Lessons from change. Performance and expansion in the telecommunications industry

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1 Lessons from change Performance and expansion in the telecommunications industry

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3 Contents That was then this is now Opportunities in adversity gave us a glimpse into the challenges companies in the telecommunications industry were facing as they confronted the implications of an economic downturn. Lessons from change goes deeper, exploring what companies are learning and how they are using their new knowledge to prepare for the recovery ahead. Introduction: the market s safe haven Telecommunications may be the market s safe haven, but increasing pressure on market position and compete in a rapidly changing environment. Securing your present: strong cash management The painfully vivid memory of the dot-com bust in 2000 and 2001 has served telecommunications companies well during the economic crisis. Many companies still have healthy cash balances and uncommitted lines of credit to meet their needs through any downturn. Protecting your assets: for risk, size doesn t matter The risks that telecommunications companies face from customer loyalty and reputation to pricing and revenue don t discriminate based on size. Improving your performance: more effective cost management is key The road to recovery may not be driven by growth opportunities. The route to more positive cash generation more likely lies in reducing costs, and maintaining revenues and market share. Reshaping your business: share networks, form partnerships As the concept of network ownership evolves, business lines are being reorganized according to the demands of the customer and convergence opportunities, rather than by network technology. Sustaining your future: symbiotic relationships Incentivizing investment is a key regulatory issue facing the industry. Telecommunications companies need to build symbiotic relationships with government to develop equity partnerships. Conclusion: protecting a good thing telecommunications companies focusing on both the top and bottom lines actively seeking to reduce internal costs, solidify market position and compete in a rapidly changing environment. A new business agenda is emerging Lessons from change more than 40,000 client meetings and has produced more than 500 cross-industry insights. Studying this material, we see a new agenda for success emerging.

4 Cost reduction That was then... In January 2009, Ernst & Young published Opportunities in adversity, 1 a survey that provided insights into the issues executives were facing as they grappled with the implications of the economic downturn. We suggested that every company falls somewhere on a stress pendulum between cash burn and cash earn; and for every business there is an appropriate course of action to take. By executing that course of action quickly and effectively, management teams can seize a potential source of competitive advantage. Cash earn Stress pendulum Cash burn Success Acquisition opportunities Portfolio optimization Supplier stability Market reassessment Working capital Liquidity management Asset impairment Capital restructuring Business unit closure Divestitures Court supervision Distressed Insolvent Stakeholder management Do nturn Stressed The telecommunications industry has fared better than many other sectors in the recession. Industry revenues and pro ts have remained buoyant as investors turn to telecommunications as a safe haven in turbulent economic times. Still, the economic downturn has placed pressure on the pro tability of the larger telecommunications companies and has hampered the industry s ability to invest in innovation, capital programs and new product offerings. The majority of respondents to our survey indicated that they see a diminished ability to deploy capital to take advantage of new market opportunities for the remainder of All survey data referenced within this report, unless otherwise noted, is from Ernst & Young s Opportunities in adversity survey. For this survey, the Economist Intelligence Unit surveyed 569 C-suite and board-level executives. Respondents were drawn from across the world and across a wide variety of industry sectors, including telecommunications. 2

5 ... this is now Opportunities in adversity gave us a glimpse into the challenges telecommunications companies were facing, but we wanted to know more. We wanted an in-depth understanding of the speci c challenges executives were experiencing, as well as the lessons they were learning and applying to prepare their companies for the recovery ahead. And so we went back to our telecommunications professionals to gain their insights. In total, telecommunications partners from our member rms around the world conducted more than 1,000 client meetings. These conversations revealed a series of strategic actions the industry is taking to position itself for success. Not all of their lessons from change may be new, but they are taking on new importance as companies strive not only to survive but thrive in the new economic environment. Questions and considerations As you take charge of implementing change within your organization, we invite you to re ect on the following questions and considerations: Pay close attention to your liquidity availability and your exposure to the downturn. Understand the impact on clients, supply chain and competitors. Do you know where you stand in your market? Embed risk management into any business models designed to evaluate future actions and consequences. What steps are you taking to protect your assets and your reputation? Focus on your current team and assets to ensure that you are making both ef ciency and effectiveness gains. How can your organization s performance be improved? Drive changes in the organization to match the transformation underway in the industry. What are you doing to position yourself for the future? Be bold about the opportunities to drive fundamental change. What approach is your company taking to not only survive but thrive? 3

6 4 Introduction

7 The market s safe haven The telecommunications industry has fared better than most through the recession, but now is not the time to be complacent. Increasing pressure on pro tability has companies focusing on both the top and bottom lines actively seeking to reduce internal costs, solidify market position and compete in a rapidly changing environment. In May 2009, Deutsche Telecom estimated that its EBITDA 2 might fall 2% to 4% this year, given the present conditions. Franco Bernabe, CEO of Telecom Italia, called the rst quarter of 2009 a crisis, the likes of which we haven t seen in 50 years. 3 Yet as tough as the economic crisis has been on telecommunications companies, it has also been a validation. According to data collected as part of our Opportunities in adversity survey, telecommunications companies have been less hard hit by the recession than other sectors of the global economy. Figure 1 Q: Please indicate whether you agree with the following statements: Telecommunications All industries We have been surprised at the speed of the downturn 80% 77% We have been surprised at the severity of the downturn 68% 73% The downturn has impacted our business more than we originally expected 52% 56% Business has improved year-on-year over the past 12 months 35% 45% Shown: percentage of telecommunications respondents compared with all respondents who strongly or slightly agree Source: Opportunities in adversity, Ernst & Young 2. Earnings before interest, taxes, depreciation and amortization. 3. Stefano Rebaudo, UPDATE 2-Telecom Italia 2008 div ' oor' to build on CEO, Thomson Reuters via Forbes.com, 8 April

8 We have seen increased price pressure from competitors, a slight worsening in bad debts and corporate write-offs, as well as big foreign exchange swings in formerly stable non-euro currencies. Jeremy Thurbin Telecommunications Client Service Partner, Ernst & Young France Recurring revenue and tight scal controls have enabled operators not only to survive, but to thrive during the economic downturn. Throughout the recession, cash ow has stayed strong. And stock prices and credit lines have held up well as investors turn to telecom as a safe sector in turbulent economic times. The gure below is based on data from the Dow Jones Stoxx 1800 as of 5 September It illustrates telecom performance vs. main index performance over the last 12 months (rebased). 4 Much of this resilience stems from the notion that telecom services are increasingly seen as nondiscretionary purchases. Fixed voice and broadband access services are perceived as household essentials, while demand remains high for leading-edge smartphones even as consumers delay replacement of entry-level handsets. In some emerging markets, where consumers might have been expected to be under even greater pressure to reduce their spending on communications services, revenues have remained buoyant. The one storm cloud looming may be the potential for a lag in revenues as mobile customers look to reduce their monthly expenditure once their contracts come up for renewal. Wireless companies have also been protected by a largely variable cost structure. One leading global operator, for example, has reported that a full 69% of its mobile costs are variable, making it possible for the industry giant to cope with all but the steepest cyclical changes. Figure DJ Stoxx 1800 price index DJ Stoxx 1800 Telecom price index S O N D J F M A M J J A Source: Thomson Datastream 4. Thomson Datastream, 5 September

9 Two classes of companies As positive as the numbers are, don t be deceived by the high average of the sector. The economic downturn has fragmented the industry into two classes. There are the largest players, which have managed the downturn fairly well. And then there are the smaller players that may be struggling. Tough economic circumstances have accentuated the scale factors we noted earlier this year in The power of the pipe interviews with leaders within the telecommunications industry in Europe and North America. The economics of telecommunications increasingly favor large integrated incumbents, as the industry stands on the cusp of a new wave of infrastructure investment. Regardless of size, operators are using the same tactics to try to retain market share more cost-cutting supported by value-based pricing strategies, including bundling and at-rate subscriptions. Many initiatives are now focused on up-selling existing customers with add-on services intended to reduce customer churn. Many new services, such as mobile internet, require major network investments, as well as larger marketing expenditures and steeper handset subsidies. But consumers appear reluctant to pay a premium for faster network access. As a result, any spending on value-added services may appear to bene t technology and internet players more than the network owner. Figure 3 Q: In the past six months, what change has there been to the following aspects of operating your business? Telecommunications Overall revenues Profitability Ability to invest in capital programs All industries 32% 47% 52% 58% 59% 58% Telecommunications companies face multifaceted challenges in maintaining pro tability. These include price de ation, technology companies in uencing the customer experience and governments demanding infrastructure improvements. In our Opportunities in adversity survey, telecom respondents indicated they were more concerned with eroding margins than revenue slowdown, compared to other sectors. The dilemma seems particularly acute because most telecommunications companies have been in a cost-reduction mode ever since the internet bubble burst in Under pressure to maintain margins in the face of rising vendor costs, this instinct seems to be stronger than ever. Expansion plans in developing markets have been and may continue to be hard hit. But even as some telecommunications companies keep cutting back, others are moving con dently ahead with their plans. Jose Maria Alvarez-Pallete, the Latin America director of Telefonica, told the Reuters Latin American Investment Summit in May 2009, We do not see the need for our investments to be conditioned to the current situation, we are still seeing growth and we still want to capture it. 5 Positioning for the future Long-term market dynamics can change surprisingly fast in telecommunications. The amount of digitized information pushed over the world s communication networks continues to grow at a rate of 60% per year, placing new demands on the technology companies and the telecommunications networks that underpin the digital revolution. 6 Operators that react too slowly to this changed environment may lose competitive advantage when a new market order begins to take shape. But moving too fast could prove equally fatal. Consumer behavior demand for mobile internet services, for example has long lagged the development of new business models and new technologies. In an increasingly complex value chain, telecommunications companies should begin to think about a strategy that strikes a balance between avoiding risk and seizing opportunity. Shown: Percentage of telecommunications respondents vs. all industries Source: Opportunities in adversity, Ernst & Young 5. Elisabeth O Leary and Robert Hetz, Telefonica sticks with Latam plans, Reuters, 8 May "EMC and IDC Study Forecasts Explosive Growth of the Digital Universe," Wireless News, 17 March 2008, via Factiva, (c) 2008 M2 Communications, Ltd. 7

10 8 Securing your present

11 Strong cash management The ability to generate free cash is a key strength of the telecom sector right now, in large part because the memory of the internet bubble bursting remains painfully vivid. Even now, the survivors balance sheet discipline remains strong, with operators quicker to conduct a top-down review of cash management than companies in other sectors. Many companies still have healthy cash balances and uncommitted lines of credit to meet their needs through a downturn. Average leverage of the large telecommunications companies (net debt to EBITDA) is now under two times and forecast to fall or remain at. 7 In Ernst & Young s latest annual review of cash management in telecommunications, we found that the working capital practices, by sales, of Europe s 15 largest telecom operators largely improved in This improvement continued into 2008 despite the downturn and re ected an increasing focus on cash and cash management among the world s leading operators. In the six months prior to April 2009, telecommunications liquidity has continued to improve. Capital programs have been subjected to increased scrutiny, and infrastructure-sharing agreements have been struck between operators, in both xed and mobile markets. A number of job cuts have also been announced, such as US operator Verizon s decision to cut 8,000 jobs in July 2009, following a 7.2% year-on-year decline in net income. 8 On a sales-weighted basis, the industry s average net trade working capital cycle fell from a negative 3.1% to a negative 3.5%, driven primarily by a 4.0% increase in payables and a 1.0% reduction in receivables between 2006 and Overall, analysts point out that this means European telecommunications companies reduced their need for working capital by more than 4.0%, from a positive 1.6% to a negative 3.5%. Receivables contributed most of the improvement. 9 This combination of steady revenues and nancial discipline has paid off handsomely. At the moment, telecommunications companies outperform most other kinds of companies in their access to capital. In December 2008, during some of the darkest days of the nancial crisis, Verizon succeeded in securing an extremely large loan. At a time when banks were scarcely even lending to each other, the banks extended a US$17b loan to the major US operator "Fitch: European High-Grade Telecoms Maintain Good Liquidity," Dow Jones International News, 29 April 2009, via Factiva, (c) 2009 Dow Jones and Company, Inc. 8. Verizon pro t falls, eyes 8,000 job cuts, Reuters, 27 July Telecommunications benchmarking series: cash on the line performance in working capital management, Ernst & Young, February Ibid. 9

12 Improving cash to conversion However, the nancial health of telecommunications companies is not distributed evenly. Although working capital has improved for the industry as a whole over the past decade, cash ef ciency still varies wildly. In Europe, cash to conversion, for instance, ranges across more than 50 days, from 19 days to +33 days. Receivables also vary wildly, ranging anywhere from 45 days to 94 days. 11 There is still room for improvement. In Europe, Ernst & Young estimates that telecommunications companies hold between 11b (US$16.2b) 12 and 18b (US$26.5b) 13 in cash unnecessarily tied up in working capital. Supporting supplier stability The market s current structure may have other negative consequences for telecommunications companies beyond the risk of being perceived as low growth. The economic crisis has led to a narrowing of the supplier base. Years of squeezing suppliers to extract better terms and prices has resulted in so much consolidation that supplier stability is now an important concern. Telecommunications companies want to ensure the availability of parts and handsets. They also fear the concentration could lead to greater pricing power among suppliers. Operators must pay attention to their market message. Investor perception of the sector s defensive qualities should be carefully managed. Structural trends remain challenging, with incumbent landline loss running at 6.4% across Europe in Mobile margins continue to decline as the market matures and competition becomes ever more entrenched. As times improve, telecommunications companies may want to deemphasize the recurring revenue side of the business and focus instead on their growth prospects in contrast to the inherently cautious nature of their core access business. Figure 4 Percentage of respondents who have seen signi cant or slight deterioration in various categories in the past six months Telecommunications All industries Access to affordable capital 17% 26% Share price 12% 23% Investor confidence 20% 18% Shown: Percentage of telecommunications respondents vs. all industries Source: Opportunities in adversity, Ernst & Young 11. Ibid =US$ as of 20 September Ibid. 14. European Telecoms H2 Outlook, Credit Suisse, 1 July

13 Tempting tax Cash-strapped governments may look to telecoms as a source of income and nd pretexts to appropriate revenue through higher communications taxes or bandwidth fees. One European telecom giant is reportedly extremely concerned about this possibility. An executive at this company has worried aloud that governments need to balance the books, and healthy-margin telecommunications companies are a recognized source of cash! In Croatia, parliament approved new taxes on mobile services in July 2009, 15 while in Spain, a tax of 0.9% of gross revenues has been levied on operators to compensate for the phasing out of public service advertising. 16 Key considerations Review cash-to-conversion rates as a means of optimizing cash ef ciency. Respond proactively to short-term changes in the marketplace and value chain. Support supplier stability to ensure ongoing product and parts availability. Manage the market message to anticipate investor sentiment. 15. Mobile operators criticise law introducing higher tax on revenues from mobile telephony, Croatia News Agency, 31 July 2009, via Factiva, (c) 2009 HINA-CROATIAN NEWS AGENCY. 16. Vodafone to appeal RTVE nancing tax, DMEurope, 4 September 2009, via Factiva, 2009 DMEurope. 11

14 12 Protecting your assets

15 For risk, size doesn t matter In the 2009 Ernst & Young business risk report: telecommunications, industry analysts and executive panelists said companies number one fear was the prospect of losing ownership of the client. This is further supported by our Opportunities in adversity survey where one in three respondents highlighted improving customer loyalty as a key management priority, the third-ranked response. Weighing against improved customer loyalty is the burden of managing upgrades to new infrastructure, with the timing and scope of such investments subject to uncertainty. Telecom executives tell us they are most worried about the reliability of forecasts regarding returns on their technology and infrastructure investments. This is all the more important given the migration toward 4G mobile technologies and ber infrastructure for xed broadband. New business lines may precipitate new types of risk. The ability to pay bills using the mobile phone, for example, could expose operators to fraud and reputational damage. Focusing on key accounts Services pricing is also a key concern. Operators have been quick to scrutinize pricing strategies, launching SIM-only offers in the mobile market and pay-as-you-go options in broadband as bundle subscription prices continue to trend downward. One major global player says that the price cuts demanded by enterprise accounts are particularly worrying. It is hardly surprising, therefore, that operators are focusing on key accounts. Another concern involves revenue cannibalization. New data services may hasten the decline of not only voice revenues, but also legacy data revenues. Protecting current assets involves paying heed to structural issues, some of which may have been masked by the effects of the economic downturn. Despite the concerns, there is hope in mobile broadband, which is often purchased as a complement to xed-line broadband. Line rental prices are also trending upward in some European markets. 13

16 Developing a holistic approach to risk The risks that telecommunications companies face, whether they are customer loyalty, reputation or pricing and revenue, appear to be common among companies large and small. Although scale may make a difference to an operator s long-term chances of success, the risks themselves are the same. Size also doesn t seem to play a role in the sophistication of risk management practices. Often, smaller companies have stronger risk programs, and larger companies have weaker risk management systems. Regardless of size, some companies are seeking to develop more holistic approaches to risk management. However, more than a quarter of the executives surveyed in Ernst & Young s The future of risk: protecting and enabling performance indicate that their organization does not have a formal process to align risk management efforts with business strategy and objectives. Implementing risk strategies that align to business objectives may prove to be an opportunity for competitive advantage. Key considerations Prepare a risk strategy that has the exibility to anticipate the threats that future technologies and innovation may create; new business lines may precipitate new types of risk Check risk management systems to ensure that they are comprehensive and facilitate performance improvements Align risk management with strategic objectives as part of a holistic risk management program 14

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18 16 Improving your performance

19 More effective cost management is key As the perceived risk of a long-term nancial meltdown fades, strategic concerns have returned to prominence. But where that may mean leaps into new markets for other industries, the majority of telecommunications companies are stepping cautiously forward, focusing on improving performance of current assets rst. While companies had this as a goal before the markets tumbled, there is a renewed sense of urgency to cost-management initiatives. Figure 5 Percentage of respondents who expect to see signi cant or slight increases in importance in the following activities over the next 12 months Telecommunications All industries Improving the performance of current assets 82% 77% Taking advantage of the situation to pursue new market opportunities 61% 71% Protecting your current assets 64% 62% Shown: Percentage of telecommunications respondents vs. all industries Source: Opportunities in adversity, Ernst & Young Change is accelerating more quickly in telecommunications than in many other sectors, but operators believe they can save still more. In fact, fewer than 50% of telecom executives who responded to our Opportunities in adversity survey said their company had been successful in achieving their cost reduction targets for rationalization of employee bene ts, IT, headcount reduction, real estate or the supply chain. 17

20 Expanding the outsourcing model The telecommunications industry is con dent that it has the skills and capabilities to deliver critical performance improvement programs. However, not all operators believe they have effective controls over third-party IT suppliers or service providers, even as IT expenditures are growing and in-house R&D budgets continue to shrink. To improve IT and supply chain effectiveness, many executives want to extend their use of outsourcing and shared service centers. Forty percent of Opportunities in adversity respondents highlighted one of these two options as a route to greater ef ciencies in their organizations. Interestingly, telecoms are more attracted than most companies to certain kinds of outsourcing. For instance, more want to increase their outsourcing of distribution and logistics and customer service compared to companies in other sectors. Key considerations Focus on improving performance of current assets. Accelerate efforts to control costs to keep up with the competition. Align with the right partners for cost-cutting opportunities in outsourcing and shared services. Revisit long-term transformation agendas to ensure that targets are realistic and strategic repositioning is in line with fast-changing external factors. Many operators are beginning a second generation of outsourcing projects that tweak earlier solutions to achieve greater quality or ef ciency. Access-network upgrades are seen as a burden to the industry. However, core network migration to all-ip technology and the associated decoupling of service provision from network provision herald greater operational ef ciency and faster, more exible service development. This is vital given that telecom executives identify improved time-to-market as the leading action by which they can emerge from the crisis stronger than competitors. There is uncertainty surrounding tomorrow s signi cant growth opportunities. Accordingly, the only route to increasing cash generation is to maintain revenues and market share, and to drive costs down. Jeremy Thurbin Telecommunications Client Service Partner, Ernst & Young France 18

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22 20 Reshaping your business

23 Share networks, form partnerships As operators contend with the impact of the economic downturn and transformational changes in the industry, the need to reshape their organizations has become increasingly vital. That reshaping, however, may not include strategic mergers and acquisitions, as many organizations appear to be transaction-averse compared to other sectors. Figure 6 Percentage of respondents who selected the following actions as the ones they will take during the next 12 months Telecommunications All industries Divestments of noncore or nonperforming businesses 27% 29% Strategic acquisitions in the core business 23% 34% Strategic acquisitions in new areas of business 16% 21% Shown: Percentage of telecommunications respondents vs. all industries Source: Opportunities in adversity, Ernst & Young As illustrated in the gure above, divestments outscore strategic acquisitions as a strategy to gain competitive advantage as compared to other sectors. Many incumbent operators now own alternative operators in territories beyond their home markets. Given the trend toward consolidation in broadband markets where there are still many players with single-digit market share the inclination to reduce their footprint, rather than expand it, is understandable. 21

24 Restructuring the organization Although the strategic delineation between core and noncore operations is more important than ever, there are inexorable factors that are forcing businesses to restructure. One factor involves regulatory pressure to assure equality of access, where all market players have equivalent terms of access to the dominant incumbent infrastructure. Negotiated regulatory settlements in countries such as New Zealand, Sweden and the UK have led to the virtual separation of parts of the incumbent s business. 17 Such separation initiatives may gain further traction in a ber environment, where competitors may become increasingly reliant on a single, high-speed network. Challenging market conditions are another driving force to restructure. The outsourcing of network management to vendors is commonplace in mobile. However, a newer breed of network rationalization has arrived as operators start sharing active and passive network components. The operational ef ciencies and ease of implementation can only improve as 4G infrastructure is rolled out. Similarly, regulatory support is likely to play an increasingly important role. Rationalization strategies may precipitate more fundamental business relationships, as illustrated in the UK, where Orange and T-Mobile have proposed a merger predicated on synergies in IT, networks, marketing and distribution. 18 The economic crisis has demonstrated that duplicated networks in mobile are a luxury the industry cannot afford. As the concept of network ownership evolves, business lines are being reorganized according to the demands of the customer and convergence opportunities, rather than by network technology. In Germany, Deutsche Telekom has announced plans to merge its domestic xed and mobile divisions, a decision preempted by the competitive threat posed by rivals with both xed and mobile assets. Telecommunications companies must also consider the rami cations associated with the move toward more open network platforms. The developer ecosystems, well established in the technology sector, represent new territory for operators. Operators must recon gure their approach accordingly, with a consistent framework for opening network application program interfaces, for example. But operators will still have to contend with a legacy world of multiple closed systems that, to date, have provided compelling customer experiences. In the future, the telecommunications sector has the opportunity to reshape the business of others. Operators are more than just communications providers. They can also act as agents of performance improvement in other sectors. For example, ICT spending in healthcare is expected to increase as populations age. Operators are conscious of the ef ciency gains they can bring to bear as demand for a more sophisticated healthcare infrastructure rises. The current environment will encourage global operators to be more willing to collaborate with other providers for sharing the network or joint investment opportunities. Jose Luis Perelli Alonso Telecommunications Client Service Partner, Ernst & Young LLP 17. Network separation ensuring equality of access, Ernst & Young, October "Deutsche Telekom and France Telecom plan to merge T-Mobile UK and Orange UK to create a new mobile champion," 9 September 2009, ENP Newswire English, via Factiva (c) 2009, Electronic News Publishing. 22