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The £90bn phone bill

What a difference a year makes. As the new millennium approached, growing optimism for future demand for mobile internet access and email, combined with a glut of corporate activity, led to a furious buying frenzy and spiralling returns for mobile telecoms shareholders.

Fuelled by the rapid acceleration of mobile phone usage and growing excitement over the potential market for mob ile data, governments came to realise that the radio spectrum frequencies were a valuable commodity, with the most efficient and transparent approach to valuing the airwaves deemed to be an auction process.

One year on and the optimism has gone. The trigger? European governments, not ably the UK and Germany, which are raising E150bn (around £90bn) from selling 3G licences – a sum broadly equivalent to the GDP of Denmark. This was a severe shock to the market as the actual sum raised was up to four times more than analysts&#39 expectations.

The reaction was unsurprising. Since March, the combined value of 3G auction “winners” Deutsche Telekom, BT, Telefonica, Vodafone and Sonera fell by an astounding E490bn, equivalent to the aggregate GDP of Denmark, Sweden and Finland!

The E150bn question rem ains unsolved – have these companies overpaid?

Analysts have no real conviction in the size of the potential market. It is currently assumed that 70-80 per cent of the population of Western Europe will be mobile by the time the new 3G networks are launched. This leaves only a few precious new subscribers to target and places an inc reasing emphasis on winning clients from the incumbent operators.

More important, though, is the potential increase in usage from existing clients in data-related activity. This is critical to long-term returns but is also the area of least visibility. That said, mobile data is universally agreed to be a huge source of future revenues.

Despite the clear potential, it is important for investors to bear in mind the scale of capital costs which must be borne up front. On top of the initial licence fees of E150bn, building the 3G networks will cost more than E100bn over the next three to five years.

Coupled with the inevi table requirement to subsidise new customers, the total inv estment required to launch a 3G network in Western Eur ope alone will top E300bn by 2005. Truly talking telephone numbers.

But what of the expected returns on these investments? It is widely accepted that it is likely to be 2005 before companies start to profit from 3G.

The companies themselves are also rather unconvincing in their long-term projections.

The German “win ners” have been the most forthcoming with details of their planning assumptions and pro jections. The two new ent-rants alone predict a combined market share of 28 per cent within 10 years.

Since around 70 per cent of the population will already own a mobile before these companies are in a position to sign up their first customer, this imp lies they take all of the incremental growth in the market from
2003 plus market share from the incumbent operators. Both companies then use this as the premise for promising returns on investment of 17-19 per cent.

Even the biggest and best equipped inc um bents, such as Vodafone, are predicting ret urns closer to 15 per cent and they start with a huge installed customer base and a significant cost advan tage. Clearly, both cannot be correct.

Furthermore, the contradictory nature of recent corporate act ivity has offered little reassurance to invest ors.

France Telecom and KPN withdrew from the UK auction as the price became too high, only to buy back later at an even higher price. Simi larly, Sonera withdrew from the UK auction only to pay a similar sum in Germany.

All in all, it will be many years before we find out whe ther companies have overpaid or not. However, given the scale of up-front costs, the bizarre behaviour of some of the participants and irreconcilable long-term assumptions, it is likely that there will be several high-profile casualties from 3G mobile.

These recent events will have far-reaching implications for shareholders, debt pro viders, customers, equipment suppliers and governments. Investors themselves will likely take particular note of five pertinent themes.

The huge increase in capital costs from building these new networks, which are significantly higher than previously predicted, greatly increase the risk profile of any future cash flows. This invariably means that the value of these companies is materially lower than before the auc-tions commenced.

New entrants are distinctly disadvantaged. They have no customers, must build networks up from scratch and the majority of the population will own a mobile before they are able to start marketing their products. This implies they will have to prise customers away from their established competitors without price discounting. Despite this, they continue to pay vast sums in the auctions.

These huge amounts are placing a growing strain on corporate balance sheets. Debt is rising fast. Most companies will be forced into equity issuance to finance their obligations. The estimated E90-100bn euros which could flood the market over the next six to nine months will provide an unhelpful technical background for telecoms investment.

The money which operators will spend on building up their network infrastructure over the next three to five years can only be good news for the leading infrastructure equipment companies such as Ericsson and Nokia.

Creative and original content will grow in value. Operators are likely to differentiate their offerings on the basis of content provision.

There is no doubt that long-term prospects for mob ile internet remain exciting. The carrot of long-term revenue growth is clearly attractive.

However, the market is currently focusing on the costs of operating in this market in the near term. Att ractive long-term volume growth is available but perhaps only at an unacceptable cost.


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