Chapter 6

CHALLENGES AND OPPORTUNITIES

Understanding the unique challenges a sector faces can help investors better shape forward-looking expectations for the sector. Challenges aren’t always all negative—they can also frequently morph into opportunities for the firms and industries that can rise above. This chapter will detail some of the major challenges and opportunities Telecom firms face by examining AT&T’s revenues. AT&T is a decent proxy for the sector overall and is useful for this particular exercise because its diverse business segments encompass the same businesses as the vast majority of other Telecom firms. This should NOT be taken as an endorsement for or against AT&T.

A great place to start gathering information about AT&T, or any publicly traded firm, is its annual report, which can be found on the firm’s website or its EDGAR filings at www.sec.gov. Such filings include earnings, profit margins, and a whole slew of information further detailed in Chapter 8. But for our current purposes, we’ll take a look at AT&T’s 2009 sales in Table 6.1. Also, we’ll focus more on Wireline and Wireless than Advertising & Publishing because they represent greater percentages of total revenue and therefore likely play a larger role in determining AT&T’s performance in the near term (12 to 24 months).

Table 6.1 AT&T’s 2009 Revenues

Source: AT&T 2009 Form 10-K.

WIRELINE

Wireline is the vast network of wires and computers (switches) that are the infrastructure for the Internet and local and long-distance calls. Despite the prevalence of cell phones and new technologies, wireline remains 53 percent of AT&T’s revenue—a significant portion and therefore an important business to understand. Wireline is composed of three segments:

Challenges

The primary challenge for wireline is the demise of the Voice segment—it’s a mature business with intense competition. Deregulation increased the number of local and long distance providers, and technology has shepherded in new competitors like cable and VoIP. Furthermore, as detailed in Chapter 4, there are usually numerous political risks (like net neutrality—the regulatory challenge du jour).

Cable

Cable firms now contend for the same residential wireline customers as telcos. Cable firms have made big investments in equipment and facilities to provide more than just TV signals. Their special coaxial cable wires can handle large amounts of data to transmit VoIP telephone calls, Internet access, hundreds of TV channels, HDTV, on-demand programs, etc. As cable offerings further saturate US households, cable firms take phone and broadband market share at the expense of wireline providers like AT&T. And the trend is likely to continue.

In fact, cable appears likely to go after what remains—wireless. Some US cable companies are now creating free Wi-Fi hotspots to improve customer retention rates—likely part of a larger wireless strategy. The difference between cable and telecom companies will likely become smaller and smaller. They may someday even be classified in the same investment sector!

A big reason for cable firms’ success in taking market share is their ability to capitalize on low-cost VoIP services, which are popular with consumers because they’re usually “all you can eat” at a fixed price.

Voice Over Internet Protocol (VoIP)

VoIP, a recent technological innovation, is an alternative to traditional voice services. VoIP converts an analog signal (in this case, the human voice) into digitized units that are bundled into packets and sent over the Internet. At the receiving end, the packets are reassembled into an analog voice signal and voilà—a phone conversation not subject to the static and faintness of all-copper networks. And it’s cheap because the cost is largely equal to the minuscule amount of Internet bandwidth used.

Because VoIP uses existing Internet infrastructure, huge network expenditures aren’t necessary. The resulting low barrier to entry has given rise to numerous VoIP providers (such as Skype and Vonage and there are dozens more in the US alone). VoIP is not only a US or residential market phenomenon—it’s global and especially popular with business customers. To compete, AT&T and other telcos now offer their own VoIP services. However, even if they manage to retain VoIP customers, it often cannibalizes Voice revenue—a choice they must make.

Although VoIP’s threat is considerable, it was previously even greater. Prior to 2006, it had additional cost advantages in the US because it was not required to make contributions to the Universal Service Fund and pay termination charges like its beleaguered Voice peers.

Net Neutrality

By levying VoIP providers the same taxes as traditional Voice, regulators helped to level the competitive playing field somewhat. But with net neutrality, regulators could completely reconfigure the field.

Net neutrality is sought by the FCC to regulate how phone and cable companies handle web traffic. On one hand, net neutrality proponents believe restrictions are required so firms providing Internet services do not favor their own online offerings or those of partners that pay a premium for higher speeds. The concern is service providers will use tiered services to create artificial scarcity and remove competition.

On the other hand, telcos believe net neutrality will force them to be “dumb pipes”—nothing more than utilities providing pipes of Internet bandwidth at regulated prices. Telcos, like AT&T, believe they should have opportunities to be compensated for the financial risks of building a network—otherwise, why be in business? Moreover, they claim data discrimination is required at some level to guarantee quality of service for all users.

As of this book’s writing, it appears net neutrality is unlikely to pass—the Republicans have gained a majority in the House, and major broadband consumers like Google have made usage agreements with service providers like Verizon instead of waiting for regulators to come up with their own rules.

Nevertheless, even if the likelihood of net neutrality passing is currently low, it poses a considerable challenge because it’s difficult to predict the unintended consequences of regulation. Try as they might, legislators have shown a great propensity to not understand the domino effect of interjecting themselves into free markets. Not all regulation is bad, of course, and historically, increased regulation has often benefited telcos—but frequently to the detriment of consumers. Even the most well-intended regulatory changes can have deleterious side effects that are difficult, if not impossible, to predict.

Opportunities

Because Voice is challenged by intense competition and Data may be significantly impacted by regulation, firms reliant on those business lines (like AT&T) must look for opportunities to offset or overcome challenges. Some opportunities are obvious—for example, AT&T, like many Baby Bells searching for additional revenue and earnings, leases network services and capacity to competitors, which contributes considerably to its Voice revenue.

Nevertheless, the wireline business remains difficult. For decades, traditional Voice has been the cash cow, but revenues have been declining and that will likely continue. In order to address the numerous challenges and consumer demand trends listed in Chapter 5, the sections in this chapter will outline some initiatives wireline businesses have undertaken.

Fiber-Optic Cable

Copper, still used in many local telecom connections, has increasingly been replaced by fiber optic cable, which is capable of transmitting much more data. In the US, AT&T and Verizon have been extending fiber-optic cables to neighborhoods and homes, providing Internet access with speeds up to 20 times faster than traditional broadband.1 Greater capacity has provided the opportunity for Telecom firms to compete more aggressively with the high bandwidth delivered by cable companies and offer the same TV channels, HDTV, and video on demand.

Bundling

Initially, firms like AT&T entered the wireless market to position themselves for growth and to offset a declining wireline business. As both wireline and wireless markets have matured, however, new products and services have been sought to fuel growth and improve customer retention rates.

Now that fiber-optic cables have enabled telephone firms to offer video, they can bundle services. Consumers like bundling because it can be more convenient (one bill) and typically provides greater savings and utility. And firms like it because it can improve client retention. Furthermore, by selling customers more services, the ARPU often increases, even if the price for each individual service is discounted.

The “triple play” (voice, video, and data services) originated with cable providers and was quickly matched by Telecom firms. However, due to the limitations of copper wires at the time, video was initially provided to Telecom customers through partnerships with satellite service providers. Recently, Telecom firms caught up to cable companies by offering their own fiber optic–based video—and have surpassed them (for now) by adding wireless services to the bundle and making it a “quadruple play.”

Time to Market

In the not-so-distant future, there will likely be a race to offer a “quintuple play”—whatever that fifth service may be. By being first to market, a service provider has the opportunity to woo customers from competitors. But while this can be a powerful opportunity, the competition will eventually catch up, the benefit of the lead will diminish, and the race will be for the “sextuple play.”

Consolidation

When competitors catch up to each other and services become more commoditized, profit margins shrink. As a result, wireline businesses have sought to either diversify into higher growth products like television and VoIP—or to consolidate.

In a mature and competitive market like wireline, consolidation can be an opportunity to increase revenue and earnings. Often, just being bigger is better. Greater operating leverage and economies of scale can provide slightly better margins that make one company a more attractive investment than another. The opportunity for consolidation is well exemplified by Frontier Communications—a rural service provider.

Consolidation has been a strong force for rural service providers, whose costs can be especially high because of low population densities and are therefore subsidized by the Universal Service Fund. Frontier Communications bought numerous rural networks from competitors seeking to get out of the low-margin rural regions—in 2010, it paid Verizon $8.6 billion to acquire 4.8 million landlines. Such acquisitions represent opportunities for buyers to improve operating leverage and for sellers to get out of businesses that can be relatively unattractive.

WIRELESS

Wireless communications require radio frequencies (rather than a wire) to carry a signal over part of or the entire communication path. AT&T’s wireless business has grown significantly and now accounts for 43 percent of the company’s total revenue (see Table 6.1). Wireless is composed of three segments:

Challenges

Due to its relatively low penetration rates in emerging markets and higher ARPU in developed markets (because of data plans), wireless is generally the growth business for Telecom firms—but competition is fierce and businesses face numerous challenges.

Little Differentiation

Ideally, AT&T could easily and convincingly differentiate its services from competitors like Verizon. But the reality is wireless services are just slightly less commoditized than wireline services—one company’s wireless minutes are no different from another’s, driving down prices and resulting in a decline in wireless voice ARPU. Moreover, services like call waiting and caller ID, which were additional fees, are now free. Even unlimited voice and unlimited texts are now standard (for a price).

Network quality (dropped calls) and coverage area can be differentiators for wireless providers, but they’re often not convincing enough in many areas to drive a consumer’s carrier decision.

Low Switching Costs

When there is little differentiation between wireless offerings, there are low switching costs. If an AT&T customer lives in a region where Verizon’s network quality and coverage area are similar, he has little reason to stay loyal to AT&T—he can switch when Verizon offers a superior deal. Low switching costs result in high churn rates (attrition), which is bad for any business.

Prepaid

AT&T’s wireless business not only competes with the other three major service providers (Verizon, Sprint, and T-Mobile) in the postpaid US market, but competes with them in the prepaid market too. The prepaid market (consumers are not on contract; they prepay for minutes) is defined by aggressive price competition among the big four and a slew of prepaid-only providers, like TracFone (owned by America Movil).

Postpaid customers usually generate higher ARPUs than prepaid ones, so any gain in prepaid’s wireless market share is a threat to company revenue and earnings. And as you can imagine, prepaid’s market share typically rises during recessions since consumers usually have less to spend and credit requirements for postpaid plans are more stringent.

Opportunities

To combat fierce competition and wireless challenges, wireless businesses like AT&T’s are constantly seeking opportunities to better retain and grow their number of wireless subscribers, revenue, and earnings.

Data

Data has been the most significant opportunity for wireless providers to offset the decline in wireless voice ARPU. Smartphones have been a savior—as consumers and businesses upgrade their handsets to more integrated devices, like Apple’s iPhone or RIM’s BlackBerries, data plans are often purchased for amounts equal to or greater than the voice service. In addition to data plan revenue, there are opportunities to sell a wide range of other services to handsets boasting a host of other features, like music downloads, games, video on demand, mobile applications, mobile banking, etc.

The rise in wireless data consumption is also aided by the rapid growth in demand for new wireless devices like laptops, Amazon’s Kindle, and Apple’s iPad. However, the spike in wireless data demand has put increasing burdens on networks.

Next Generation Networks

Carriers may choose to invest heavily to upgrade their networks, expand capacity, and offer better call quality and data speeds than their competitors—a company can choose to simply expand the current network capacity or upgrade to the next generation of wireless technology. In both cases, the opportunity is to improve wireless subscription numbers and to have the capacity to sell more data-intensive services.

Handsets

Carriers have sought to motivate customers to upgrade from low-end phones to smartphones—they are a primary driver for wireless data consumption and revenue. One of the most successful strategies to attract upgrades and new clients is exclusivity on a “must-have” phone, as AT&T did with Apple’s iPhone. Although it’s not known how much AT&T paid for years of exclusivity, it was likely worthwhile because consumers flocked to AT&T, locked themselves into minimum two-year contracts, and also upgraded to its data plans. Because wireless services are pretty fungible, handset exclusivity can be a big opportunity for a carrier to stand out from the crowd.

Pricing

Opportunities to improve client retention rates and ARPU often involve pricing strategies. A common tactic is to subsidize a consumer’s handset price for a two-year contract. For example, both Verizon and AT&T sell a $599 16GB Apple iPhone 4 for $199 with a two-year contract. The price attracts consumers who cannot pay $599 up front or those looking for a deal. The carriers more than make up for the cost of the subsidy with the phone’s accompanying data plan—plus the contract ensures a more predictable and stable revenue stream.

Even if a carrier does not have an “it” phone, there are opportunities to market phones and data plans to a wide range of consumer segments. For example, instead of one “all-you-can-eat” data plan, which is too expensive for many consumers, wireless providers have recently rolled out tiered pricing plans for a wider range of data consumption.

Family Plans

Family plans are another opportunity to increase retention rates and revenue and cash flow predictability. Family plans allow additional cell phone users to be added to a plan for as little as $10 per month. The low costs reduce ARPU, but similar to the bundling strategy mentioned previously, by simplifying billing and offering greater value, it is less likely a customer will switch to a competing carrier.

Spectrum

The opportunity to own spectrum is valuable because it’s a finite resource and is needed to offer wireless services. In the US, for example, AT&T and Verizon have a material advantage over their competitors because their spectrum portfolios are much more extensive. Carriers with less spectrum may not be able to offer comparable data speeds and will likely need to spend more on building cell sites to more efficiently use the spectrum they do have. Often, the larger wireless companies have an advantage in acquiring spectrum because they are more able to afford the large sums governments charge.

Innovation

Rapid innovation has created numerous wireless opportunities in a short period. Such change and opportunity can be exemplified by Apple’s iPhone, which sold millions of handsets in just a few years, spawned the development of thousands of applications, and expedited consumer demand for wireless data plans.

Companies can successfully innovate beyond just product and service offerings. Bharti Airtel, India’s largest wireless provider, has grown rapidly by adopting an innovative business model. It’s practically a virtual business—its network is supplied by Ericsson, and its IT and billing are handled by IBM—it manages only sales and marketing!

ADVERTISING & PUBLISHING

Advertising & Publishing (only 4 percent of AT&T’s revenue) produces the Yellow and White Pages directories and sells directory advertising, Internet-based advertising, and local search. Although it’s a small portion of AT&T’s revenue and therefore an unlikely determinant of operating results in the near term, Advertising & Publishing has been surprising resilient—Yellow Pages ad revenue is $13 billion per year in the US, which is more than all magazine advertising combined.2

The challenges for published directories include high competition (there are more than 200 Yellow Pages publishers in the US3), the public’s growing use of Internet services, and diminishing use of paper directories. Additionally, there are some state legislative initiatives to get rid of the Yellow Pages because they annually account for more than five pounds of paper for each man, woman, and child in the US.4 White Pages are not threatened because they are required by law in most states, but they generate little to no ad revenue for publishers.

In the long run, the opportunities in Advertising & Publishing appear to lie in Internet-based ads—it seems likely the industry will eventually need to consolidate to maintain competitiveness in the face of declining use.

Chapter Summary

By marrying the trends in consumer demand from the last chapter and the challenges and opportunities from this chapter, an investor should be able to hypothesize which Telecom industries and companies should benefit from prevailing trends. Here are some of the major threats and opportunities:

• The primary challenge for wireline businesses is the demise of the voice segment—it’s a mature business with intense competition. Moreover, the data segment is threatened not only by competition, but by possible regulation too.
• The opportunities for Wireline lie in its ability to increase data speeds and offer more services. Also, it can improve operating performance through consolidation and can increase subscriber retention rates by bundling services.
• Wireless’s challenges are similar to Wireline’s. There’s little differentiation in services and switching costs are low, which result in a competitive environment.
• Wireless’s opportunities are to increase services and products that drive data demand, which has been a primary growth driver. Handset pricing and family plans are strategies to increase subscriber retention rates.