Deutsche Telekom is struggling to reduce costs in some of its core business areas because of higher-than-planned spending on cloud and digital transformation, Light Reading has learned.

The cost "lag" at some divisions, as described by a Deutsche Telekom AG (NYSE: DT) spokesperson, could endanger the targets the German operator announced during a capital markets day in February 2015, although it has not changed its guidance.

Under the strategy set nearly three years ago, Deutsche Telekom said it would look to reduce so-called "indirect costs" outside the US market by €2.4 billion ($2.8 billion, at today's exchange rate) annually, compared with 2014. Its aim is to realize 75% of those savings, or €1.8 billion ($2.1 billion), by the end of next year.

Figure 1: Deutsche Telekom's headquarters in Bonn, where many of its staff are based.

A commonly used accounting measure, indirect costs are expenses that cannot be allocated to a specific project or function, such as a facility or a service a company has developed. They often include many personnel and administrative costs, for example. Together with direct costs, which can be attributed to particular items, they make up a company's operating costs.

Of the €29.7 billion ($35.2 billion) that Deutsche Telekom recorded in non-US "adjusted" operating costs in 2014, about €19.3 billion ($22.9 billion) was booked as indirect costs. Were the operator to realize its short-term goals, those costs would fall to €17.5 billion ($20.7 billion) in 2018.

But they are evidently not dropping as quickly as the operator would like. Outside the US, Deutsche Telekom maintains four big operating units -- Germany, Europe, Systems Solutions (which covers its T-Systems IT business) and GHS (Group headquarters and services). And only the latter, which appeared to account for as little as 5% of costs last year, is getting anywhere fast when it comes to slashing expenses, according to a Deutsche Telekom spokesperson.

"In general, we have made very good progress in our segment GHS while other segments are lagging behind," he told Light Reading. "This is mainly due to slightly higher than expected transformation costs. We will continue to work toward our target going forwards." The spokesperson also revealed that Deutsche Telekom will provide an update on progress during a capital markets day scheduled for May next year.

The remarks suggest that Deutsche Telekom is not far off its program, and that its goals remain achievable. Missing them would certainly not be a disaster if the company's investors can be convinced that spending on transformation will ultimately pay off.

A miss would, however, add to the pressure on Deutsche Telekom over its transformation strategy.

Perhaps more than any other Tier 1 telco, the German incumbent has justified its investments in cloud and digital transformation on the basis of cost savings. Through pan-net, its most radical initiative, it aims to replace legacy systems in individual European countries with a single, highly automated network. That project is expected to reduce the number of service platforms throughout Europe from 650 to just 50.

Having regularly told investors that pan-net will lead to cost savings, as well as speed up service development, Deutsche Telekom will be held to account if the savings do not materialize. (See DT's Pan-Net Still at Start of the Marathon and Deutsche Telekom Turns On Pan-European IP.)

Moreover, any slippage on indirect cost targets could threaten profitability, because direct costs are not expected to fall. In fact, Deutsche Telekom predicted, in February 2015, that direct costs would rise at a compound annual growth rate of 1% to 2% between 2014 and 2018.

Next page: Trailing targets

Trailing targets
Given that projection, the implication is still a reduction in total operating costs, outside the US, of €943 million ($1.1 billion) to €1.38 billion ($1.64 billion) in 2018, compared with 2014.

Tracking Deutsche Telekom's progress toward this target is not easy. Except in its capital market day presentations, the company does not include a figure for total operating costs in its financial statements, let alone provide any indication of direct and indirect costs. Yet by deducting adjusted EBITDA (earnings before interest, tax, depreciation and amortization) from revenues, one can arrive at a ballpark figure for operating costs (this same calculation was used to roughly gauge GHS costs as a proportion of the total, as discussed earlier).

Figure 2: Cost Progress ( euro B) Source: Deutsche Telekom.

At about €27 billion ($31.2 billion) in 2014, this revenues-minus-EBITDA figure is somewhat lower than the €29.7 billion ($35.2 billion) that Deutsche Telekom generated in non-US operating costs that year, according to its February 2015 presentation. The capitalization of some costs, which entails moving them on to the balance sheet, could explain some of the difference.

What is clear is that revenues-minus-EBITDA numbers have been falling, if not quite as dramatically as targets would seem to require. Last year's €26.5 billion ($31.4 billion) is about $500 million ($592 million) less than in 2014. Over the first nine months of this year, revenues minus EBITDA equaled €19.2 billion ($22.8 billion), down €373 million ($442 million) compared with the same period in 2014.

If the figure in the final quarter represents the same percentage of the annual amount as it did last year, Deutsche Telekom would be looking at €26.3 billion ($31.2 billion) in 2017 -- around €670 million ($794 million) less than in 2014.

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Presented with details of Light Reading's calculations, Deutsche Telekom did not dispute the methodology and numbers but did feel the comparisons over the first nine months of the year were not strictly fair. "We've been talking about annual figures," said the operator's spokesperson. It was then he acknowledged that divisions besides GHS are lagging on cost-cutting activities.

For investors, there may be cause for optimism. While operating costs might not have fallen much in the last few years, staff numbers including the US business are down 5% since 2014, from nearly 228,000 that year to around 216,500 in September. Most of those cuts seem to have happened since the beginning of 2016, which could explain some of the recent spending on "transformation." As automation allows Deutsche Telekom to continue pruning its workforce, it may incur further one-off costs. But it should eventually be left with a much sleeker business. (See Efficiency Drive by Major Telcos Has Claimed 74K Jobs Since 2015.)

Unsurprisingly, Deutsche Telekom has been rather coy when asked what impact automation could have on its headcount. But it has only recently said that "brutal automation" will be needed as it develops a "zero touch" network it can operate with minimal human intervention. And it will be remarkable if pan-net does not lead to further job cuts in the next few years. While that is a major worry for employees throughout the Deutsche Telekom organization, any prospect of juicier profit margins should bring a smile to investors' faces. (See 'Brutal' Automation & the Looming Workforce Cull and DT: Brutal Automation Is Only Way to Succeed.)

— Iain Morris, News Editor, Light Reading