Break up to break out

The communications industry has entered a new phase of competition in which trailblazing young firms are winning against traditional firms and second entrants. The challenge for established players is to radically reshape business designs, which for many will mean breaking up existing organizations.

Between 1991 and 1998, the market value created by upstart outfits, such as competitive access providers, wireless carriers, Internet service providers and satellite operators has grown at a rate of four times more than that of the regional Bell operating companies, long-distance carriers and other traditional organizations.

Some of the winning players to date include MCI WorldCom, which in just five years has become the most successful end-to-end business customer provider in the world; UPC, a leader in residential communications in Europe; America Online, the dominant Internet aggregator; and Level 3, a prominent player in wholesale transport.

These trailblazers share several characteristics. They focus on relatively narrow customer segments. They jump technologies, focusing on broadband, IP, software and content activities while avoiding excessive infrastructure investments. They adopt new approaches to capturing value with little hesitation about substituting basic subscriptions or contracts with other sources of revenue. And they secure strong strategic control, protecting profit streams from competitors or powerful customers.

Financial markets have supported these operators enthusiastically, and higher revenues allow them to aggressively build their business designs through mergers and acquisitions. But building competitive new organizational units within the umbrella of an integrated operator requires emulating the pure play business designs. This has proved all but impossible in practice.

The internal complexity associated with adopting a structure of multiple, sometimes incompatible, business designs undermines the competitiveness of each unit. Financial performance, organizational capabilities and shareholder expectations will be very different for each unit. Moreover, managers rarely have the stomach or the incentive to allow the new units to cannibalize existing service offerings.

The way for incumbents to achieve sustained growth in profits and shareholder value lies in creating the mechanisms for an organizational breakup of the company. A judicious breakup or spinoff can create equity at a high multiple that can be used to acquire the missing components of a business design.

Traditional telecommunications companies have been loath to radically change their scope of operation. The pervasive industry wisdom that big is beautiful has driven the mergers of RBOCs in North America and similar attempts in Europe. However, these traditional mergers rarely unlock shareholder value in a sustained manner.

Two notable exceptions are particularly instructive. U S West engineered a breakup into three focused companies: U S West Communications, MediaOne Group and New Vector (the company's cellular subsidiary). Initially creating a tracking stock for its cable TV, wireless, directory and Time Warner investments, U S West used the higher multiple of this stock to acquire Continental Cablevision. That enabled U S West to create a consumer broadband access business - MediaOne - and contributed to the creation of the leading wireless operator in North America, AirTouch.

Investors received these moves warmly, first on a stand-alone basis and then as acquisition targets by AT&T and Vodafone. U S West's bold breakup has increased value for shareholders by more than 40%.

Nokia has progressed through two new business designs. First, it moved away from being a diversified conglomerate to focus on GSM products. Then, it shifted emphasis from product alone to building a strong consumer brand faster and earlier than its key competitors. As a result, Nokia has grown its market value-to-sales ratio from 0.4 in 1990 to more than 4 in 1998.

The greatest obstacle to changing the scope of incumbent operators lies in the need to place bets. Operators are wary of leaving companies with which they are familiar. But unless they embrace the challenges of breaking up to break out of stagnation, traditional operators run the risk of being redesigned by force.