Shareholder Value 2.0: Investors now rating telcos as 'utilities'. What to do?
[Ed - this is a summary of the Shareholder Value session at the 7th Telco 2.0 Executive Brainstorm, held in London on the 4th-5th of November. We'll be covering the same issues from a North American perspective in the 8th Executive Brainstorm in Orlando on the 9th-10th of December.]
This session covered the broad strategic and financial issues facing the telecoms industry, and its relationship with the capital markets. The presenters were Richard Kramer of Arete Research and Chris Barraclough of Telco 2.0. This article comprises a Report of the Session, and a Telco 2.0 Summary Analysis.
Report of the Session
SmartPhone Profit Smash in 2010
Richard Kramer opened on the future of the devices market. He argued that an epic battle for the device market is ahead; a combination of heavy investment in eye-catching new gadgets and savage price competition means that the smartphone industry profit pool will probably be net zero this year. A similar phenomenon can be seen happening with the network vendors - who have the further problem of growing competition from IT vendors, the replacement of expensive specialised hardware with generic IT equipment, and the pricing power of a consolidating telecoms industry.
In the devices world, a major driver of these changes was the arrival of Silicon Valley in the device market. North American vendors - Apple, Palm, Motorola, RIM, and Google as the main sponsor of Android - are finally pushing back after years of domination by the Scandinavian and Korean vendors, but this is likely to be the last hurrah, as vast numbers of Indian and Chinese engineers arrive in the industry. In the short term, Samsung is likely to benefit the most, but eventually, the chipmakers will start to hollow out the device makers. As the technology shifts towards system-on-a-chip packages, their makers will tend to work directly with carriers.
Telcos are rated as Utilities
Kramer expects that the big distribution players will win video, and the big Web 2.0 players will win applications; so it should come as no surprise that it is a fact, not a judgement, that telcos are now viewed as utility players by investors in all markets. In practice, this means that telco shareholders expect a focus on operational efficiency (cost reductions) and a strong dividend yield. They do not want to see free cash flow invested back in the business on the basis of expected growth, and no investors want to see separate LTE networks for each operators in each country.
As a result, the media and tech industries, despite being of comparable size and profitability, are rated significantly higher by the markets.
A maturing market in a recession is a tough place to be
Chris Barraclough also emphasised a realistic view of the industry's prospects in these times of recession. Summarising the strategic trends affecting telcos at the moment, he pointed to the increasing availability of substitutes for their products and the associated rising price elasticity of demand, the rapid rise in costs generated by the demand for bulk data (especially in wireless), and a regulatory environment that has been distinctly unfriendly in Europe for some years and is now becoming more stringent in the US.
It's probably not the time to change into a content player...
Further, there is little reason to imagine that the industry will change this through innovation in products or services. The experiences of investing in content providers and mobile TV demonstrate this clearly. Exclusive agreements to sell the latest shiny gadgets are by definition a short-term fix only, as the vendors have no interest in restricting their addressable market. App stores may be interesting, but they also generate significant traffic costs. As prices in the core business of voice and messaging are still falling, it's no surprise telcos are considered utility players.
... though there are other ways to create value from core assets
But there is hope. When Amazon was facing plateauing sales and heavy competition, it was able to fundamentally change its business model; the classic example of this is Marketplace, the service through which other businesses sell their products via Amazon. Marketplace enabled them to increase the number of SKUs on offer by a factor of 10, which means that it now represents 5% of revenues and 30% of profits. This seems counterintuitive - it meant letting competitors sell next to Amazon's own product lines. But, being a two-sided business model, it means that Amazon benefits from their success.
What do operators need to replicate this? Leadership - it's vital to get support from the top. Data-mining skills - Google makes money from a fraction of the telcos' data resources, because it exploits them efficiently and provides value to both sides of the model. And industry collaboration, because no operator is big enough to provide the ubiquity that upstream customers need.
Panel - Telcos can get something done...
In the panel discussion that followed, an important point that arose was that tech stocks are much more highly valued than telcos' even though they have a high failure rate. Richard Kramer pointed out that Google, for example, frequently shuts down failed projects. Investors in the tech industry - including big, reliable companies like IBM - are willing to tolerate repeated small-scale failures as the cost of progress. But telcos are rarely forgiven, so there is a significant deterrent to innovation - probably because the telecoms industry seems to struggle to come up with strategies to limit its commitment when it experiments, so the cost of failure is cripplingly high.
Providing they underpromise and overdeliver...
However, as Werner Vogels of Amazon remarked at a past Telco 2.0, it's probably best to start a project and deliver on it, and let the market be pleasantly surprised.
...and invest intelligently...
Telcos are currently businesses that employ a lot of capital, and which are under constant pressure to defend their margins. Chris Barraclough presented a chart showing asset utilisation against profit margins for different companies; Amazon, for example, operates at low margins but utilises its assets at very high intensity whereas most operators generate relative strong margins but have relative low asset turnover. Two-sided businesses tend to start with relatively high asset utilisation (ie they need limited capital investment) and low margins (they price low to win customers and build scale). However over time, as Google has shown, they can progressively lower opex and increase margins through capital investment. If they get this right and develop a leadership position, as Microsoft has done, they can yield very strong returns. Telcos need to get away from the obsession with margin. Too many projects at operators are blocked purely on the basis of margin. Yet a low(er) margin, low capex two-sided business model can still generate similar (or higher returns) than their existing high margin, high capex one-sided business model.
Delegates: the Future is Uncertain
Delegates were asked to vote on possible future scenarios. Several picked that operators should cut costs and become "Much More Efficient" while a signficant minority felt that they should continue witht the Telco 1.0 business model but do it better: "The same but better". 25% of so felt that a Telco 2.0 future was the answer (Progressive Change) while around 10% felt that the answer for Telcos was to harvest and accept a 'Slow Death'. All in all, no clear winning overall scenario emerged. These is because as an industry we are currently entering a phase of Fear, Uncertainty and Doubt (FUD) and there is no industry consensus on what the future holds.
Richard Kramer remarked that the scenarios delegates were asked to vote on didn't include two key limiting cases - 'Explosion of Innovation' from Telcos (an aggressive move to Telco 2.0), and 'Implosion of Telecoms', or to put it another way, telepocalypse.
Summary - Telco 2.0 Analysis
Investors aren't showing much faith in most Telcos' futures today...
Years of average performance have bred investor cynicism in Telco growth abilities, though at least most have reasonably stable cash-flow, so that Telco stocks were turned to for a dividend-rich harvest during the stock market volatility of the credit crunch.
...and Techs are valued, but risky
Likewise in Tech stocks, despite some strong recent performers such as Apple iPhone, the high points are likely to short-lived given the market outlook.
So, how should Telco and Tech companies respond?
Investors don't set strategies, CEOs do...
Most investors follow the success of yesterday's strategy in today's results and the majority of their interests are therefore logically locked-in on near term issues.
Yet they love CEOs and companies that beat the market norms with smart moves, and it is clear that maintaining or marginally improving the status quo will not be a formula for beating the average in these markets. New growth strategies are needed (see the unambiguous delegate votes from the May 2009 and Nov 2008 Telco 2.0 Executive Brainstorms).
... and some Telco 2.0 Strategies will work...
Some of the positive themes emerging from this session and the EMEA brainstorm overall were as follows.
• Telco 2.0 'two-sided' telecoms business model strategies are seen to be one of the few contenders for strategies to produce new growth in Telecoms and indeed in some related Tech markets, relying as they do on the evolution of core assets and capabilities rather than the complete invention of a new industry and set of assets.
• In the last 12 months there has been a significant increase in interest in and activities demonstrating Telco 2.0 Strategies, as shown by the senior delegates attending Telco 2.0 brainstorms, and many of the speakers and exhibitors.
• Many Telco 2.0 strategies are well suited to low-cost innovation and market testing, as many carry in-life Telco 1.0 advantages such as better retailing capabilities, and require relatively small amounts of investment given smart planning and alignment of resources. O2's Top-up Surprises is a good example of this.
• The new Telco 2.0 Use Cases presented were received well, with the majority of attendees concluding that they represent real market opportunities that can and should be addressed - or at least tried.
...but the clock is ticking...
However, a key conclusion of the Telco 2.0 Team following the EMEA brainstorm is that the 'clock is ticking' for Telcos in particular, who face an increasing challenge to exploit these opportunities for the following reasons:
• Telcos are not the only type of business capable of realising many of the opportunities. The national infrastructure interests of governments are increasingly setting some national broadband agendas, and the actions of adjacent market players such as Google have rapidly eroded the value of assets once thought to be Telco-specific such as location services.
• There has been a major global recession that has impacted opportunities overall and particularly in previously attractive industries such as Finance and Insurance, and which has also even more sharply focused Investors' interests in Telcos' cash and dividend flows.
• Telcos generally have a poor track record of innovation, and while some of the larger Telcos such as Vodafone appear to be taking significant steps in collaboration with partners in other regions, most telcos appear slow to embrace the level of legitimate intra-regional collaboration required to produce the sufficient scale in shared commercial platforms required to create new competitive 'upstream' markets.
...and Fortune Favours the Bold
In our view, the mixed outlooks of EMEA delegates on the prospects ahead reflect both the uncertainties and differences in perceptions of the large variety of organisations and markets represented.
As Kramer commented - "There has never been a more interesting time in my 15 years covering these (TMT) sectors. The one certainty is that the status quo will not be maintained. There will be some spectacular losers and some spectacular winners."
In short, the "big ideas" are beginning to encounter reality, and the opportunities to create new value are in the critical, market-defining stage. Not all of the opportunities will be realised, but it looks increasingly possible that some will, and that the winners - those that lead and participate, rather than the fast-followers - could ultimately emerge in a very strong position relative to their peers.
[Ed - if you missed the EMEA event we'll be exploring the American perspective at the 8th Executive Brainstorm in Orlando, 9th - 10th December.]