Searching for profitable mobile growth
Guy Zibi, Director of Pyramid Research’s Communications, Media and Technology (CMT) group, explores the changing face of profitable mobile growth in emerging markets. The following is an extract from ‘Low-cost Mobile Business Models: Strategies for Profits at the Bottom of the Pyramid”, a strategic analysis report by Pyramid Research.
The world’s total mobile subscriber base continues to expand at a strong pace, and is expected to break the 3bn mark by the end of 2007. According to Pyramid Research estimates, global mobile network operators (MNOs) will add about 1.45bn new subscribers over the 2005-2010 period.
Under our forecasts, nearly 85% of those new subscribers will come from so-called emerging or high-growth markets, led by the likes of India and China, but also markets such as Iran, Indonesia, Nigeria, Russia, Algeria, and even Mozambique.
Reaching such levels of penetration and remaining profitable is a difficult proposition, in light of the lower average spend prevalent in lower end market segments. The challenge for MNOs is to achieve high margins with customers spending less that US$5/month on mobile services. Difficult though it may be, we argue that resolving this equation is possible – as the diagram suggests, there are tangible examples of carriers driving strong low-end subscriber and bottom line growth.
The challenge for the lending community will be to adjust to an emerging market paradigm that challenges pre-conceived notions of a mobile operator’s key performance indicators.
Some of the world’s most profitable MNOs – profitability defined for the purposes of this discussion in terms of Ebitda margins – operate in markets where average revenue per user (Arpu) are lower than US$10, and prepaid Arpu is already trending around US$5 to US$7.
Companies such as the Philippines’s Smart, Morocco’s Maroc Telecom, or MTS in Russia consistently generating Ebitda margins at 50% or higher, making the demonstration that low Arpus are not incompatible with strong profitability.
The MNO business model mindshift
The review of low-cost business models combined with the practical realities of supply and demand in high-growth markets lead us to a conclusion that – in our view – should now be obvious. Reaching the next billion (and indeed, the billion after that) cannot occur unless there is a dramatic shift in business model – what we call a ‘business mind-shift’.
To be sure, this will not apply everywhere. We do not believe that the first tier of emerging markets (based on income levels) truly needs such a mindshift. South Africa, Turkey, and Russia will reach the 100% penetration level without the MNOs having to fundamentally change their business approach.
For most others, driving growth will require a rethink of key profitability indicators, as well as the model that leads to the achievement of that profitability.
This is not necessarily new. Driving growth in emerging markets has traditionally been a difficult challenge. In a first phase of growth (which we call the ‘value’s phase), MNOs have had an explicit focus on so-called ‘value’. The core of the business model was to drive profitability by capturing and serving so-called profitable customers. The rest of the market was largely ignored, and for years, penetration levels hardly broke the 1% mark (in many emerging markets, Pay TV, for example, has never got out of this phase).
The second phase, the subscriber and Arpu phase, started around 2001-02, largely spurred by a sharp up-tick in competition, as well as increased capital inflows into the sector. To drive growth, carriers had to move beyond ‘profitable’s customers, and develop new models to expand their addressable markets.
Strategically, the business focus is to accelerate customer acquisition, bring in as many subscribers on mobile networks while keeping a tight control on Arpu. Here, the catalyst was prepaid billing, which ushered in dramatically new levels of convenience and expanded MNO reach. The ceiling of this phase depends on the demand fundamentals of each market.
In India, this shift allowed the market to grow from 1% to almost 5% penetration, nearly 50mn new customers. In markets such as Nigeria or Cameroon, that ceiling may lie more around the 25-30% mark. Most high-growth markets are still here. Some MNOs will be content to stay there and continue to generate cash, though at static levels. Those who seek to go beyond will have to make yet another mindshift.
We refer to the third phase as a ‘death of Arpu’s or ‘traffic’s phase. While the second phase focused on the subscriber as the core of all key performance indicators, MNOs in the third phase focus on traffic.
Profitable traffic, from wherever it may come, however it may come, is the name of the game. The concept of subscriber and the concept of Arpu (while still relevant in many respects) lose much of their potency and are replaced by indicators built around profitability for each minute of traffic sold.
In turn, this change in mindset drives a change in how costs are regarded and managed, and the manner in which revenue and margins are generated. Markets such as India, Pakistan, or Sri Lanka have already entered this phase. Sub-Saharan Africa, Central and Eastern Europe, Latin America, and the Middle East and North Africa have not, and some markets in these four regions may not need to.
This is the phase that, in our view, will take most markets in Sub-Saharan Africa from the 20-30% mobile penetration level (which some will reach over the next two-to-three years) to 60-80% levels, with MNO profitability to boot.
The next business models (which we refer to as low-cost business models) will push the limits of technology and business innovation, and will be primarily traffic-based. Traditional performance indicators such as Arpu and SACs will lose much of their relevance, and will be superseded by traffic-based indicators.
Value will be derived from leveraging large masses of traffic volumes; solutions currently perceived as relatively extreme will be implemented, from lifetime subscriptions to network operation outsourcing or discriminatory, QoS-based pricing.
All these solutions are vital to growth, but are hardly no-brainers; they have to be well managed or they’ll damage the bottom line. Specifically, MNOs can manipulate a number of fundamentals, on the cost and revenue fronts.
Revenue side: Arpus and SACs will matter less
There are a number of key strategic revenue drivers in low-cost models: effective segmentation, low-denomination vouchers, lifetime subscriptions, low airtime prices, limited mobility, and community phones. All are attractive, but carry a number of inherent risks.
Low denomination vouchers, for example, have become a staple of low-income mobile business models, and show exactly how innovative strategies impact traditional fundamentals of operator performance. The relatively high cost of prepaid recharge vouchers has long been an obstacle to usage; low denomination vouchers lower the affordability threshold, and allow subscribers to purchase airtime for as little as US$0.05.
Their main risk lies with a potential decline in usage and Arpu. A subscriber can theoretically spend as little as US$1/month and stay on the network. This in turn could carry negative implications for overall revenue and (depending on acquisition and maintenance costs) profitability.
The impact of low-denomination vouchers on Arpu is generally negative, but we do not believe that matters too much. With more users able to stay active on the network for small amounts and many maintaining multiple SIM cards, Arpus are set to decline sharply until they reach a certain equilibrium.
The key is for the carrier margins to be strong at that equilibrium level. In the Philippines, that level is about US$5-6. In other markets, it is bound to be slightly lower. But ultimately, Arpu is not the most relevant indicator in this context, as it is bound to fluctuate; the most relevant indicators will be more tied to the profit generated for each minute of traffic sold.
Cost side: bringing down Opex and Capex
On the cost side, there are a number of various tools to reduce operating expenses. In a nutshell, the low cost player will not subsidise handsets, will leverage technology to maximise average subscriber per base station averages (to more than 3,000), will seek to build its own transmission backbone if possible, will outsource network operation, and may even decide to do away entirely with manned customer care.
Network costs, in particular, have the distinction of being tied to the Opex and Capex lines, allowing for any cost optimisation to be felt at multiple levels. With low-cost models, any assessment of Capex utilisation has to be associated to an assessment of impact on operating expenses.
The most aggressive low-cost players have not only accelerated a sharp decline in the average cost of TRXs, they have also been pushing infrastructure suppliers to make compelling value propositions for Opex reduction.
A number of key trends underpin this evolution.
Telecoms equipment costs have been declining sharply, driven by carriers such as India’s Bharti or China Telecom. By some estimates, equipment costs have been declining by nearly 20% annually over the past four-to-five years.
A driver of this decline has been the consolidation of procurement. As carriers consolidate, their purchasing power increases and they do not hesitate to leverage it – indeed, cost savings from joint procurement deals are often put forward as justifications of mergers and acquisitions. Along the same lines, carriers such as Bharti, which deploys around 10,000 base stations annually, generate enough volumes to influence market prices.
The Huawei factor has been another source of price pressure. With its mere participation in RFPs, the Chinese manufacturer keeps the pressure on its rivals. The most aggressive low-cost players now often seek to involve Huawei, if only to make sure that other manufacturers will make competitive proposals.
Outsourcing as key to Opex reduction
The outsourcing of network operation and maintenance is another path taken by a number of low-cost players. Indian players, in particular, have led the way. Bharti has awarded outsourcing deals to Ericsson and Nokia. Hutch Essar has similarly awarded managed services contracts to Nokia, for management of networks in 19 of the 23 regions in which the carrier operates. In Pakistan, Telenor Pakistan has awarded deals to Nokia and Siemens. Under all these deals, hundreds of staff has moved from the operators’s books to the vendors’s books.
Do such deals work
An analysis of the performance of these carriers after the deals were consummated suggests that their impact is generally positive: all the operators above have shown a positive up-tick in their key performance indicators, although the improvement cannot directly be tied to the managed services deals, at least not to those deals alone.
Likewise, we have not seen substantial practical evidence that outsourcing network operation necessarily saves money; spending merely appears to move across cost lines, although there may be some marginal savings, and savings from intangibles such as time are difficult to assess.
The key upsides of these deals have appeared in the following:
Risk-sharing: Most network operation deals have payment on a per usage basis. This means that the service provider gets to share much of the network risk with its suppliers.
Cashflow improvements: With payment on a per usage basis, payments are deferred, rather than upfront. Traditionally fixed costs become variable, essentially costs of goods sold.
Focus: The key upside of network outsourcing may be that it puts the carrier in a position to focus on driving revenue growth. In many emerging markets, where competition is acute and tremendous innovation is required to drive growth, such concerns are not trivial. The challenge of the Indian operators is that they have to manage the acquisition of millions of subscribers, deploy thousands of base stations annually, and keep existing subscribers happy. This is especially the case in markets where technical staff is hard to find. If that burden of finding, training, and retaining hundreds of technical staff and managing dozens of sub-contractors can be shifted to suppliers, management can more easily focus on the marketing side of the business.
Ultimately, network outsourcing is not a prerequisite for a low-cost model, but it certainly helps, provided the agreement is sensible for carriers and vendors. Most operators in emerging markets remain wary of outsourcing. Some of the largest ones, in particular, have built their own large engineering teams and feel they can drive revenue growth without having to outsource a key part of their business.
For others (ie, late market entrants in extremely competitive and high-growth markets), outsourcing network operation is as good an option as any.
Time for a financial lending mindshift
As emerging market models evolve, so must the assessment of local MNO ventures. The lending community will have to learn to live with an environment in which acquisition costs and Arpus do not matter as much, and put more weight on indicators such as cash cost per minute, average price per minute or free cashflow per minute.
Not adjusting would mean missing out on otherwise excellent lending opportunities.
Guy Zibi can be contacted at:
tel: +1 617 494 1515
fax: +1 617 494 8898