8/11/2019 Radar 2014_0819 - DeepDive Telcos and OTTs b

1/3

Suggestion and feedback:xrizos@westpac.com.au 1

#3

19 August, 2014

Selected digestible insights joining the dots between

Socio-economics, Strategy, Transformation and Delivery

The Radar

FINANCIAL SERVICES

CBA results (WBC, ANZ and NAB have Sep Fin Year End and only

provide trading updates. WBC does not report quarterlies)

3 years after Ian Nareev became CEO, CBAs profit is 35% higher

at $8.6B, share price is up 70% from 3 years ago. ROE is ahead

of rivals at 18.7% (vs 16% big-bank average), and it currentlytrades at a 15% premium to its peers.

> Some analysts have asked if CBAs best days are behind. The big

picture is that during a period of relatively weak credit growth, CBA

delivered 12% cash profit growth, which is 2x the growth in

nominal GDP. It did this by focusing on IT and productivity.

NAB: still facing UK drag. ANZ: soft revenue growth, stiff

competition for big corporate customers and competitive Asia.

Leadership changes across banks (NAB, CBA, BOQ, Westpac):

CBAexec team reshuffle: hunt for a new Business and Private

Banking boss after incumbent Grahame Petersen announced he

will retire at the end of 2014. Simon Blair, in charge of the

International Finance Services, will step down from his role andthe banks exec committee. He has been replaced by Rob

Jesudason, currently Head of Strategic Development.

NABEnterprise Services and Transformation exec Lisa Gray left,

replaced by former Chief Risk Officer of BNZ Renee Roberts. She

has been given a less hands-on role than former CBA operations

chief Michael Harte, with NABs CIO David Boyle reporting to her

and the GM for NextGen Steve Collier remaining in his role.

BOQ: surprise resignation of CEO Stuart Grimshaw to join US

NASDAQ-listed pay day lender pawn shop operator EZCorp:

interestingly the AFR flagged Lisa Gray as a potential candidate.

WBC: Former CBA core banking chief Dave Curran joins Westpac

as its new CIO. Westpac NZ chief executive Peter Clare steps

down following a major heart operation.

> Unrelated changes but they seem to paint the picture of a slightly

changing landscape among the leadership of the sector, hence

inevitably creating new dynamics and opportunities.

RBA data shows that retail deposit rates offered by the 5 biggest

banks fell in July14, and have declined markedly since the last

RBA rate cut in Aug13. Market leaders such as UBank and

RaboDirect,which until recently offered deposit rates over 4%,

have both kneecapped their best rates to 3.81% and 3.2% resp.

> This is because funding from bond markets has become cheaper

since the GFC: so banks are cutting rates previously used to attract

deposits as a source of funding when capital markets where more

onerous > This means that many savers and retirees are earning

negative real returns on their cash - historically a rare event.

They are implicitly encouraged by the RBA to chase higher income

with riskier investments like popular ASX listed equity hybrids

An interesting reflection raised by some analysts: With profit

comes pressure for the Big 4 because they form the bedrock of

most SMSFs and retirement savings managed by big super

funds. But questions are being asked about whether or not the

big banks can continue to deliver strong capital gains. High-

profile brokers question whether the banks have passed the

sweet spot in the earnings cycle. Pressures are building on profit

margins, and bad debt charges are at a cyclical low. They say

asset performance can only deteriorate from here as interestrates normalise and financial stress increases with rising

unemployment: They are amongst the most expensive banks in

the world, based on peak-cycle earnings, the final nail in the

coffin for the sell case is capital if APRA pushes for higher

capital requirements which will have to be met either from

lower payout ratios or dilutive capital raisings, it is hard to see how

the value of these shares could move much higher.A contra

view is that Banks are heading into a period of increased lending

as the economy shifts from mining which was self-funding, to the

non-mining sectors.

> The point here is not to resolvethe debate, but to be informedof those views that provide a valuable insight into the cyclical nature

of our economy

OTHER INDUSTRIES

Data and privacy: Optus has flagged the complexity and cost

(above $200m) of the Federal Govts plan to make phone

companies retain metadata, whilst PM Tony Abbott and Attorney-

General George Brandis said they are working on the hypothesis

that the data is readily available because companies already keep

it for commercial reasons.

> Beyond the political argy-bargy it reinforces the insight that

Datais a strategic asset that businesses, activists and policy makers

are trying to figure-out, creating tensions along the value chain.What this means for us is that developing a sound understanding of

this governance is as important as developing apps.

Medicare Services outsourcing: Whilst the banks have been

previously shortlisted to take over Medicare's $30 billion Benefits

Payments responsibility, Australia Post looks now well positioned

to take on that role given its network and digital capability. The

outsourcing proposal was a recommendation from the

Commission of Audit and aligns with the Abbott govts pre-

election pledge to streamline the public service.

> A good prompt to keep reflecting on the nature of servicesin the

context of our Strategy, to draw actionable concepts/ideas: e.g.

what added-value services can augment everyday banking?

After 8 years without a dividend increase, Telstra is this year

taking baby steps to shareholder returns, distributing $4.7B to its

shareholders in the form of a $1B share buy-back and a 15

dividend, taking total dividend payments to 29.5 for the year..

Yet analysts were expecting more from a solid $4.3B profit.

> Even after the payout, Telstra has a free cash flow of $5.1B, which

is signalling it is trying to find the right balance between returning

cash to shareholders and retaining enough cash for future

acquisitions to grow. Indeed, not only all companies now face

pressure to have growth plans compared to the years after the GFC

when the focus was purely on yield, but Telcos are also facing a fight

for their relevance as disruptors like Google Hangouts, Viber,

Facebook andWhatsApp use their global scale to provide services

so cheap that call and texting revenues are disappearing, and whats

left is eaten by these new rivals. Hence reducing Telcos to utilities

providing little more than a network of dumb pipes(see deep dive).

MACRO-ECONOMICS

Not since 2002, before the China-driven resources boom began,

has Australias jobless rate been as high as last months 6.4%.

The concern among analysts is that Australias policy makers are

pursuing Austerity (RBA not cutting rates, govt concern about a

rather manageable budget deficit). Yet between the 2 issues,

deflation currently seems a greater risk than inflation: China is

slowing down with growing alarm about a property slump (-9.2%

home sales in 1H14) in a country already beset by ghost cities.> This means increased pressure on Australia to diversify the

economy toward growth engines that rely less on China, and with

fiscal policy makers pursuing austeritypolicies from Washington to

Canberra, the onus seems all the more on central Banks to manage

downside risks.

mailto:xrizos@westpac.com.aumailto:xrizos@westpac.com.auhttps://www.ubank.com.au/https://www.rabodirect.com.au/http://www.ncoa.gov.au/https://www.google.com.au/hangouts/http://www.viber.com/http://news.yahoo.com/keep-using-facebook-chat-iphone-without-installing-facebook-181444737.htmlhttp://www.whatsapp.com/http://www.whatsapp.com/http://news.yahoo.com/keep-using-facebook-chat-iphone-without-installing-facebook-181444737.htmlhttp://www.viber.com/https://www.google.com.au/hangouts/http://www.ncoa.gov.au/https://www.rabodirect.com.au/https://www.ubank.com.au/mailto:xrizos@westpac.com.au

8/11/2019 Radar 2014_0819 - DeepDive Telcos and OTTs b

2/3

2

DEEP-DIVE: Telcos and the digital threat (how not to become just utilities providing little more than a network of dumb pipes)

1. Earnings reported this week cant hide that Telstra, SingTel-

Optus and Vodafone are already in the fight of their lives

- Telstra reported a solid $4.3 billion annual profit, and its share

price surged to a 12-year high, but this is masking the threats that

loom over the Telcos.

- They are facing a future in which we are making more phone calls,

sending more messages and downloading more content than ever

before. And yet incumbent Telcos, such as Telstra, that for more

than 100 years have run a deceptively simple business modelbuilding networks which we then pay to use, are increasingly

reduced to utilities providing little more than a network of dumb

pipes.

2. This isbecause free or virtually free instant messaging (IM) services

- also known as Over-The-Top (OTT) messaging - such as Google,

Viber, Facebook and WhatsApp use their global scale to provide

services on top of the networks so cheap that call and texting

revenues disappear entirely, and whats left is eaten by these new

rivals. Analysts around the world believe the Telcos business model

will be outdated within 10 years.

Indeed voice and SMS that make up a significant portion of the Telcos

revenue started going down a few years ago and its accelerating:

- In 2011, SMS represented 39.8% of worldwide data services revenue,

with MMS accounting for additional 14.2%.

- But then, in 2013, it dropped for the first time ever, as OTT

competition intensified. Last year the Telcos lost about $US25B

globally in voice revenue, $US50B in the case of SMS to OTT. Gartner

predicts that as early as next year the volume of OTT will have

overtaken the volume of SMS, and with that threatening what was

once a great cash generator for mobile network operators.

3. OTT messaging apps are outcompeting SMS for several reasons:they run over data channelswhile SMS runs over voice. They bypass

mobile networks and roaming because of more pervasive Wi-Fi. On top of this, tablets are becoming increasingly popular and most of

them do not have voice/SMS services, but run data/OTT instead.

4. However Telcos are circumspect: they sees the need to react

quickly but face a conundrum: while data usage has exploded in

volume, there is a long tail of SMS revenue.

WhileDeloitte expects instant messages on mobile phones to reach

more than double the volume of SMS messages this year 50 billion

IM messages vs 21 billion SMS messagesglobal revenue from IM will

be approximately 2% of SMS: partly because OTT messaging services

tend to be free or cheap (eg WhatsApp charges only $0.99 per user

per year and that's after the 1st year, which is free); but also because

global consumers who don't own smartphones still send text

messages.

5. The reasons for this crash:

- Where a Telco charges 55c to text a picture (eg Vodafone), WhatsApp

and Viber enable phone calls and messages to be sent free of charge

over the internet. So carriers have answered this threat with near-unlimited phone calls and texts. However while this might delay the

switch for some customers, it also shrinks the already falling profits from those services.

- Because internet access is so widespread thanks to infrastructure investments in mobile towers by old Telcos such as Telstrathe

costs for tech giants like Google to offer new services have been slashed. This is the Catch-22: it has helped internet usage boom without

a matching rise in the amount of revenue generated by Telcos. E.g. Optus reported a +40% increase in data downloads between 2013 and

2014, yet contributing revenue rose by just 10%as an analysts commented: phone call dollars got replaced by digital dimes.

- Finally, Tech companies dont have the same legacy and workforce costsFor instance: WhatsApp had just 55 staff in February 2014;

for every $1 in revenue made by a Telco worker, the average Amazon employee makes $2.

The

Fab Five

are

followed

by even

more

attackers

OTT Services Businesses

Transfer of revenueData: 10-15% in 2011

to 25%-40% in 2015

Revenue and Usage

are out of sync

Source: EY

http://www.deloitte.com/view/en_AU/au/industries/tmt/tmt-predictions-2014/index.htmhttp://www.deloitte.com/view/en_AU/au/industries/tmt/tmt-predictions-2014/index.htm

8/11/2019 Radar 2014_0819 - DeepDive Telcos and OTTs b

3/3

3

6. The battlegrounds and strategic imperatives to transform for the smartphone society

A primal reactions from the Telcos could be to block OTTs, charge or throttle the data: However, retribution appear to be short-term

counter-productive tactics because it triggers higher customer churn and lower data usage, and because it also goes against the principle

of Net Neutrality. Net Neutralityhas not had a very high profile in Australia, but has reached High Courts in Europe to the point that

it has even been enshrined into national law in places like France, The Netherlands, Slovenia and Chile.

Instead, the strategic play is about repositioning in the value chain and owning the customer experience. Key dimensions are:

- Personalization of service suites and the customer experience: asservices become more complex, being able to tailor the customer

experience is essential. For providers, this means giving users platforms on which they can bundle their apps, information, entertainment,

shopping, communications, and problem resolution.

- Staunch defence of relationships with end customers: The battle for customers will not be won with services alone, but with every

aspect of the ecosystem. Devices have a crucial role to play partly because they often clinch a decision whether or not to sign a Telco

contract. Apple has been showing how this can work with the iPhone. Google is strengthening its position with the rapid dissemination of

Android. Even Amazon has joined the device race with its Kindle Fire Tablet andnew Fire Phone.

- Cost-efficient broadband network build-up: When relationships with end customers are eroded, cost efficiency and bandwidth become

critical to remain competitive. Only Telcos that have large infrastructures will be able to survive. All the more that OTTs are increasing

data traffic. By 2020, the OTTs' video offerings will account for more than 50% total data volume. That's why the Fab Fiveneed the

telcos' broadband networks for their business model, who on the other hand must find a way to monetize this exponential traffic increase.

- Realignment and radical streamlining of operating modelsRoland Berger believes the different infrastructure strategies will leave the

Telco more fragmented. For strategic and financial reasons, they are likely to realign and resize their operating models around network

companies ("NetCo") providing the pipes, customer-centric sales and service company ("SalesCo"), managed by corporate services ("HQ")

setting the strategy.7. This is likely to lead to 4 plausible scenarios:

i. Clash of the titans:If the addressable market expands but the

industry consolidates, we could expect to see a clash of the

titans' between a few large Telcos and Web 2.0 players eg

AT&T versus Google.

ii. Survivor consolidation: If consolidation without growth

occurs, we could expect a sort of nightmare scenario - huge,

monopolistic operators and stultifying conservatism.

However competition, rather than consolidation, is likely to

dominate. We might see either a "Generative Bazaar" if both

fragmentation and growth occur; or a "Market Shakeout" if the fragmentation persists without growth.

iii. Generative Bazaar: In this scenario, barriers between OTT and Telcos blur as regulation, technology and competition drive open access.Infrastructure providers integrate horizontally to form a limited number of network co-operatives providing pervasive affordable and

open connectivity to persons or devices, including an expanding class of innovative asset-light service providers.

iv. Market Shakeout:This would happen under prolonged economic downturn: investors would force carriers to disaggregate assets into

separate businesses with different return profiles. Retail brands would emerge to repackage services from disaggregated units.

8. So what

> Firtsly, as a reader of this memo, if you are still paying for

phone calls, especially international, you might want to

urgently consider using apps likeviber,Skype,ooVoo,FaceTime

etc..

> Secondly, banks should ponder the insights from the OTTs

as a cautionary tale, and a metaphor: what Over-The-Top

services could plug onto the financial pipes that they run

today?

- When telcos tried to compete with OTTs to create their own

alternative apps, results were almost universally uninspiring.

- Partnerships with OTT services seem a more promissing

avenue (ie not trying to recreate what Tech players do better

anyway):Reliance with Whatsapp in India,Airtel with Facebook

in Africa,Netflix with Comcast, Verizon and AT&T in the US.

- In AustraliaTelstra has cash ($7.48B) and plans to use it to

stay in the game, even at the risk of partnering with the enemy.

These include eHealth, cloud computing and video platforms.

EgTelstra spent an extra $US270m to buy online video platform

start-upOoyala that lets websites host streamed content.

- For several years Telcos have been looking to banks for the

holy grail of internet partnerships.The idea is simplebillions of dollars worth of transactions cross their networks every day, from which

banks generate profits, and the Telcos want a taste of the action. But negotiations have gone nowhere fast because both the banks and

the Telcos think they should have the most hand in the relationship. Meanwhile they will likely keep eyeing each other, maybe until a

cheaper payment optionPaypal, Amazon or Bitcoinsforces a marriage of convenience?

Scenario A

Scenario BScenario C

Scenario D

Clash of

Giants

Survivor

Consolidation

Generative

Bazaar

Market

Shakeout

Today

Future Scenarios

Market

Industry Model

Fragmented /

Horizontal

Concentrated /

Vertical

Declining

Expanding

Operator-centricBank-centric

Multi-

consortium

Payment network

Example: the evolv ing m odels of the mob i le money ecosystem

http://en.wikipedia.org/wiki/Net_neutralityhttp://en.wikipedia.org/wiki/Net_neutralityhttp://en.wikipedia.org/wiki/Net_neutralityhttp://www.techradar.com/au/news/phone-and-communications/mobile-phones/amazon-phone-release-date-news-and-rumors-1085821http://www.rolandberger.com/media/publications/2012-03-06-rbsc-pub-How_telcos_transform_for_smartphone_society.htmlhttp://www.rolandberger.com/media/publications/2012-03-06-rbsc-pub-How_telcos_transform_for_smartphone_society.htmlhttp://www.viber.com/http://www.skype.com/en/http://www.oovoo.com/home.aspxhttp://www.rcom.co.in/Rcom/personal/prepaid/whatsapp.htmlhttp://africa.airtel.com/wps/wcm/connect/africarevamp/nigeria/3g/home/tariff-plans/facebook_bundleshttp://www.usatoday.com/story/money/business/2014/02/25/netflix-verizon-att-talk/5805595/http://www.smh.com.au/business/telstra-takes-controlling-stake-of-ooyala-20140812-102zmh.htmlhttp://www.usatoday.com/story/money/business/2014/02/25/netflix-verizon-att-talk/5805595/http://africa.airtel.com/wps/wcm/connect/africarevamp/nigeria/3g/home/tariff-plans/facebook_bundleshttp://www.smh.com.au/business/telstra-takes-controlling-stake-of-ooyala-20140812-102zmh.htmlhttp://www.usatoday.com/story/money/business/2014/02/25/netflix-verizon-att-talk/5805595/http://africa.airtel.com/wps/wcm/connect/africarevamp/nigeria/3g/home/tariff-plans/facebook_bundleshttp://www.rcom.co.in/Rcom/personal/prepaid/whatsapp.htmlhttp://www.oovoo.com/home.aspxhttp://www.skype.com/en/http://www.viber.com/http://www.rolandberger.com/media/publications/2012-03-06-rbsc-pub-How_telcos_transform_for_smartphone_society.htmlhttp://www.techradar.com/au/news/phone-and-communications/mobile-phones/amazon-phone-release-date-news-and-rumors-1085821http://en.wikipedia.org/wiki/Net_neutrality