When is Vertical Integration Possible?

Very few firms in the global telecom service provider business are likely to make significant moves to vertically integrate into other elements of the business. In part that is because such moves entail lots of execution risk (moving outside the perceived core competence), lots of capital and lots of scale.

According to McKinsey, there are four reasons to vertically integrate:

• The market is too risky and unreliable—it "fails";
• Companies in adjacent stages of the industry chain have more market power than companies in your stage;
• Integration would create or exploit market power by raising barriers to entry or allowing price discrimination across customer segments; or
• The market is young and the company must forward integrate to develop a market, or the market is declining and independents are pulling out of adjacent stages.

Generally speaking, “failing” markets have one or just a few buyers and sellers, a situation guaranteed to lead to big efforts to gain and sustain advantage. The relationship between content owners and distributors is a good example of such instances, and therefore also a reason vertically integrating content and content distribution makes sense, as Comcast and AT&T have done.

Another instance where vertical integration makes sense is when market power is held by others in the value chain or ecosystem. Consider the internet ecosystem, where devices claim about 15 percent of revenue and internet access about 14 percent, while application providers get about 18 percent.

Over time, revenue claimed by app providers will grow faster than any other segment. That likewise makes vertical integration rational for at least some tier-one service providers.

One way of describing the dynamic is to argue that “you have to own at least some of the content and apps flowing over your network.” In other words, own the actual apps, not simply the access pipe.

Vertical integration, in the internet era, can confer the traditional advantages of raising barriers to entry. When the leaders in one app segment can integrate the leaders in other strategic app segments, entry barriers arguably are created. That is the logic behind the “winner take all” trend in applications generally.

That typically does work so well with communications service providers, who rarely have the market dominance some leading app providers have attained.

Whether telecom becomes a declining market could affect the usefulness of a vertical integration strategy where service providers move to occupy other adjacencies. You might argue that moves into content ownership illustrate that trend.

The internet of things markets might provide another incentive to vertically integrate, though it is not yet clear.

source: A.T. Kearney, IP Carrier

But most service providers will not have the requisite scale to make such moves, sustain them and wring business value out of them.

It is getting harder these days to illustrate the structure of telecom value chain layers. Traditionally, the seven-layer open systems interconnect model had the physical layer at the bottom, the applications layer at the top. Originally developed as a framework for data communications, the stack later became seen as a sort of metaphor for business value as well.

In that scenario, customers might constitute something of a layer eight, driving the revenue model. And some might add a new layer zero of actual physical network elements. More relevant is the addition of a layer for devices, which some place below the communications layer, while others might place the device layer above the communication layer.

Precisely where such layers are placed probably does not matter so much as the understanding that vertical integration can occur both forward (towards customers and retail distribution) or backwards (“down the stack” to incorporate inputs).

As a practical matter, for telecom service providers, the issues are to move either up the stack or down the stack to enhance the value of the present business, especially by adding different revenue sources.

In the monopoly past, creation of network infrastructure elements and architectures, as well as devices, was handled internally, in some cases, by entities such as Western Electric, with development work handled by Bell Laboratories, for instance.

All that changed with deregulation, as the service provider functions (in the U.S. market) were broken into a couple of roles, while research and manufacturing likewise were separated. Western Electric the internal operation became Lucent the independent unit. The research function (Bell Labs) was spun off to AT&T, which operated solely in the area of long distance services, while the “Baby Bells” were created to handle local access.

source: www.intechopen.com

In some cases, vertical integration might prove useful. But most service providers are going to move horizontally, to gain scale in the present business. That has proven the most-prevalent revenue growth strategy in the telecom business over the last four or five decades.

source: Deloitte

Pick Your Poison: Smaller Markets or New Competitors

Amazon.com has launched its own delivery service, after already taking a stake in an  air freight company (Air Transport Services Group) and creating a branded “Prime Air” service. The launch might be characterized as a test, but that might also have been said of the Prime Air service, which has expanded. Amazon also has built its own air freight hubs.

That investment aims to vertically integrate at least some of Amazon’s own long haul operations, by creating its own internal logistics network for air freight.

The latest move goes further, and aims to create an Amazon-owned delivery service direct to its customers. In large part, the move aims to speed up delivery options, but also free up space in Amazon warehouses, as goods would move directly from manufacturer locations to distribution, bypassing delivery companies such as United Parcel Service  and FedEx.

source: myz

Some of you already will have understood the similarity to trends in the global telecom business, where enterprises that formerly were “customers” actually vertically integrate their own long haul or access functions as well as data center operations (fixed internet access or mobile access).

That removes demand from the public telecom markets. It is not so much that the enterprises become competitors as that they cease to be potential customers. Some might see an enterprise that builds and operates its own communications networks as a “competitor.”

In most ways, it is worse than that. Competitors represent a threat to revenues and profits, to be sure. But there always is the possibility to reclaim market share from such firms.

When enterprises create their own facilities-based networks, they remove demand from the markets all the competitors serve. In part, that limits the size of markets, as some amount of present revenue and future growth is removed.

It is not an unusual story. In many ways, cloud computing internalized by enterprises eliminates demand for data center services. Other trends, such as open source, also limit sales and growth  in other areas such as servers and associated gear.

None of this is unusual, as a business strategy. Telcos often speak about “moving up the stack” into the applications layer. In industrial value chains, “backward integration” is the equivalent of a service provider moving further “down the stack.”

Forward integration, in an industrial value chain, normally describes occupying new niches in the value chain (towards retail and away from raw materials) that correspond to a telco “up the stack” strategy.

If, as many expect, enterprises in the 5G era are more able to create their own mobile and wireless networks using a mix of unlicensed and shared spectrum, as well as licensed spectrum, then two things will happen.

In some cases, end user demand will be removed from the market. In other cases, former enterprise customers could become actual direct competitors to service providers. Pick your poison.

Telecom Growth Will Tilt to Business Segment in Coming Years

Though many of us expect enterprise customers will drive incremental 5G revenue growth (because of internet of things), business segment revenue was moving to the forefront even before observers predicted IoT would emerge as the key driver of incremental revenues.

To be sure, business segment revenues arguably have driven telecom service provider profits for many decades. But Bain and company analysts predict that the percentage of total revenue will continue to tilt in the direction of business sources for the foreseeable future.

source: Bain and Company

How Much Can Mobile Operators Earn from IoT Connections?

Just how much revenue might mobile operators earn from connecting internet of things devices? It all hinges on volume. Mobile connections might generate monthly revenue of perhaps $1.50, while connections to specialized low power wide area networks might generate about 15 cents from each connection, per month, according to Analysys Mason.

Perhaps among the optimists, Analysys Mason believes mobile operator connectivity revenue could amount to as much as US$28 billion in 2025, about 14 percent of total potential IoT revenues.

source: Analysys Mason

By way of comparison, application revenue will constitute 61 percent of total value chain revenue and hardware will generate 25 percent. So up to 86 percent of IoT revenue will be earned by app and device/infrastructure suppliers.

LPWA networks (such as LoRa, NB-IoT and Sigfox) might reach US$22 billion in total value by 2025. Connectivity revenue might generate eight percent of the total revenue from the LPWA value chain.

source: analysysmason.com

source: ABI Research

Spectrum Abundance Will Bring More Private Mobile Networks

The mobile business always has relied on its access to licensed spectrum as the foundation of its revenue model. Spectrum scarcity, among other elements, has shaped the business model in fundamental ways.

That is not unusual. Many industries rely on relative scarcity to create value that can be monetized. In the internet era, such scarcities also create incentives for innovators to attack.

If one assumes spectrum scarcity will in the future be replaced by spectrum abundance, it is inevitable that disruptors will enter the market. In many cases, those disruptors will be “former customers.”

Look to the undersea capacity business for clear examples of how this will work. In the past, enterprises generally have purchased communications services from communications service providers.

Of course, since the 1980s, it has been possible for enterprises to create their own virtual networks. In some cases, at least portions of such networks could be created on a “owned facilities” basis.

Source: Dean Bubley

That has taken the form of ownership of actual fibers within third party cables, in some cases taking the form of owned point-to-point microwave facilities and in other cases rental of wavelengths.

If you assume orders of magnitude more communications spectrum will be released in the future, it is logical to assume that many enterprises might evaluate the creation of private networks, for a variety of purposes.

Creation of multi-tenant indoor mobile networks is one application. Such “neutral host” facilities would offer “inside the venue” access to all mobile operators, on a for-fee basis. Think about the Boingo business model, or any standard roaming agreement, and you get some idea of how value is created: the mobile operator or enterprise gets access in hard to reach places.

Also, in the same way that enterprises have created their own computing networks, so all the new spectrum and protocols can enable private enterprise mobile networks, especially to cover campus locations, support industrial, medical or other internet of things networks.

That is going to remove some amount of potential business from the public markets. Again, look at the undersea capacity markets. Some enterprise customers (Google, Facebook, others) now find that have so much volume that they can build and operate their own global networks.

That essentially removes sales opportunity from the “public” markets. On trans-Pacific routes, such private networks already have removed as much as a third of demand from the market. On routes between North and South America, private networks carry as much as 70 percent of total traffic.

Something like that is possible in the mobile business, as enterprises use the bounty of new spectrum to create their own private networks. The only issue is how extensive the trend might eventually become.

In some cases, the private networks arguably will mostly have the same business function as Wi-Fi, which is to say there will be little negative impact on suppliers of access services.

Access to the cloud still will be necessary, but the private location-based mobile networks will take the place of Wi-Fi.

In some cases, such as neutral host facilities, mobile service providers will substitute services spending for capital investment to build their own in-building networks.

The clearest winners for such new private networks will be software, hardware and device suppliers. Again, Wi-Fi infrastructure provides some guidance. If internet of things connectivity becomes as big a deal as many expect, that revenue generation by devices, software and transmission hardware will be key.

source: analysysmason.com

Will Valuation of Telcos Fall?

Something new is happening in the global mobile business. Facing financial distress, entities tend to sell themselves. But what happens if potential buyers simply see such dire circumstances that a purchase does not make sense?

That appears to be a danger for Oi, the bankrupt Brazilian former incumbent. Inability to merge or sell has been an issue for Reliance Communications in India, as well.

So the new trend that bears watching is whether business conditions might get so severe that a struggling service provider cannot sell itself, because there are not willing buyers.

In other cases, such as the proposed T-Mobile US acquisition of Sprint, no acquisition premium has been proposed, as normally would happen. In other words, the buyer sees little reason to pay any premium.

All those situations--no takeover premium; no ability to entice a buyer or no ability to arrange a merger--suggest that the value of telecom assets is in some growing number of cases in danger of falling.

Whether that value can fall so far that complete shut down (liquidation) is the only available option is among the questions that must now be asked.

If that starts to appear in numerous markets, the logical consequence will be that equity values of most telcos will start to fall. That is a significant new business problem, in addition to revenue growth, profit margins, falling average revenue per account, competition and growing capital investment or operating cost issues.

A half century ago, the idea that a country’s national telecom provider could go bankrupt likely was seen as highly unlikely. Since all telecom companies were “sole provider” government-owned entities or monopolies, a bankruptcy, one would have argued, would imperil the national economy and therefore would be prevented by government intervention.

In the competitive era, we have become accustomed to the idea that smaller and competitive service providers indeed can go out of business. But there have been few examples of tier-one, former-incumbent service provider bankruptcies.

That now has happened, as Oi, the former incumbent in Brazil, has entered bankruptcy, albeit the more-familiar “restructure to stay in business” variety, not the “going completely out of business” version of bankruptcy.

Under the best of circumstances, a firm attempting such a gambit would wipe out its equity holders, restructure its debt and try again. In other cases, a buyer might be sought. It is not clear whether any buyers exist for Oi, some would argue.

The problem is the seemingly-unstoppable decline in the legacy fixed network business, which obliterates the contribution made by Oi’s mobile business.

Like many other markets, Brazil’s mobile market features four strong contenders, a situation many would say leads to depressed profits, as beneficial as that level of competition might be for consumers.

Though it is possible to envision a stable oligopoly, a mobile market with four roughly equally-matched suppliers is not sustainable, many would argue. Eventually, consolidation that creates a clear leader, with at least one strong follower, is probably necessary to sustain long-term profitability in the market, as that situation discourages uncontrollable price competition.

In principle, oligopolies are the likely “normal” market structure in the capital-intensive telecom business. In the mobile business, the key question now is whether “three” contestants is stable and sustainable, or whether even that is too many, in some markets.

Oi has nearly 19 percent share. Vivo, the market leader, has nearly 29 percent market share. TIM has 26 percent share, while Claro has 25 percent share. The “perfectly stable” market structure might have something approaching a 50-25-13 market share structure (plus or minus five share points for each contestant).

With such a structure, no provider has huge incentive to launch destructive pricing wars to gain share, as the other contestants can be expected to simply respond, depressing prices and profits across the board, without changing market structure.

source: Anatel

AT&T Shifts to Next Wave of Revenue Growth

It you are familiar with the concept of the product life cycle, you know that "nothing lasts forever."

Applied to the telecommunications business, that means we should see evidence that lead revenue drivers have changed over time, and predict that further change is coming.

At first, revenue growth comes as subscriptions grow. Then growth is driven by customers who buy "more" services (both additional services and quantity of such services).

For the past several decades, global growth has been driven primarily by consumer subscriptions to mobile services. When accounts are saturated, growth shifted to minutes of use, then messaging, then mobile internet access.

That remains the likely pattern in many developing markets, where account saturation has not yet been reached. But the principle remains: lead revenue sources have changed several times in the history of telecommunications, from account growth to long distance to mobility; consumer to business lead growth and back again; with periods where mobile growth was driven by accounts, then voice usage, then messaging and now mobile internet access.

Consider AT&T, whose growth, at a high level, shifted from fixed network services to mobility, but whose next wave of growth will be fueled by content services. After the acquisition of Time Warner’s content-producing assets, entertainment will be the second-biggest producer of AT&T revenues.

While business solutions (mobile and fixed) will be the largest single revenue segment, entertainment will be second at perhaps $65 billion, with consumer mobility third at $35 billion or so.

AT&T’s moves suggest it believes further revenue growth is not going to come from consumer mobility, even if that had fueled decades of incremental revenue leadership. With accounts now saturated--virtually everyone who wants to use mobility now does--revenue growth has to come from selling more things to mobile and other customers, or convincing customers to buy in larger quantities.

You see the limitations of the “increase quantity” strategy clearly in the use of “unlimited usage” plans for domestic voice, messaging and internet access. AT&T and the other leading mobile operators are not paid more when customers use more.

The “growth by acquisition” trend seemingly will be unchallenged over the next decade, as acquisitions have contributed most of the growth in developed markets since about 2000.

The bigger trend is the shift away from “mobility” as the revenue growth driver. Once the driver of industry and firm growth, even mobility has reached the peak of its product life cycle. New sources, with equivalent scale, must now be found. In the near term, entertainment content is one answer. Tomorrow, it is likely to be enterprise services supporting internet of things.

source: Business Insider

In fact, the firm projects a five-year EPS growth rate of nearly eight percent, with a majority of the growth fueled by the Time Warner content operations. .

There have been waves of growth in the telecommunications business over the last 50 years, and in many developed markets, signs of a peak already are in place. In Western Europe, revenue growth now is negative, and has been for some years.

It will be some time before hard decisions must be taken by executives and firms in many developed markets where mobile accounts and revenue still are growing, if at lower rates than has been the case over the past couple of decades.

What the AT&T acquisition of Time Warner shows is that, in the U.S. market, the era of consumer mobility has reached its limit.