Russell McGuire

In a recent consulting engagement, I was asked about the strategic issues facing U.S. mobile operators. I think I answered reasonably well, but it made me realize that the topic deserved a more thoughtful updating based on recent activities. With that in mind, I’d like to provide a high level outline of what I think are the biggest issues. I think each of these could be a future article in and of themselves.

1. Duopoly, The Rule of Three, or the Rule of Four
Perhaps the biggest strategic issue being played out right now is one of industry structure. Each quarter, Verizon and AT&T become stronger. Their strong balance sheets, fueled by rich cash flows, enable them to strengthen their hand. Meanwhile, the other two national operators (Sprint and T-Mobile) fight it out for third place. The Rule of Three claims that any market can only support three large generalists, implying that only one of those two can survive. Boston Consulting Group takes it a step further with their Rule of Four implying that perhaps two is the right number. American regulators would apparently block a combination of Sprint and T-Mobile, believing that a market with four competitors is better for consumers than a market with three competitors. But, in the long run, will that ultimately result in the failure of both #3 and #4, and in the short run, will it cause behaviors that damage the entire industry?

2. Wildcards: Google, Dish, América Móvil
Over the past few years, Google has done an admirable job of shaking up the broadband industry with the introduction of Google Fiber. In markets where the company has announced plans to build out local infrastructure, existing competitors have had to respond with improved offers to customers. Now, Google is rumored to be preparing to offer wireless services. Would they have a similar impact on the wireless competitive space, or are the disruptive moves already being introduced by T-Mobile and Sprint significant enough that Google’s impact would be muted? Meanwhile, Dish Networks has been spending tens of $billions accumulating a rich treasure chest full of spectrum which they are obligated to begin building out for wireless services. What will they do and how will that impact the competitive environment? Finally, América Móvil has spent the past few years preparing for a major global strategic shift. They already have a strong foothold in the U.S. prepaid market as an MVNO (TracFone), but their relationship with AT&T has been significantly altered perhaps positioning them for a more aggressive move into the U.S. Any of these three potential new entrants could have significant impacts on the American mobile market and must factor into the strategic scenarios for the four mobile operators.

3. Licensed versus Unlicensed Spectrum
As we’ll discuss more below, spectrum is the lifeblood of any wireless network. The global mobile industry has been built on licensed spectrum. Licensed spectrum has many advantages over unlicensed spectrum, including the ability to use higher power radios with better signal-to-noise resulting in greater range, throughput, and performance. Lack of unmanaged contention for the airwaves results in predictable and manageable performance, all resulting in higher reliability of each connection. The industry has invested hundreds of $billions to build out networks that provide a wireless signal for the vast majority of the U.S. However, the cost to build out a wireless network with unlicensed spectrum is a small fraction of that to build with licensed. Companies offering services with unlicensed spectrum are also unburdened by the regulatory requirements placed on Commercial Mobile Radio Service operators. The Cable MSOs have been most aggressive in shifting their focus from licensed to unlicensed spectrum. After decades of positioning to participate in the traditional cellular industry (winning spectrum in auctions, investing in Clearwire, partnering with Sprint, etc.), in 2012 Comcast, Time Warner, and others sold their licensed spectrum to Verizon and aggressively started building out a nationwide WiFi footprint using unlicensed spectrum. About a month ago, Cablevision introduced their Freewheel WiFi-based smartphone service to compete with mobile operators. Expect others to follow.

4. Spectrum Portfolio
Although mobile operators are toying with unlicensed spectrum, their strategies remain very centered on licensed spectrum. To effectively meet the growing demand for capacity, all operators will need more spectrum of some kind. However, not all spectrum is equal and operators know they need a balanced portfolio. There are a variety of criteria that factor into the attractiveness and utility of any given spectrum, but the easiest to understand is simply whether the spectrum is low-band, mid-band, or high-band. Low-band spectrum has a frequency less than 1GHz and provides the best geographic coverage (the signal travels farther) and in-building penetration (the signal passes more easily through walls). However, at these lower frequencies, there tends to be less spectrum available, and it has generally been made available in smaller channels, limiting the capacity (the amount of bandwidth that can be delivered to customers). High-band spectrum generally has a frequency above about 2.1GHz and, while it lacks the coverage of low-band spectrum, there’s generally more of it and it generally comes in larger channels providing lots of capacity. Mid-band spectrum (between 1GHz and 2.1GHz) provides a compromise – reasonable (but not outstanding) capacity with reasonable (but not outstanding) coverage. In the early 1980s, as the local telephone monopolies covering most of the country, Verizon and AT&T received free 800MHz low-band spectrum in each market they served. In 2008, the FCC auctioned off 700MHz low-band spectrum. Of the national players, only Verizon and AT&T had deep enough pockets to compete and walked away with strengthened low-band spectrum positions. Today, these two have the vast majority of low-band spectrum and T-Mobile and Sprint are hoping that the 2016 600MHz incentive auction will help them begin to balance their portfolios and are demanding that the FCC enact rules to avoid another Verizon/AT&T dominated auction process. All players have reasonable amounts of mid-band spectrum (with AT&T and Verizon again using their strong balance sheets to further strengthen their positions in the recent AWS auctions). The majority of Sprint’s spectrum is high-band 2.5GHz spectrum.

5. Network Technologies
Mobile operators face a number of strategic decisions over the next few years related to network technologies. There are enough uncertainties around the key decisions that each operator has a slightly different strategy. Two of the biggest decisions relate to small cell deployments and migration to Voice over LTE (VoLTE). AT&T has the most comprehensive strategy which revolves around their broader Velocity IP (VIP) Project, which they hope will free them from much of the regulatory oversight they currently endure in their monopoly wireline footprint and therefore provides tremendous financial incentives. This is driving a relatively aggressive small cell deployment and a moderately aggressive VoLTE plan. Verizon has been the most aggressive of the national players in deploying VoLTE, while (until recently) being the most hesitant to commit to significant small cell deployments.

6. Cash Management

6a. Capital Expenditures
None of this is cheap. It takes deep pockets to acquire spectrum and even deeper pockets to build it out. In a technology-driven industry, new network architectures will always require significant investments. As price wars constrain revenue, while demand for capacity continues its exponential growth, CapEx as a percent of revenue will likely become a significant strategic issue for all operators.

6b. Expense Management
Operating expenses and overall cash flow also can’t be overlooked. Growing demand for capacity and small cell deployments require increasing backhaul spend (although the shift to fiber for macro sites has helped bring that under control for most operators). But the biggest issue will likely continue to be the cost of providing smartphones and tablets to customers. As an illustration of how significant this cost is for a mobile operator, in Sprint’s 2013 Annual Report, the company reported equipment net subsidies of nearly $6B on service revenues of just over $29B (over 20%). In 2012, T-Mobile introduced equipment installment plan (EIP) financing as an alternative to subsidies and early in 2013 announced that it was eliminating all subsidies. Since then, the other three national operators have similarly introduced device financing. From an income statement perspective, this helps T-Mobile’s earnings since the device is accounted as an upfront sale, typically near full price. However, T-Mobile and their competitors have introduced zero-down zero interest (or close to it) terms, and they are discounting the monthly bill for the customer by roughly the same amount as their monthly equipment financing payment to keep the total monthly cost to the customer competitive with the traditional subsidized plans. The net result is that T-Mobile (and their competitors who have all followed suit) are taking on the financing risk without significantly improving their cash flow. For 2014, T-Mobile reported just over $22B in service revenues (a 17% increase over 2013). They also reported equipment sales of $6.8B (a 35% increase and 30% of service revenues). But, they also reported the cost of equipment sales at $9.6B (an increase of 38%) and they reported that they financed $5.8B in equipment sales (an increase of 75% over 2013 and 26% of service revenues). As of the end of 2014, T-Mobile had $5.1B in EIP receivables (an increase of 78%). That’s a lot of cash tied up in customer handsets. The strategy has worked in terms of attracting customers to switch to T-Mobile (which is why their competitors have had to respond), but it’s less clear that it’s been financially beneficial for the company in the long run. Verizon, for one, seems unconvinced and has been unenthusiastic about device financing. I believe this will continue to be an area of strategic deliberations at all mobile operators.

7. Plan Types
This shift from subsidized devices is also part of a disruption in how the industry views plan types. For decades, the industry focused on postpaid phone plans. These plans were subsidized, but the customer was locked in for two years, “ensuring” that the operator earned back their up-front investment in the device. Because operators, for the most part, managed this business with appropriate discipline, only prime credit customers could get a subsidized device and these tended to be fairly profitable customers. Those that didn’t qualify settled for a prepaid plan where they purchased the phone upfront at or near full price, which provided better cash flow early in the customer life, but less profitability over time. Eliminating subsides also eliminates the 2 year service plan (although the long term device financing still provides customer lock in) blurring much of the distinction between postpaid and prepaid. The number of people with multiple wireless devices is also increasing as we are carrying iPads and other tablets, as automakers are integrating wireless connectivity into the cars we drive, and as we move towards a day when virtually any product with a power supply will be wirelessly connected to the Internet. Different operators are taking different approaches to how to structure their plans to accommodate these changing customer behaviors within their business models, and I’m sure it will continue to be a topic for internal debate and discussion as the industry models evolve.

8. Commoditization
In many respects, wireless service is increasingly viewed as a commodity by customers. Operators continue to trumpet their network differentiation, but to the consumer there is generally the perception that all operators offer the same devices, in the same ways, and support those devices with networks that work reasonably well just about everywhere we go. Over the past 6 to 12 months, T-Mobile and Sprint have been very aggressive about reducing pricing or offering more for the same price, in a successful effort to take customers away from Verizon and AT&T. Those two larger operators have had to respond with lower prices or increased buckets of data. The operators may be denying it, but it sure looks like a commodity market to me, and I imagine that’s a discussion that’s happening in each operator’s strategic planning meetings.

9. Quad Play or Cord Cutting
For well over a decade, there’s been an ongoing strategic debate within the industry about whether a combined wireless and wireline bundle is critical to market success. At times, some players have decided that it will be and have taken actions, such as the strategic alliances between cable MSOs and wireless operators (Sprint, Clearwire, and Verizon), or advertising campaigns focused on integration across multiple screens (TV, computer, phone). So far, there’s little evidence that it really matters. Consumers take what landline voice, broadband, and video services they can get from the duopoly of cable provider or “telephone” provider and then they can choose from a competitive landscape for their mobile needs. For the last few years, it appears that none in the U.S. industry have seen any need to focus on a quad play future. In fact, the focus has been more on cord cutting and over-the-top players. However, in Europe, there’s a very different story playing out and it is driving massive industry consolidation. Especially while wrestling with the questions about commoditization, operators will once again question the benefits of a differentiating bundle.

10. Re-intermediation
Another common tactic to combat commoditization is to “move up the stack.” In the mobile industry, that would be “move back up the stack.” The introduction of the iPhone, followed by Android devices, led to the disintermediation of the mobile operator from much of the value chain. Prior to the iPhone, operators carefully managed their portfolio of phones, telling OEMs what features to build and it was the operators who largely drove demand for different devices. Operators collected the vast majority of revenues in the industry, directly charging the customer for the phone, the network service, any applications, any content, and any value added services (such as navigation or entertainment). The iPhone (and then Android) enabled better apps and content, provided a better marketplace for buying them, and provided an open connection to the Internet for a wide variety of over-the-top services. Although the operators had poorly managed the apps/content/services opportunity and therefore they didn’t have much “value add” revenue to lose, they clearly lost the opportunity to be more than just the underlying network. Over the past several years, the industry has tried to claw its way back up the stack. Operators pursued “open” strategies, introducing APIs for app developers and other tactics to try to be a “smart pipe” rather than just a “dumb pipe.” They have also tried to encroach on other industries by offering new mobile-enabled services, such as mobile payments and home security/automation. These efforts have not yet had meaningful success, although AT&T’s progress with Digital Life is promising. If operators want to escape the commodity “dumb pipe” trap, at some point they will need to figure out how to reclaim more of the stack.

Obviously, the mobile industry is dynamic and I expect these 10 topics to drive significant strategic decisions across all operators in the coming months and years. If you’d like to discuss any of these topics, drop me a note.