SOUTH AFRICAN TELECOM IN 2010: HIGH STAKES FOR THE BIG WINNERS

 

May 2010

 

Authors		Andrew Snead - Partner
		Joao Sousa - Partner
		Tammy Whyman - Principal
		Delta Partners Intelligence Unit

 

 

 

 

 

 

 

The various elements of the South African telecommunications industry are likely to combine and result in an exiciting and dynamic year for his market

 

 

KEY HIGHLIGHTS

 

 

 

Introduction

 

No look at South Africa in 2010 would be complete without some mention of the FIFA World Cup which has set the imagination of the country’s population and, indeed, that of Africa alight. This year brings the world’s greatest spectacle to the African continent for the first time and there is a high sense of excitement. The announcement of South Africa as the tournament’s host sparked a positive frenzy of infrastructure upgrading and expansion, the likes of which the country has not seen before

 

The scope of infrastructure investment does not merely include transport and sports facilities, the country is also heavily focused on increasing its telecommunications capacity and quality. However, the World Cup is not the only impetus for the infrastructure rollout. Increased competition, Government encouragement for a ‘next generation’ telecoms sector (capable of servicing the needs of schools, universities, hospitals and small businesses) and the recognition of a significant wireless data opportunity has resulted in material investment across the industry

 

Beyond infrastructure investment, the South African telecommunications industry has proved that change is the only constant in the market, as evidenced by the introduction of RICA; formalization of the ECNS licenses, a change of guard in the Department of Communications and, after much speculation, a reduction in interconnect rates

 

This white paper discusses various elements of the South African telecommunications industry and how these are likely to combine to result in an exciting and dynamic year for this market. The paper will draw on lessons learnt from international peers and will give an overview of key industry events that will shape 2010. While challenges remain, 2010 is a year in which the market is expected to start fulfilling its potential

 

 

Prediction 1: MTN and Vodacom will continue to compete in corporate services but will find it difficult to realise synergies with the mobile business due to organisational and commercial differences

HIT: Vodacom was over-enthusiastic in its Gateway investment, taking more than R3bn impairment on the investment, partially due to the negative impact of the macroeconomic environment

 

Prediction 2: An international player may enter the mobile market via acquisition or a new licence

MISS: SA players proved to be the ones moving abroad, not vice versa (although Bharti came close, once again). However, it is possible that another player could come in via an acquisition in 2010 or 2011

 

Prediction 3: Telecom infrastructure sharing will increase across South Africa (i.e., towers and sites, backbone fibre, submarine cables)

HIT: Neotel, MTN and Vodacom agreed to lay fibre backbone and Cell C is rumoured to be selling its towers. Telkom has recently signed a wholesale agreement with MTN that also involves a tower sharing component

 

Prediction 4: Telkom’s nomadic W-CDMA offer will struggle to achieve significant results

HIT: The service has only a few thousand niche subscribers. However, Telkom’s big wireless bet is now the national 3G service to be rolled out in 2010

 

Prediction 5: Telkom will be placed under increasing pressure to deliver a clear strategy

HIT/MISS: A new strategy has been communicated, including the re-entry into mobile, but the jury is still out regarding execution

 

Prediction 6: Several VANs will be forced to sell or merge as they will lack the cash to make necessary capital investments

MISS: Perhaps the prediction came a bit early, but we can still expect consolidation in 2010 for the ECNS licensees

 

Prediction 7: Several service providers will be eliminated, as their contracts will not be renewed by the operators

MISS: Most consolidation or buy-out of service providers happened in 2008 and not 2009. However, as margin pressures continue, we can expect operators to negotiate commissions downwards

 

 

South African telecoms in the big picture

 

 

Whilst the voice market growth was lower than previous years, the broadband market (as predicted) grew considerably, albeit from a low starting point, reinforcing expectations of considerable latent demand.

 

When looking at subscribers and revenues, the fixed business has declined, particularly in revenue terms. Telkom attempted to mitigate the subscriber loss impact on revenues through the migration to calling plans.

 

However, it is clear that the fixed-line market is an extremely mature business and revenues will continue to erode due to mobile and VoIP substitution.

 

Mobile, by far the largest contributor of revenues, grew by around 8%. Nevertheless, all operators experienced less growth towards the end of 2009 principally due to the mobile registration (RICA) process which both limited gross adds whilst shaking out the double-SIM market.

 

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Broadband was the growth leader in 2009. Whilst starting from a small base, the market experienced significant growth in both fixed and mobile broadband. However, mobile has been (and will continue to be) the predominant access technology. For fixed line broadband to become more relevant, local loop unbundling (LLU) and/or fibre to the home (FTTH) will need to become a reality.

 

When comparing with a selected peer group of Argentina, Brazil, Ecuador, Malaysia, Mexico and Turkey, the South African fixed-line and broadband penetration remains very low, especially given the comparatively high mobile penetration, reflecting the lack of true competition in the fixed-line market.

 

This peer group was carefully selected to ensure that comparisons were the most reliable possible. The selection comprised countries with a similar population size, gross domestic product (GDP) per capita, and population density. All of these factors will create different challenges to developing a telecom industry.

 

 

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Is mobile voice communication in South Africa really that expensive?

 

Much has been said in 2009 regarding the price of mobile communications in South Africa. From a consumer perspective, the comparative effective price per minute supports the commonly held view that prices remain expensive and there is room for further price reductions. Whilst this is possibly true, one should also consider other factors too.

 

Key considerations

 

Cost of entry - such as the price of a handset and SIM card. South Africa, in relative terms, offers very low-cost SIM starter packs (costing the customer very little, if anything) and highly subsidised handsets, even for prepaid, which is a rare practice worldwide. Consumers have been taught by operators that handsets are effectively ‘free’ whilst also offering attractive post-paid promotions (including fridge freezers and microwaves) to entice new customers. Whether such customers deliver positive value to the operator over their respective contract period is highly questionable.

 

Cost to serve - including urbanisation and fuel costs. When viewed in a global context, South Africa is not a particularly dense country; it has a medium degree of urbanisation and has high energy prices (with unreliable sources that call for costly back-up alternatives) which contribute to the cost per minute.

 

 

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Attractive and prolonged prepaid promotions. All players generally offer attractive pre-paid promotions (e.g. free on-net minutes for a given recharge amount) that frequently run for long periods or are quickly superseded by alternatives. The &lsqou;true&rsqou; effective rate per minute is therefore lower than the published rate

 

Quality and customer experience. Although the recent network performance of all operators is not without question, there is a significant degree of investment taking place which should, if executed properly, deliver highly reliable, fast and innovative services to the South African market. Markets with the lowest price per minute are often characterized by low levels of investment, innovation and quality

 

As illustrated in Exhibit 3, South Africa already has one of the fastest 3G networks among its peers and is now in the process of launching infrastructure capable of delivering 21mbps. Generally, operators that have invested in building advanced high speed data networks have tended to also have a comparatively higher rate per minute. (See exhibit 4)

 

In summary, there are grounds to suggest prices could reduce further in South Africa although the debate warrants broader consideration, beyond price per minute, which is too one-dimensional. We would recommend all factors are considered within the assessment (including entry costs and investment levels) to ensure the long term objectives of price competitiveness, quality and innovation are achieved.

 

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How can operators ensure a return on investment?

 

 

Infrastructure sharing

 

Operators need to move from rhetoric to reality regarding infrastructure sharing and optimized sourcing. Tower sharing has been a popular and well understood topic of debate for some time but the market is yet to fully exploit the opportunities. Telkom recently announced its wholesale agreement with MTN. Cell C is reportedly conducting a process to sell-off and lease-back its towers. However, given the rate of infrastructure build-out across the country, it is not clear that enough is being done to fully exploit the potential benefits at a time when the upside could be at its greatest.

 

On the fibre side, Neotel spearheaded an innovative network agreement, first with MTN, and then with Vodacom, to share the costs of rolling out a national fibre-optic backhaul network. This agreement has enabled Neotel to lower CAPEX and decrease its dependency on Telkom which has struggled to meet the demands of all operators.

 

 

Increasing focus on wholesale and maybe time for a new MVNO?

 

Given the current level of network infrastructure deployment, operators will be seeking to drive utilization and monetize their investment. Price reductions will drive an increase in minutes of use (MOU), given an assumed level of elasticity. The expected explosion in downloading (and uploading) of high-bandwidth applications and content through lower cost smartphones will also create significant demand on network resources.

 

However, operators will undoubtedly seek to drive wholesale revenues, as illustrated by the recent deal between MTN and Telkom. Beyond such mega-deals, operators could also position themselves to serve the smaller niche data players with wholesale-type solutions. We expect the wholesale data market to grow significantly given the low level of penetration and demand for high-bandwidth services within the Government, corporate and small and medium enterprise (SME) space.

 

Another option is for operators to launch additional Mobile Virtual Network Operators (MVNOs), such as Virgin Mobile. However, one must consider if there is there room for another MVNO alongside the new entrant Telkom.

 

 

Handset subsidies and channel partner commission costs

 

Operators need to address the high subscriber acquisition costs in the form of handset subsidies and sales channel commissions. Our internal benchmarks suggest that subscriber acquisition costs in South Africa are materially higher than some of its peers. The ‘middle-man’ has clearly enjoyed his time in the sun but perhaps the point has arrived for operators to apply a greater degree of pressure on activation (and ongoing airtime) commissions and handset subsidies.

 

 

Outsourcing and moving towards a lean operation

 

Beyond infrastructure sharing, operators also need to determine how they can reduce operational expenditure (and improve capability) though optimizing other sourcing decisions through managed services and outsourcing deals. Example areas include: finance and accounting, order management, facilities management, call centre operations, network maintenance and support. In addition to improving capability and cost, such deals can also help drive cultural change, a delicate yet critical nettle for operators to grasp.

 

 

The impact of RICA

 

RICA was signed into law and implemented across South Africa in July 2009. As part of the legislation, it has become the responsibility of mobile network operators to implement a registration process whereby consumers must provide proof of identity and residence (passport and hotel address in the case of tourists) when purchasing a new SIM card.

 

While the rationale for the legislation is laudable - primarily to help law enforcement agencies track criminals - the execution has resulted in a number of issues.

 

Firstly, such a process impacts the rural community significantly. It is very challenging for rural people residing in township settlements to provide an acceptable proof of address. The result is that many rural airtime resellers have suffered a material loss of sales, impacting rural family wealth.

 

Secondly, the process is very open to abuse. Any person may register an unlimited number of SIM cards and re-sell them on the black market which undermines the core objective of the initiative itself.

 

Thirdly, the process has been marred by technical challenges (including the Gateway system and password hiccups) which have inhibited the registration process, severely impacting the customer experience and operator revenues.

 

 

Inertia on the SA regulatory front

 

The new presidential administration brought with it a wave of Governmental change, including the appointment of Siphiwe Nyanda as the new Minister of Communications. Mr Nyanda has set out a clear agenda to address the issue of competition within the South African telecommunications market, proactively pushing for competitive reform, not always with the full support from the Independent Communications Authority of South Africa (ICASA), the industry’s regulatory authority.

 

The most notable area of progress has been in relation to interconnect, where termination rate reductions have been implemented (an industry-led agreement to reduce peak rates from R1.25 to R0.89 following strong Government coercion) and a proposed roadmap for future reductions. Looking ahead, greater clarity is required on spectrum allocation and local-loop unbundling in particular.

 

 

Looking ahead at the future of telecoms

 

Telecoms will continue to be a growth industry in South Africa. The market is undoubtedly maturing on the voice side, yet significant future opportunity remains. Fixed-line voice will continue to fall, mobile voice will be relatively flat, and broadband will drive growth. Given that South Africa is so far behind its peers in terms of broadband penetration, we expect to see annual growth rates around 20 per cent. The year 2010 will be a key year for the South African telecoms market with existing mobile operators aggressively focusing on mobile broadband and Telkom entering the mobile space.

 

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Other growth drivers include m-payments (a ‘stickiness’ rather than revenue generating proposition) and the expansion of the information and communication technologies (ICT) sector. Telecom and IT spheres are becoming increasingly entwined and the current infrastructure investment should catalyze the outsourcing and managed services space, bringing Telkom, the mobile operators, niche data players and IT players (such as Dimension Data and Internet Solutions) into direct competition on the customer side, yet underpinned by cooperation on the infrastructure side. The era of ‘coopetition’ has begun.

 

As with other markets across the globe, Google and Apple will also play an increasingly relevant role with their ‘over-the-top’ business applications suites. Naturally, they will also drive consumer data usage through their ever-expanding application libraries. How operators extract value from such applications is probably the most relevant question in the industry today.

 

One of the key enablers to mobile broadband growth is smartphones and ‘app-phones’. The South African market has been dominated by Nokia and Samsung in recent years, both of which offer smartphone-like devices targeted more towards the middle to higher end. Perhaps this stranglehold will be broken by the increasing relevance of lower cost manufacturers such as ZTE and HTC.

 

 

The future of broadband is mobile

 

With fixed minutes in decline and very low internet and broadband penetration rates, it is clear the next area of growth will be data. Broadband subscribers are expected to reach over 9 million by 2013, representing an annual growth of over 20 per cent for the next four years.

 

With a poor fixed-line infrastructure and the high cost of access devices (i.e., laptops and desktops), mobile broadband with its instant connectivity and the ever-decreasing cost of 3G handsets is clearly outpacing fixed-line as the preferred connection type.

 

According to the Bank of America, Merrill Lynch, Vodacom and MTN combined have 1.3 million internet users versus Telkom’s 600,000 ADSL lines (moderately lower than our estimates). However, for the prepaid user, the cost of 3G dongles is still a significant barrier to entry. We can expect to see low cost dongles as manufacturers and resellers are willing to cut margins in return for higher volumes. Once the price for dongles, netbooks and smartphones starts to fall, mobile broadband access will grow materially.

 

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ICT services

 

The demand for valued-added information and communication technology services is increasing as corporates and small and medium enterprises (SMEs) require more sophisticated services and look for ways to outsource non-core business functions. The telecom value chain is converging and telecom operators face the opportunity and need to expand their focus and better serve the Corporate and SME market.

 

By selling ICT services linked to the telecommunications services, a telecom operator is better positioned to:

 

Protect traditional revenues (be proactive not reactive)

 

Grow new revenue streams

 

Manage margins on traditional services, avoiding competition on price per bandwidth (whilst accepting new-wave services are likely to be margin dilutive)

 

Reduce risks on investments in next generation networking (NGN)

 

The ICT market will not be the sole preserve of Telkom or the traditional IT players such as Dimension Data. No doubt the altnets (particularly Neotel) and the mobile players will be evaluating opportunities to expand their corporate and SME relevance, potentially complementing their HSPA and fibre infrastructure investments with femtocells, which provide wireless broadband access directly to a premise.

 

Developing a strong positioning in the IT/IS services requires the set up of specific competencies and partnerships. Both MTN and Vodacom have created units that are dedicated to the mobile and ICT needs of corporate clients and they are acquiring businesses such as Verizon and Gateway to deepen their expertise and product portfolios. However, without real local loop unbundling, the mobile operators may be limited in their ability to compete successfully. As highlighted earlier, we fully expect Google and Apple to play an increasing role in the ICT market as they expand their simple software-as-a-service (SAAS) application offerings.

 

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Mobile payments

 

With a very significant unbanked community, South Africa offers a material opportunity for the mobile-payment (m-payment) and money-transfer space. Though operators have attempted m-payments in one form or another, the space remains relatively nascent and fragmented. However, this will change in 2010 as both banks and operators address the key issues (such as ease of use, reliability and access) and Vodacom launch M-Pesa which has the potential to catalyze the market.

 

M-Pesa has close to 10 million users and over 2 million daily M-Pesa transactions in Kenya alone. Whilst Safaricom’s very strong market position and local Government support has been key to this success (potentially explaining why M-Pesa has been less successful in Tanzania), it is clearly an effective proposition. In terms of key benefits for the operator, M-payment solutions can help drive customer retention (particularly important in maturing markets such as South Africa) whilst reducing airtime distribution costs.

 

The key question is whether Vodacom can adapt M-Pesa to the local market reality (including financial regulations and licensing requirements) and use it to increase its market leadership. If so, MTN and Cell C will have to innovate and react.

 

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Role of the private equity and M&A

 

 

According to independent M&A intelligence service Mergermarket, M&A activity in South Africa dropped 61 per cent in 2009. In 2010, we can expect South African operators to continue to proceed with caution.

 

The largest and most lucrative African markets have already been conquered by the major regional players. Few attractive greenfield opportunities exist and prices for many assets have been expensive raising questions surrounding shareholder value creation. Operators are perhaps starting to look further afield, as illustrated by MTN’s current discussions with Orascom.

 

Operators with a high dependence on the South African market, such as Telkom, will perhaps look for further diversification opportunities where they will find themselves up against a new breed of bidders, such as Russian, Chinese and Indian players.

 

In the early 2000s, private equity funds fuelled much of the growth of the emerging GSM operators. Since those groups have grown and consolidated, private equity has been less active in recent years. However, interest in the telecom space has picked up again with a large number of infrastructure transactions (tower, fibre, submarine cable and satellite) being discussed. Investors such as former US Secretary of State Madeleine Albright, billionaire investor George Soros, and banker Jacob Rothschild have created a $350m fund to invest in Nigeria’s Helios towers. This type of activity is expected to grow, especially in key markets such as South Africa, Nigeria, Ghana and East Africa.

 

 

Operator outlook for 2010

 

Telkom

 

In addition to the windfall gained from the Vodacom sale, Telkom was afforded the opportunity to start anew. In November 2009, Telkom embraced this by announcing a new ‘Renaissance’ strategy focused on creating a full mobile offering and going aggressively for the data centre business.

 

Telkom’s entry into the mobile market may be considered a bold move at this relatively late stage of market maturity. However, the company does have some advantages over other new entrants such as a full national core network, expertise in network technology and a significant (yet decreasing) customer base.

 

 

Vodacom

 

For Vodacom, control by Vodafone has placed increased focus on operational efficiencies. The fruits of its cost containment programme paid off in 2009 as EBITDA margins increased, despite a slowdown in revenue growth. Vodacom did not take its eye off the market during this period, successfully defending its market share in South Africa and lowering its churn levels. Vodacom has had less success in the push to diversify its revenues outside the South African mobile market. The international operations performed poorly, due to weak market conditions and competitive offerings in the respective markets.

 

These pressures are likely to continue in 2010, requiring further attention from management with perhaps an increasing focus on Vodacom Business which still remains a fraction of total operator revenues despite continued efforts to grow this business.

 

 

MTN

 

For MTN South Africa, 2009 was particularly challenging. It was the first time that the firm reported negative subscriber growth, largely due to the impact of RICA and system and billing issues.

 

ARPU also fell slightly due to pressure on consumer spending. However, MTN’s continued product innovation and strong marketing campaigns allowed it to defend market share. A new, segment-driven market approach should be expected, resulting in a better service offering and customer experience.

 

 

Cell C

 

In a recent article, the Cell C CEO, Lars Reichelt, remarked on Cell C’s ambitious plans to strengthen its market position.

 

Cell C certainly surprised the market by announcing plans to launch a new high-speed data network in 2010. Cell C is planning to surpass the current market offering in terms of speed by launching an HSPA+ network, capable of delivering very high-speed wireless broadband services. This bold move is expected to change the market dynamics, especially as 3G connectivity has become a critical component in mobile offers in South Africa.

 

 

 

Winners

 

South Africa will successfully highlight the country’s character and infrastructure during FIFA World Cup.

 

Broadband will explode in 2010 and 2011

 

The consumer will benefit from a continued decrease in prices and strong promotions

 

Network superiority will become even more important as operators compete strongly on mobile data

 

Operators that perfect customer retention tactics will win

 

 

Losers

 

LCR will lose. As interconnect falls, LCR operators will need to convert subscribers to their networks or will fail to have a relevant discounted offer.

 

Operators who go in to price-war mode and cannot reduce operational costs will lose. In a mature and increasingly-competitive market, cost reduction is a must.

 

Incumbents will be pressured. Regulatory changes will put pressure on current business models forcing incumbents to reinvent themselves.