Outsourcing trends in the European telecommunications industry

by Stefan Eikelmann eikelmann_stefan@bah.com Dr. Michael Fritsch fritsch_michael@bah.com Monique Oudijk oudijk_monique@bah.com Michael Stomberg stomberg_michael@bah.com Outsourcing trends in the European telecommunications industry

Survey description: In summer 2002, Booz Allen Hamilton conducted a major survey of changing operating practices at forty of Europe s largest telcos. Booz Allen Hamilton interviewed Senior Executives and examined the issue of how the core competencies of operators are shifting in response to changing market conditions, and given this, what significance would be attached to outsourcing activities along the entire operator value chain. Participation in the survey was higher than average, underscoring the acute relevance of the topic. Taking part were market leading operators, Incumbents, as well as their competitors, Challengers, from the mobile, fixed line, cable network and ISP sectors (exhibit 1). This document summarizes the findings of the survey and incorporates the experience Booz Allen Hamilton has gathered from working with clients in the telecommunications industry and reflects learnings on critical success factors for outsourcing in general. Exhibit 1 Interview Statistics

1 Outsourcing trends in the European telecommunications industry Summary of the Findings Our findings provide clear evidence that changing market dynamics in the telecommunications industry require all companies in the industry to redefine which business activities are crucial to their success. There is clear pressure to re-assess which activities will be important in the future. Today s strategic core competencies and cash cows are likely to lose importance tomorrow, such as operations of voice and data networks. As a result of this pressure to change, operators will increasingly seek to outsource activities in order to achieve cost reductions and flexibility and to focus operations on new, key strategic areas, such as product management, marketing and sales. This survey indicates that most operators have recognized the need to shift boundaries, to alter the perception of where and how they add value. In future, serious examination will be given to outsourcing of even those activities hitherto perceived as mission-critical. For example, 90 % of the Challengers questioned are contemplating outsourcing IT, billing and network operations. While it is unsurprising that the Challengers express more enthusiasm for such radical change, the startling fact is that even one in five Incumbents is after all considering it. The companies surveyed dealt with different intensity with shifting the focus of their activities from technology to the customer, and from operations to the design of the value proposition. Overall, a tendency similar to equipment vendors is evident, where most companies have already outsourced manufacturing to specialized service providers (e. g. Ericsson to Flextronics). This survey leads us to expect that, having initially outsourced peripheral activities such as logistics and facilities management, operators in future will increasingly seek to outsource call center operations, data center operations, some support systems for IT applications (administrative and ERP systems) and finally also core IT systems and billing operations. This shift in activity will likely result in a corresponding shift in value we estimate that the market for outsourcing services in the telecommunications industry will increase by over 9bn a in Europe over the next years. Network operation is (still) generally regarded by most operators as one of the key in-house activities, but even in this instance, there are some exceptions. Some operators have already outsourced network operations, freeing themselves to concentrate on providing services for customers, (and, in some cases, for other network operators) and on customer management. It is clear that there is an important evolution underway, with many companies seeking to move away from vertical integration models to broad structures which integrate partners and suppliers more closely. However, even though this transformation will require an enormous amount of effort, the potential of up to 20 % in increased efficiency is an enticing reward.

2 Today's Market dynamics require a redefinition of the concept of a telecommunications operator Pressure on telecommunications companies in Europe is growing tremendously. After the euphoria of liberalization and the e-business and dot.com booms, market dynamics have shifted dramatically. The expectations of sustained strong growth, which drove telcos to pursue ambitious acquisition and growth programs and pay large amounts for UMTS licenses, have resulted in significant network over-capacity and debt. Simultaneously, new income streams have proved elusive. Consequently, the telecommunications industry has entered a crisis that has triggered a wave of consolidation and restructuring. In light of this uncertainty, the forty operators interviewed by Booz Allen in summer 2002 have provided a unique insight into how today s operators are responding to this change. The first observation to make is that in general Incumbents and Challengers differ considerably in their views (see exhibit 2) while there are only marginal differences across the various telco segments (fixed, mobile, cable and ISP). The present combination of market saturation, growing business complexity and a shift in demand, coupled with enormous pressure from the capital markets, is forcing companies to act. They need to reassess their strategic direction and thus their activities along the value chain in order to adapt to the new challenges. Telcos can apply at least two different levers to implement the strategic adjustment of their business activities: Re-balancing activities or shifting core competencies along the value chain or Separating concept/planning and operation Service provider vs. network operator When asked about their future core competencies all Challengers in each segment of the industry tend to emphasize service and customer focus, while Incumbents continue generally to regard themselves as infrastructure operators (see exhibit 3). However, both groups are aware that although infrastructure operation contributes the major part of the total value added of their company, it will not be sufficient to Exhibit 2 Which Recent Changes Have Had the Greatest Impact on Your Company? (relative number of answers) Incumbent Telcos Challenger Telcos Stagnating growth 38 % 6% Financial pressure 5% 36 % Market and industry consolidation 3% 28 % Increasing complexity new products and technologies 36 % 23 % Changing demand 18 % 17 %

3 Exhibit 3 Which will be future core competencies of your company (relative number of answers) differentiate their company in the future and to secure its shareholder value over the long term. As a result, the skill of developing and marketing products and services (marketing, sales, customer service) is becoming increasingly important for a telco s success. Design vs. operation The companies interviewed see a further shift in the separation of the design, planning or strategic control of an activity and its actual implementation or operation. While for example it remains crucial to define the scope of services and the service levels for customer support, implementing these at the operating level (e.g. operating a call center) presents no great opportunity for differentiation. Less vertical integration trend toward outsourcing Overall, both levers - "shifting activities and separating planning and operations" to implement strategic adjustments - are reinforcing the trend toward outsourcing. It tends to extend beyond the outsourcing of typical peripheral activities, applying increasingly to activities previously regarded as core competencies along the value chain (e.g. IT operations, billing and network management). In this respect, the evolution of telco operators is mirroring the development of players in more mature industries such as consumer goods or automotive.

4 Exhibit 4 Telcos motives for outsourcing decisions Motive Cost reduction Focusing resources / Specialization Access to new competencies / technologies and acquiring complementary expertise Flexibility Speed/ Time to Market Creation of internal market discipline / Transparency in costs and performance Description of Advantages Typically an outsourcing service provider achieves lower costs through Advantages of scale, as the service provider delivers the same services to multiple companies Lower wage costs / different wage tariff structure Greater flexibility in employee structure Latest technology By outsourcing those activities that offer fewer opportunities for differentiation in the market, telcos are seeking to focus their scarce resources on (future) core competencies (e.g. customer service and product marketing), thus achieving competitive advantages Reduced management complexity Some service providers possess technologies and competencies to which other telcos have no access or that they would need to develop themselves. By outsourcing or partnering with a service provider telcos are looking to tap into new activities on the value chain (e.g. application development, content) and add to their own competencies By outsourcing, telcos minimize innovation risks By outsourcing activities to a service provider telcos will have more variable costs In sectors where utilization of capacity is subject to fluctuations, or it is hard to estimate future resource requirements, outsourcing is seen as a possible way of lowering fixed cost By using a service provider that already uses technologies and processes that a telco would otherwise have to develop itself, telcos are seeking to reduce the "Time to Market" and to exploit new technologies more rapidly Putting an activity out to tender to service providers requires the Service Levels necessary to be defined plus in order to compare external offers with their own activities an analysis of their own costs. Analyzing outsourcing opportunities in this way is itself a step toward creating transparency. Market prices should be used when negotiating outsourcing contracts, and benchmarks should be used regularly to maintain market discipline. Telcos can thus make sure that they are always working with an optimized price/performance ratio. Importance for Telcos (average) most important least important Motives for outsourcing As part of the study, interviewees were asked to prioritize separately the reasons for outsourcing decisions (see exhibit 4). Though one of the main reasons stated for outsourcing is to focus scarce resources on the (new) core activities, cost reduction is the most important driver behind outsourcing, 35 % of all respondents mentioned it as number 1. Some telcos are demanding guaranteed minimum savings as the prerequisite for outsourcing. Says one mobile Incumbent : activities where outsourcing promises to yield less than 15 % cost savings potential do not even earn a closer examination. However, many of those interviewed admit that in the past they have not always performed the business case analyses necessary to evaluate the financial benefits of outsourcing, and in some cases it has become clear that price and/or quality of the supplier is poorer than that of an in-house service. Indeed, some activities are even being insourced again. In pursuit of cost performance one Challenger said: We re-evaluated network maintenance that we had outsourced several years ago and found that we could provide better quality at lower cost with an optimized in-house support team. Consequently, we decided to bring it back in-house. As a consequence, all of those questioned today insist on a detailed business case-based analysis as a prerequisite for outsourcing decisions and stress the need for continued monitoring going forwards.

5 Whereas Challengers state that access to new skills and technology is the second most important motivation for outsourcing (20 %), for Incumbents this is seldom the case (5 %). The latter in many instances see outsourcing as a "politically correct" opportunity to reduce employee headcount and thus improve valuation. They hope that transferring resources to an outsourcing service provider who can also exploit cross-company economies of scale will be easier to accomplish than undertaking their own restructuring measures. This is even more the case in those countries where a reduction in headcount is difficult to implement due to labor legislation. On average more than 15 % of those surveyed indicate the flexibility and variability of costs gained by using an outsourcing service provider also as the major motive. New boundaries for core competencies Beyond the motives for outsourcing, we explored the current and future extent of outsourcing along the value chain and the consequent shift in the value added of telcos (see exhibits 5 and 6). We find that across multiple industry segments and companies outsourcing is tending: more towards activities (network, IT, billing) with intense infrastructural impact and where separation is possible - more in the area of operation than in concept and development (see exhibit 5) IT and call center operations are primary candidates for outsourcing Even the Incumbents are no longer so firm in their conviction that IT, previously run as a clear core competence together with the network, is a necessary inhouse activity. Only IT design, demand management and IT planning are labeled as clear core competencies and thus not being considered for outsourcing. Nevertheless, the former monopolists in particular have had legacy systems in place for many years now with a high degree of heterogeneity, making it difficult to separate and outsource individual activities. Exhibit 5 Future shift in the telcos extent of value added

6 Exhibit 6 Activities currently under consideration for outsourcing (relative number of answers) Whereas Challengers currently consider outsourcing of billing and other core IT systems in third place (see exhibit 6:14 %), Incumbents are much more reserved in this respect (0 %). Though they can see potential in outsourcing IT support systems such as financial / administrative systems, they are still wary of outsourcing their core IT systems straightaway, because of the complexity and heterogeneity of their system landscapes. Both Challengers and Incumbents agree that application-independent IT operations ( machine operations ) is a candidate for outsourcing; 12 % and 16 % for Challengers and Incumbents respectively. Both also see good potential in outsourcing call center operations. The subtle difference is that some of the new market players are putting complete operations out to contract (while maintaining detailed quality of service stipulations). The dominant market companies on the other hand contract out only a part of call center operations, while continuing to handle complex customer issues (so-called 2nd level support ) themselves. What is striking is that Incumbents still name low value peripheral activities such as facilities management and the installation of infrastructure as future outsourcing candidates (7 %). These do not appear at all in the outsourcing deliberations of the Challengers mainly because they have often already been outsourced. The attitude of the Incumbents and the Challengers toward outsourcing of core activities such as billing and network management are diametrically opposed: it does not even warrant a mention with more than three-quarters of the Incumbents but is under future consideration at more than 90 % of the Challengers. In conclusion, we expect that telcos, who have not already done so will begin by outsourcing their IT support systems such as desktop support, financial administration systems, payroll and the business support services like logistics and invoice printing. As a second, very topical wave, we expect continued outsourcing of call centers or parts of them, application-independent machine operations, parts of IT applications such as ERP, parts of business support systems and data warehouses. We estimate that this will lead to an increase of the market for outsourcing services in the telecommunications industry of over 9bn u in Europe over the next years. In addition, the

7 Challengers in the mobile communications market are also increasingly outsourcing the operation of their telecommunications infrastructure (approx. 10 % of the mobile operators interviewed). Billing operation no longer counts as a core competence Whereas in the past billing was generally understood as an absolute core competence and a necessary inhouse activity, this survey shows that only 8 % of Incumbents and only 10 % of the Challengers interviewed still regard billing as critical in-house activity. Most telcos no longer consider the billing operation as a differentiating core competence and consequently 70 % of those questioned are in principle ready to hand over billing operations to an external partner. Only the design of the billing process and specification of the service features are regarded as a core activity. Still, only 50 % of those interviewed believe that they will be able to find a convincing supplier for these services. As a result, examples of successful outsourcing of billing are rare as yet. Outsourcing success factors In light of the expected shift of the boundaries of a telco and the associated increase of outsourcing volumes, professional management and handling of the outsourcing process from strategy definition through to implementation gains importance. Based on the experience of the interviewed telco managers we have distilled five key success factors for outsourcing in the future: 1. Detailed, objective business case analysis Every outsourcing decision should be based on a business case that takes into account both the internal optimization potential and the costs involved in migrating the service to the outsourcing provider, as well as the costs of future interface management. Negotiations with partners/outsourcing providers should begin in earnest only when all technical and commercial considerations clearly show outsourcing to be viable within an acceptable time frame. 2. Process optimization and transparency in costs and service. In many cases processes are handed over in full and unaltered. The outsourcing providers are then in a position to deliver savings that the telcos could also achieve to some degree under their own management. Therefore, before outsourcing the telcos should first optimize their processes in-house. Inviting service providers to bid for an activity calls for the Service Levels required to be defined in full and with built-in assurances for future compliance. It also requires that telcos have analyzed their own costs in detail so that they are in a position to compare external offers with their own activities. Thus, analyzing outsourcing opportunities in this manner is in itself already a step toward creating additional cost transparency. 3. Detailed Service Level Agreements (SLAs) Telcos must agree detailed SLAs at the process level with the supplier, using an analysis of their own costs and the Service Levels required. It is important that parameters can be measured easily and verified regularly. Moreover, contractual penalties should be arranged that kick in if Service Levels are not met. 4. Balanced sourcing of the supplier relationship A relationship of trust becomes increasingly important when there is mutual dependence involved. Customers and suppliers should seek a win-win balance in their relationship. Neither blind trust nor putting the squeeze on the suppliers will deliver success over the long term. Rather, partnership relations should be established that optimize the processes for both parties through collaboration and thus reduce costs. Whether a single supplier should be contracted to handle an activity or multiple suppliers at the same time depends on the particular situation. A single supplier offers the advantage that responsibility can then be designated in full, along with corresponding quality control and cost-effective interface design. However, this could lead to strong dependence in the long run. Spreading the total order volume over

8 several suppliers reduces this dependency, however, at the expense of some scale benefits. 5. Quality control and management of suppliers Outsourcing contracts should be negotiated on the basis of market prices. Regular benchmarks contribute to maintaining this market discipline. This enables telcos to be certain that they are always working with an optimized price / performance ratio. Good service providers are proactive in offering these benchmarks and invite the customer to let an independent third party assess their services. The continual and expert management of the outsourcing service provider by the business unit / technical department especially in the transitional phase will furthermore be absolutely essential. Outlook Changed market conditions require a strategic and operational readjustment on the part of the telco companies for reaching sustained differentiation in competition and profitable opening up of new markets. With growing requirements to build new capabilities and to become more efficient in existing operations, the pressure to outsource parts of the value chain increases. Consequently, we expect telecommunications operators to change their value chain and focus in the near future. This will require new capabilities (similar to those capabilities that the automotive industry has built over time) to professionally manage suppliers and partners to build a successful extended corporation. However, this transformation of the telecommunications industry will only be successful if the growing supply for dedicated outsourcing services adapts to the changing needs of the telecommunications companies.

9 How can Booz Allen Hamilton help? Booz Allen Hamilton supports telcos in preparing and implementing all aspects of outsourcing decisions. As a consultant operating independently of suppliers and with many years of project experience, we are able to provide expert advice and comprehensive support for all the steps involved in ensuring successful outsourcing: Strategy definition Definition of core / non-core competencies Evaluation of financial and operating potential of outsourcing RFP process and supplier evaluation Supplier selection and negotiations Implementation program management Founded in 1914, Booz Allen Hamilton is one of the leading international management and technology consulting companies, with over 11,000 employees. Our staff work together in international project teams at more than 100 locations worldwide, achieving sales of approx. 2.1 billion US$ in fiscal year 2001/2002. Further information is available at www.bah.com Stefan Eikelmann, Partner and Vice President, Booz Allen Hamilton Amsterdam. Stefan Eikelmann primarily advises telecommunications, media and IT companies in executing strategic transformation programs. Dr. Michael Fritsch, Principal and member of the management of Booz Allen Hamilton Germany. Dr. Michael Fritsch mainly supports IT and telecommunications clients with operational and strategic challenges. Monique Oudijk, Project leader in Booz Allen Hamilton Amsterdam and member of the Operations Competency Center. Monique Oudijk advises clients on the execution of transformation and purchase optimization programs. Michael Stomberg, Senior Associate in Booz Allen Hamilton s Technology Practice. Michael Stomberg mainly advises clients in the technology sector on strategic matters, innovation and corporate venturing.

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