Will Big Get Nimble, Or Nimble Get Big?

Will Big Get Nimble, Or Nimble Get Big?

The next few years will see a battle between incumbent telco conglomerators seeking security in size and new entrants seeking growth through focus.

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Will Big Get Nimble, Or Nimble Get Big?

Vincent Tobkin, director and co-leader of the Bain & Co. Telecoms & Technology Practice, San Francisco, and Michael Garstka, vice president and a leader of the practice in Asia, argue the next few years will see a battle between incumbent conglomerators seeking greater security in size and new entrant deconstructors seeking greater growth through focus.

Every other month, another record breaking telecoms merger is announced. As telcos get bigger through a series of ever more breathtaking mega deals, increasingly embattled European telcos are feeling the pressure for bold moves of their own.


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But as incumbent telco CEOs pursue even greater scale and scope through acquisitions, building even larger telecoms conglomerates, a new type of competitor has entered the game. Rather than accepting the "bigger is better" accepted faith, they are forging a new religion of focus. This difference of strategic views suggests the next few years will see a battle between telcos with radically different models - traditional incumbent "conglomerators" seeking strength and protection in size vs. new entrant "deconstructors" seeking acceleration through focus.

A Salutary Lesson

The computer industry provides a salutary lesson on the values of swift and differentiated strategy in periods of such industry turbulence. There is a stretch of the M4 leaving London that a friend used to refer to as the "valley of the dinosaurs." Left and right as you headed out to Heathrow were the offices of Data General, Digital Equipment, Bull, and Wang. Together with IBM, these were the corporate icons that dominated the early years of the computer age. But when technological change accelerated and PC growth took off, these companies were slow to adapt.

Former startups now dominate the global computer industry, based on a strategy of "layer dominance": Intel in microprocessors, Microsoft in operating systems and applications, Cisco in networking technology, and Dell in PC assembly. These startups are now among the world's 50 largest public companies. Of the former computer dinosaurs, only IBM is in the top 50. The lesson? When turbulent change happens, it happens very fast, and with dramatic outcomes.

Today 10 incumbent telcos are among the world's 100 largest public companies, with a combined market value of over $1 trillion. In most countries, incumbent telcos such as Telefonica, Singapore Telecom, and Telstra are the largest listed companies on their local stock exchanges.

But if these incumbents cling to their previously successful business models in the face of the changes sweeping the telecoms landscape, they risk being displaced, like the dinosaurs of the early computer age.

The First Generation Telco

The first generation telco is a former national monopoly incumbent, such as Deutsche Telekom. The incumbent strategy has manifested itself in the form of a vertical and horizontal conglomerate. Driven by a universal service obligation, they have sought to serve all customers, with all products with a common service level. As they were historically the only player in their industry, the incumbent business model involves owning an end-to-end network and participating in all value chain activities (sales, billing, customer service, network operations). They typically own 100% of all of their assets.

The traditional financing approach has been to use limited leverage and to operate cashflow. The management culture is still primarily shaped by their utility/civil service heritage. The leadership is typically inbred, with promotion coming from within and life time employment the expectation of the workforce.

To date, this strategy and business model has served well. The incumbent has enjoyed a monopoly at home, and operated as part of an oligopoly of other incumbents on the international stage. As a result, the incumbent has a legacy of high margins and even now continues to generate significant positive cash flow.

The Second Generation Telco

In a handful of markets, this model began to come under pressure as regulators first experimented with deregulation. Deregulation launched a series of second entrants - MCI and Sprint in the US, and Mercury Communications in the UK. Second generation telcos were staffed primarily by former employees of the monopoly incumbent. They tended to copy the business model of their rival incumbent, but inevitably on a smaller and typically less efficient scale. They served all segments, with all products. They participated in most pieces of the value chain, and they spent a lot of capital building a transmission network and then an access network, because that is what telcos did. Then they crashed into the access barrier.

In fairness, they had limited choices. If they did not want to be the commercial mercy of the incumbent, they had to build facilities. There were major arbitrage opportunities with most customer groups. They typically had service obligations in their licenses that required build out. The regulatory environments provided limited degrees of freedom, and there was no WTO.

The economics of the industry were not that well known. But effectively, during this period the battle was between two companies with similar business models, but with radically different scales. The incumbents felt some pain in price decline and share loss but they pretty much held their own, and the historic business model remained intact.

An Industry in Turbulence

But the environment in which telcos now operate is going through a period of extreme turbulence, driven major change across a number of dimensions.

- Technology and Deregulation: Acting together, the two primary sources of turbulence are technological change (fiber optics, compression, processing power, and the shift to packet switching/IP) and deregulation (WTO, collapsing accounting rate system, spectrum auctions, and the move to local loop unbundling). While deregulation obviously varies by national market, the combined impact of these two factors is that the barriers to entry have fallen.

As a result there is now competing infrastructure in more network elements than ever before, and the fundamental economics of the industry have changed. This has generated a different set of "make vs. buy" or "build vs. rent" tradeoffs, opening up a radically expanded set of business model options for new entrants, but also incumbents.

- Fast Growing Adjacent Markets: These technology and regulatory changes have also spurred growth in markets that barely existed five years ago. The number of mobile subscribers will soon outstrip fixed lines in many markets. Data and internet usage are exploding. In many markets, data traffic already exceeds voice traffic. Mobile data services are set for take off. To succeed in these fast growing new markets, competitors must operate at a pace of decision making and execution that is unfamiliar to traditional incumbents. Pricing packages change daily, new products and channels are introduced monthly, and networks elements are swapped out every couple of years, not once in a career.

- Increasing Capital Markets Options: Some second entrants such as MCI were built on the back of the then-new high yield debt markets. The high yield debt market is now a ready source of finance for new entrant build out and growth. Since then the capital markets have further increased in sophistication, allowing the telcos to reduce their asset intensity by moving selective assets off balance sheet and placing them with investors willing to take on a set of focussed financial and business risks.

For example Nextel in the US last year sold one sliver of its wireless network - its communications towers - to SpectraSite for $630 million.

- Market and Investor Expectations. Investors are no longer content with utility type returns from telcos, rather they are looking for aggressive capital gains. For a while, incumbents have been able to ride this wave. They started with artificially low share prices driven by government privatization objectives, and they were able to drive early earnings growth by cutting out the legacy public sector work force overhang. But the market is now asking incumbents such as BT and Telstra where the growth will come from.

Having lost its infatuation with incumbents, the market is now placing very high values on focussed, high growth mid-size telecoms players with strong management teams. This provides focussed new entrants a lower cost of capital, an acquisition currency for accelerating inorganic growth, and an equity magnet for attracting and retaining the best talent in the industry.

The Third Generation Telco

The new entrant - or the incumbent telco if they are bold enough - can now deconstruct the telco of the past and reconfigure the select set of relevant pieces it needs to attack a focussed set of profit pool opportunities. Like the aggressive start ups of the PC computer revolution, these companies have focussed strategies seeking to establish layer dominance. This enables them to focus management attention and executional aggression on building industry leading capabilities in a critical element of the value chain, outsourcing the rest to other competitors. The result is competitors with radically different business models now attacking the incumbent and second entrant.

Some of these third generation players and the layers they are focussing on are outlined below.

- Transmission Layer: The transmission layer was one of the first attacked by focussed new entrants. The profits in the telephony business were concentrated in long distance, and acquiring the under utilised rights of way from railroads and power companies dramatically lowered the capital intensity and barriers to entry.

MCI and Sprint kicked off this wave in the US. Level 3 and Qwest are the latest generation, taking advantage of WDM technology dramatically to lower the unit cost of transmission. A number of players have replicated this strategy across other national markets, and Viatel has done so on a pan-European level. Global Crossing has extended the strategy to the international transmission value chain element, breaking the traditional international incumbent oligopoly.

- Access Layer: Recognizing that these emerging transmission networks needed local loop, access layer focus has become a major area of growth. Taking advantage of the introduction of SDH technology, early US competitive access providers (CAPs) MFS, Brookes Fibre, and Teleport quickly rolled out metropolitan fibre networks. Recognizing their strategic value, WorldCom acquired the first two, and AT&T the third in short order. COLT followed a similar access layer strategy in the UK and is now rolling out across Europe. PowerTel is doing so in Australian capital cities.

The broadband access race outside the fibered city centre is now being fought between fixed wireless players WinStar, Teligent, and NextLink and DSL-focussed digital local exchange carriers (DLECs) Covad, Northpoint, and Rhythms Netconnections. Maturing LMDS and DLS technology combined with regulatory decisions on spectrum and incumbent local loop unbundling have created the opportunities for these players. These highly focussed access layer models have not yet emerged with the same aggression outside the US, but soon will.

- Intermediary Layer: A completely new breed of player has emerged to create an intermediary layer between telcos. Whereas historically international interconnect was managed on a cozy bilateral basis, the last few years have seen dramatic change. The initial chink in the international oligopoly was second generation telcos such as Mercury Communications in the UK, which leveraged its international facilities duopoly at the gateway to Europe to develop a fast growing and profitable wholesale and refile business, vaulting itself into one of the top ten global carriers. But rapid deregulation of national markets and expanding international capacity has created a new environment.

A new breed of "facility-less" wholesalers or more appropriately market makers has emerged. Two of the players in this space are BandX and Arbinet, whose vision is to create a "bandwidth exchange" similar to a commodity or financial markets exchange.

- Customer Relationship Layer: Another set players are following an even more focussed approach, that of managing the customer relationship. These players focus on building a brand and excelling at customer relationship management. In their pure form they are "network-less" telcos, leveraging the abundance of infrastructure in deregulated markets and the interest of carriers in growing wholesale businesses to utilize this capacity.

One example is Australian based One.Tel, which has established a counter cultural "surfer dude" brand to draw in new customer segments. Backed by the Murdoch and Packer families, One.Tel is now aggressively rolling out the model across Europe. Virgin has similarly leveraged its strong brand to launch Virgin Mobile in a mobile reseller in the UK. Virgin has recently announced plans to roll out this model across Asia.

- Internet Infrastructure Layer: The latest set of layer focussed players are those building the infrastructure of the internet in the rapidly growing adjacencies to the traditional telecoms space, these include web hosting focussed competitors such as Exodus Communications and Digital Island, and business ISPs such as PSINet and Concentric Networks

The Battle is Joined

Over the next few years the battle will play out between these three generations of telcos. The outcome is far from certain. Issues and options are different for each player. For the focussed Third Generation Telco, the critical issues are around the long term sustainability of the model.

- Can the company scale fast enough (network roll out, customer acquisition) to dominate their selective layer?

- Once dominated, is the layer defensible and standalone sustainable?

- Can dominance in this layer be leveraged to extend into adjacent layers to further fuel growth?

First Generation Incumbents should view the threat from this new generation competitors in a very different light than second entrants. These focussed players will be targeting the incumbent's most lucrative profit pools, rather than the second entrant's more broad-based attack. Price declines will be more severe, and incumbent share loss will accelerate. These focussed new entrants pose a significant challenge. One incumbent strategy is to seek protection in size.

We would argue this is merely putting off the day of reckoning. Incumbents should be asking themselves the following hard questions:

- Would we operate more efficiently and aggressively, and would the market value us more highly than it does today if we operated as a series of separate companies?

- Where should we focus on which customer, product, and geographic niches to maximize growth and profitability?

- Perhaps more importantly, what do we stop doing?

- What should my business model look like?

- If we could start from scratch, which parts of our business and network would we keep, and which not?

- How do we accelerate into high growth markets?

- Can we do it internally, or do we need to develop a "new co" vehicle freed of the inertia of the existing organization?

- What new capabilities do we need?

- How do we attract and retain the best talent in a more competitive market?

- How do we increase the return on assets of our business as prices and margins fall?

- Are there ways to dramatically reduce our asset intensity?

For broad-based Second Generation Telcos, the choice is more severe. They are caught between the two models, lacking either the scale economies and cash flows of the incumbent or the agility and focussed executional aggression of the third generation models.

We would argue they need to transform themselves into a series of more focussed and aggressive companies. US second entrant MCI failed to do so, and was acquired by WorldCom.

In contrast, Australian second entrant Cable & Wireless Optus is following the opposite path. In mid-1999 CEO Chris Anderson aggressively restructured Optus into three focussed operational business units - Optus Mobile, Optus Data & Business Services, and Optus Consumer & Multimedia. The operational focus has lead to accelerated growth across the businesses, but particularly in mobile where Optus Mobile has continued to aggressively gain share vs. Telstra. The C&W Optus share price has almost doubled since the restructuring.

We believe it is clear that it is radical strategic and structural change, not incremental operational adjustments that incumbents and second entrants need to be considering in this time of turbulence. Both speed and strategy matter. Over the next 12 to 24 months, today's management teams may well determine their company's destiny in a more profound way than ever before. Success should not be assumed:

- IBM successfully morphed from a mainframe company to a services company, but Wang and Digital did not.

- Intel shifted from being a memory to a microprocessor company, but its Japanese and Korean competitors continue to lose money in memory chips.

- AOL aggressively shifted from a proprietary on-line service to the leading global Internet service provider, Prodigy and CompuServe did not.

In reflecting on the management angst and inertia in transforming Intel, former CEO Andy Grove noted that even he moved too slowly. "In times of change, managers almost always know which direction they should go in, but usually act too late and do too little. Correct for this tendency: advance the pace of your actions and increase their magnitude. You'll find that you're more like likely to be close to right." His advice is equally applicable to the CEOs and management teams of incumbent and second entrants today.


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