The Telecom Crunchonomics

Over the past few months, the world has been shaken by a financial crisis with tremendous impact across various industries. The economic downturn started with the collapse of the housing market in the United States of America, triggering large losses in financial institutions and severely damaged confidence in money markets.

Experts at the Organisation for Economic Co-operation and Development (OECD) have projected that most major economies will be in recession in 2009 with recovery expected by mid-2010. Emerging markets are likely to be strongly impacted by the downturn although until recently they were relatively unscathed. However, economists are projecting that negative economic growth in most countries will be re-balanced by an earlier-than-expected improvement in private consumption driven by lower inflation.

What does this mean for the cellular telecoms industry? In this report, we assess the general health of the sector and some key opportunities and challenges for 2009.

Tighter credit access, increased cost of living, currency fluctuations, and uncertainty in the depth of near-term financial troubles are likely to affect telecom players’ activities. However, the telecom industry is well placed overall to face the financial crisis until world economies likely rebound in mid-2010. It is ironic though, that fear and uncertainty suddenly reflects on the cellular telecom industry so skilled in driving hype.

Telecom players are being measured, today more than ever, on their ability to respond to short-term liabilities. Our key findings show that:

• Revenues: Total revenues generated by mobile operators, within the 30 OECD member countries, are expected to grow by 4.5% this year to reach 401 billion Euros. In 2009, we expect revenues to grow by 4%.
• Liquidity: EBITDA represents 30% of total revenues and is expected to remain stable by 2009. Operating Free Cash Flows range between 15-20% of total revenues, showing healthy signs of profitability, enhanced by synergies within large telecom groups.
• Funding: Although the market capital of telecommunication services has declined by 35% this year to date (NYSE, NASDAQ), it has been outperforming the S&P 500 index over the last two months (when the financial crisis began in earnest).
• Cost Control: Next year, mobile operators should maintain Capital Expenditure at around 13% of revenues to address high-speed service market opportunities. Operating Expenditure currently represents around 68% of total revenues and should be managed carefully over the coming quarters since substantial marketing efforts will be required to differentiate offerings in saturated markets and address consumer needs.

The economic downturn is expected to see telecom players review their positioning in areas such as consumer segmentation and pricing. Handset manufacturers will suffer from lower demand in high-end devices and extended replacement cycles, despite growth in emerging markets. Average Selling Prices (ASPs) will keep declining as the need for highly capable WCDMA devices in lower price tiers increases.

The financial crisis in context

A Tale of Four Indicators…

Since the failure of financial systems around the globe, investors are re-assessing the wealth of their assets, re-considering long-term plans and focusing on short-term survival. Four indicators come into play:

Capital: typically made up of highly secure debts and cash equity; it is an indicator of solvency which ensures that losses can be absorbed. In a period of recession, capital can be eroded as bad debts increase, triggering the need for capital raising. The latter will be a difficult task to achieve in a time when confidence has disappeared.

Liquidity: the larger the liquidity, the longer a company can secure its position through difficult times. Companies are now, more than ever, being grilled over their Cash Flow performances. Can a company afford to carry its activity on its own, without the help of distressed banking systems and investors?

Funding: most companies can finance their activities through public/private deposits, and hedge funds. If the stock market goes down, a company would be unable to replace its funding.

Risk management: most companies are being assessed on the basis of their market share and profit & loss account. However, a company can also file for bankruptcy because it ran out of money.

…And a Gloomy Macro-Economic Outlook

On the 25th of November, the Organisation for Economic Co-operation and Development (OECD) published its Economic Outlook which analyses current and future trends in economic development of the 30 OECD-member countries.

The Outlook reports that there has been a huge fall in global financial wealth and that the current uncertainty is exceptionally large and mostly to the downside. The financial crisis has spread to emerging economies which, until recently, were relatively unscathed.

Looking towards 2009, OECD economists affirm that a severe downturn is in prospect. Activity is expected to weaken further in most major OECD economies in the short term, with area-wide OECD growth likely to be negative for a number of quarters. Economic growth is to remain minimal for the remainder of 2009 for most OECD countries, with recovery not expected before the second half of 2010.

Of particular concern is the possibility of a negative feedback loop, whereby economic weakness exacerbates difficulties in already fragile financial markets. It could lead to more de-leveraging, tighter credit and real economy distress, including the possibility of deflation.

In emerging economies, growth has moderated but remains strong. In China, yearly growth fell to 9% in Q3 2008 with pressure on exports and capital raisings, however, there has been a rebalancing towards domestic consumption. In India, the slowdown became more pronounced, with growth now running below 8%. This slackening in growth has been led by a fall in investment, with private consumption holding up.

OECD economists explain that from previous experience of downturns in OECD countries associated with banking crises, the recovery is typically more anaemic than usual. The financial crisis is shaping the economic outlook although it can be offset by falling oil and other commodity pricing.

The cellular industry's balance sheet

The analysis provided in this report will cover all 30 OECD countries which will help to assess projected economic growth against cellular growth. Country members of the OECD are: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovakia, Spain, Sweden, Switzerland, Turkey, United Kingdom and United States of America.

Operator revenues

Amongst all 30 members of the OECD, the total revenues generated by mobile operators is expected to reach 401 billion Euros this year from 384 billion Euros in 2007, or a 4.5% yearly growth. In 2009, we expect total revenues to reach 418 billion Euros, a 4% growth from 2008. In most markets, despite the fact that the financial crisis will impact household wages, labour conditions and investments, domestic consumption is likely to remain stable next year.

The USA represents just below 30% of the total revenues of all OECD countries and is expected to reach 116.5 billion Euros this year, following a 6.7% yearly growth. Canada, in contrast, is expected to pass 10 billion Euros, just 3% of total revenues. Despite the fact that the USA have been in the epicentre of the global financial crisis, mobile operators in the country are clearly beating the gloomy trends. In 2009, we expect a 4.89% revenue growth set to reach 122 billion Euros.

The OECD reported that the US economy was confronting substantial challenges even before the recent financial turmoil, and that it is likely to have already entered a recession. Consumer spending is projected to decline or remain sluggish in the short term, as unemployment rises and credit remains tight. Experts at the OECD said that the US economy is projected to grow again during the third quarter of 2009.

We estimate that the top three US mobile operators (Verizon Wireless, AT&T and T-Mobile USA) will report double digit growth in annual revenues this year. With a clear focus on driving data usage, they are well positioned to compete effectively in the high-speed services battlefield.

In Western Europe, mobile operators are facing intense levels of competition in mature markets where voice revenues are stalling and new roaming regulations are affecting revenues. In the UK, mobile operators are reporting declining or flat revenues between 2007 and 2008, but the effect of roaming regulation on annual revenues will be diluted next year with a trend towards flat growth. We expect UK total revenues to grow by 1.14% in 2009 reaching 25.8 billion Euros, against a 6.4% decline for 2008 to 25.5 billion Euros. In Germany, Italy and Spain, the situation will be similar. Only France seems to stand out, with revenue growth projections of 3.7% in 2008 and 4.5% in 2009. Austria, Iceland and Norway are, however, expected to report negative revenue growth in both 2008 and 2009.

In Eastern Europe, cellular markets seem to be immune to the financial conditions with Czech Republic, Slovakia and Poland only expected to stop reporting double digit growth in revenues in 2009. Hungary, in contrast, is a highly penetrated market and mobile operators are already reporting flat growth in revenues for 2008, with a similar trend for next year. OECD economists are projecting that Hungary will go through a recession in 2009 before recovering in 2010. The decline will be driven by weakening export demand and slowing investment, but lower inflation is set to improve consumers’ purchasing power in the country.

Japan and South Korea have both been hard-hit by the financial turmoil. Economists affirm that Japan and South Korea’s expansion came to an end. Both countries have been negatively affected by the sharp rise in commodity prices which boosted headline price consumer inflation. Although Japan has learned from the bubble period and its corporate sector shows signs of resilience to external shocks, the financial crisis could reduce private consumption along with a risk of possible deflation. From a cellular perspective, we expect Japanese operators to report flat revenue growth in 2008 and 2009 at 0.99% and 0.48% respectively. In South Korea, total revenues are expected to grow by 7% this year and 2% in 2009.

Liquidity

Over the last few weeks, mobile operators in mature markets seem to have shifted their focus from revenue stimulation to operating profitability. This is a direct response to the financial crisis which forces most telecom players to show signs of healthy liquidity to face short term debts and challenges. It also reflects the fact that, in mature markets, where penetration is high and competitive pressure drives down voice revenues, short term solvency is as important as revenue share.

When assessing the share of EBITDA out of the total revenues for all OECD countries, the result shows that mobile operators are making very healthy margins. This year’s EBITDA is expected to represent 33% of total revenues generated by mobile operators, aligned with 32% generated last year. If 2009 witnesses the rise of mobile data services offsetting the decline in voice revenues, we could expect EBITDA to remain at a similar level by the time world economies rebound.

With regards to short term liquidity, we have calculated Operating Free Cash Flow (OCF) as a simple measure defined as: EBITDA - CAPEX. The result shows interesting trends amongst operators’ performances, and OCF represents around 20% of total revenues generated by mobile operators. This ratio is positioning the telecom industry as a rather healthy industry. In some cases, this ratio ranges between 30-35% with, for instance, most operators in Canada and Eastern European markets. Considering the opportunities driven by synergies within large operator groups, a safe assumption would be that the telecom industry seems to have sufficient liquidity to face the financial crisis even if private consumption only comes back to typical levels by 2010.

Cost Control

Managing costs will be the key challenge for the coming quarters, especially in mature markets. If mobile operators expect to offset voice price decline by driving mobile data usage, it will require network coverage improvement, consumer segmentation/targeting and marketing efforts. In other words, mobile operators that decide to squeeze CAPEX and drastically reduce OPEX should not dismiss the effect such decisions can have in the medium to long term.

Governments around the world are setting higher priorities on managing the so called ‘digital dividend’ opportunity, with the French government paving the way in Europe. Improving network coverage to allow consumers to use data services should be at the top of mobile operators’ agenda. From Q1 2007 to today, CAPEX represents around 13% of total revenues generated by mobile operators in the OECD countries. In our opinion, mobile operators should keep CAPEX levels at the same rate over the coming quarters. A CAPEX squeeze could put some players into trouble in the medium to long term, a lesson learned from the dotcom crash in the early part of this decade.

From Q1 2008 to today, OPEX represents around 68% of total revenues generated by mobile operators in OECD countries, compared to 70% for full year 2007. Decreasing OPEX seems to be inevitable and a wave of initiatives has already started from several telecom players. The push towards higher data usage will necessitate higher marketing spend and this should not be dismissed since it will help mobile operators to differentiate themselves against competitors in mature markets. The financial crisis and fear of recession will have a direct impact on the level of subsidies and replacement cycles. If it takes longer to replace a handset, or if consumers choose cheaper deals when upgrading and/or renewing their contracts, mobile operators can chose to rationalise handset subsidies. The logic behind it would be that they could cut subsidies on prepay and lower tariffs and focus their efforts on high-value consumer segments only. OPEX reduction will be a tricky factor to manage since it can indirectly influence price elasticity.

Funding

When looking at the position of the telecom industry in money markets, the trend shows the value of the sector going down but outperforming other sectors.

The Standard and Poors 500 index (S&P 500) is a value-weighted index of the price of large cap common stocks actively traded on either two of America’s largest stock markets: NYSE and NASDAQ. Telecommunication services only represent 3.7% of the S&P 500.

During the year to date, we have seen the value of telecommunications services decline by around 35%. However, the growth of the telecom industry has been outperforming the S&P 500 growth over the last two months when the worst effects of the financial crisis kicked in. Companies that were financing their regular treasury operations through hedge funds and commercial papers have felt the heat of the financial crisis over the last two months with the example of AT&T back in early October. However, today’s trend shows that although the S&P 500 (INX) value declined by 8.6% between October and November 2008, the value of telecommunication services grew by 5.60%. With positive credit ratings, secured liquidities and no direct impact from export activities, the telecom industry’s most urgent concerns are currency fluctuations and private consumption scenarios.

Time for change

The financial crisis is opening doors to opportunities, with the possibility for mobile operators to rationalise strategies, take risks and pro-actively take actions on outstanding issues to secure medium term positioning.

It is time for change, another influence echoed from the USA to the rest of the globe recently. If mobile data services are expected to drive revenue growth, it is time to start delivering on expectations and take action to make it happen. O2 (Telefonica) UK recently published research that highlights the fact that one in ten current mobile broadband users feel that they have been mis-sold. One-third of consumers felt deceived regarding the ongoing cost of the service which was higher than expected; one-fifth were upset that they could not use mobile broadband where they wanted it despite being told by providers that there would be coverage. Peter Rampling, Marketing Director at O2 UK, said that “across the industry there are too many customers whose mobile broadband expectations have been set too high and have been disappointed”.

The big challenge for mobile operators is that in saturated markets, they now have to improve customer service. Until recently, the notion of a market-share-earning gold rush had operators target ‘subscribers’ and only now is competitive pressure dictating an empathatic move towards targeting ‘consumer’ needs. On top of improving network coverage outside of the most populated urban areas, the challenge remains to build consumer confidence around new technologies especially in times where they become even more sensitive to pricing and contracts’ small print. Indeed, if private consumption declines or remains sluggish throughout 2009, and if consumers rationalise their spending on mobile services, value for money will be a topic of interest. Mobile operators are expected to focus primarily on high-value consumers, including the enterprise segment, although the cost of running unlimited data plans will sooner or later outpace revenues generated from it. Instead, the aim should be to reach mass adoption of mobile data services. However, to do so, mobile operators should position themselves as credible multimedia providers. Most players today are limited by the legacy of voice services; moving towards data services will require huge marketing efforts and a clear understanding of consumer needs.

Consumers across major economies are worried about increased cost of living, access to credit, larger debts and mortgage costs. Mobile operators should not dismiss the idea of rationalising their portfolio of services and simplifying offers. A good example of such a strategy is Softbank Mobile in Japan. Since it re-launched in January 2007, Softbank Mobile has simplified its offers, capitalised on its rich services portfolio and expanded its handset portfolio. As a result, the mobile operator’s disruptive pricing has transformed the Japanese market, forcing its competitors to react in a market highly penetrated and driven by high replacement cycles.

Handset vendors' mayhem

Handset vendors are in the eye of the storm and are expected to suffer from the economic downturn. Declining or even sluggish private consumption, increasing cost of living and limited access to credit are common factors that have a direct impact on the spend on devices. The financial crisis is expected to push ASPs towards lower targets in 2009, reducing margins further and making it harder to manage handset subsidies and commercial incentives.

Handset manufacturers are seeing the yearly growth in their revenues slow down or flatten out. Operating profits are becoming harder to manage with ASPs falling on a quarterly basis. In Q3 2008, Nokia outperformed its competitors in terms of shipments, whilst Sony Ericsson jumped to third place, overtaking troubled American manufacturer, Motorola. Samsung maintained its strong second position with a 13% quarterly growth.

Both Nokia and Samsung can expect seasonal demand to increase handset shipments in Q4 2008 with intense competition in high-end devices. The Korean manufacturer is looking at actively supporting promotions during the holiday season with co-sponsored promotions with mobile operators.

Over the coming quarters with the economic uncertainty and expected slower growth, handset manufacturers will have to strengthen inventory management and manage pricing strategies. One could also argue that demand in high-end devices could possibly slow down next year, with consumers picking mid-range devices, between an ASP of €150-€250. There is intense competition already in manufacturing low-tier WCDMA devices especially targeting emerging markets which are predominantly prepaid markets. Original Design Manufacturers (ODMs) are likely to play an important role in bringing new desirable products to western markets next year with lower ASPs and operator-branded handsets.

2009 will be a rocky year for some manufacturers. Nokia is well positioned to break through into the services space with the launch of its ‘Comes with Music’ service although there is still some uncertainty as to how such vendor services will be integrated into mobile operators’ own service platforms. LG and Sony Ericsson are likely to capitalize on their core competences and segments, rationalising their portfolio to address profitability challenges. This might well mean that they can reduce the number of devices in their portfolio and focus on added-value segments. Samsung, on the other hand is renowed for its extensive portfolio of devices mainly addressing mid to high tier consumer segments. It will be interesting to observe how the Korean manufacturer responds to the recession in its domestic market which has already been described by OECD experts as severely impacted. However, the country is expected to benefit from the large depreciation of the Won, in the medium term, which may lead to an upturn earlier than expected.

Their opinion...

Martin Garner

Martin Garner is Director of MNG Research. Prior to setting up his independent telecom consultancy, Martin was Director of Telecoms Products and Services at Ovum, the analyst firm. He has 15 years experience in telecoms, with 9 years as a consultant.

The last time the telecom industry went through a rough financial cycle was in early 2000s following the dotcom crash. What have we learned from this crisis that remains relevant in today’s market conditions?

The background was built on the notion that we were in a transition to a ‘new networked economy’ driven by a rapid expansion of mobile around the world and rapid economic growth within countries. On top of that, the deregulation of the industry allowed telecom players to expand their footprint quite aggressively leading to (over-) investment in mobile licenses with the belief that it could play a strong role in the networked economy; and inflated stock market valuations of Internet and telecom companies, leading them to have great purchasing power.

The crash was triggered by a loss of confidence in the technology sector, with investors questioning that:

• Many of the dotcom entrants had weak business plans and inexperienced management
• The best approach to building an Internet business was to go all out for reach and market share, only later worrying about profitability
• WAP was a painful experience, leading to disillusionment with the potential for mobile Internet

From this phenomenon, we have learned that:

• Networked effects may well exist, but are easy to over-estimate and hard to demonstrate.
• Profitability is really important, even in the early stages of a company’s life
• Banks and financiers can have a major causal effect both in boosting investment bubbles, and in de-flating them – something that we’ve just seen very emphatically re-inforced over the last few months.

What opportunities could emerge from the current financial crisis?

The big one is the opportunity to undertake relatively cheap acquisitions of distressed assets - for telecom players that have cash and a plan. Now is also good timing for trying out new business models and many companies are more experimental and open to suggestions in looking at ways to save OPEX. Having said that, the pace of innovation can slow as companies are less willing to invest and are using cash-generative areas to fund their way out of difficulties. It raises the profile of alternative sources of funding from vendor finance to angel and private investors.

Ericsson

Ericsson is a world-leading provider of telecommunications equipment and related services to mobile operators globally. Ericsson has network equipment installed in over 1,000 networks in more than 175 countries.

Is the general economic downturn likely to impact the telecom industry?

While operators are financially healthy in general, they are not immune to the effects of a rapidly weakening macro-economic environment. Looking back at the last market downturn, we can see that our customers are in a much improved situation now. In 2001, many operators had over-invested and weakened their balance sheets with too much debt from acquisitions and 3G license fees. Consequently, they had little choice but to focus on cash generation and put many projects on hold. Today, their networks are tightly trimmed and well utilized but traffic continues to grow which requires continued investments. However, there is a historical correlation between GDP and operator CAPEX but with some time lag. Operators usually continue with funded projects but often become more cautious when making new commitments. There is another correlation between operator revenue growth and CAPEX which implies that operators have to invest to increase their revenues and ultimately their profits.

It’s too early to say how the financial market turmoil will affect our business in the short term but we expect to continue to benefit from ongoing trends to expand and upgrade fixed and mobile networks to accommodate accelerating demand for mobile broadband and interactive HDTV. This in turn will increase business as well as personal productivity while positively contributing to sustainable societal and environmental improvements. With this view of the longer term and a cautious near term perspective, we are planning for a flattish equipment market in 2009 assuming many operators will continue spending at current levels while operators with lowered spending offset by increases in other markets e.g. China. However, with our focus on operational excellence to keep cost in line with our sales opportunities combined with our market leading position and solid balance sheet, the company is well prepared to meet tougher market conditions.

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.