing and the importance of the current wave of regulatory pressure which is driving down roaming, SMS, data (potentially) and mobile termination revenue.
Figure 19: Changes in the European mobile business model (% of revenue)
0 10 20 30 40 50 60 70 80 90 100
2006E 2010E
Roaming SMS data Mobile Termination Non SMS data Outgoing voice Assuming
elasticity 1x
3.2x increase
Reduction of 2/3rds
Source: Deutsche Bank estimates
Putting these trends into context, in Figure 20 we have attempted to assess the drivers of the mobile business model in each region.
Figure 20: Comparing mobile markets (2006E)
Europe USA Japan Asia Middle East Africa Latam
Stage in product life cycle Maturity Growth Maturity Mixed (but mostly
growth) Growth Growth
Competition Severe Controlled Controlled Light Light Severe
Regulatory threat Significant Negligible Limited Limited Limited Significant
Source: Deutsche Bank
Over the past 20 quarters, growth in the European mobile market has slowed down dramatically due to a combination of penetration peaking, price declines and regulation. To compensate for this slowdown and in order to support returns and cash flow generation, capex levels have been volatile but essentially flat, as there are spurts of 3G investment and then a slowdown to reflect, in many countries, a lack of usage and demand.
Figure 21: Western European wireless operators:
Aggregated revenue and EBITDA growth (YoY)
Figure 22: Western European wireless operators:
Aggregated capex growth (YoY)
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06
Revenue EBITDA
-40%
-30%
-20%
-10%
0%
10%
20%
30%
1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 4Q05 1Q06
Source: Deutsche Bank Source: Deutsche Bank
Whilst penetration is king to the mobile business model it is also important to stress ARPU, elasticity and pricing. Due to a combination of penetration-mix effects, price cuts and regulatory pressure, ARPU in Europe has contracted in recent years (we show the trends in the UK since 1993 in Figure 23), whereas it has been more stable in the US. This may also reflect different usage patterns and price points.
Figure 23: ARPU per month for UK operators (£)
0 20 40 60 80 100 120 140 160 180
Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006E
Vodafone O2 T-Mobile Orange
Source: Deutsche Bank estimates and company data
In Figure 24 we compare the revenue yields in each market (mobile and fixed line) in the UK
Figure 24: Comparative UK fixed and mobile pricing (GBp)
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70
Q1 1993 Q1 1994 Q1 1995 Q1 1996 Q1 1997 Q1 1998 Q1 1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006E
0.0 2.0 4.0 6.0 8.0 10.0 12.0
Mobile Fixed Fixed/mobile ratio
Source: Deutsche Bank estimates, OFCOM and company data
Broadband and regulation
Broadband is a generic term describing the consumer demand for greater internet access speeds, and is predominantly a battle between two technologies; cable and DSL. Other technologies, such as WiFi, WIMAX and satellite are either infant or are merely used to infill footprint where cable and DSL are uneconomic.
Generally, North America and Korea have a strong cable broadband presence and the EU is led by DSL. There are, of course, exceptions such as the Netherlands, but strength of cable in any market is driven by the legacy position of the technology and TV distribution (cable dominant in TV distribution in most of these countries) and the cable operators’ historical ability to fund a network upgrade from narrowband to broadband in the early part of the century. In Figure 25, we show the relative penetration of broadband at the end of 2005 in most OECD countries and the split by technology. The lack of cable broadband in France, Germany and Italy is as stark as is the scale of cable in the USA and Canada.
Figure 25: OECD broadband penetration (as % of population by technology) 2005
0.0 5.0 10.0 15.0 20.0 25.0 30.0
Iceland Korea Netherlands Denmark Switzerland Finland Norway Canada Sweden Belgium Japan United States United Kingdom France Luxembourg Austria Australia Germany Italy Spain Portugal New Zealand Ireland Czech Republic Hungary Slovak Republic Poland Mexico Turkey Greece
DSL Cable Modem Other
Source: OECD
In Figure 26, we show the scale of relative cable and DSL broadband in the OECD, where DSL is 2x the size of cable and in Figure 27, we reinforce the fact that the EU is dominated by DSL.
From a regulatory perspective, the strength of cable has huge implications. In the US, and increasingly so in the Netherlands, technology-based competition is removing the need for regulatory body to set wholesale DSL tariffs, as effectively two competitive networks control access pipes into homes and businesses. Where DSL is dominant, regulators are forced to maintain wholesale access in order to compensate for the fact that there may only be a single access pipe connected to a home or business.
Figure 26: Broadband access technology (2005) - OECD Figure 27: Broadband access technology (2005) – EU 15
DSL 62%
Cable Modem 31%
Other
7% Cable Modem
16%
Other 2%
Assessing the long-term penetration of broadband is difficult, but as shown in Figure 28 there remains growth if only to fully penetrate current internet (PC) demand. Thereafter, broadband growth will depend upon the success of non-PC access technologies (such as television and mobile). However, as we showed earlier, to date broadband is following the “S” curve trends of other technologies.
Figure 28: Internet subscribers in total OECD (m)
0 50 100 150 200 250 300
1999 2000 2001 2002 2003 2004 2005E 2006E 2007E
Total Internet subscribers (including broadband) Broadband subscribers
Source: OECD
As we show in Figure 29, email communication remains the most popular use on the internet (both in a broadband and narrowband world). However, broadband has also opened up new markets, such as gaming, music and film downloading, and is also a substitute for traditional voice telephony. In particular, we would highlight the growth in business models, such as Google and Party Gaming, which have been spawned by broadband growth.
Figure 29: Applications used by broadband versus dial-up
91%
82%
72%
57%
46%
38%
40%
16%
84%
67%
60%
38%
22%
21%
17%
7%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
e-mail General surfing Making purchases Banking Music or film downloads Gaming Chat & voice calls Real time gambling/trading
Broadband Narrowband
Source: Deutsche Bank, Ofcom
Figure 30: Value transfer to new media: Aggregated market cap of Time Warner and Disney compared with Google ($m)
Figure 31: Growth in internet gaming (revenue ($bn))
-50,000 100,000 150,000 200,000
Q1 2002 Q3 2002 Q1 2003 Q3 2003 Q1 2004 Q3 2004 Q1 2005 Q3 2005 Q1 2006 Q3 2006
Time Warner/Disney Google
-2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0
1998 1999 2000 2001 2002 2003 2004 2005E 2006E
Source: Datastream Source: Deutsche Bank
Telecoms and PayTV: Converging through fear
What is convergence? Convergence is an overly used generic term, which is hiding an underlying rationale: “fear” – the opportunity cost of inactivity and business model evaporation.
Telecoms and PayTV operators are increasingly fearful of their existing business models, which are historically technology dependent, and are therefore executing the “prisoner’s dilemma” – entering each others markets with a marginal cost pricing model. This expansion of strategy is being driven by:
Expectation of declining returns;
Expectation of declining returns;