November 8, 2009

After the Downturn: The Four Trends Shaping Telecom’s Future

Telecom industry players must examine their position, and start creating the strategic capabilities that will bring them success, long after the recession has ended.

As the global downturn begins to show signs of abating, forward-looking players in the telecom industry must begin to focus on the strategies that will ensure their success in a more stable and growth-oriented economic environment. Based on an extensive series of interviews with industry leaders, combined with primary research and a review of a wide range of industry and economic data, Booz & Company has identified four opposing forces with the potential to redefine the boundaries and practices of the industry: Commoditization versus innovation, lean operations versus strategic investment, consolidation versus fragmentation and re-regulation versus deregulation. 

“These trends require industry players to understand the interplay between opposing forces and what that dynamic will mean for them. All industry players must examine their place in the industry, determine their aspirations for the future, and create the right set of strategic capabilities to get them there,” stated Ghassan Hasbani, partner and head of the Communications and Technology practice at Booz & Company in the Middle East.

Trends and Tensions

The downturn—combined with the very nature of telecommunications, the kinds of services it offers, and the large amount of investment capital required to sustain and grow the industry—has created these opposing forces. Industry players must now pay strict attention to the dynamics of these tensions if they are to sustain their business after the recession ends: They are likely to transform the structure of the telecommunications industry, potentially driving all players onto very different paths than they are taking today. Those that fail to recognize and respond to these new sector realities will find it difficult to maintain their competitive advantage in the long run.

Commoditization Versus Innovation 

As basic network services become more and more commoditized, industry players need to determine whether they have the scale to compete by offering the lowest possible cost. “Because commoditization leaves little room for differentiation in network services, the industry is likely to see a clear move to acquire scale even as a new wave of innovation emerges, with industry players seeking out ways to set themselves apart from competition,” commented Mohamad Mourad, Principal at Booz & Company.

The downturn hastened the move toward commoditization, particularly for traditional network services. For the integrated IP networks of the future, the last and only true network differentiators are speed of access and reliability. The long-standing force behind the trend toward commoditization of basic network services such as Internet access has been the increasing standardization of core network components, as well as market leaders’ desire to increase scale in the face of growing competition. Players that can maintain or increase their scale in the current environment and after the downturn ends will enjoy healthy returns and a strong position in the industry.

Similarly, suppliers of network equipment have long struggled with the rapid commoditization of new generation technology. Converging standards make network components an increasingly undifferentiated commodity, forcing suppliers to reduce prices on a regular basis and bringing on severe global price wars.

Opposing the trend toward commoditization, innovation in advanced applications and services is injecting new life into a maturing industry, and bringing it real economic benefits. “As network services become commoditized and margins erode for those not able to increase scale, telecom players are turning their attention from infrastructure investments to applications and content innovation,” stated Karim Sabbagh, the partner leading the global Communication, Media, and Technology practice at Booz & Company.

Innovative value-added services are also on the rise. Leading players such as Facebook and Google started small, but succeeded in creating new markets by generating demand for services. Now they can use the scale and share they have achieved to launch new applications that bring significant benefits to users and generate revenues through advertising. Despite their current difficulties, equipment manufacturers are also moving to promote innovation to counter commoditization. Next-generation technologies must offer high-speed access and support differentiating services and applications. Solutions that allow for user-generated content, facilitate the convergence of low-cost services and applications, and enable innovative pricing plans will be increasingly in demand.

Building Capabilities to Address Commoditization and Innovation
Maintaining the proper balance between commoditization and innovation will become a key strategic capability for successful telecom players. Doing so will involve deciding what their role should be. Every player must begin by assessing the sustainability of its infrastructure investments. Third and fourth players in some markets will be forced to give up the race for speed in their infrastructures, retire from infrastructure completely, and find an alternative path to growth. Others will be forced to pursue innovation in the services or content and media part of the value chain. “Even large multinationals and strong national incumbents may struggle to sustain an innovation agenda against agile global niche players with new technology and innovative business models,” Hasbani said.

Lean Operations Versus Strategic Investments

This tension may be the one that sets its two forces most strongly in opposition to each other. In the past year, industry players have made deep cuts in spending in preparation for recession-induced declines in revenues. The impact of the recession on most consumer-focused operators, together with the overall decline in prices for commoditized basic connectivity, will require all service providers to continue cutting costs as margins erode.

At the same time, no player can overlook the need for strategic investments dedicated to developing new targets and capabilities. In order to have the cash flow available for future strategic investments, further cost reductions will be required. This will require advanced cost-management measures that address truly structural cost drivers.

Lean Operations
“The downturn has forced telecom operators to reduce spending, explore ways to cut operational costs, and defer or reduce capital expenditures. These pressures extend along the value chain,” commented Hasbani. Both supplier and direct financing for infrastructure projects have become scarce. The downturn has also influenced how consumers use communications services, forcing operators to further reduce basic prices and subsidize all communication devices. In general, operators have not been as severely affected by the downturn as other industries.

Yet with operating margins already tight in many markets, cost-management measures that began as a natural evolution in response to increased competition, market liberalization, and deregulation have become a short-term necessity, as telecoms look to weather the economic storm. So far, most telecom players have been managing their costs in traditional ways, but the long-term effects of changes in customer behavior, and thus pricing, are uncertain, so it has become imperative for all telecom players to go beyond manipulation of traditional operating expenditure levers and take more advanced measures to address their structural cost drivers. That means further emphasizing a variety of cost-management trends that are beginning to emerge in the telecom industry, including increased outsourcing of operations and sharing of infrastructure, “pay as you grow” and deferred payments, and hubbing.

Strategic Investments
Telecom players with a lean financial structure and a strong balance sheet will be able to use their strong cash flow to attract financing or invest directly in anticipation of the recovery. Players that can successfully use the value released from their cost-optimization efforts to make smart investments will find themselves in a position of strength as the industry emerges out of the downturn. “Players that make strategic investments and position themselves to win the race for speed and scale on the network side can look to a variety of new technologies that may give them an enduring advantage,” stated Hasbani.

As the global telecom market evolves, every player must make investments that create sustainable competitive advantage. New business opportunities that offer room for growth are emerging in adjacent industries such as mobile banking, education, and healthcare. The convergence of media and telecom, in particular, remains fertile ground.

Building Capabilities to Address Lean Operations and Strategic Investment
Cost optimization has become a necessity rather than a differentiator. Now is the time, therefore, to apply advanced measures to address structural cost drivers and reconsider operating models at every stage of the value chain. Industry players must define the cost structures that will allow them to build a sustainable market position, with decent margins, as the downturn draws to an end. Striking the right balance between sustainably cutting costs and making the right investments will be a key capability for every successful telecom company.

Consolidation Versus Fragmentation 

The recession has had a significant impact on mergers and acquisitions activity in the telecom industry. Yet there is a clear structural shift toward a significant consolidation of both operators and suppliers, much like the wave of M&A activity that swept through the U.S. telecom sector following the bursting of the dot-com bubble. “The accelerated pace of technology innovation will create select opportunities for fragmented businesses and service offerings outside of areas of consolidation, eventually allowing them to define categories of their own and assume a leading position,” explained Sabbagh.

The downturn has created a great deal of uncertainty regarding the valuation of targets. Although the downturn has reduced company valuations and created attractive acquisition targets, shareholders remain risk-averse and reluctant to pursue them. The consensus is that equity markets are unlikely to be the source of significant financing in the short term. Although an environment in which cash is constrained is a challenge for the industry overall, it is an opportunity for players that have maintained strong cash flow.

Even for those without strong cash flow, there may be other options such as equity-based stock transactions (or “paper deals”). These could provide an ideal solution for stronger operators looking to acquire or merge with companies in distress, and for fragile operators that have struggled to secure financing and are seeking funds, but whose shareholders do not want to exit the industry. The dynamics of the trend toward consolidation vary among the different sectors of the industry: telecom carriers, manufacturers, equipment manufacturers and handset makers.

At the same time that the rate of industry consolidation picks up, ongoing innovation in technology and business models will create opportunities for fragmented businesses and service offerings outside these areas of consolidation. These new ventures will serve as a complement to industry heavyweights in the marketplace. Niche players will not be restricted to current markets, however. They can define categories of their own and assume a leading position in newly defined areas.

One source of opportunity lies in building on a specific technology solution that works on the edges of the mainstream technologies. However, new technologies are rarely successful without corresponding innovations in business models. Other opportunities may come in the form of new business models, creating a multitude of Mobile Virtual Network Operators (MVNOs) offering services to niche market segments. First movers in this arena will have a particular advantage, as they can define their own markets early on. “The commoditization of network infrastructure will offer such players a cost-effective base service upon which they can build their differentiated offerings and fill the capacity on underused networks,” said Mourad.

Building Capabilities to Address Consolidation and Fragmentation
Every player in the industry must develop the capability to assess its position within its market and then develop a strategy appropriate to it. Du, for example, operates within a single market, the United Arab Emirates, where it competes with the global operator Etisalat. In hopes of improving its position, it has opted for an innovation-based strategy that focuses on differentiation rather than scale. Alternatively, some operators have begun to build portfolio management capabilities that allow them to look at their business units as ‘separate’ businesses that could be sold if they don’t return sufficient strategic and financial benefits. Some globalizing players are building operating models that will allow them to realize synergies across geographies.

Re-regulation Versus Deregulation 

“The reluctance among incumbent operators to invest in fiber infrastructure outside core urban areas has troubled regulators worldwide for some time,” Hasbani commented. Regulatory bodies are slowing their efforts to liberalize telecom markets and are regulating markets less stringently, in part to help operators survive the cost and pricing pressures they are currently facing. At the same time, telecom regulators are renewing their focus on the further development of the telecom sector—an initiative that will result in long-lasting structural changes. In accelerating these trends, the recession is undermining the free market–focused regulatory philosophy that has long prevailed among most regulators.

Recent business cases suggest that if operators were willing to invest heavily in new national network infrastructures, it would take them a decade to achieve their objectives while remaining financially viable. However, many governments see the building out of broadband infrastructure as an important factor in promoting economic recovery and a key enabler for the economy in the long term. Regulators are increasingly shifting their focus toward sector development by fostering investments. Moreover, some governments are engaging in such investments. “We expect a renewed wave of regulation with respect to these national networks in terms of competition and infrastructure,” said Hasbani.

With regulation focusing more on the infrastructure side to ensure fast deployments of national broadband networks, we expect the ongoing deregulation trend to continue along the key dimensions of easing retail regulation and licensing. Over time, new licensing will be based more on services than infrastructure, across wireless and fixed markets. As a result, a new wave of virtual network operator (VNO) licensing will likely emerge.

Along the same lines, further decisions may be made regarding network neutrality. Regulators may grant infrastructure providers some advantages—either in wholesale price regulation, acceptance of infrastructure consolidation, or regulatory holidays—demanding in return that any service on the network will benefit from the digital superhighway of the future without discrimination.

With every telecom player focusing more on creating innovative services, the overall trend toward industry convergence will be accelerated. The most prominent aspect of this trend is the convergence of telecom and media, driven by the proliferation of content and applications services. As such, regulators are beginning to be more open to viewing their roles in different ways. “The long-standing separation between the regulation of telecom and that of media will slowly be eliminated, with “digital authorities” converging to serve as integrated steering bodies that regulate all elements of the digital economy,” explained Hasbani.

Building Capabilities to Address Deregulation and Re-regulation
Managing the interplay between the continued deregulation of retail services and the renewed regulation of national networks will become a critical strategic capability for industry players that hope to succeed in a more regulated environment. As regulators focus on the promotion of infrastructure and less-open markets, successful telecom players will target less-regulated areas such as service innovation.

In order to win in this environment, operators must instil innovation as a core capability in their organizations and explore the possibility of expanding into adjacent sectors such as banking, healthcare, and education, among others. Pursuing such opportunities requires a variety of capabilities, such as the ability to structure partnerships and alliances, and to learn the dynamics of industry sectors new to most telecom operators.

Positioned for the Future 

“The very different environment that telecom industry leaders will face once the recession ends and the recovery begins demands that every player make a conscious decision about its future role in the industry and the capabilities it will need to succeed,” said Hasbani. These capabilities will differ substantially for individual players. Industry leaders will continue to balance, manage, and lead all facets of their business, even as they fight to maintain and extend their scale. The four trends outlined will require dedicated focus and difficult decisions on the part of all industry players if they hope to build the capabilities that will create the right to win.

To define their position in the telecom world of the future, telecom industry players should ask themselves:

  • What will your market position be in two to three years, and who is aiming to take that position away from you?

  • What will your role be in the telecom value chain in the next three to five years?

  • Which elements of your value chain are consolidating? What should your role be in that process?

  • What is your right to win in your current position in the market and along the value chain—and in your targeted future position?

  • Which core capabilities will you need to achieve and sustain your right to win, given both where you are today and where you aim to be?

  • Of the capabilities you have now, which ones will you not need to achieve this role? What do you intend to do with these assets?

  • How does your ambition reflect public aims and approaches to regulation?

  • Where do you want regulation to go, and how can you influence its direction?