Transformation can be hugely valuable for telcos if they can grow platform and product innovation revenues to add to their core services. In this post previewing some of the findings from the new Telco 2.0 Transformation Index to be published next week (w/c 20th January) we show how this could work.
[Ed. For more on the Index, please email firstname.lastname@example.org or join us at OnFuture America 2014 in Silicon Valley, May 20-21, where we’ll be sharing some of the findings.]
‘Platform’ and ‘product innovation’ business models produce higher returns on capital
Telcos predominantly sell three undifferentiated services to downstream customers: voice, messaging and connectivity. This amounts to an infrastructure-led business model (Telco 1.0). Infrastructure businesses (e.g. Vodafone) are highly capital intensive (high EBITDA margins), and show low innovation (its few products are tied to the capital investment - the network) with relatively low returns on capital.
The operational and financial business models of both Google and Unilever, however, are very different to that of a Telco. Platform businesses (e.g. Google) require a mixture of capex (to build and maintain the platform) and opex (to run and market it), generate strong innovation, utilise a lot of brands (predominantly from other companies) and enjoy high returns on capital. Product innovation businesses (e.g. Unilever) have relatively high operating expenses (low EBITDA margins), but these operating expenses generate strong innovation and high returns on capital.
These differences are summarised in Figure 1 below.
Figure 1: Mapping the financial/operational differences between Vodafone, Google and Unilever
The table shows just how much higher the cash return on invested capital (CROIC) is at Google (18%) and Unilever (68%) as opposed to Vodafone (6%). This is naturally reflected in the price to book ratio: Google and Unilever have ratios 2.5 and 4 times higher than Vodafone respectively.
So if a CSP were to expand so that 15% of its operations are platform-based, that should (in theory at least) lead to a 45% increase in share price. Here’s how: suppose an infrastructure-led CSP has a book value of $85m. Figure 1 suggests a price to book ratio of 1.6, implying a total share valuation of ($85m × 1.6) = $136m.
Now suppose the CSP added a platform business to its existing infrastructure such that 15% of its revenues came from here. Its total share valuation is now ($85m × 1.6) + ($15m × 4.1) = $197.5m - 45% larger than $136m and, since the number of shares has not changed, its share price would also be 45% higher.
If a CSP were to expand so that 5% of its operations are product innovation based, this should lead to a 22% increase in share price (using the above methodology and the data on Unilever from Figure 1.)
Telcos need new approaches to generate new value
Historically, being a good CSP has involved making effective capital investment decisions and operating an efficient network. The internet has changed everything. It has fractured the integration between network and services so that voice and messaging are no longer the sole domain of the CSP. Enter the disruptors - such as Google, Apple and Facebook.
Inspired by the success of these internet giants, companies of all sizes are rethinking how they do business. They are creating and embracing diverse ecosystems, partnerships and innovation through a culture supportive of collaboration, rapid development and emerging technologies. This new approach is based on a two-sided business model (or platform model) that bridges between upstream customers (sometimes called ‘merchants’) and downstream customers (or ‘end-users’). For example, in Google’s case, the upstream customers are advertisers, and the downstream customers those that view and click on adverts.
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