Growth drives long-term value, but what drives growth? The answer could make the difference between thriving and barely surviving in Western Europe's telecom industry. Asmus Komm and Sven Smit look at telecom growth opportunities, and explore eight megatrends and microtrends that can open new revenue pools to industry players
McKinsey's research detailed in ‘The granularity of growth' by Mehrdad Baghai, Sven Smit, and Patrick Viguerie, clearly illustrates how growth plays a crucial role in long-term profitability and survival.
Companies that grow at above-GDP rates are six times less likely, on average, to go bankrupt or be acquired. Furthermore, company growth that exceeds GDP expansion corresponds to a 28 per cent greater long-term total return to shareholder (TRS). Even ‘cash cows' deliver inferior long-term TRS on average, and are more likely to ‘die', if their growth is slow.
Unfortunately, analysts expect most large Western European telecom players to grow at rates below GDP, planting them firmly in the high-death rate category. This represents a dramatic turnaround from the industry's pre-2001 performance, when most of Western Europe's telco players enjoyed strong double-digit growth, driven primarily by the expansion of the mobile and broadband markets. Even during the transitional period from 2001 to 2005, most players grew in the two to four per cent annual range, largely matching GDP levels.
Telco incumbents that focus primarily on their core (home) markets will find it difficult to achieve growth rates that align with or exceed GDP. While nominal GDP in Western Europe is forecast to grow at 3.7 per cent per year through 2009, the telco core market, made up of fixed and mobile voice and basic data, will only grow at about 1.6 per cent annually. In addition, the average incumbent player still retains a high share of slow- or no-growth fixed voice revenues, which could limit its core telecom portfolio to an annual growth rate of only about one per cent.
In line with this general picture, capital markets do not predict much growth for Western Europe's telco incumbents, since current performance explains most of their entity value. Furthermore, the share that reflects expected performance improvement continues to decline, and now represents less than 10 per cent of total value.
So should Telco's in Western-Europe forget about growth and focus on returning the bottom line and return dividends to shareholders, or pursue share buy backs? The answer is, it depends: like for many utilities it is a very viable strategy to return high dividends and pursue share buy backs to create value. On the other hand expansive "growers" for example, pursuing emerging markets have succeeded in finding valuable growth. For those that consider growth we have postulated eight trends shaping the future telecom market that can support growth strategies.
Eight trends shape future telecom markets
Our research indicates eight telco megatrends will shape the West European telecom market through the end of the decade. These trends will threaten most incumbent business models, but will also give rise to substantial new growth pools. We will examine each of the eight trends in some detail.
Trend I: Convergence. Convergence has been and is much talked about, both in terms of fixed and mobile convergence as well as content/infrastructure convergence. Some evidence suggests that fixed/mobile convergence could accelerate as technical and usage barriers disappear. Driven by Internet protocol (IP) proliferation, data and voice traffic will converge. While a huge potential for new products and business models will emerge, few additional revenues streams will be created directly for the "infrastructure business". Telco players are likely to be challenged to monetise the additional customer value resident in the newly converged offers, as convergence can lead to more competition.
Trend II: The Commoditisation of Traffic. Competitive pressure on usage-based voice and data pricing will accelerate the shift towards flat rate type offers. Incumbents will increasingly compete as access "pipes", and will likely find themselves unable to fully rebalance their declining traditional traffic revenues with higher access revenues unless markets consolidate a lot more than today.
Trend III: Broadband Proliferation. Spurred by continuing price declines, fixed line broadband penetration will continue to rise but the additional revenue potential will be limited (without value-added-services/content). Broadband penetration and usage is an opportunity for in nomadic and mobile data applications, leading to more revenues from WiFi hot spots and 3G data networks despite likely pressure on price levels.
Trend IV: Value-Added-Services (VAS) and Content-Driven Traffic. Fixed and mobile broadband networks will enable a multitude of value added services and new forms of content. These services represent substantial revenue potential beyond the traditional telecom business, examples of which include eHealth applications, gaming and gambling, and telematics, for telcos the challenge is - like in the emergence of the Internet - to capture revenues beyond increased price for bandwidth. In a way VAS is a diversification opportunity for telcos on success of which has limited proof to date.
Trend V: Reshaping the Value Chain. Both regulation and technological progress increasingly enable attackers to break up the existing integrated incumbent value chain to compete on their favorite parts (eg, city/local access or call origination/termination via the Internet) and thereby put pressure on the most valuable pockets. Investing in attackers abroad is the growth opportunity for telcos as "at home" this trend challenges revenues.
Trend VI: Consolidation in Western Europe. Incumbents face limited organic growth opportunities in their core home markets. Large players will increasingly seek the opportunity to grow inorganically and to form global players by acquiring small and medium sized players in other markets. The development of the US market is a case in point.
Trend VII: Regulatory Focus on Wholesale Favouring Attackers. Regulators will continue to shift focus from retail to wholesale prices in order to foster competition. With mobile penetration approaching saturation levels, mobile operators with significant market power could face the same rigid regulatory pressure as fixed-line incumbents.
Trend VIII: Growth in Emerging Markets. Rapid economic growth in emerging markets (eg, in Eastern Europe, Middle East, and Asia), driven by mobile voice and broadband, will remain a major revenue pool for telecom players following a geographical diversification strategy, the challenge is to find non-fully valued assets in the space.
From megatrends to growth pools
Based on the above eight telco megatrends, we identified over 20 growth pools with a collective growth potential of USD 63 billion from 2006 to 2009. The identified growth pools will grow from USD 121 in 2006 to 184 billion in 2009 (Figure 3).
Players should prioritise and select a growth portfolio based on these revenue pools. To be effective, they should make this assessment based on the specific profile, positioning, and capabilities of a given company, and consider it in terms of three different dimensions:
Players need to assess growth opportunities in terms of barriers to entry and familiarity from their own individual perspective. Barriers to entry include legal, regulatory or technological aspects, while familiarity reflects the extent to which a player already operates in or near a particular market segment. The most favourable growth pools combine a sufficient level of familiarity with some substantial barriers to entry that limit competitive pressure.
Growth opportunities differ widely in their size, expected ebitda margins and required capex. By ranking growth pools along these dimensions, players can identify growth ‘nuggets' with high margins at relatively low capex and, more generally, select the most favorable trade-offs of capex demand and likely operating margins.
The development of growth pools typically follows an S-curve characterised by a moderate start, a rapid uptake phase, and a moderate maturation phase. Incumbents should ideally move when the pool enters the uptake phase in order to leverage scale-up capabilities and to avoid over-paying.
These three dimensions should be applied as filters for potential growth initiatives to identify the most promising portfolio of growth pools based on a player's needs, capabilities, and assets.
Several industry players have seen the ‘writing on the wall' and are already moving into selected growth pools.
If players aggressively leverage the identified growth pools in their core businesses and especially in adjacent markets, total annual growth rates of 8 to 9 per cent appear within reach.
Total revenues can be fuelled by three sources: inorganic growth (ie, acquisitions), market growth, and organic share gains. Inorganic growth and organic share gains have historically contributed three to four per cent and one per cent of growth, respectively, and will likely remain at that level for the best-performing players. Therefore, in order to achieve growth rates significantly above GDP, players need to tap market growth pools, and our research indicates that determined moves into a well-selected portfolio of growth opportunities can deliver an additional four percent, for an overall growth rate of eight to nine per cent.
Reaching these growth levels will not be easy as they often represent strategic shifts for the company involved, players will have to compare these possibilities to the alternative of dividends and share buy backs and there own capabilities.
Asmus Komm is a principal and Sven Smit is a director in McKinsey & Company's Hamburg and Amsterdam offices, respectively. Sven Smit is also co-author of ‘The Granularity of Growth: Making choices that drive enduring company performance' (with Patrick Viguerie and Mehrdad Baghai) published by Marshall Cavendish and Cyan Books.