Europe's Long Walk to 5G
Balancing the books
But something will have to give. Excluding its large US business, Deutsche Telekom's capital intensity (capital expenditure as a percentage of revenues) has soared from 14% in 2013 to about 20% last year. Orange's has risen from 14% to 18% over the same period. Telecom Italia's domestic business has seen the most dramatic increase, with capital intensity rocketing from 18% in 2013 to a possibly record-breaking 37% in 2018, including fees for spectrum licenses. Those figures cannot rise interminably.
What makes them harder to stomach is the lack of any immediate sales opportunity for telcos building 5G networks. If mobile telecom history is a reliable guide, customers are unlikely to pay more for a 5G service than they do for a 4G one. And there is little scope for pricing innovation. The UK's Vodafone hopes charging for different connection speeds and unlimited usage will draw consumers away from plans based on monthly data caps. But if its move proves popular, rivals will eventually respond. Its competitive, SIM-only rates have already sparked concern about a "race to the bottom," says James Crawshaw, a senior analyst with Heavy Reading.
Table 1: Capital Intensity in Europe (€B)
|DT non-US capex||5.9||6.2||6.6||6.8||7.5||7.8|
|DT non-US revenues||41.6||40.3||40.3||39.4||39.2||39.1|
|DT non-US capital intensity||14%||16%||16%||17%||19%||20%|
|Orange capital intensity||14%||14%||16%||17%||17%||18%|
|Telecom Italia (domestic) capex||3.0||2.8||3.9||3.7||4.6||5.6|
|Telecom Italia (domestic) revenues||16.4||15.3||15.0||15.0||15.4||15.2|
|Telecom Italia (domestic) capital intensity||18%||18%||26%||25%||30%||37%|
Trying to justify the move to reporters at the 5G launch, Vodafone executives said profits would accrue partly from the "spectral efficiency" of 5G compared with 4G. The basic argument is that sending one data bit over a 5G network is much cheaper than transporting it on 4G. But the difference is a point of contention. 5G costs four to five times less, said Scott Petty, Vodafone UK's chief technology officer (CTO), during the 5G press conference. At the end of 2017, Johan Wibergh, Vodafone Group's CTO, reckoned it would be ten times cheaper.
Whatever the actual figure, investors do not seem convinced that fatter profit margins lie ahead. Vodafone's share price gained 2% on the day of the 5G launch but has lost 15% of its value this year. Rival BT, which also recently introduced 5G services, is down a fifth over the same period.
Skepticism that spectral efficiency will boost earnings seems warranted. Operating costs are unlikely to budge significantly without staff reductions or other measures to cut overheads, such as the sale of real estate. The 4G standard was similarly touted as a more cost-efficient technology than its 3G predecessor, and yet the margin for earnings (before interest, tax, depreciation and amortization) at Vodafone Group has risen just two percentage points in the 4G era, from 29.9% in the fiscal year before Vodafone UK's 4G launch to 31.9% in the most recent one. Spectrally efficient technology seems like a mechanism for coping with a spike in data traffic rather than a route to bigger profits.
"5G doesn't change the overall cost structure for an operator to run the network," says Bengt Nordström, the CEO of Northstream, a consulting company. "It significantly reduces the cost of introducing higher data speeds and adding more capacity. But if operators want to increase profitability it is going to be through their digital transformation programs."
The debt profile of some large European operators makes all this a bigger worry for investors. Telecom Italia's net debt last year was equal to about 3.3 times its earnings, a high level by comparison with most peers. With a ratio of 2.65, Deutsche Telekom is skirting a comfort-zone limit of 2.75. "Our numbers don't indicate that we're going to leave the corridor … but there is going to be very little wiggle room," said Timotheus Höttges, the German operator's CEO, during its last earnings call.
All together now
What Europe desperately needs is more consolidation, according to some analysts. The US, a market of 330 million people, has four big mobile operators, and that number could fall to three if T-Mobile eventually merges with Sprint. In China, three operators serve a population of 1.4 billion. With about 510 million people, the European Union (EU) is home to several big telco groups -- including Deutsche Telekom, Orange, Vodafone and Spain's Telefónica -- as well as numerous sub-scale operators that compete alongside the giants. Many of the small players struggle, says Ericsson's Solomon. "The fixed cost base is similar to an operator with larger market share and it is much harder to sustain and generate returns," he says.
In this worldview, everyone is worse off as incumbents settle for a smaller market share and competition drives down prices. Solomon thinks an operator needs an EBITDA margin of 38% to achieve "optimal levels of investment" and says the European average is much lower. Vodafone's adjusted EBITDA margin was 31.6% across its European markets last year. Deutsche Telekom's was 30.8% after adjustment for special factors.
Unfortunately, for the investor community, European regulators have continued to oppose merger activity, arguing it would lead to price inflation and hurt consumers. In the less competitive US market, customers have tended to pay much higher rates for telecom services, note fans of the European approach. Yet this means European operators face spending constraints, according to Nordström. "The biggest challenge for Europe compared with the US is that our revenues per user are much lower, and so our starting point is that we have less money to spend if you break it down to investment per user," he says. "That is fueled by resistance to consolidate markets in Europe."
When regulators did allow Hutchison and Orange to merge their Austrian operations in 2012, the deal led to a 20-30% improvement in network coverage and higher connection speeds, according to analysis carried out by the GSM Association, a lobby group for the mobile industry.
As the EU selects new leaders -- to the annoyance of critics who see it as an undemocratic and byzantine institution -- the telecom industry is waiting to see if a more investor-friendly regime will emerge. But a more relaxed attitude toward in-country takeover activity would not solve the problem of European fragmentation or aid the development of a cross-border market for telecom services. Even Deutsche Telekom's efforts to build a single network across multiple European countries have been somewhat frustrated by national regulators' demands for local data facilities -- to prevent information from being stored in another European jurisdiction.
Those objections will not easily be addressed in today's political climate. For populists throughout the region, the EU is an unaccountable, Kafkaesque monster that has stripped nation states of their rightful sovereignty. UK voters chose to leave the EU during a referendum in 2016 (triggering the currency devaluation that explains why beer and food are now relatively cheap for European visitors). With or without a deal, that "Brexit" is due to happen in October. And it could spur demands for referendums in other member states.
The arguments for and against more European integration will rumble on. But as China and the US flex their 5G muscles, it is hard to find anyone in the industry who doubts the need for a new approach. "Thinking about connectivity as the bedrock for a new industrial strategy is vital, and I don't see the EU doing that right now," says Solomon. "If we remain fragmented, other superpowers will accelerate forward into the digital domain."
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- DT Rushes High-Priced 5G to Market for Samsung-Loving Urbanites
- Vodafone UK Takes Wrecking Ball to 5G Market
- BT & the Unbearable Lightness of 5G-ing
- Ericsson Warns of No-Deal Brexit Threat to UK and European Telecom
- Europe's Telcos Less Tight-Fisted Than Yanks
— Iain Morris, International Editor, Light Reading