Wednesday, 18 March 2015

The wave of cellular network operator consolidation is being driven by cutting costs and achieving economies of scale.

The wave of operator consolidation across the Americas and Europe is driven by the urgent need to cut costs and achieve economies of scale. With average revenue per user (ARPU) falling, even for supposedly premium LTE and fiber services, and with huge infrastructure upgrades still ahead, carriers need to find drastic cost efficiencies or be consigned to a spiral of rising debt and falling margins.

Even in the US, the big four operators, whose ARPUs are the envy of the rest of the world, are seeing their profits squeezed by price competition and huge capital expenditure (capex) bills, and now they are being hit by another factor, the inflated cost of spectrum. All four have seen their market values slashed in recent days, with investors scared by the bids being made in the current AWS-3 spectrum auction, as well as warnings of difficult quarters from the two market leaders and the ongoing price wars.

Such jitters will put even more pressure on carriers to adopt a dramatically different approach to building their networks, including the software-defined strategies which will eventually eat into the revenues of traditional equipment makers.

Sprint hammered despite its auction caution

All four national US cellcos have seen their stock being dumped in the past week, and have lost a total of $45bn in market value between them since mid-November, according to Wall Street Journal calculations. That loss in value is greater than the combined market capitalisation of Sprint and T-Mobile.

Sprint suffered the most, with a drop of 16 per cent in the second week of December, reflecting the persistent lack of confidence in the carrier, which has been less aggressive than T-Mobile USA in price cutting, but has failed to increase its premium base significantly either. It has also been hit by delays in its ambitious LTE rollout plan, and the transition has caused temporary network quality issues which have added to its churn woes.

The drop in Sprint’s value shows the new coolness on carrier stocks is not just about the headline factor of the huge prices bid in the AWS-3 auction, which have now topped $43bn. Sprint was the only one of the big four to stay out of that process, saying it has enough capacity to support its Network Vision multimode infrastructure and its Spark triband LTE offering for now. It will concentrate on leveraging its great asset, its huge quantity of 2.5GHz spectrum, to improve its cost:capacity position relative to its rivals, and wait until the 2016 600MHz auction to acquire more frequencies.

Staying out of the AWS-3 madness has not saved Sprint from investor anger, partly because of its ongoing issues, and partly because the current spectrum sale has set new expectations for the 600MHz incentive auction of broadcast frequencies. Since sub-1GHz bands are generally seen as "beachfront" assets, investors fear that the 2016 sale may command even higher prices than AWS-3, and at that stage, Sprint is expected to be a heavy buyer, as is TMo.

Of course, it is not as simple as that. Many market changes will have occurred by the time the delayed 2016 procedure gets under way, and many operators will be setting higher value on capacity bands by that stage, rather than coverage-focused sub-1GHz frequencies.

However, for now, fears that operators will never be able to call a halt to spectrum spending – even with the use of Wi-Fi and other options – are haunting the carrier stocks. T-Mobile lost 10 per cent in the first week of December, while Verizon lost six per cent and AT&T five per cent, partly because of the high sums they will end up paying if they are successful bidders.

But warnings about lower profits in the current quarter, issued by both Verizon and AT&T, are also a big factor, especially as these negative vibes are not about the wireline business but about wireless, which is usually the growth driver. The markets are concerned that the price wars, and the ever greater promotions and discounts operators must offer to lure and retain consumers, will drag on into next year.

The need for consolidation

Consolidation is the usual remedy for excessive price wars, as seen in other competitive markets like France. In a research note last week, Jefferies analysts Mike McCormack, Scott Goldman and Tudor Mustata wrote that they had "doubts for the sustainability of the four-player market," and that "without a more accommodative M&A environment, short term lower pricing for consumers will likely end poorly for all”.

These are the kind of opinions which send investors running, but have less impact on competition authorities. While Sprint owner Softbank argued persuasively, earlier in the year, that a merger with TMo would create a more viable third player and more profits all round – which could then be invested in services and capacity – it backed away from making a bid in the end, deterred by likely antitrust scrutiny of a deal which would reduce the number of carriers. Other offers for the fourth operator could still materialise in 2015, from Dish or even Vodafone (see separate item), but for now TMo is aggressively independent and continually upping the ante in terms of consumer offers. Even Verizon, usually aloof from such mud-fighting, has been forced to join in, hence its warning about current profit levels.

Dump market share to maintain profit?

Apart from mergers, carriers may also choose to preserve profit margins by sacrificing market share, losing the lower value consumers and keeping those who choose an operator not on price but for network quality, added value services or choice of devices, for example.

AT&T and Verizon are both working hard on adding new revenue streams, many of them not dependent on the fickle consumer – Verizon’s alliances with carmakers are a good example, as is the involvement of both giants in GE’s Industrial Internet initiative and in smart city projects.

If they can build new revenues, and increase wholesale activity (which protects them from the cost of acquiring and retaining users), they may decide to take the hit of lower subscriber numbers. The Jefferies note argues that it is better to lose customers than ARPU, calculating that a fall in ARPU is 2.5 times more damaging to EBITDA (earnings before interest, taxes, depreciation, and amortization) profits than a loss of subscribers. "The bottom line is the industry needs to stop obsessing about subscribers when ARPU is so much more important," they wrote. "In our opinion, going negative on subscriber growth may be just what the doctor ordered."

Another analyst, Kevin Smithen of Macquarie Capital, urged Verizon and AT&T to let about five per cent of their customer bases go, and concentrate on a clear network performance advantage over rivals, which would be helped by a lower burden of subscribers, and would drive higher (or at least stable) ARPU. Sprint and TMo could then pick up those users – a total of eight million to nine million between them – and gain what they most need, better scale to improve cashflow and lower debt. That would see a clear divide between the two pairs of operators, with the leading two investing their improved profits in spectrum and network quality, not on subsidies and customer retention.

That model reflects what has already happened in the US, with Sprint and TMo increasingly focused on prepaid and lower cost businesses and AT&T and Verizon staying at the premium end. However, LTE has changed that pattern somewhat, because the smaller operators will need to climb back up the value tree in order to recoup their investments, hence the spread of price wars and heavy discounting from the low end segment and right into postpaid 4G.

LTE has been a big disappointment as a profit generator, especially as it has coincided with a rise in usage which is far bigger than anticipated a few years ago, and a period of heavy spending on device financing. The network upgrade which was supposed to improve the carriers’ economics with its lower cost of capacity and its improved spectral efficiency has caused further pain to some, forcing them to make major investments in spectrum and infrastructure, only to hunt in vain for ROI in a price-competitive market.

The Jefferies trio added: "In our view, innovation, both in the network and in the handset, has caused increasing industry pain. Now, with too many competitors in the market, carriers are unable to price at levels to properly re-coup investment."

Domain 2.0 and the new approach to networks

The carriers will learn some lessons from this difficult period. One will be to think about their infrastructure investments in a completely new way in future. This is one driver for general interest in virtualised and software-defined networks, which currently come with all kinds of uncertainties and upfront costs, but should eventually allow operators to adopt the economics of IT – commoditised hardware running network functions as apps in the cloud, and supporting very low cost cell site end points.

AT&T is a leading light in this process with its Domain 2.0 program, which sets out a multi-year process to move its network functions to the cloud and create a next generation platform based on SDN (software-defined networking). This will be directly responsible for a reduction in capex spending, it says. Verizon expects to spend about the same on its networks in 2015 as it did in 2014 – its LTE roll-out is almost complete in coverage terms, but now it needs to shovel in more capacity – but AT&T says it will reduce its bill from $21bn this year to $18bn in 2015, and down from there.

This week, it announced new vendors for Domain 2.0, taking the total to 10, and said in a statement that it expected its next generation network “to reflect a downward bias toward capital spending. This will come from relying less on specialized hardware and deploying more open source and reusable software".

The latest additions to its supplier roster are Brocade, Ciena and Cisco. These suppliers will see it as an important endorsement – AT&T is such a frontrunner in telco software defined networks (SDN) that inclusion on its list is seen as a signal that a vendor is geared up to adapt to the software-led world and its new economics, rather than battling against the huge upheaval. In the first wave of Domain 2.0 selections, Cisco was omitted, which helped create considerable market concern that it would struggle to convert its hardware-based business to SDN, despite all its high profile efforts in this direction. Cisco subsequently acquired one of the Domain 2.0 choices, Tail-f, but has now also joined the elite club under its own steam. The other participants so far are Affirmed Networks, Alcatel-Lucent, Amdocs, Ericsson, Fujitsu, Juniper and Metaswitch.

With its high profile focus on SDN, AT&T is differentiating itself clearly from its arch-rival in terms of its approach to its network. Verizon was the clear winner of the race to get to LTE first, but AT&T has been more experimental with its architecture, and more concerned with adopting technologies which alter the cost structure – it was a pioneer of mobile offload with its acquisition of Wayport; it is prominent in industry developments and organisations for both small cells and WiFi; it is intensely involved with NFV and SDN.

Its architecture chief, John Donovan, summed up the differences in philosophy at the recent Barclays 2014 Global Technology Conference, saying: "Can we benefit from standards? Yes. Can we flatten the network? Yes. Can we reduce components? Yes. But I'm more enthused about making that stuff software-defined than I am about next-gening it.”

And in a new blog, he is pledging to make the AT&T network 75% software-driven by 2020, building on existing projects such as the virtualisation of network analytics, edge routers and some data platforms, during 2015.

This emphasis keeps Donovan out of the most hype-infested areas of debate about "5G". The senior EVP of architecture, technology and operations is not uninterested in a possible air interface upgrade, but only if it is a real leapfrog “that would allow us to carry more bits per hertz, so that we can gain more efficiency in our spectrum ... It's sort of a high bar saying if you can clear this, then it might make sense to take a look. Absent that, then it's good to sit and talk and plan, but it's not going to trigger any sort of investment cycle."

This is the sort of comment which strikes fear into the hearts of traditional network vendors, many of which are busily testing technologies which could go into a brand new air interface and power a conventional 5G upgrade. But the operators know there are likely to be more significant, and possibly more immediate, cost gains to be made from turning the network into software.

The initial effort and disruption will be just as great as ripping and replacing a generation of mobile kit, but the eventual savings should be greater for many, and they will gain a flexible network which can support many kinds of as yet unimagined new services and behaviours, without the need for yet another rip and replace.