As evidenced by their recent interventions, European authorities have understood that European telecommunications companies have a serious problem with profitability (ROCE or “return on capital employed”, in financial terms), which explains both their stock market performance and their difficulties in carrying out the investments that European citizens seem to require.
Scale is the solution, but how to acquire it?
Operators argue that such profitability problems could be solved by obtaining greater dimension or scale, which requires mergers between operators. For the purposes of the present discussion, it is important to distinguish between intra-market consolidations that take place within the borders of a country, such as the one announced by Orange and MásMóvil in Spain, and those that take place between operators in different countries.
The European Commission (EC) states that it has no problem with operators acquiring the scale they need to be sustainable, as long as they do so through the latter type of operations, cross-border consolidations. However, operators seem determined on gaining such scale by going against the advice of the authority, as the example cited above, and many others prove. So little does the EC like intra-market consolidations that it only approves them under very onerous conditions and has even gone as far as to prohibit them. Even in a case as simple as the Orange-Voo-Brutele operation in the Belgian market, the merger has only been approved after conditions have been imposed on the participating operators.
In short, the authorities understand the need for scale for telcos, but the problem is that they only let them acquire it through cross-border mergers. So why do operators insist on getting it the other way, in-market? Is there a reason for this to happen? An article recently published in Competition Policy International proposes an explanation based on economic theory for these phenomena.
The indivisibility of telecommunications networks
This article is based on the fact that all assets in which companies invest have a certain degree of divisibility. For instance, a car costs the same whether you need it for 10 km or 100,000 km. There is no possibility of buying a car that only runs 1 km. To put it in another way, the car is indivisible with respect to the number of kilometers. This indivisibility means that the asset initially requires a large (relative) investment, but results in a decreasing cost for each unit produced as production increases, i.e. scale increases.
Telecommunications networks are mostly composed by highly indivisible assets. Networks are deployed by coverage area, and therefore require a minimum investment regardless of the number of customers contracting services in that area.
What does a telecommunications operator sell?
The article raises this question, to which it says the answer is not as obvious as it seems. In fact, telcos manufacture traffic, which is what customers from all their possible sides demand. With respect to users, when they want to send a message to a friend or book a hotel online. With respect to digital platforms, sending a movie or streaming video to its audience. However, telcos do not currently sell the service based on data traffic (Gigas, minutes), but typically sell flat rate access, so that residential customers who contract with telcos can generate and receive as much traffic as they wish. This is the commercial structure that has prevailed since around 2005, and gradually in all EU countries and many other regions.
Thus, when assessing the scale that an operator needs to be viable, it must be measured, not in terms of traffic as might be expected, but in terms of the number of customers it has. Operators’ revenue and, therefore, profitability are linked to what it charges for each customer, not for each Giga it transmits.
Scale in access can only be achieved through intra-market consolidation
Telecommunications operators deploy their network by geographic area, and it is in these geographic areas that they have to acquire the necessary scale to be viable. This viability depends on the revenue they can obtain from each customer, and on the cost of the provision of service. It has already been seen that this cost, given the indivisibility of the networks, is reduced as the operator acquires more customers in the deployed area (what they call take-up), and there is a minimum take-up in order to achieve viability.
What happens when other operators compete in the same area, whether they enter with their own network or supported by wholesale access regulation? The article explains that the two magnitudes that affect the operator’s viability move against it: revenue per user tends to fall and so does market share, thus increasing the cost of provision.
This does not imply that market entry is not possible or undesirable. As long as the initial operator shows signs of profitability, it is logical that other players will want to imitate its business model. But entrepreneurial activity, as all human activity, is prone to error. Thus, it is very likely that at some point there will be errors in entry, whether due to optimism or to favorable regulation.
When the mistake happens, the operators in the market confront a diabolical situation, in which, to achieve the minimum take-up for viability, they have to lower prices, which in turn will increase the minimum take-up that makes them viable. It is obvious that, under these conditions, some exit from the market must take place to restore the conditions of viability for all operators. The error that has occurred must be addressed in some way.
And given that the operators, in principle, have invested heavily, no one is willing to simply leave the market and abandon their assets: they will try to exit by selling them to the highest bidder. That is, by concentrating with another player in their area of coverage.
What about cross-border consolidation then?
Telecommunications operators cannot achieve the scale they need with the current business model through cross-border consolidations. As we have seen, what they need is a minimum scale in relation to their network coverage area. The scale they need is not in absolute terms, to be large for the sake of being large, but in relation to the geography they cover. An operator with 1,000 customers accounting for 40% take-up on its coverage area may be viable, while another with several million may not be profitable if its market share is low because of geographical dispersion.
The article explains that, in the past, when operators “manufactured” and billed traffic minutes, scale had to be achieved in this commodity. Although the indivisibility of the network was the same, with this unit, viable scale could be achieved with cross-border consolidations. This is probably why, at the turn of the past century, these mergers were more favoured by operators.
Since then, the situation has completely changed, probably also affecting the performance of the mergers made at that time, and not precisely for the better. In any case, the article provides a theoretical explanation that is consistent with the observed reality, which should make the authorities reflect on whether the path they are proposing for operators to solve their profitability issues is the most appropriate one. And it should not be forgotten that these profitability problems are, in essence, the problems that European society will have if operators are not able to invest as expected from them.
Read the full article here