Why Operators are not opening their networks

Apparently cable operators are reluctant to open their networks, because this would strengthen the position of the incumbent telco's. This is an artifact of a somewhat shortsighted vision.

The response was to be expected and is caused by the view of operators on their competitive market. A known problem with Porter's 5-forces model is that of defining the relevant market. Cable operators traditionally regard their market as distributors of broad casted content. Therefore new competitors using DVB-T, such as KPN, are seen as new entrants and internal competition would come from other cable operators. This is a flawed definition of the market.

First of all, cable operators are hardly each others competitors, because the coverage of their network is non-overlapping. This means that cable operators compete with operators using different network technologies, such as fiber, DSL or DvB-T. In the Netherlands this implies that KPN is their main competitor.

Secondly, a significant share of the ARPU is not generated by analogue tv, but by other services and often in triple-play bundles. Since voice and broadband represent significant revenues, cable operators compete directly with incumbent telco's that use DSL in stead of Eurodocsis. Therefor, again, KPN should be considered an internal competitor in stead of a new entrant.

So what are new entrants?

In my opinion Over-The-Top operators are new entrants. Such operators do not own a network, but piggyback on operators networks to deliver services. This reduces integrated service providers to "bitpipe" providers wih a percieved low added value. Examples of such providers are Skype, Google, Microsoft, Yahoo, YouTube, Apple, Vuze (bittorrent), Joost.com, etc.

If cable operators -and incumbent telco's- would have defined their internal market larger, they could have a different perception of internal competition and competitive pressure of new entrants. This would have made them understand that there are other, new market forces at play and they cannot control it.

Only bold operators neutralize these new entrants by embracing them in there networks. Such bold operators would seamlessly integrate the OTT services in their offerings, likewise Apple has integrated YouTube on its Apple iPod Touch.

Further Analysis of the Telecom Market

My analysis of the current telecom market found some resonance. People recognize that web 2.0 is a catalyst for market transformation. Yet, web 2.0 seems a difficult terminology to grasp. The terminology was first introduced by Tim O'Reilly as a business revolution in the IT industry caused by the move to Internet as a platform. It seems at best that web 2.0 can only be characterized in non-exhaustive terminologies, which, at least partially, explains its inflation.

Some characteristics can be (according to Best and others):

• rich user experience
• user participation
• dynamic content
• meta data
• web standards
• scalability
• openness
• freedom
• collective intelligence by way of user participation

A terminology that struck here particularly in this context was "crowd sourcing", we will come back to this issue later.

Back to my initial assessment.

A first remark on the observation that the market is stagnant in the Netherlands (I've not assessed this for more markets but I have reason to believe this is generic for all developed countries). To understand the reasons for stagnation, you need to understand the three key drivers behind the phenomenal growth in the '90's and early 00's.

1. Privatization and deregulation: In the '80's the US privatized and split-up AT&T followed by an active deregulation policy of the FCC. This trend was adopted in the '90's by most EU members. KPN was privatized in 1989, and had its IPO in 1994. Until 2006 the State had a golden share in KPN.

2. The rise of GSM: GSM was formed in 1982 and the GSM specifications were set by 1987. ETSI adopted the standard and ratified it in 1990. Its first commercial deployment started in 1991 in Finland ans soon spread over the globe. In 1993 the first GSM network in the Netherlands replaced the analog ATF-1~3 networks. In 15 years time mobile penetration rose from near 0% to 130% in the Netherlands. Historically, this is nothing less than a revolution!

3. The rise of the Internet and broadband: The history of the internet is well documented and in the Netherlands specifically it was commercially launched in 1989 by NLNet (only B2B) and XS4ALL (1993, now owned by KPN) via dial-in. Soon this created the demand for broadband. I recall being in a technical summer school as a student at KPN research in 1995 and we were "enlightened" by promising technologies such as ADSL, ATM and fiber. Not a lot of people realized this but just a few years later, KPN followed BBNed (Telecom Italia!) as market leader in DSL in the Netherlands and most of their networks were ATM over DSL. Cableco's followed with Eurodocsis and the rest is known. Currently the broadband penetration is over 33 lines per 100 inhabitants, which is about 70% of households in NL. Yet if you look at the traffic of the Amsterdam internet exchange, the largest Internet exchange in the world, you see two things:

1. the avg bandwidth is low (typically less than 64kbps per connection or 1 E0)

2. the bandwidth is rising dramatically since the emergence of Youtube:

The crossroad of these three drivers, each by itself a revolution, caused a phenomenal growth of the industry into maturity in about 10 years time. It seems that whereas the 90's were the decade of the rise of the networks, the 00's are the decade of the transformation of societies caused by the paradigm changes of the 90's (Internet as a platform or web 2.0!)

Next the categorization of the traditional, vertically integrated service providers:

Not knowing of the existence of the article "Unbundling the Corporation (Harvard Business Review; Mar/Apr99, Vol. 77 Issue 2, p133-141), we split a typical Telco up in three layers. It's a reassuring though that we derived these three layers independently from the authors of this publication (both were principles of McKinsey at the time). The article gives more substance behind the thought. If you read the article you will see it matches completely. They analyze:

1. CRM:

• Economics: high customer acquisition makes it imperative to gain large wallet shares; economies of scope are key
• Culture: Highly service oriented; "customer comes first"
• Competition: Battle for scope, rapid consolidation, few big players will dominate

2. Product Innovation:

• Economics: early market entry allows for premium price and lager market share. Speed is key
• Culture: Employee centric; coddling the creative "stars"
• Competition: Battle for talent; low barriers for entry; many small players thrive
  

3. Infrastructure Management:

• Economics: High fixed costs make large volumes essential to achieving low unit costs; economies of scale are key
• Culture: Cost focused; stress on standardization, predictability and efficiency
• Competition: Battle for scale, rapid consolidation, few big players will dominate

As you see this resembles my observation nearly perfect. As a result of this I conclude that:

• the high fixed costs are high barriers for entry in the infrastructure space. Yet, they also restrict innovation, for instance the roll-out of FttH. Hans and I discussed that the ambition level of KPN to install 5k FttH lines per month is hardly noticeable. At this rate only 600k households will have FttH in 10 years time, or less than 10% of all Dutch households. A national roll-out (7M households) would cost about EUR 7B, a number the market could bare. Compare this investment to high-visibility investments in the high-speed railway (EUR 6.3B and counting) and the railway track "Betuwelijn" (EUR 4.7B and counting). Imagine what a catalyst to the economy it would have been if this money was invested in FttH in NL. A collegue and I discussed the role of the regulator in this area. I believe this role is imperative, as without it, the market will not have sufficient incentives to invest in infra's with a 30 years business case. Especially because the highest risk for such long depreciation cycles is the regulatory authority and the State itself. Not coincidentally the countries with the fastest growing FttH deployments are countries with a strong state influence (Korea, Dubai, etc.).
• the high costs of customer acquisition (I was involved in a pilot which resulted in a CAC of over EUR 400 for a consumer customer of EUR 240 ARPU and less than 15% operational margin) will drive any company with a significant customer base to diversify its product/service portfolio. Banks are entering the Telco space (as they have done in the '90's), but strangely enough, Telco’s do not demonstrate such bold moves into new markets. Maybe their CRM capabilities are lagging too much to pursue such a strategic shift.
• The battle for talent is withholding the operators from succeeding in the product innovation space. Google and the likes are much more successful. Sergey Brin (CTO and founder of Google) announced a contest for the most innovative application for their new mobile platform Android. The winner gets $10M. How many submits do you think they will get? Typically just one new service development would cost a traditional telco such an investment. This demonstrated the power of "crowd sourcing". Other examples are the X-price (for commercial space exploration) and others.

Ultimately, I believe there is a burning platform. The current business models and positions are not sustainable. There are very successful companies that have demonstrated several strategic shifts in the past. Take Nokia. Once it was in the timber/paper industry, then in rubber boots via TVs into mobiles. So it transformed from an agricultural monopoly into an industrial company into a high-tech company. It takes bold leaders to make such shifts. A more local example is Akzo, which sold its bulk-chemicals and medical divisions and is focusing on paints.

I believe it is worthwhile to analyze this further, including quantitative data, references to Harvard Business Review, statistical data, apply Porter’s 5-forces model and so on.

The road ahead for telecom

In my first attent to create a blog, I post a summary of a mail with my point of view on the Dutch telecom market. The mail stirred up some debate.

A collegue and I have been discussing the Dutch market conditions for some time. The big paradigm that is currently materializing is that of a shift of vertically integrated service provides towards horizontal providers. The Dutch regulator actually published a report on this some years back and the EU regulators are in favor of such a shift.

What this means is that physical (access) networks must be opened for third party (over the top) service providers to deliver services. Based on this shift, Koen and I have been discussing what the competitive, strategic position is of current operators like KPN and UPC. Using Porter's 5-forces model for competitive analysis, you can see a trend of worsening conditions for existing operators.

On one hand these operators have shareholders who still have growth expectations (KPN announced another 2000 lay-offs yesterday, but also a "path to revenue growth" of 25% in three years), on the other hand there is a consolidating market (NL: Central Bureau of Statistics shows stagnation or even a modest decline since 2002) while competition of OTT providers is starting to become significant. It seems that shareholders expectations are not in line with market realities. There may be an overvaluation of the operator market (not specific companies, but the market in whole).

As an example take Skype. In 2003 there were 10k users on-line and operators were probably not even aware of Skype. In 2004 KPN commented that Skype was not a serious service because it offered no QoS. In 2005 Skype partnered with ePlus (KPN mobile in Germany) to provide Skype over 3G. Still, analysts all over the industry said that the volume of Skype did not have any impact.

I see this differently. Skype generates more voice minutes that KPN per year. Yet Skype generates roughly 5% of the revenues that KPN does. That's not a problem, since they hardly have any costs. Yet, on a macro level, They've subtracted 4B EUR revenues from the total market. What's even worse, the price/value perception of customers has been seriously impacted by Skype and has driven down price points further.

This made me think that existing operators have three areas of interest:
CRM
Services
Network

The CRM capability is best explained as follows. Consider mobile payment. Who would you trust more, your bank or your operator, to handle your mobile payments? Rabobank has started such services (MVNO), ING bank has it on the drawing boards, etc...

Services: operators have a track record of not producing killer apps like Google, Yahoo, Skype and others have. Ultimately, the best people of the industry are not working for them, but rather for companies like Joost.com. Ultimately, if operators are forced to open their networks, I believe they will have difficulties to defend their position and since they have a nearly saturated market share, they much to loose and little to gain. To make a point, look at the website stats of Comcast and compare it with Youtube:

We can argue about the validity of statistics, but it does show a pattern. The only operator on Alexa's global top-100 is Free (http://www.free.fr/). http://www.alexa.com/site/ds/top_sites?ts_mode=global&lang=none
If you take a look at P/S (price/sales) of companies, you will find a similar trend. Companies like Google have a ratio of 5~10, companies like KPN typically have a ratio of less than 2.

Network: I believe this is the only area where operators can defend their position. The downside is that "network only" is a commodity/utility. I was absolutely shocked the first time I read the business case of Reykjavik Energy who had plans to deploy ftth as a barebone, utility service. The business case used a depreciation period of 30 years and a break-even in 16 years. It took some time to realized that the htc and twisted copper pair which is being used for broadband is already 25 years old. I realized that investors in operators expect shorter paybacks and that may be a reason why operators are struggling to invest in ftth (too low NPV, due to too high discount rate). In essence, investors may be looking for a different risk/return profile. Wireless equivalents to ftth could be WiMax or other technologies, although wireless inherently has less protective entry barriers.

So, it seems that the key question is: how can operators protect their shareholder value?