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A DELICATE DANCE
Senior Investment Analyst
Feb 06, 2020
Telecommunication has oscillated between being a growth sector and a mature utility industry multiple times over its long history – from the days of Alexander Graham Bell and his first working telephone in 1876, through a long period of stability until the 1980s, up until the major investment in the 1990s in mobile networks and fibre-optic cabling.
The world has now reached a point where we’re upset if we can’t make a phone call or gain quick, efficient access to the internet anywhere on earth. The rise of mobile technology has allowed many developing countries to effectively skip generations of telecoms technology – most African countries now have more than 95% mobile telephony population coverage without ever having reached more than 5% fixed-line coverage. The development of telecoms has enabled billions of rural people in developing countries to integrate much deeper into the wider world.
Having access to the world’s knowledge and entertainment at your fingertips wherever and whenever via mobile internet is a product that sells itself. At first glance this can only be an amazing business. However, the industry faces challenges on three fronts:
A major problem for the industry is that while the telecoms companies have made money building networks, the best money is now being made by businesses selling services over those networks, which include content companies such as Naspers, Google and Facebook rather than the businesses that own the networks.
Compounding the issue is the fact that as services become ubiquitous, people start to view them as utilities, or even as a ‘right’. This places pressure on politicians to step in and attempt to reduce prices. Many countries now also see some degree of free internet access as a basic human right, and the resulting political intervention is typically negative for long-term profitability.
Another factor attracting the attention of governments and regulators is the tendency of telecoms to consolidate over time. These companies are natural monopolies, with excellent returns to scale. Most developed markets now have only a handful of telecoms operators. The US, for example, has AT&T, Verizon and Sprint, and the UK has Vodafone, BT, O2 and EE. By enforcing competition law, governments seek to regulate anti-competitive behaviour by companies.
Governments have generally done well to foster competition in the telecoms industry. Competition among network equipment providers has – through both greater efficiency and improved technology – brought down the cost of carrying network traffic.
However, governments control the limited spectrum (the right to use certain radio frequencies) that mobile telecoms companies need to operate their networks. This has created a further avenue for governments to extract money from the industry – in addition to the usual taxes on business.
The ubiquitous nature of the telecoms companies makes them an easy target for governments, especially in the developing world. Countries with informal economies, high levels of corruption and limited government capability often struggle to collect taxes. They therefore effectively use the telecoms industry as a tax-collection agent, as they then need to focus only on a few entities. Many African countries, including the DRC, Uganda and Nigeria, have additional excise duties on airtime. The industry is also taxed via handset import duties, VAT, profit tax and some form of special telecoms development fund.
All these factors have left telecoms companies in a rather tight squeeze: prices are under pressure from regulators and competition at the same time that the taxation and regulatory burdens are growing.
The price of a one-minute phone call in South Africa today is roughly 75% lower than it was 20 years ago in absolute terms, while the price of most other consumer items is 3.2 times higher. The trend for data is the same: lower unit prices, despite inflation in the economy. Telecoms companies have been able to grow, despite this price pressure, by increasing volumes. Voice usage has reached its natural limit for a large proportion of the population, but there’s still ample room for data volumes to grow.
The problem is that for customers at the higher end of the mobile data usage spectrum, technological changes serve to limit their consumption. Once a customer reaches a certain level of usage, it makes more sense to switch to fixed-line fibre internet. This effectively puts a cap on the revenue that providers such as Vodacom or MTN can generate from a high-end customer.
The telecoms industry is highly capital intensive. In 2019, MTN and Vodacom spent around 17% of their revenue on capital expenditure – for comparison, Pepkor spent 2%, and Tiger Brands 3%. They both therefore show high profit margins, with Vodacom and MTN both having EBITDA margins above 40%. Viewed in isolation, these high margins create the impression that these businesses make excess profits, which entrenches consumers’ view of being treated unfairly.
Is there an investment case to be made for telecoms companies in South Africa at present? As is the case with any business, there’s an appropriate price for local telecoms. While the outlook for future growth may be muted, these companies continue to generate significant profits and dividends. Like most utilities, they’re also predictable businesses.
But as we as do with all companies, we need to ensure that we incorporate all available information into our valuations. For the telecoms industry, we expect that striking a balance between business growth, technological challenges and government regulation is likely to be challenging over the medium term, creating unquantifiable risks.
Given the sustained spotlight on telecoms operators, our view is to hold shares in these companies only when they’re particularly cheap. As the tide of sentiment continues to shift away from the sector, opportunities for investment may arise. But for now, we prefer to sit this industry out.
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