The Cellular Telecom Crunchonomics: One Year On

In December last year we wrote The Cellular Telecom Crunchonomics report to assess the potential impact of the financial crisis on the telecom industry. Back then, most countries were entering a recession and disruptive consequences were in prospect for developed as well as emerging markets. Amidst the uncertainty surrounding global financial wealth, our findings forecast that the cellular telecom industry was well placed overall to face the financial crisis. But what has really happened in the last 12 months?

Most economists underestimated the depth and scale of the financial crisis, and in this report we aim to analyse the validity of our predictions. The key finding is that the recession has been exacerbating the difficult and already existing market conditions in developed countries which led to a squeeze in capital expenditure. This has delayed all near-term and long-term network expansion plans for many large operator groups.

Between Q3 2008 and Q3 2009, as total revenues for the Organisation for Economic Co- operation and Development (OECD) countries fell by 2.5% on average every quarter, mobile operators managed to pace their operating expenditure (OPEX) reduction accordingly. As a result, OPEX is moving towards 60% of total revenues over the past few months compared to 63% a year ago. Structural costs, marketing expenses and handset subsidies have been substantially reduced. Following those cost control policies, EBITDA remained stable at 33% of total revenues year on year. However, in order to preserve cash flow generation, mobile operators took the decision to squeeze capital expenditure (CAPEX). Consequently, operating cash flows increased to 22% of total revenues from 20% a year ago, and CAPEX is now moving towards 10% of total revenues compared to past industry consensus of 13-14%.

These trends clearly reflect the fragility of some of the largest operator groups’ balance sheets, which rely heavily on large debts and equities and where cash flows have been inflated with capital that should have been invested in value-generating projects. In 2010, most economies will remain weak and most developed cellular markets saturated, which suggests that if mobile operator revenues keep falling, infrastructure expansion plans will be delayed further and OPEX will continue to shrink.

The industry is facing a dilemma as it must invest in 3G network expansion and service improvements to meet consumer expectation as well as generate substantial profits to offset falling voice revenues, yet at the same time it is cutting marketing budgets and squeezing capital expenditure. Nevertheless, as we explain throughout this report, the recession has been exacerbating the existing difficult market conditions. Mobile operators’ performance has been mainly impacted by user saturation in developed markets, regulatory pressures, on-going voice-centric price wars and the slow adoption of high-speed services.

2010 will be a tough year for the mobile operator community as market conditions will not ease and they will have to invest in innovative solutions to differentiate themselves and generate profits. In addition, handset and infrastructure vendors – which have suffered the most from the global downturn – have a lot of work to do to maintain their position. Handset vendors have suffered over the last 12 months from destocking, high currency fluctuations, and user saturation but surprisingly some players have recently given rather bullish predictions for 2010.

The financial crisis, 12 months later

In mid-2008, financial systems around the globe failed and spread monetary chaos to vertical value chains in developed countries with knock-on drastic consequences on emerging economies. In December last year, experts at OECD were gravely looking towards 2009, claiming that a severe downturn was in prospect. The consensus was that OECD economies’ growth was likely to be negative for a number of quarters with a recovery expected by the second half of 2010.

Even though these predictions were correct, most experts actually underestimated the depth of the recession. For the first time in years, experts even had to revise their predictions numerous times as the effect of the downturn became so volatile.

OECD economies were forecast to decline by a mere 0.4% between 2008-9, but in reality GDP declined by 4.1%. In Mexico, GDP growth fell 8% in 2009, compared to the original flat growth predicted a year ago (0.4%); in Slovakia, the promising 4% predicted growth turned into a 6% decline. Across OECD-member states, only Australia and South Korea bucked the trend, reporting 2009 GDP flat growth of 1% and 0.1%, respectively. All other countries averaged a 4% yearly GDP decline.

In the fourth quarter of 2008 and the opening quarter of 2009, world trade collapsed following the tightening of financial conditions. Export and import have been declining by double digit rates with Japan strongly affected by a free fall in export and production. Currencies heavily fluctuated, disadvantaging cross-border trade, even though money markets seemed to have stabilized more rapidly than expected – mainly due to government intervention.

Inventory levels eventually played an important role in dragging down economic growth, with production cut-backs in the initial phase of the recession followed by large scale destocking in early 2009. In the US, industrial production has declined more than in the country’s previous recessions. Across all markets, domestic demand and private consumption fell dramatically despite the original expectation that it would rebalance economic conditions. Higher disposable income – helped by tax cuts implemented through mid year – has been outweighed by higher savings driven by a deteriorating labour market, tight financial conditions and on- going housing market corrections.

By the closing quarter of 2009, OECD economies look to be approaching the bottom of the recession, the deepest decline in post-war history. In the US, the severity of the financial crisis is moderating, and in Japan, business confidence is stabilizing. In large non-OECD countries, a recovery is already in motion, especially in China.

Experts have concluded thus far that the consequences of the recession could have been worse and, at present, most economies are at the early stage of a weak and slow recovery. However, the negative economic and social impact of the downturn will be long-lasting.

The cellular industry's balance sheet

Last year, our findings showed that as the financial dominoes started to fall, the cellular telecom industry was well positioned to face upcoming challenges. 2009 GDP growth was at the time forecasted at -0.4% and we estimated that 2009 mobile operators’ total revenues – for the 30 OECD countries - would reach 4% yearly growth, outperforming once again the overall economic trend. However, the final reported (and often restated) revenue figures for 2008 brought operators’ total revenue to EUR 411 billion, 2% higher than our previous expectation, and our estimate for 2009 went down by 6% to EUR 408 billion.

As we stated, operators’ performances would be most affected by currency fluctuations and a possible fall in domestic consumption. As shown in the economy dashboard on page 4, this scenario occurred with currency fluctuations reaching a peak in late 2008 and picking up more normal growth patterns since then. Domestic demand fell by 3.7%, the first decline registered across OECD markets in the past decade. Private consumption fell by 1.5% this year with significant reductions estimated in Ireland (7.2%), Mexico (6.8%), Spain (4.4%) or the UK (3.4%).

As we correctly anticipated, the top three US mobile operators (Verizon Wireless, AT&T and T-Mobile) are reporting double-digit growth rates for 2009, countering the country’s economic instability. USA/Canada total operators’ revenues are likely to grow by 4.3% this year to reach EUR 125 billion – which is only EUR 1 billion off our original prediction.

In contrast, the OECD’s Euro Zone has suffered more than expected from the downturn, with a 2009 GDP yearly growth estimate being revised to a 5% decline compared to a previous decline of just 0.1%. Operators’ total revenues in the region remained flat in 2008 at EUR 179.3 billion and are expected to fall by 4.3% this year to reach EUR 171.6 billion. In Western Europe, UK operators’ performance has been hard-hit by GBP exchange rates falling for almost 12 months preceding Spring 2009 – revenues in the country fell to EUR 25 billion in 2008 and are estimated to decline further this year by EUR 3 billion. On average, a 5% decline in revenues is also expected this year in Spain, Portugal, Ireland, Greece and Austria. Eastern European countries have also been badly-hit by the recession with currency fluctuations dramatically impacting operators’ revenues with countries such as Poland and Czech Republic reporting double-digit positive growth in revenue in 2008 but likely to report a negative double-digit decline this year.

It is important to stress that across Western Europe, most cellular markets have reached user saturation which translates into a slowdown in connections growth and consumer spend – see our report Multiple connections per user: The impact on penetration and ARPU. This phenomenon is having a stronger impact on recent and future operators’ revenue growth than the recession itself. The downward trend in connections and revenue figures throughout mid-2009 is not linked to a chaotic money market but rather to intense competition, price- wars in the prepaid segment, accelerating fixed-mobile substitution, declines in voice revenue and slow take up of data consumption.

Japan followed a similar scenario to the OECD’s Euro Zone with 2008 operators’ total revenue falling below GDP growth. Last year’s revenues in the country fell by 1.4% and are expected to decline by 2.7% this year. GDP fell by less than 1% in 2008 and 2009 estimates have been revised from 0.1% flat growth to a 5% decline. In contrast, South Korean operators registered total revenues in 2008 of EUR 14.1 billion and are expected to grow by 7% this year. It reflects the positive growth the Korean economy experienced following the fiscal stimulus and a rise in private consumption in the opening quarter of the year.

In terms of liquidity, the cellular telecom industry countered the uncertainty surrounding the impact of the financial crisis by reporting stable margins and cash flows. Our predictions from last year came true as we expected EBITDA to remain at similar levels to 2008 by the time world economies rebound. EBITDA has indeed been maintained at 33% of total revenues this year. This is the result of mobile operator strategies that focused on maintaining EBITDA levels in order to preserve strong cash flow generation. During the initial phase of the recession, investors were actively reviewing the profitability and solvency of mobile operators’ activities and their capacity to face short term challenges that the downturn will bring. In reality, short term liquidity increased between 2008-9 with operating cash flows standing at 22% of total revenues this year compared to 20% in 2008. In Q1 2009, operating cash flows grew by 6% year-on-year despite the fact that the recession was at its peak. Mobile operators have indeed managed to react quickly to those challenges, and efforts focused mainly on reducing structural cost and subscriber acquisition cost by lowering advertising and marketing expenses.

As a result of those cash flow optimization strategies, mobile operators have managed to pace operating expenditure (OPEX) along the decline in total revenue. During the initial phase of the recession in Q4 2008 and Q1 2009, OPEX stood at a high 63% of total revenues since revenues were declining rapidly but cost structure was still representative of pre-recession activity. During those two quarters, most mobile operators launched a wave of initiatives to reduce OPEX drastically, the effects of which have been measured in Q2 and Q3 2009 when OPEX declined to 60% of total revenues. Hence, overall between 2008-9, OPEX has been kept at 61% of revenues which is a very impressive performance.

However, in order to preserve cash flows, mobile operators took the initiative to reduce capital expenditure (CAPEX), a move we previously described as a risky decision. Indeed, a year ago we mentioned that even though a reduction in operating expenditure was inevitable, mobile operators would still have to keep CAPEX at normal level – around 13-14% of total revenues – since a squeeze in CAPEX could put some players at risk in the medium to long term. But nine months into 2009, we have seen CAPEX reduced on a quarterly basis to the lowest levels since 2007. Two thirds of the operators measured in this analysis have reported a decline in CAPEX which has been migrating down to 10% of total revenues this year compared to previous industry consensus of 13-14%. Such decisions to reduce CAPEX, as well as advertising and marketing investment, will not help mobile operators increase high-speed network coverage in saturated markets, to differentiate themselves from voice-centric competition, to develop consumers’ appetite for data services and to generate substantial profits.

Finally, from a funding perspective, we have witnessed that throughout 2009 the Standard & Poor’s 500 telecommunications services sector has not been outperforming other sectors as previously expected. The S&P 500 Index is a value-weighted index of the price of large cap common stocks actively traded on NYSE or NASDAQ stock markets. In November 2008, the adjusted market capital of the telecommunication services sector was clearly growing faster than the finance or information technology (IT) sectors. But over the past 10 months – led by the positive effect of governmental monetary policies – the telecommunication service sector has been reporting slower monthly growth than the IT sector or the overall S&P 500 Index. The adjusted market capital value of the telecommunication services sector actually stabilized throughout the year and declined by only 2% between November 2008-9 – but it declined by 33% compared to 2007. As we previously mentioned, such a trend clearly highlights the fact that the cellular telecom industry was not immune to the global financial crisis but was well positioned to counter short term challenges.

Time for change

The global economic downturn has led to a general slowdown and delay in the development of high-speed data services across most markets. Large operator groups have been focusing on short-term financial challenges and the intense competitive pressures on their domestic market, de-prioritising network coverage improvement plans in emerging markets. As most economies have now started to recover from the recession - and since mobile operators are reporting healthy balance sheets - we hope that 2010 will mark the time when mobile operators invest money in high-speed network coverage to meet the growing expectations behind data services.

In December last year, we claimed the financial crisis was likely to generate new opportunities, enabling mobile operators to rationalise strategies, take risks and pro-actively take actions to materialise data service expectations. Since then, however, we have seen mobile operators standing still, putting network coverage expansion plans on hold, carrying on a voice-centric price war, and saving cash – especially in Western Europe. 2010 will be another tough year with financial conditions only starting to ease up, and there is a risk that large operator groups will keep delaying plans to expand networks and further reduce marketing and advertising budgets. Over the past couple of years, mobile broadband expectations have been set too high and many consumers have been disappointed. But devices such as Apple’s iPhone and HTC’s Magic finally developed users’ appetite for data consumption and in 2010 users are likely to want more smartphones and data services. There is an urgent need to expand high-speed networks to more urban areas and, more importantly, rural areas, and invest in customer service and better marketing. As an illustration, Swedish infrastructure provider Ericsson recently announced that the anticipated decline in GSM sales, accelerated by the current recession, is not yet offset by the growth in mobile broadband.

Mobile operators such as Play (P4) in Poland, VimpelCom in Russia, AT&T, China Unicom or Japan’s SoftBank have all shown that it is possible to disrupt a market by launching effective and well-targeted 3G offers under a new appealing brand or banner. Large Europe-based operator groups – under intense financial pressure – could see their existing and potential 3G market share in their overseas operations decline rapidly if local operators or possible future new entrants rationalise their strategies around aggressive 3G investments. Eastern Europe is, for instance, a region with untapped 3G opportunities in which T-Mobile, Orange or Vodafone are rapidly losing ground to competition and should push forward 3G development.

2010 will be a tough year not only because the industry will still feel the effect of the global downturn, but because many markets have reached user saturation and there is an urgent need for mobile operators to differentiate their offerings. In a recent study, we found that, on average, Western European consumers each held 1.5 cellular connections per user, meaning that market growth is driven by this phenomenon of multiple connections. In every quarter we find that an increasing number of operators are reporting declines in net additions (around 65 globally so far in Q3 2009) and quarterly growth in mature regions is averaging 1%. This phenomenon of user saturation is the main reason behind operators’ slowdown in performances this year and 2010 will be a tough year if operators do not invest money in improving data networks and rethinking their position through innovative offers and creative marketing. It is our belief that the recession has just been exacerbating existing difficult market conditions.

Handset vendor recovery

In December last year we predicted that handset and infrastructure vendors would suffer greatest from the financial crisis. Handset vendors were already reporting rapidly declining revenues and margins, and in Q4 2008 and Q1 2009 the decline was even more pronounced. In our previous report we mentioned that the downturn will drag down handset vendors’ margins and make it harder for them to manage device subsidies and commercial incentives. We also said that Q4 2008 and Q1 2009 will be the toughest quarters, during which inventory management will play an important role.

And so it turned out. Across most industries, heavy de-stocking dragged down economic growth significantly in the opening quarter of the year. Handset vendors in the cellular telecom industry saw channel inventories falling from approximately 6 weeks to 4 weeks due to operators’ and distributors’ extensive de-stocking, which brought their stock levels better into line with sales. On top of that, the volatility of money markets and the decline in private consumption – as demonstrated previously for mobile operators – had a large impact on vendor performance.

Between 2007-8, global shipments from the top 5 handset vendors (Nokia, Samsung, LG, Sony-Ericsson and Motorola) grew by 2%, but throughout 2009 shipments are likely to decline by 10% year on year. Growth was substantial in China, India and the USA but Europe is still the region most affected by user saturation, driving down demand. Looking at next year’s prospects, Nokia – the world’s largest mobile device manufacturer – announced during its recent Capital Markets Day that it expects global device volumes to rise by 10% in 2010. If we consider that mobile operators are reducing the number of devices in their portfolios to order large volumes of high-value generating devices, then handset vendor supply chains will have to keep up with the fast adoption of smartphone devices and that segment’s rapid price erosion towards mass market.

As a result, in 2009 the top 5 handset vendors rationalised their portfolio mix by launching fewer devices and focusing on high-end and low-end segments. The market has therefore witnessed a recovery in operating margins over the past 9 months, driven by the effect of OPEX reduction plans ignited in late 2008 which includes lower handset subsidies. In 2010, we expect manufacturers to report healthier operating margins driven by larger smartphone portfolios in the mid price tier, a refresh of their high-end portfolios by Spring 2010, more predictable quarterly demand, stabilised money markets and reduced operating expenditures.

Definitions

Revenues

Total operator reported revenue, includes all recurring and non-recurring revenue. Recurring revenues are defined as Revenues generated by the use of the wireless network (i.e. excluding handset revenue and connection fees). Commonly includes voice, data and messaging and includes the traffic generated by the operator’s subscribers and the traffic generated by the other operators.

Gross Domestic Product

Gross domestic product is an aggregate measure of production equal to the sum of the gross values added of all resident institutional units engaged in production (plus any taxes, and minus any subsidies, on products not included in the value of their outputs). The sum of the final uses of goods and services (all uses except intermediate consumption) measured in purchasers’ prices, less the value of imports of goods and services, or the sum of primary incomes distributed by resident producer units. Real GDP is working-day adjusted.

EBITDA

Operating profit before depreciation, amortisation, profit or loss on disposal of fixed assets and exceptional items

Operating Free Cash Flow

Simple measure of Free Cash Flow: EBITDA - Capex

CAPEX

Capital expenditures in tangible and intangible assets excluding licenses

OPEX

Simple measure of OPEX: Recurring Revenue - EBITDA

S&P 500 Index

An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

Companies included in the index are selected by the S&P Index Committee, a team of analysts and economists at Standard & Poor’s. The S&P 500 is a market value weighted index - each stock’s weight in the index is proportionate to its market value.