Transcript After the Gold Rush: McKinsey Perspectives on Telecom 2001-02

After the Gold Rush:
McKinsey Perspectives on Telecom 2001-02
Doron Fertig
Phoenix Center 2001 U.S. Telecoms Symposium
July 11, 2001
KEY THEMES – TELECOM
1. We expect a period of relative industry stability to emerge, driven by
diminished competition, consolidation, and a non-interventionist
regulatory environment. This period will favor incumbents, particularly the
ILECs.
2. However, we anticipate that meeting growth expectations (top line and bottom
line) will become more difficult and, as a consequence, we foresee a decline
in industry capex and a dramatic uptick in outsourcing in an attempt to
manipulate cost levers.
3. We believe that customer inertia (and other aspects of buying behavior) will
emerge as a greater barrier to the success of new services and providers
than previously anticipated.
4. Operational and systems issues will continue to hamper the development
and roll-out of “next generation” communications services to mass market and
SME customers.
5. The combination of regulatory permissiveness, collapsing valuations of
attackers, and historic anomalies in valuation (ILECs vs. LD) will drive a
potentially massive restructuring of the industry.
1
INDUSTRY SECTORS
Sector
Origin date(s)
• Wireless
1980’s, 1990’s
• MANs
Late 1990’s
• CLECs/DLECs
1990’s
• ILECs
1870’s
• Backbone
1900, 1970’s, 1990’s
• Edge Networks
Late 1990’s
– CDNs
– Hosting
• Cable
1970’s
2
INDUSTRY SECTORS
Sector
Origin date(s)
• Wireless
1980’s, 1990’s
• MANs
Late 1990’s
• CLECs/DLECs
1990’s
• ILECs
1870’s
• Backbone
1900, 1970’s, 1990’s
• Edge Networks
Late 1990’s
– CDNs
– Hosting
• Cable
1970’s
3
McKINSEY PERSPECTIVES ON THE ILEC SECTOR
• Organic growth alone, without substantial investment, will be insufficient to meet long-term
expectations for ILEC performance
– Residential market growth is anemic (1-2%)
– Wireless growth slowing and will not support overall ILEC goals
– The lucrative enterprise market remains out of reach for ILECs. Breaking into the market will require
massive investments of capital, time, and sales & marketing skill
• Consequently, we expect substantial pressure on ILECs to pursue acquisitions of IXCs
– Relative valuations are at historically anomalous levels
– AT&T and WorldCom, in particular, own enterprise customers that would be highly valuable to ILECs
– Merger approval may be no more difficult than plain-vanilla LD entry approval
• DSL will continue to grow in value for ILECs who execute deployment strategies effectively
– Well executed DSL rollouts generate attractive returns for ILECs (all-in IRRs=32%, all-in ROICs=24%)
– However, the standalone DSL business case is substantially less attractive (e.g., dilutive to core
business)
– DSL will retain a clear advantage in addressing SME broadband needs
Source: McKinsey
4
McKINSEY PERSPECTIVES ON THE ILEC SECTOR (CONTINUED)
• ILECs are well positioned to compete in the MAN sector
– ILECs have the financial and manpower resources to aggressively deploy next-generation technology
– ILECs’ ability to deploy a broader, deeper network will be a substantial competitive advantage in the
wholesale market
• CLEC encroachment
– We expect the long-term CLEC threat will not go away, even CLEC industry restructures
– The SME market is the ILECs’ to lose—there is a near-term opportunity to capitalize on CLEC
problems by building deeper relationships with SMEs and improving sales & marketing execution
Source: McKinsey
5
VOICE AND RESIDENTIAL SERVICES ALONE WILL NOT ALLOW ILECS TO
ACHIEVE EXPECTATIONS
ILEC revenue growth (1999-2000)
Percent
40
35
Data revenue
growth
30
• Data revenues >13% of total ILEC
25
revenues, yet amount for ~50% of
revenue growth
20
• Line growth anemic (1-2 residential,
2-3% business)
15
10
Total revenue
growth
5
Voice revenue
growth
• Data revenue essential to
sustaining margins
0
1Q99 2Q99 3Q99 4Q99 1Q00 2Q00 3Q00
Source: Legg Mason; company reports; McKinsey
6
MAKING INROADS INTO THE ENTERPRISE MARKET IS A KEY ISSUE FOR
ILECS
Telecom services revenue growth
$ Billions
$414
9.1%
47.5
Local data 22%
43.3
L-D data
$395
$367
$340
$308
30.4
23.9
27.7
25.7
32.8
58.9
68.8
36.3
42.3
36.3
41.2
14%
37.6
47
77.4
58.3
69.7
Internet
33%
84.3
89.5
Wireless
15%
81.3
79.4
76.6
73.7
71.1
L-D voice
90.1
91.6
92.1
92.4
92.6
Local voice 1%
2001
2002
2003
2004
2005
Source: JPMS; FCC; IDC; company reports; McKinsey
• Enterprise-related
CAGR
(3)%
Key
enterprise
services
services will post
some of the highest
growth rates during
the next 5 years
• ILEC success in
residential and SME
markets has not
carried over to the
enterprise segment
Traditional
and
emerging
ILEC
service
areas
• Traditional ILEC
services are not high
value-added for
enterprise customers
• Difficult for ILECs to
make inroads against
well-established IXCenterprise
relationships
7
VALUE SHIFT INCREASING ILEC OPTIONS
Changes in telco valuation, 1996-2001
Market cap
Billions
180
160
SBC
140
Verizon
120
100
While IXCs reorganize and CLECs
struggle to survive, ILECs will
positioned to acquire and invest
• ILECs valuations increased an
80
AT&T
BellSouth
average of 7% CAGR since 1998
while IXCs have declined 15%
60
WorldCom
• CLEC valuations down 50%-100%
in last 12 month
40
20
McLeod
Teligent
0
1996 1997 1998 1999 2000 2001
Source: Compustat; McKinsey
8
WELL-EXECUTED DSL STRATEGY GENERATES SUBSTANTIAL RETURNS
ILEC DSL ROIC impact based on mass deployment by a large ILEC
Percent (2005E)
All-in
ROIC**
17
ROIC incl.
indirect
operating
benefits*
Stand-alone
ROIC
8
4
• IRR=32%
• NPV=$10.9
• IRR=22%
• NPV=$4.9B
• IRR=17%
• NPV=$2.7B
* Stand-alone + avoided dial-up capex + opex saving from fiber architecture + value added services margin
** Includes defensive budget of line retention for voice (2010)
Source: JPMS; McKinsey analysis
9
DSL BENEFITS ARE DRIVEN BY MORE THAN ACCESS REVENUES
Average ILEC profit from value-added
services*
$/sub/month
1.1
Benefit from avoiding line loss (SME example)
ILEC per line economics
$ month
57.0
0.8
26.4
0.4
0.0
0.1
2001
2002
2003
30.6
9.5
2004
2005
• ~$700M in NPV for a large ILEC
• Includes services such as:
– Video on demand
– Hosted software
– Interactive gaming
– Streaming audio
Revenue Cash
cost
EBITDA Depre- Operating
ciation
profit
ILEC economics if voice line lost to CLEC
$ month
$49
swing
in 
0.0
(18.5)
Revenue Cash
cost
* Based upon mass deployment by a large ILEC
Source: JPMS; McKinsey analysis and estimates
21.1
(18.5)
(9.5)
(28)
EBITDA Depre- Operating
ciation
loss
10
ILECS COULD DOMINATE THE SME MARKET AT THE CLEC’S EXPENSE
Line loss to CLECs is slowing
Annualized rate of line loss, percent*
SMEs increasingly hesitant to trust
telecom needs to unsound CLECs
7%
CLEC/DLEC
6%
• Northpoint
• Winstar
• Teligent
• E.spire
• US LEC
• Allegiance
5%
4%
3%
2%
Value change
(4/00-4/01)
(100%)
(99%)
(99%)
(95%)
(83%)
(72%)
1%
%
4Q00
3Q00
2Q00
1Q00
4Q99
3Q99
2Q99
1Q99
4Q98
3Q98
2Q98
1Q98
4Q97
Telecom sector
overall high-yield
performance (2001):
* Based upon ILEC reported sequential growth in lines lost (596,000 lines in 4Q00)
Source: Legg Mason; Merrill Lynch; McKinsey analysis
(12%)
11
INDUSTRY SECTORS
Sector
Origin date(s)
• Wireless
1980’s, 1990’s
• MANs
Late 1990’s
• CLECs/DLECs
1990’s
• ILECs
1870’s
• Backbone
1900, 1970’s, 1990’s
• Edge Networks
Late 1990’s
– CDNs
– Hosting
• Cable
1970’s
12
McKINSEY PERSPECTIVES ON THE BACKBONE SECTOR
• Underlying economics are very challenging and will make returns on capital
unattractive in the near future
– Long-haul pricing is in free fall, which we expect to continue (CAGR of -37%, 2001-04)
– Next-generation networks will provide cost advantages, but will not provide an
economic uplift for the sector overall
• We see no credible scenario under which backbone traffic will grow fast enough,
and for a sustainable period, to alter the sector’s unattractive economics
– Traffic growth will be strong, but come largely at the expense of higher-margin service
offerings
– Financial viability is highly dependent upon players achieving economies of scale,
which only a few carriers (likely WorldCom and AT&T) will be able to accomplish
• Industry restructuring is a forgone conclusion with standalone players unlikely to
survive; potential outcomes include:
– Verizon and SBC likely to acquire AT&T’s Business Services and WorldCom’s
enterprise business
– Consolidation of backbone players and edge service providers (e.g., Qwest-Exodus)
– Bankruptcy of several standalone players possible (e.g., Level 3)
– While there is some potential for horizontal consolidation this will not solve the margin
problem, which stems from a lack of enterprise value-added services penetration
Source: McKinsey
13
BASIC IP WILL EXPERIENCE COMMIDITY PRICING, UNDERMINING
CARRIER MODELS FOR RETURN ON INVESTMENT
Price per unit of traffic
$/Megabyte
0.16
• Bandwidth glut will continue to
0.14
drive down prices
0.12
0.10
Long distance
voice
0.08
0.06
Switched non-IP
data
0.04
Private line*
IP (Internet)
0.02
0.00
1999
2000
• Intermediaries (e.g., hosting
companies, bandwidth traders)
bring increasing transparency
to pricing
• Economic uncertainty may
slow traffic growth further,
exacerbating oversupply
2001E 2002E 2003E 2004E
* Includes long-distance private line, non-ILEC private line, and special access
Source: JPMS; McKinsey analysis
14
THE PRINCIPAL COMPETITION TODAY IS FOR LOW-MARGIN BANDWIDTH
Forecast distribution of long-haul traffic
Petabytes/month
100% =
90
125
184
30
Long distance
voice
41
52
7
8
Switched nonIP data
Private line
7
295
509
950
CAGR
20
13
4
8
3
10
60%
9%
30%
6
14
competing primarily for lowermargin long distance voice
and IP traffic
18
20
21
69
21
79
56
43
IP (Internet)
20
1999
• Level 3, Qwest, Genuity, etc.
110%
• AT&T/WorldCom dominate
higher-margin private line and
switched non-IP traffic
30
200E
2001E
2002E
2003E
Source: FCC; AT&T Labs; IDC; interviews; JPMS; McKinsey
2004E
15
SCALE, NOT NEXT-GENERATION ARCHITECTURE, IS THE KEY DRIVER
OF NETWORK ECONOMICS
Impact of next-gen
network on total capex
$ Billion
Impact of next-gen
network on total opex
$ Billion
~55% cost
improvement
Impact of greater network scale
Cost/Tb/month
$ Thousand
900
~25% cost
improvement
~90% cost
improvement
17.1
4.4
1.1
9.1
3.3
8.0
225
75
Existing
network
capex
cost
Next-gen
network
copex
savings
Source: JPMS; McKinsey
Next-gen
network
cost
Existing
network
capex
cost
Next-gen
network
copex
savings
Next-gen
network
cost
Market
share
2%
5%
20%
16
THE PRINCIPAL COMPETITION TODAY IS FOR LOW-MARGIN BANDWIDTH
Addressable long-haul data revenues
CAGR, %
$ Billions
180
9
58.3
41
170
150
47
140
125
Internet (IP)
Private line*
Switched non-IP
Long distance
voice
115
11
7
13.4
Lower
margin
services
36
26
17
15
17
9
14
15.1
12
16
19
23
28
33
20
Higher
margin
services
84
84
81
79
77
73.7
1999
2000E
2001E
2002E
2003E
2004E
3
* Excludes special access private lines and local data private lines. IP-VPN revenue excludes cannibalization of
private lines
Source: FCC; AT&T Labs; IDC; J.P. Morgan Securities Inc.; company interviews; McKinsey analysis
17
CRITICAL ISSUES
ILECs
IXCs
• Can the ILECs meet growth
• Is there a meaningful likelihood of some
expectations? How (e.g., enterprise)?
• Can ILECs successfully increase the
profitability of DSL?
• How can ILECs protect high-margin
wholesale businesses from nextgeneration MAN entrants and CLECs?
• How will the regulatory and business
climates evolve in support of ILEC entry
into long distance services?
• How can ILECs maximize return on
capital employed? Should companies
look to operational improvements or
restructuring of wholesale/retail
businesses as the solution to regulatory
constraints?
event occurring (e.g., unexpected
acceleration in traffic growth) that could
revitalize the sector?
• What kind of restructuring will the sector
undergo?
– Is there a place for standalone, attacker
backbone players (e.g., Level 3)?
– What combination are likely to occur
(e.g., backbone + hosting, backbone +
MAN)?
– Is any horizontal consolidation likely?
Who would be the potential candidates?
• After restructuring, what happens to the
enterprise businesses of WorldCom and
AT&T (e.g., do RBOCs absorb them
effectively)?
18