Hard choices for Europe's telcos

It once seemed that Europe's telecommunications operators could do no wrong: Emboldened by a general belief that they would reap outrageous benefits from the rise of the Internet and from even newer technologies such as the Wireless Application Protocol (WAP), their shares were star performers. But the bright future that seemed so assured a year ago has disintegrated into uncertainty.

After leading the bull market up to the year 2000, the telecom sector is now leading the downturn, and day-to-day trading remains volatile. Blame for the industry's change of fortune can be apportioned among various factors. Most incumbent operators amassed huge debts, largely from the scramble to stay ahead in the wireless arena. Over the past two years alone, companies spent $46 billion for third-generation (3G) mobile licenses in Germany and $36 billion for licenses in the United Kingdom.

Meanwhile, new technologies such as WAP and UMTS (the Universal Mobile Telecommunications System) failed to take off. Finally, the gap between the best and the worst performers in the market widened across business lines, making it even more difficult for the laggards to attract capital to pursue their growth strategies. Without a truly significant breakthrough that would generate additional revenue, it is difficult to see how some integrated incumbents will regain healthy growth rates or even survive.

The sector must therefore contemplate a fundamental restructuring. The present market structure in Western Europe--five large integrated incumbents and ten smaller integrated companies--can't be sustained. Most companies will have to embark quickly on the unpalatable task of shedding their assets and stepping away from areas they thought were core businesses.

When they have done so, Europe will be left with two or three large integrated telecom companies holding majority stakes in data, wireless and wireline services.

In the absence of a market breakthrough, overall revenue growth for the telecom sector is likely to fall by 2004 from the heady 20 percent realized in 1999 to levels approaching the growth rates of Europe's gross domestic products. Such anemic progress won't satisfy the expectations of the market and will make it harder for incumbents to service their debt.

The remedy for most companies lies in abandoning efforts to compete in all three main business areas: wireline, wireless and data services.

Wireline generates about 70 percent of total gross cash flows for most incumbents, so it will remain a major cash source for all of them. But providing both wireless and data services isn't an option for them all even though these are the two most promising avenues of growth. Most companies will have to choose between the two, and some of them will have to be content with offering only wireline services.

During the late 1990s, an incumbent's natural advantages, particularly its infrastructure, sufficed to secure a good share of a growing market. These assets remain vital but will no longer be enough to capture market growth, particularly as deregulation and new technologies open the infrastructure and the market to new contenders.

Soon, factors that are influenced by scale, such as efficient marketing and the rapid development of new products and services, will become more relevant.

Moreover, to capture the growth potential of wireless or data services, a company needs deep pockets. It would cost tens of billions of euros to buy even a 5 percent share of the European mobile-telephone market. Yet most integrated incumbents have already made their big investments, particularly in 3G mobile licenses. By mid-2001, the total debt held by the eight largest European telecom operators already amounted to ?240 billion ($213.7 billion)--double the figure for 1999. Thus burdened, most incumbents will find a sustained integrated strategy out of reach.

This state of affairs leaves many incumbents retaining their wireline businesses but having to decide whether they should sell their wireless or data operations.

Under pressure
Europe's wireless industry is under intense pressure. Demand for the new technologies in which the sector has invested so heavily has fallen short of projections, and returns from that investment are unlikely to materialize for five to ten years.

So far, the flurry of mergers and acquisitions has meant that the six leading wireless operators hold more than 70 percent of the subscriber base in Europe--a clear sign of the value that operators attach to scale in this business.

Vodafone Group, for example, has said that synergies from consolidation could represent up to 20 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) within two to three years. Among the benefits of size and geographic coverage are preferred access to new technology, the development of a global brand that offers scale advantages in marketing, faster launches for new products and services, better offerings to corporations, and preferential roaming agreements.

The pace and extent of the restructuring still to come will be affected by the emergence of mobile virtual-network operators (MVNOs), which buy capacity from existing network owners. MVNOs will have an increasingly great impact as more countries change their regulations to give these asset-light operations access to networks. The development of wholesale markets will also determine how quickly MVNOs expand throughout Europe. Since incumbents have to bear the heavy infrastructure costs that virtual networks avoid, those incumbents will need efficiencies of scale to compete.

How quickly applications for wireless data services catch the public's fancy is another question that will affect the timing of this restructuring. If our expectations are confounded, and public acceptance takes less than five years to develop, the contenders would have more room. Some of the pressure would thus be lifted from incumbents, which would share in the accelerated market growth. For most incumbents, though, we expect that growth will come too late to help them carry on as integrated operators.

Because of the need for scale, European wireless will eventually be dominated by three or four large operators--focused companies and incumbents that have successfully followed an integrated approach. At the national level, some domestic operators will remain competitive thanks to their existing infrastructure, but they will find their market share slowly eroded by larger rivals. Smaller companies that avoid being swallowed by the bigger fish could merge among themselves or forge alliances in an attempt to build regional competitors.

The unfolding of such a scenario could, however, be hindered by government antitrust watchdogs and by regulators pushing for increased competition and lower prices. Moreover, some mergers could make redundant the licenses for which each successful candidate paid billions of dollars. Writing off so large an investment would be a bitter pill to swallow.