For many years, industry observers have been calling for telecom operators to transform and respond to the disruptive forces of over-the-top players like Google and Facebook, and the burgeoning service and application demands as smart devices proliferate. While operators have made strides in transforming their businesses, they are confronted with a variety of challenges that hinder progress. These challenges are multi-faceted and essentially depend on an operator's ability to navigate complicated regulatory, operational, technical and commercial market demands, while fulfilling investor expectations.
Commonly, operators' strategic decisions are driven primarily by investor expectations, which in many cases result in a myopic focus towards increasing shareholder value at the expense of longer term considerations. In the last decade, some investors have placed greater emphasis towards financial measures which are intended to reflect value creation over the longer term, such as an operator's return-on-assets (ROA) and return-on-invested-capital (ROIC), and its strategy for technology evolution. While these new measures are a step in the right direction, they are not necessarily adequate in fueling operator transformation.
An operator's technology evolution is a balancing act, which is intended to benefit from the marketing hype and performance improvements offered by new technologies, without unduly compromising financial and operational performance. Until recently, telecom technology innovation has primarily focused on leveraging Moore's Law to enhance platform performance. However we are now entering a new era in architecture, where Moore's Law is enabling telco platforms to be virtualized with network function virtualization (NFV) and software defined networking (SDN), and Shannon's Law is driving the need for heterogeneous mobile networks. With these new architectures, automated operational solutions are needed to orchestrate network and service resources. As these solutions are adopted they will drive telcos away from traditional operational models that emphasize the management of complexity, to operational models that are more commonly adopted in IT environments, where there is an emphasis to abstract complexity with automation techniques.
As telecom operators advance their network and service environments, they are challenged by their customers who are more demanding than ever before, and are more commonly expecting personalized products and services. This is fueling interest in customer-centric alternatives to conventional product-centric business models. When adopted, customer-centric business models leverage extensive customer intelligence to adapt and refine the solutions that are delivered to individual subscribers. Companies like Amazon, Google, Facebook and Tesco have demonstrated that tremendous value that can be garnered from customer-centric business models. Furthermore, customer centricity is at the heart of agile techniques that are becoming widely adopted for software development.
Theoretically, if a company's ROIC exceeds its weighted average cost of capital, (WACC), the intrinsic value of its invested capital is increasing, and vice-versa. However the ROIC of a company can vacillate between reporting periods as a consequence of non-operating factors, such as changes in accounting methods. For example, after declining from 11.5 to 3.7 percent between 2005 and 2012, Verizon's ROIC increased dramatically to 12.5 percent in 2013 largely as a consequence of a change in its “accounting polices to recognize actuarial gains and losses in the year” for its pension funds. AT&T reported a similar gain in the 2013, see Exhibit 1.
Exhibit 1: Historical ROIC estimates for Verizon and AT&T
Source: Morningstar 2015
Exhibit 2 summarizes ROIC estimates for several telecom operators and compares these estimates with other non-telecom technology companies. These estimates include the median, minimum and maximum ROIC for the companies over the past ten years, and their estimated ROIC for 2014. With the exception of outliers, the telecom companies that are profiled have generally achieved ROIC in excess of their WACC estimates. In particular, companies generally have WACCs in the order of 4 to 8 percent, while their median ROICs (excluding Sprint) over the past ten years have ranged between 7.1 and 15.9 percent. We believe that this is reflected in investor sentiment towards the sector, with Price-to-Earnings ratios having tended to index above the S&P500 over the past decade. However in terms of their ROIC, telecom companies tend to lag technology companies like Apple, Google and IBM. Others including Amazon, Facebook and Samsung Electronics have more modest ROICs, which are still favorable, particularly given their respective growth strategies.
Exhibit 2: Historical company returns on invested capital (ROIC)
Source: Morningstar and Tolaga Research 2015
* Facebook's figures are taken after 2010 when the company went public
While financial metrics such as ROIC and ROA are useful indicators for assessing the performance of telecom operators, they cannot be treated in isolation and since they are lagging indicators are not necessarily reflective of a company's future performance, particularly in the long term. Furthermore, seminal research presented by Clay Christensen from Harvard Business School shows that if a company focuses on maximizing capital efficiency it is challenged in transforming its business to cater for disruptive innovations.
For over a century, since Henry Ford's invention of the automobile production line, product and service companies, including telecom operators, have successfully implemented product-centric strategies. These strategies are generally underpinned by a virtuous cycle which involves the invention, development and marketing of differentiated products that a company believes will be desired by its customers. This contrasts customer-centric strategies, where company activities are driven by the specific needs of individual customers, particularly those that are in market segments with the greatest life-time value. Customer-centric strategies rely on detailed data intelligence that is garnered through profile information, transactions and other recorded activities of the customers. Since telecom operators have access to tremendous insights and intelligence of the real-time activities of their subscribers, they are uniquely positioned to provide powerful customer-centric solutions.
Even though companies like Apple have enjoyed, and continue to enjoy tremendous gains from product-centric strategies, these strategies are generally becoming less effective, particularly for service led solutions, such as those offered by telecom operators. Most traditional companies continue to be product-centric, but some players like Tesco have achieved tremendous progress towards customer-centricity. Furthermore, as agile software development grows in popularity, it enables developers to make incremental customer-centric changes to complex software environments. This contrasts conventional waterfall development processes which define product design at the outset.
The telecom transformation towards customer-centricity is challenging. However, we believe that with the correct strategies, telecom operators can leverage their transition to SDN, NFV and heterogeneous radio network architectures as a means for driving customer-centricity, through the following initiatives:
While telecom industry transformation has been painfully slow, it is clear that ecosystems are aligning to drive a shift in strategy towards virtualized infrastructure with automated network operations and service creation. We believe that will provide the building blocks for telecom operators to transition from product to customer-centricity. However to successfully transform, telecom operators must change their organization structures and operational models appropriately and convince their investors to believe in the value that will be created in the long-term.