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Where do telecom operators go from here?

10 October 2013

Cyrus Mewawalla, Partner+44 (0) 20 3393 3866 [email protected]

www.cmresearch.co.uk

Authorised and regulated by the Financial Conduct Authority

CM Research22 Upper Grosvenor StreetLondon W1K 7PE

TelecomsMediaTechnology

Contents

Analysing Trends in Technology, Media and Telecoms 2

1. How have Telco valuations changed since the last two stock market crashes?

2. Why have Telcos performed so badly?

(a) Debt

(b) Technology

(c) Regulation

3. How can Telcos grow earnings in the future?

5. What kind of technology cycles should Telcos latch on to?

‐ Example 1: Big Data

‐ Example 2: Software Defined Networks

6. Conclusions

How have Telco valuations changed post the dotcom crash?


Technology analysts were blamed for the stock market crash of 2000 for publishing over‐inflated valuations. But they were right about many internet valuations; it was Telco valuations they got dramatically wrong. Amazon and eBay – symbols of the dotcom era – are worth more today than at the peak of the 2000 bubble. By contrast, Vodafone and AT&T – like most Telcos – are significantly down on their 2000 valuations.

Amazon

eBay

VodsAT&T

Share price performance since the 2000 internet crash

Source: FT.com

How have Telco valuations changed post the credit crunch?


Since the 2007/8 financial crisis, Telcos have been the worst performing sector across 13 TMT industries, bar one, down 14% on January 2008 levels.

By contrast the internet sector (e.g. Google, Amazon, eBay, Priceline) is up 250%. And the software sector (e.g. SAP, Oracle and Salesforce) is up 120%.

TMT sector performance since the 2007/8 financial crash

Source: FT.com, CM Research. Bar chart shows cumulative sector performance from 1 January 2008 to the periods ending 31 December 2008, 2009, 2010, 2011, 2012 and 30 September 2013 of a selection of stocks that we believe are bellwethers for each sector aggregated on an equal weighting basis.

Why have Telcos performed so badly?


The message from both the 2000 crash and the 2007 crash is that the market overvalued Telcos. Why? There were three big problems:

1. Debt: They had too much of it

2. Technology: They were unable to monetise the big technology cycles of the day

3. Regulation: They were over‐regulated

Why have Telcos performed so badly? Problem 1: Debt


You don’t want to be holding debt in the middle of a debt crisis. Telcos were highly indebted in 2000 and 2007. Telecoms remains the most debt laden sector in the global TMT space.

Source: Company data, Bloomberg, CM Research

Telcos Rest of TMT

Why have Telcos performed so badly? Problem 2: Technology


The chart below can be applied to almost any technology growth cycle. The steep curve is where the technology is going. The shallow curve is where the Telco is going. For some reason, Telcos are unable to latch on to technology cycles and profit from them the way their

peers in the TMT sector are doing. Another way to look at this chart is to pretend that the steep curve is the cost base of a Telco and the

shallow curve is the revenue base: an income gap is developing. Some industry commentators forecast this income gap will bankrupt several high‐profile operators within

five years.

Source: Cisco, ITU, CM Research

Why have Telcos performed so badly? Problem 3: Regulation


In the schematic of the internet value chain below, the shaded areas represent regulated activity. Regulators cap super‐normal profits, reducing the incentive to invest in new technologies. So the unregulated parts of the internet value chain have grown by 25%, compared to 2‐6% for the rest The trick for Telcos is to re‐engineer their businesses so that the profitable bits are outside the remit of

the regulator.

Source: Company data, CM Research

So how can telecom operators grow earnings in future?


Telco's are in dangerous position now. They need to do something drastic, because their core revenue streams are all falling simultaneously. A seminal paper by Chetan Sharma called “The Fourth Wave” best sums up the state of telecoms today. Voice, Messaging and Internet Access revenues are already – or close to – terminal decline. Over‐the‐Top (OTT) services represent the fourth wave of revenues that is just starting to take off now. But which technology cycles do Telcos need to latch on to in order to build these OTT services?

The Fourth Wave

Source: Chetan Sharma Technology and Strategy Consulting

Social‐ games, music, video‐ location shopping‐ Google Glass‐ new advertising models

Cloud‐ everything everywhere‐ cyber security ‐ IT cost reduction‐ age of software

Mobile‐ wearable devices‐ location services‐mobile payments‐mobile ads

Big data‐ Re‐imagination ‐ privacy issues‐wearable devices‐ age of software analytics

Copying Apple‐ Ecosystem lock‐in‐Walled gardens‐ Hardware/software integration

Cyber security‐ Telecom equipment focus‐ national security issues‐ software defined network‐ open standards

Regulation‐ Net neutrality‐ Data privacy‐ Internet regulation‐ Anti‐competition cases

TV‐ Internet TV‐ Second/third screens‐ 16k / flexible screens‐ Social networks

Software definednetworks

‐ Cost reduction‐ service enhancement‐ Network function virtualis

What are the big technology cycles that will create OTT opportunities?


Telcos need to latch on to one of these technology themes and create OTT services out of them. Many of these technologies require Telcos to make a heavy investment in software. Let’s examine two of them in more detail: Big Data and Software Defined Networks.

Source: CM Research

The Big Data Technology Cycle: What is it?


Big Data is one technology cycle Telcos can latch on to.

Big Data refers to data that cannot be analysed on a traditional database.

Its scale is mind boggling. 90% of the stored data in the world today was

created in the last 2 years. This data is created from hundreds of sources,

including emails, documents, apps, pictures, videos, tweets, and credit card data.

Much of this data is unstructured which means it cannot be easily compartmentalised by field.

Unstructured data – such as video – is difficult to analyse because it depends on a machine interpreting nuances that only humans can truly understand.

For investors, the big money lies in developing a Big Data Analytics Engines that can reliably interpret these nuances in real time.

Ease of use Classification Data type

DatabasesEasy and cheap to analyse XML data

Data warehousesEnterprise systems

Social mediaVoice, music & video

Difficult or expensive to analyse DocumentsEmail

RFIDGPS

Requires extensive infrastructure QRTemperature

Structured data

Unstructured data

Sensor data(machine‐to‐machine)

Source: CM Research

Categorising Big Data

The Big Data Technology Cycle: Behind the value chain


What does the Big Data value chain look like?

Source: CM Research

Gather raw data on industrial scale Improve Big Data quality Commercialise Big Data

Big Data Production Big Data ConsumptionBig Data Management

Social mediaDocumentsDatabasesWeb crawlersWeb robots (bots)SensorsVoiceMusic & videoEmailRFIDCall recordsPayment detailsGPS

Volume

Variety

Velocity Big Data quality

Storage

Security

Databases

Analytics

Data Mining

Digital Marketing

Re‐selling

Search

The Big Data Technology Cycle: Where do Telcos sit in the value chain?


How do the main players interact in the Big Data value chain?

The big internet champions like Facebook and Google straddle the entire value chain: they control how the data is produced, managed and sold.

By contrast Telcos are instrumental in Big Data production, but are not so good at managing or commercialising the data.

Perhaps, like many technology companies, Telcos need to invest more in software.

Source: CM Research

Big DataConsumption

Big DataManagement

Big DataProduction

Social networks

Cybersecurity

Telecom operators

Analytical engines

Search engines

Marketing agencies

Regulatory oversightPrivacy, piracy, security

Operating system and browser software developers

Cloud services providers

Apps developers

Data centres

Social mediaDocumentsDatabasesWeb crawlersWeb robots SensorsVoiceMusic & videoEmailRFIDCall recordsPayment detailsGPS

Third party resellers

Hardware makers

Data scientists

The Big Data Technology Cycle: Winners and losers


Internet companiesThe big Internet companies control where the data comes from and where it goes to. Amazon, Baidu, Facebook and Google may soon sell lucrative, proprietary Big Data Analytics services to end users.Data storage, networking and hardware companiesHardware makers like Cisco, Dell, Lenovo and HP are investing heavily in Big Data appliances. Data storage companies like EMC and NetApp could benefit from the explosion in data.Enterprise software companiesOpen‐source database platforms like Hadoop threaten Oracle, IBM and SAP. Cloud database services like Salesforce.com are likely to be the fastest growth sector this year within the enterprise software space.Cyber security companiesCyber‐attacks remain the biggest investment risk faced by players in the Big Data space. When the CEO of a FTSE 100 company is fired for failing to prevent a big cyber attack, cyber security share prices will take off.Telecom operatorsAs more business‐critical data flows through the cloud, Telcos should – in theory – gain more pricing power when carrying that data. But machine‐to‐machine (M2M) revenues are likely to be regulated. The trick for Telcos is to create a Big Data Analytics product that is unregulated and can provide a growing revenue stream. That requires heavy investment in software.

The SDN technology cycle: What is it?


Software Defined Networks (SDN) is another technology cycle Telcos can latch on to. SDN is a new architecture for telecom networks in which the emphasis shifts from hardware to software. It will be hugely disruptive because it fundamentally changes who controls the telecom network.

Source: CM Research

The SDN Technology Cycle: Timing


We are early in the SDN investment cycle. In 2012, the SDN equipment sector was worth less than $400m.

Stanford Univ Open Flow MIT Technology Open Networking Several SDN SDN technologyResearch Project Switching Review coins Foundation founded start‐ups begins to go into SDN specification the phrase, by Google, Facebook, acquired by mainstream

released "software defined Microsoft, Yahoo equipmentnetworking" Deutsche Telekom and makers

Verizon

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

SDN Research & Development SDN Commercialisation

Source: CM Research

Telcos are evaluating SDN technology carefully: it could enhance network services whilst simultaneously lowering costs.

But the key question is whether regulators will allow Telcos to keep the gains from their SDN investment. The smart Telcos will develop SDN products that are outside the regulator’s remit.

The SDN Technology Cycle: Market size forecasts


The network equipment sector is worth $68bn this year, with SDN accounting for less than 1%. But by 2020, SDN could account for a third of global networking equipment sales.

Source: IDC, Gartner, CM Research

The SDN Technology Cycle: Winners and losers


Telecom equipmentSDN’s open hardware standards threaten to commoditise the telecom equipment sector, most of which still promotes closed, proprietary systems. Cisco has the most to lose: it supplies 59% of the world’s switches, 53% of its routers and 52% of its data centre equipment. To survive, Cisco will have to transform from a hardware company into a software company. But, as with most such transitions, revenues and earnings may dip in the process. In mobile equipment, Ericsson and Nokia are also under threat.Servers and network storageSDN technology could reduce high‐value servers to generic white boxes. This threatens the big server makers IBM, HP and Dell. The proprietary network storage systems of EMC and NetApp could be made obsolete by open software‐defined‐storage standards.SoftwareThe software sector will be the biggest beneficiary of SDN. Cloud software companies like Facebook, Google, Netflix and Salesforce will be able to programme networks to enhance their web services. Cyber‐security companies like Check Point, Verint and Fortinet will see ballooning demand for their products.Telecom operatorsIf SDN technologies allow Telcos to transform into a network version of Apple’s App Store where third party developers create new network applications, Telcos may profit from an innovation boom. But if regulators cap the returns Telcos can make from their infrastructure investment, the bulk of the profits will flow to the Internet companies who will be able to programme the network in a way that enhances their own services.

If operators do not latch onto these technology cycles they risk becoming irrelevant


Social‐ games, music, video‐ location shopping‐ Google Glass‐ new advertising models

Cloud‐ everything everywhere‐ cyber security ‐ IT cost reduction‐ age of software

Mobile‐ wearable devices‐ location services‐mobile payments‐mobile ads

Big data‐ Re‐imagination ‐ privacy issues‐ wearable devices‐ age of software analytics

Copying Apple‐ Ecosystem lock‐in‐Walled gardens‐ Hardware/software integration

Cyber security‐ Telecom equipment focus‐ national security issues‐ software defined network‐ open standards

Regulation‐ Net neutrality‐ Data privacy‐ Internet regulation‐ Anti‐competition cases

TV‐ Internet TV‐ Second/third screens‐ 16k / flexible screens‐ Social networks

Software definednetworks

‐ Cost reduction‐ service enhancement‐ Network function virtualis

As voice, messaging and internet access revenues decline, Telcos need to make a success of the technologies that are developing around them and sell them via OTT services.

Conclusions


Telcos’ have consistently underperformed analyst and market expectations … their stock market recoveries after the 2000 crash and the 2007 crash were weak relative to the rest of TMT.

Their core revenues – voice, messaging and internet access – are now in terminal decline (or at least moving towards terminal decline).

Their future is tied to over‐the‐top services such as internet TV, mobile payments and cloud services. Telcos remain the most over‐regulated part of the internet value chain, so any super‐normal profits they

attempt to make from new technology cycles risk being capped by the regulator. In order to survive, Telcos need to latch on to one of the many emerging technology cycles mentioned on

page 19. But they also need to change their business models:

i. By moving towards software servicesii. By restructuring their businesses such that their new products are not regulatediii. By consolidating to eliminate excess competition

SK Telecom is an example of how the move to software can raise shareholder returns. BT’s ring‐fencing of its regulated activity into Openreach is an example of the type of internal

restructuring that can raise shareholder returns AT&T and Verizon are living proof that industry consolidation will raise shareholder returns.

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