The Telecom Business Cycle: Gravity Pulls

Investors seeking defensive investments in a volatile market traditionally favored equity in the utilities, consumer staples, healthcare or telecom sectors. Conventional wisdom was that telecom assets could provide more stable income production and a lower correlation of returns relative to the broader market, with the potential to reduce overall volatility for a diversified investment portfolio. Telecom equity, with stable dividends, was treated by investors like bonds.

Those days are over. France Telecom and Telecom Italia have recently cut dividend forecasts and back off from promised share buybacks. Deutsche Telekom and Telefónica are under pressure to generate cash to maintain dividend policies even as revenues and profits fall. Some telcos rethink their commitment to markets where they are not leaders. In 2011, Vodafone cleaned up its portfolio and divested more than €20 billion in assets in Poland, France, and China. France Telecom sold Orange Switzerland to Apax, a PE fund, for €1.6 billion (roughly 6.5 times EBIT). KPN is looking for a buyer for its operations in Germany and Belgium. Deutsche Telekom, which tried and failed to sell T-Mobile US to AT&T in 2011, may sell its UK and Netherlands units next year. Telefónica, struggling to reduce debt while its home market in Spain remains in recession and financial crisis, plans to sell shares in its German and Latin American phone units in IPOs announced last week. With the sector’s valuations beaten down by Europe’s economic crisis, tough competition, and regulatory pressure, some of these telecom assets are at their cheapest for a decade.

Times have changed. The past decade has seen European telcos recover from the crash of the “internet bubble”, to go on buying sprees in eastern Europe and Asia in pursuit of growth, often with minority stakes and local partners. Contraction, expansion, contraction. Volatility has entered the telecom sector, and it is here to stay.

It is clear that some industries are more cyclical than others. For a long time telecom used to be less volatile than the economy as a whole and show consistent and steady growth. (Noam 2006) looked at US telecom industry data going back to 1875, and found that in each of the 11 recessionary years after WWII, telecom line growth and call volume growth were positive. With the exception of three Depression years, telecom industry revenue rose every single year from 1920 until 2000, on average 8.4%. Only 2 of the 11 recessionary years since WWII showed revenue growth below this average. Interestingly, Noam doesn’t find a correlation between changes in industry structure (monopolistic and competitive periods in the past century) and the industry business cycle. The cause of that steady growth in the twentieth century, even when the broad economy underwent a negative cycle, had to be found elsewhere, such as in new technologies (fax, online, ISDN, internet, etc.) and positive network externalities resulting from previous growth phases.

Growth for Telecoms and Utilities

Historical industry sales growth for US utilities and telecoms, past 10 years [1]

In the twenty-first century the telecom sector may have become more volatile than the broad economy, more like the construction business and less like energy and water utilities (see figures). Its underlying dynamics resemble those of the famously unstable airline industry: high fixed costs and low marginal costs. Where do these business cycles come from? Shocks in monetary policy or aggregate demand for telecom services don’t provide an explanation. In innovative industries, Schumpeter’s (1939) process of creative destruction is a good starting point: periodic bursts of innovation create small new firms, whose products fetch a high price that attracts entry. Output then expands and prices go lower. Industry growth rate slows below that of individual firms, and a consolidation occurs.

EBITDA/Sales for Telecoms and Utilities

Historical industry EBITDA/Sales margin for US utilities and telecoms, past 10 years [1]

The industry economics that characterize network industries provide cause (Noam 2004, 2006). These economic fundamentals are:

  • High fixed cost and low marginal cost: supply side characteristics that lead to “natural” monopolies. There is a bonus for scale and market share growth.
  • Inelastic demand
  • Lumpiness in investment: capacity expansions offered by new technologies (mobile technology generations, fiber) are made in large steps, which amplifies swings.
  • Lags in supply: the feedback loop from small shifts in demand to adjustments in supply is very slow due to the lumpiness of investment, the slowness of regulation, and the “chicken and egg” effect of developing network externalities for new technology generations; a slow feedback loop creates oscillations – developments often progress in spurts and investment spending is cyclical.
  • Network externalities: as an increase in the number of subscribers increases the utility or value of the communication service, the expectation of growth gets factored into the service price. Returns to scale (output as a function of capital and labor) are increasing. This accelerates until the expectations of further growth decline (at saturation), at which point the cycle is reversed. In essence, this is a hype cycle.
  • Technological uncertainties and technology shocks: bursts of change are followed by breathing periods allowing demand to catch up with supply.

These economics encourage individual firms to seek market share, to gain economies of scale on the supply side and network effects on the demand side. Whilst that makes sense for each individual telco, in the aggregate it leads to oversupply. Competition then drives prices down to marginal cost and to levels which don’t cover the total cost (for smaller players first). The industry contracts and concentrates. Eventually, demand catches up with supply. Prices rise, new entrants emerge. Supply expands, and then over expands. A new cycle emerges. Credit limits linked to asset valuations amplify the magnitude of each cycle.

The telecoms business cycle: entry at the bottom, consolidation at the top

For a telco, traditional strategic differentiation — price competition and product differentiation through innovation — creates merely temporary advantage. Competition will catch up over time, commoditizing the product. When price and product differentiation don’t create sustainable advantage, the remaining telco strategy is to regain control over prices and reduce price competition by M&A. This is what happens today: the industry consolidates and the remaining players behave oligopolistically and cooperate (e.g. through network sharing).

Today’s downturn, however, is not the end of the story. There will be excitement about the next technology shift, public policy support, investment, new entrants competing with incumbent platforms, overinvestment, saturation, dropping prices, failures and consolidation again. Since the underlying scale economies of communication services and connectivity (infrastructure) services are different, both will have their own business cycle which might work in favor of unbundling (even if business cycles in different industries influence each other). In fact, similar dynamics play out across the entire information sector. Computers, silicon, consumer electronics, newspapers, advertising, television, music, online retail, search… all information industries are going through cycles of product shifts, investment, overinvestment, price deflation followed by crashes and restructuring. As more and more traditional industries are swallowed by the volatile information industries (see previous post), increased volatility might well be the future of our economy and society at large.

Noam E. (2004) Telecommunications: From Utility to Volatility. Utilities Policy 12 (2004) 1–4

Noam E. (2006) Fundamental Instability: Why Telecom is Becoming a Cyclical and Oligopolistic Industry. Information Economics and Policy 18 (2006) 272–284

Schumpeter J. A. (1939) Business cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process. McGraw Hill

[1] Dataset for all publicly traded firms in US industries (total 5892 firms) by Value Line and Aswath Damodaran at http://ow.ly/blooK

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5 Responses to “The Telecom Business Cycle: Gravity Pulls”

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