Crystal Ball 2011

It’s clearly been another topsy turvy year. We have endured global weather shifts of seemingly Biblical proportions. We have witnessed previously-unstoppable political movements hit major headwinds and even reversal—while new political coalitions rise up to challenge. We are watching rapacious investment bankers proclaim a new global M&A boom (also of an unprecedented, Biblical scale and scope). With a supposedly apocalyptic year of 2012 just one year away, I wonder who could venture a guess as to 2011? Welcome to the third annual Crystal Ball perspective! (see: Crystal Ball 2010; Crystal Ball 2009)

Overall, it feels a lot better this year than last. Balance sheets look better. Industry innovation is still dizzying. To get to the future view, we probably need to sort out the effects of the underlying drivers: Cyclical versus Structural--consumer buying and supplier innovation patterns that should hold true, versus budget deficits that will never get paid back or industry economics that are essentially stalemate in nature. But inevitably, these dynamics will all lead to further industry turmoil in the tech and telecom sector.

M&A?--absolutely. Also, Netco and Servco is now back in common parlance again, as country markets legislate structural separation and as innovation trickles down and up to the service providers. Most playing fields will become more clear. Some playing fields will get even more murky.

What Happened in 2010?

In last year’s article, I predicted that six trends will continue to march on: (1) direct foreign investment driving more cross-border M&A activity globally; (2) media companies consolidating and resetting their long tail of print and online properties; (3) mobile handsets becoming the portal of choice for businesses and consumers; (4) streamlined number of global players in managed services on that “road to the final four”; (5) pay-as-you-go broadband deployment; (6) quad play losing its luster for the telcos and cablecos.

We saw a lot of this come to fruition, and these trends will continue forward. We did see renewed company focus on cleaning up international portfolios; we saw Apple, Android world, and almost every other OEM redefine what is a smart, connected device; we are seeing mergers of professional and managed services firms at all sizes and shapes; we continue to see downward revenue pressure for the service providers, while their business complexity increases in delivering the quad play--and while their capex budgets continue to explode, especially on the wireless broadband side. I see nothing in 2011 that would change my forward view here. These are predictable cyclical truths, especially on the cross-border M&A side as foreign currencies strengthen and if interest rates hold for a bit longer.

Who’s Making the Money?

What’s more interesting are the structural underpinnings that are determining the industry’s long term “end state”. Rethinking the future landscape requires understanding the core economics. A.T. Kearney just completed an end-to-end strategic review of the “internet value chain economics”, for a global telecom services provider. 

I can share with you a few insights by sector, most not so surprising: Online revenue growth is 5x that of hardware and software, and 2x that of internet access; China already has more internet subs than Western Europe and 60% greater than US; 73% of the bandwidth is consumed by file-sharing and VOD but these applications account for only 8% of the industry revenues! Industry concentration (the market share of top 3 players) pretty much explains Return on Capital Employed, i.e., the higher the better. So game consoles, operating systems at 80% industry concentration also reap the highest ROCEs (>30%).
Smartphones and web search ROCE performance follows after that; core network and access perform below that level, barely returning cost of capital at 10-15%; and then you have the fragmented e-retailer, web hosting and adult-oriented businesses that are inherently more local, that deliver the lowest ROCE on average. Returns on content distribution are not as high as you might expect, and closer to that of a basic telco. The laws of industry economics still apply, even in a fast-moving tech and telecom world. 

So, all else equal, there will be continued global consolidation in all these sectors. Expect further downward margin pressure on all access businesses: expect further downward margin pressure on even the highly-touted smartphone and tablet sectors, as more entrants make a move into the enterprise space. Valuations for social networking companies are due for a major market cap downgrade, from irrational exuberance (and addiction) levels. Telcos and cablecos, still seeking to avoid becoming “just a dumb pipe” (by evaluating and funding a portfolio of new and exciting ventures, including buying big –time TV studios and media companies in several G-7 markets), will confront and eventually accept the increasingly sensible prospect of carving out businesses, raising dividend payouts and returning more cash to shareholders. That’s what the numbers tell us.

What Does it Really Mean?

What this means is the preeminence of three macro waves: (1) the future of funding broadband is very scary; the commercials do not pay since there is such a fundamental mismatch between revenues and capex. Capped plans are not the end-all economic potion, as industry fragmentation and hypercompetition are also at play, all driving down ARPU. I also believe that (2) there will be more winner take all, by sector. For some this will require overpaying in short term to get on the right consolidation, and ROCE path.
For example, would it be so ridiculous for either Microsoft or Cisco to buy (even overpay) for RIM to double down on the business sector, while shoring up the strategy for their weaker consumer businesses? Or for a major high-tech OEM to buy Sony dirt cheap as a way of making follow-me video electronics even more real and compelling? And (3) the final macro trend is obviously that consumers are harvesting all the economic surplus--producers are innovating themselves to the limit, but have to sacrifice margin in pricing/marketing costs due to industry pressures, so the end consumers are the ones who benefit most from such supply-side innovation. Anyone who has gone early Christmas shopping in Best Buy this year can attest to that.

This means the operators, whether Netco or Servco, need to keep their eye on the ball in two evergreen ways: Back to the Basics in operational improvements to buy some time and runway; and Implement Consolidation plays in order to get to critical scale for the global battle. Shareholders are in for a rough ride in 2011 and beyond, if they don’t do both in parallel and with gusto.

Alex Liu is a frequent contributor to Connected Planet and a Senior Partner in A.T. Kearney’s global Communications and High Technology Practice, based in San Francisco. alex.liu@atkearney.com