After the hammer falls

The results of the recent auction of new mobile phone licenses in the U.K. were a surprise to many. The bidding to provide third generation mobile services capped out at nearly $34 billion - far more than predicted. Most telecom operators, their advisers and investors now are revising their forecasts for 3G auctions in the rest of Europe.

Although the license values attracted much attention, most commentators have missed the full implications of these auctions. They could mark a watershed in the competitive dynamics of the mobile industry: Power will shift to customer franchise owners and away from those who simply control spectrum (Figure 1).

3G technology promises to offer a broad bundle of mobile personal services, including communications, messaging, entertainment, contacts, news, alerts and reminders, as well as myriad forms of personalized commerce. The challenge facing mobile operators is to use the right mix of those services to develop the broad and deep customer franchises required to earn a return on their 3G licenses.

To the extent that the operators cannot develop such franchises on their own, they will have to leverage someone else's customer base. That will provide an attractive opening for a new set of wireless players: companies with strong customer franchises in other industries and the ambition to expand into the services made possible by 3G technology (Figure 2).

In short, while service providers' high-stakes 3G competition started with a focus on licenses, now it will turn to customers: acquiring, retaining and, above all, developing rich relationships with many of them.

Why licenses cost so much

Despite recent adjustments, the mobile communications and Internet industries have generated enormous shareholder wealth. It is therefore not surprising that 3G wireless, the intersection of those two industries, has become such an intoxicating prospect for operators and investors (Figure 3).

This enthusiasm has consequences, however. First, if an incumbent did not win a 3G license, investors would view its growth potential as significantly reduced. Second, any credible new entrant can raise capital to finance a 3G license fairly easily. Thus, the competition for licenses will remain fierce.

The structures of 3G auctions also will drive up prices. In the U.K., the government offered five licenses - just one more than the number of incumbent operators. The incumbents had to win licenses or suffer the consequences. That left eight potential entrants to battle for the sole remaining license - ensuring that the two most bullish aspirants would determine the auction result. As it turned out, the last two bidders, TIW/Hutchison and NTL, both had experience in winning wireless licenses. By the time the hammer fell, the total license fees amounted to almost $600 for every person in the U.K.

The mechanics of other European auctions will differ from the bidding in the U.K., but apparently, they all will be characterized by committed incumbents and several potential entrants chasing fewer licenses.

Other auctions may deliver even higher pop license values than those in the U.K.

In Germany, for instance, 3G spectrum is being auctioned as a series of 12 blocks. In the initial auction phase, companies can bid for two or three blocks. Depending on how many blocks the winners bid for, between four and six licensed operators will emerge. If all four incumbent operators successfully bid for three blocks each, they will squeeze out any new entrants. These dynamics could see the German per pop license value exceed the U.K.'s by a wide margin.

Post-auction priorities

The immediate imperative for 3G operators will be to build their networks quickly to start recouping the fixed license costs. Incumbents will have a head start over new entrants, given their existing infrastructure. But many operators - old and new - will face delays as standards and interoperability issues are resolved and as the infrastructure and handset manufacturers try to keep up with demand.

The operators also must develop their overall 3G customer propositions. Those propositions will need to achieve two goals if they are to meet the operators' financial expectations.

First, they must differentiate 3G from existing services and persuade millions of consumers to switch from today's 2G and 2.5G mobile service. Second, they must make 3G services an integral and indispensable part of many people's daily routines to generate incremental revenue from a wide range of personal services.

While most operators recognize the necessity of working with partners to put together a range of personal services, they also assume that the network operator will own the lead brand and control the customer relationship. That assumption, however, may prove invalid in many cases.

European cellular markets typically have three or four competitors. Operators have tended to build vertically integrated businesses, combining networks, service creation and service provisioning. Separate service provisioning businesses existed only where mandated by regulation, and their economics have been unattractive compared with those of network operators. Competition has focused on bringing new customers to cellular service, and margins have remained high.

Most 3G auctions will result in one or two new operators entering each market. When aggressive new players have been introduced into other cellular markets in the past, the competitive dynamics have changed dramatically.

For example, certain attractive cellular markets in the U.S., such as Jacksonville, Fla., saw a big change in competitiveness when new operators began providing PCS. There were radical price declines and attempts to build new sources of advantage through bundling cellular with other services such as Internet access, paging and long-distance.

In European markets, the introduction of new entrants through the 3G auctions may have a similar destabilizing effect on the prevailing dynamics. The differences between incumbents and entrants, in terms of capabilities and competitive position, will be stark.

Leading incumbent operators will have massive installed customer bases, well-known brands, established distribution networks, a customer service and billing infrastructure and mature cellular networks - all of which they can leverage when building the 3G business. New entrants will face the challenge of getting to a competitive position in each of those categories.

Wholesale changes

Moreover, providers naturally will rush for customers. But by the time 3G services are ready for full launch in 2002 or later, mobile penetration will be well above 50% in most European countries. If a slowdown in the overall growth of customer numbers has not occurred by then, it will not be far away. The customers with the most attractive characteristics for 3G already will have 2G or 2.5G services.

Some operators will lead in this effort, and some will lag. The economic consequences of trailing in this market will be much more severe than they were in 2G because of the high interest payments on license fees and buildout costs. This inevitably will send the laggards to companies with powerful customer franchises. Customer relationships will be the scarce resource, and these companies will offer a shortcut to an improved competitive position.

However, the balance of power will rest with the customer franchise owners. If they have ambitions to offer the types of service that 3G allows and if they see those services as a way of reinforcing their existing franchises, they will demand more than conventional co-branding and co-marketing arrangements. These "retailers" will become mobile virtual network operators in deals that give them control over the customer experience and information and a greater share of the returns from 3G services. Armed with enormous customer bases and marketing savvy, these customer-owning players have the potential to become powerful forces in their newly adopted industry.

There appears to be no shortage of companies that can expand their franchises into the personal services that 3G will provide. They range from mass-market retailers such as Carrefour, Tesco and Metro to cable TV companies such as NTL and UPC and Internet access providers such as America Online and Freeserve.

The deal between One2One and Virgin in the U.K. can be seen as an example of this logic, although it covers only 2G to date.

Even the strongest and biggest 3G license holders will have to take this new level of competition seriously. Incumbents may have to consider more co-branding and co-marketing arrangements, if only as a defensive measure to deny other operators the customers gained in those deals. But the incumbents must put their biggest efforts into building, testing and refining their own customer propositions.

A plan for action

Now is the time for mobile operators to position themselves to succeed in the 3G environment. The smartest players should take these steps:

- Develop a deep understanding of consumer behavior in response to a broad range of 3G-enabled services. They should focus initially on learning the lessons from early adopters of today's technology in Japan and Scandinavia. The mantra "follow the customer" will be important.

- Develop service offerings that become an integral part of consumers' daily lives. These players will become the primary suppliers of a range of personal services and will leverage customer relationships to extract value from non-mobile transactions.

- Deepen the franchise with their most attractive existing customers by migrating them to 2.5G services.

- Actively manage partnerships with companies that have strong customer franchises. Doing this will leverage the volume of customers that those partners control and block those companies from linking with competitors.

Operators can earn a good return on their 3G licenses if enough value is created for customers. For new entrants, that will probably mean ceding some ownership and control to outside companies to leverage their customer franchises. For incumbents, it means building their own customer propositions to ward off the new competitive challenge that those outsiders will bring to the game.