Daily commentary
I have developed a great respect for T-Mobile as a wild card in the mobile space. Their actions as the smallest of the 4 major US mobile carriers are having implications both in terms of telecom pricing and revenue models and in terms of handset subsidies and net margins. The net benefit will accrue to customers. The question is whether a Sprint takeover ends this dynamic and what impact it will have on share prices in the space. Thoughts below – mostly outside the paywall
It has been far too long since I have taken on the tech sector for a post here at Credit Writedowns, as I have been posting on macro a lot more of late. But given the CES events this week and the T-Mo actions of late, I have to say something. The T-Mobile CEO John Legere is really shaking up the industry.
Here’s what happened to get us here, as I told it in May: “T-Mobile’s network sucks and people are leaving in droves for that reason. The company simply does not have the scale to make the capital investment to have a true nationwide network and that has become a problem. But, if they offer a lower price, people will stay and might even switch to T-Mo, especially if they do try to make upgrades to 4G LTE.
“What I am seeing, therefore, is a company that has been forced into a corner. They have been forced by circumstance to unbundle their handset subsidy, which most US and European mobile telecom operators, simply tack on to the monthly fee…What T-Mo has done is give users the ability to see through the pricing and decide how they want to bundle or unbundle the subsidy. ..
“I believe this kind of pricing strategy will erode margins. First, it will cause telecom companies to lose fees, especially as customers lengthen their upgrade cycle…Once one carrier unbundles, the others will be forced to do so as well. Let’s see how subscriber numbers evolve first. But I believe unbundling is a pandora’s box that will hit all mobile telecom operators.
“And as the subsidies for handsets disappear, this will put more price pressure on handset makers. More and more, people will move down market to lesser phones at full cost that have still superb features…
“Bottom line: I see this as a great boon for consumers, a potential life line for T-Mobile and a problem for mobile telecom companies and handset makers.”
These predictions proved true. T-Mo’s American competitors have been forced to offer unbundled value packages. And as they have done – even though AT&T in particular tried to bamboozle customers with terrible packages, eventually the carriers were forced to lower their fees. So the evolution of average revenue per customer has begun to decline. What’s more is we are seeing a price war for customer acquisition develop on the back of this. AT&T feels most threatened and is trying to take T-Mo customers. And T-Mo has responded in kind. At the same time, handset average sales price has also declined in part due to the price discovery that unbundling has created. The result: better, cheaper plans and better, cheaper handsets for mobile customers. That’s all good.
I am a T-Mo customer and the way I told the story last July gets at why this is so good for customers:
“I used T-Mobile until late last year. I had become fed up with T-Mo’s terrible coverage. And while I was in the middle of a two-year plan, I decided to eat the early termination fee and switch to a much cheaper T-Mo piggyback carrier called Simple Mobile. I bought the unsubsidized handset from Simple, tested their service for a few months and called T-Mo to cancel early this year. That’s when I met the Uncarrier promotion. I was told I could switch to a T-Mo pay as you go offering that was just as cheap as Simple without an early termination fee. So I did that and feel very happy having done so.
“That’s a story that is being repeated everywhere. And so the other carriers are responding with massive price cuts and unlimited talk, text and data plans.”
At the same time, T-Mobile has benefitted. Immediately after the ‘Uncarrier’ strategy came online, customer loss ended and T-Mobile reported the largest growth in customers in four years. They have added 4.4 million customers in 2013, 1.6 million in Q4 alone. Of the 1.6 million 800,000 were the most profitable post-paid customers. And T-Mobile’s postpaid “churn” – the percentage of customers that leave in a given quarter – dropped to 1.7% in Q4 from 2.5% int he year ago period. In short, because T-Mobile has taken a ‘customer first’ approach, T-Mobile is adding customers, adding the most profitable customers and reducing churn. See comments from VC Fred WIlson, for example. So while T-Mobile’s competitors are losing customers to T-Mo and being forced to offer lower cost value plans and make other customer-friendly concessions, T-Mobile is still winning share and making more money. Clearly, the ‘customer first’ approach is profitable.
The missing link here is in infrastructure. T-Mobile’s network is not great and that’s why they were losing customers. I almost switched for that very reason. The problem was not that T-Mobile’s network is slow, rather it is that the network is porous and only well served in large, urban areas. Every time I would leave and go somewhere far from a city center, my signal strength would drop, sometimes I would receive no service and mobile data rates were poor. The long term strategy for T-Mobile has to be in using its acquisition strategy to fund infrastructure development to reduce churn.
And we see this happening. First, there is the build out of 4G LTE with $4.7 billion of cash from parent Deutsche Telekom in 2013 and another $3 billion promised in 2014 and 2015. But T-Mobile has also widened its 4G HSPA+ network by repurposing its 1700 MHz band for LTE and shifting HSPA+ over to the 1900 Mhz band where AT&T iPhone customers live and breathe. This has made it much easier for AT&T users to switch to T-Mobile because they can bring their handset with them, have the mobile work straight away at fast HSPA+ speeds, and pay no early termination fee. It’s basically an instantaneous switchover with no loss of data speed (at least in urban areas).
The most important development on infrastructure is T-Mobile’s plan to buy Verizon spectrum for $3.3 billion. This is very important because it addresses the rural network deficit. Kevin Fitchard from GigaOm explains:
“Low frequencies propagate further, making it ideal for building a coverage network that can reach for miles in rural areas and penetrate walls in urban jungles.
T-Mobile is.. in the process of building a very high-capacity LTE network in the big cities using AWS frequencies (networks just as powerful as Verizon’s). But the big knock on T-Mobile has always been that its impressive 3G and 4G speeds disappear once you leave the city limits. These low-frequency airwaves will let T-Mobile build wide-sweeping networks to fill in those gaps.”
So there you have it. T-Mobile now is becoming competitive with the other networks both on speed and reach. It has a more customer-centric approach and it has lower prices. That will win share and push prices down across the board – both for telecoms and handset makers.
After the jump, I want to talk about what industry consolidation will mean in terms of this picture and raise some issues regarding share prices and financial leverage.
The first issue to note is that AT&T and T-Mobile are the only US operators left that use the global GSM standard. After several mergers over the years, there are no other carriers on GSM. The other two major US carriers, Sprint and Verizon have networks based on a different networking protocol called CDMA. The importance of this is two-fold. First, the separation in network standards makes T-Mobile and AT&T natural rivals for customers. This is why AT&T is most threatened by T-Mobile’s moves and why T-Mobile has moved HSPA+ to the AT&T band. T-Mo wants to pick up AT&T customers while still expanding its faster LTE network.
Second, the fact that GSM and CDMA are very different means that network integration issues in the case of a merger are more problematic across network types. GSM to GSM mergers work better than GSM/CDMA ones. And so AT&T and T-Mobile are also natural merger partners. Indeed, AT&T tried to take over T-Mobile but the deal was blocked for anti-trust reasons and T-Mobile was able to secure a multi-billion dollar merger breakup fee windfall as a result. Every time you see T-Mobile transforming the industry with a new ‘Uncarrier’ move, you should be saying, “this is why that AT&T – T-Mobile merger was anti-competitive”. Without T-Mobile, there would be much less movement on price and business model in the US mobile telecom market.
What should concern us then is that Sprint is rumoured to want to take over T-Mobile. Last December, banks were said to be readying proposals for the deal. And at the CES, T-Mobile CEO John Legere did not deny talks were ungoing. He merely said “I can tell you that the T-Mobile brand, attitude, and identity is here to stay.” That sounds like an admission that a merger is going to happen but that the branding of the combined company will be T-Mobile branding. We can’t be sure this is the case, however.
Here’s what I see happening: Both T-Mobile and Sprint are also rans as national carriers. They want to close the gap to AT&T and somewhat close the gap to Verizon. They both believe they can most easily do so by merging. However, a merger is a difficult CDMA/GSM integration mess that will make the strategy more difficult. Merging will create problems in terms of churn as the integration is ongoing. Therefore, the best way to prevent churn and to continue to take customers is to have both sides adopt the T-Mobile strategy and perhaps eventually the T-Mobile branding as the networks are merged. Once the merger is complete, the combined entity will be a GSM carrier that is competitive with AT&T and with a network equivalent to both AT&T and Verizon.
The problems I see with the merger are three-fold. First, there is execution. This is a difficult undertaking and the potential for disaster is high. But T-Mobile believes it can pull it off because it is already doing the same thing with MetroPCS, a regional carrier with an incompatible network. That puts T-Mobile in the driver’s seat here because they have the integration expertise and the strategic vision that will make the deal work. But as the smaller operator, they are the target of acquisition. So Sprint will have to pay a high premium.
This leads to the second problem, that Sprint is already leveraged. The Softbank, Clearwire, Sprint deal from last year has created a lot of leverage that makes yet another deal difficult financially. And I believe the combined entity would be subject to financial difficulties in a severe economic downturn.
Lastly, this deal is anti-competitive and would face scrutiny from regulators. I do not believe it should get through as it would dwindle the US mobile market to three carriers. That is too few for a market of this size.
Instead, we might see DISH try and bid for T-Mobile as DISH, the satelitte company wants to get more heavily into the data business because it feels like it has an orphaned TMT footprint that will lose customers as competitors offer end to end solutions for TV, media, data, telephony and communications more generally. These companies all feel small and want to merge because they do not have a broad enough spectrum of TMT assets. Verizon has it all and so does AT&T. But the others are single market players with the exception of Sprint, which also has data in addition to mobile telephony.
I believe a deal will happen and the acquirer will overpay. Therefore, this is bullish for T-Mobile US’s shares, bullish for Deutsche Telekom’s shares and bearish for shares of DISH, Softbank and Sprint. Because the T-Mo strategy will continue irrespective of what happens, the margin pressure will continue on AT&T, Verizon, Samsung and Apple.