Investors relearn steps as telcos dance with value
Broadband and butter don't have much in common on the surface - but a supermarket-style preference for value may gradually affect the telco market, writes Rob O'Neill
When the mainstream media talks about business, the story is usually about winners and losers – which companies are gaining revenue and market share, and which are not.
Only rarely do they address the underlying battle for value between consumers and investors.
By and large, the media takes the side of its readers, the everyday consumer. In this scenario, companies that deliver great products and services for the lowest price are the heroes.
Investors, the people taking most of the risks in the market, often fade from view.
Over the last decade in New Zealand, telecommunications consumers have been the winners, mainly because of regulatory interventions that have created hyper-competitive markets. After years of dysfunctional monopoly-owned networks, consumers are, rightly, enjoying the value unleashed, in part, by regulatory change.
Managers in telecommunications businesses, however, are faced with the challenge of both winning market share and maintaining or boosting margins for their owners. It’s a tricky balancing act.
Improved services also have to be paid for – especially in rapidly changing, capital-intensive businesses such as telecommunications, where expensive network upgrades are a constant.
At the core of the battle is the concept of value – and who gets it. For consumers, it comes in the form of low prices, high speeds, large data caps and great services. For investors, it comes in the form of dividends and share price improvements.
Blair Galpin, senior equity analyst with investment adviser Forsyth Barr, says the single biggest challenge in the telco industry is to increase overall margins, as opposed to moving that margin share around between the different players, and different parts of the industry.
“For that to happen, we have to see consumers willing to pay more for the services they get,” he says. “That’s the biggest challenge.”
Galpin has enjoyed a box-seat view of these developments for over a decade. In senior roles at Telecom, he witnessed the operational and structural separation of the market. More recently, at Forsyth Barr, he has analysed battles over the regulated price of network services provided by Chorus and their impact on the industry.
It is, to some extent, a story of lost opportunities.
“I believe the value the consumer gets from telco services has increased dramatically over the last three or four years and we haven’t seen even a small proportion of that being recovered in higher prices,” Galpin says.
“I think there has been an opportunity to charge more for services and that hasn’t been taken.” The biggest price drop, he says, was that in the price for unlimited data caps three years ago.
“I didn’t see the need to reduce the price on that. My view was demand would have met that and consumers would have paid a higher price for unlimited data. But once you’ve given it away it’s hard to claw it back.”
Last year’s telco industry report, the Commerce Commission’s Annual Telecommunications Monitoring Report, said there was not enough margin in the industry, but added that providers could be more aggressive on pricing. There’s an obvious disconnect here, Galpin notes.
“As a telco provider, you don’t want to be lumbered as a ‘dumb pipe’. The challenge is that in extending beyond that dumb pipe you are increasingly coming up against international competitors in other spaces.”
Those players include giants such as Apple, Google, Facebook and Amazon.
Efforts by local telco operators and banks to launch their own payment products is a good example. This came at a time when Apple and other handset providers had already taken a lead in this emerging market.
The “value question”, though, is complicated.
“To increase your margins, you’ve got to sell more or you need to get more for what you sell, or you’ve got to reduce your costs,” Galpin says.
There is organic market growth as our population rises – by around two percent each year. But, at the same time, traditional revenue pools (calling revenues) and margins are shrinking.
Consumer demand is strongest around mobile, but, at the same time, demand for high speeds and large data caps is also growing.
“So, you have this ongoing demand, whether from business or the consumer, for more and more use of telco services,” Galpin says. “Separate to this is what people are willing to pay for it.”
Another way to improve your margin is to bring it in from other related industries. Spark has done this through the acquisition of datacentre and IT service providers.
There are still reasonable margins being generated around the traditional PSTN (Public Switched Telephone Service), Galpin says. There is also quite a lot to be made on mobile calls.
But there are also emerging risks to margins that are already smaller than they used to be.
If you look out three to four years, the question is, does traditional mobile calling become an app on your phone anyway?
What Spark has shown is that you can increase your revenues but that doesn’t necessarily increase your margins because you are replacing a high-margin revenue stream with a lower margin revenue stream.
That’s the real issue, Galpin says. Margins are shrinking and there is a risk of further shrinkage in older style products.
In this mix there is also a demand for capital investment and the risk of further regulatory shocks. Regulatory risk has reduced but has not gone away. As long as there are three competing mobile operators regulatory risk remains focused on Chorus’s fixed-line and fibre business, Galpin says.
Margins could be improved through reduced capital investment, but while capex could be less “lumpy” in the future, it probably won’t reduce overall.
“I don’t see a significant drop off in capital spend in the industry and, potentially, you might need an increase in capital spend for a while,” Galpin says.
Spark has recently talked about replacing its aged PSTN network. It may also need to replace the Southern Cross trans-Pacific cable. As to reducing costs, the options are similarly limited. Broadband retailers have been shifted, through regulation, from spending capex on infrastructure to operational spending, through Chorus.
“The biggest cost to, say, Spark – excluding employee costs – is going to be Chorus.”
Spark’s response has been to aggressively push wireless broadband products in an effort to reduce this operational spending and to service customers through existing wireless infrastructure. Galpin says that may well produce short-term benefits to Spark – up to the point where it needs to invest more in its mobile network to deal with increased usage.
“What the long-term capex implications are around aggressively pushing this are relatively unknown until we move to 4.5G and 5G mobile,” he says.
“If you look at the numbers, Spark is aiming to have about 10 percent of its broadband numbers on wireless broadband so it’s not a small number for a fairly new service.”
But, again, this is not an example of margin growth in the industry.
“What you are talking about here is shifting profitability in the industry from one player to another,” Galpin says.
The difference between broadband and butter
Despite regulatory uncertainty, created by interventions over the last couple of years, there is no shortage of investors.
However, the profile of these investors has changed. The type of conservative, dividend-oriented investors Chorus attracted when it first listed are not coming back at the same level.
“I don’t believe investors have completely gotten over the changes, but memories are starting to dim,” Galpin says.
“There’s still a lot of uncertainty around what Chorus looks like. It’s attracted certain investors but maybe not quite the same mix that was there when it was initially offered.
“There’s always an investor at a certain price, just a different type of investor.”
The good news is the major retail players all appear to have healthy balance sheets, with Spark even returning cash to investors, through special dividends.
International ownership in both Spark and Chorus has also been creeping up, Galpin says. The view generally is that there is not much regulatory risk around Spark.
Around Chorus, there is still uncertainty about future pricing through to 2020; how the pricing model is going to be set, and what the price is going to look like.
A potential danger is current telco behaviour and marketing, which could be helping to create a new generation of highly price-sensitive consumers. New Zealanders are already famous bargain hunters, with some of the highest levels of buying “on sale” at supermarkets seen anywhere in the world.
Buying telco services is not like buying half a kilo of butter – at least not yet. There is still some pain involved in switching providers and most customers don’t do it without good reason.
Galpin says those aged over 35 tend to be stickier customers and more loyal to existing suppliers.
Younger consumers, who are targeted by brands such as 2degrees and Skinny, are different, however. They are increasingly being trained to look for the best deal. If that behaviour persists, demographic changes could bring an unpleasant surprise for retailers and for their margins.
* Rob O'Neill is an independent journalist. This article first appeared in The Download, a publication produced by Tangible Media for Chorus.