The case for PE investing in the mobile market

In this article I explore the investment opportunity for Private Capital looking into investing in Mobile Network Operators (MNO). I first look at the outlook of macro trends that will play an important role in shaping the industry and markets in which MNOs operate. I then synthesize the implications of these macro trends in three scenarios, and move to discuss what strategic moves can be taken to ride the opportunities and control the risks. I end the discussion with recommendations for investors to build their Capital playbooks.

?[1] A new set of structural cycles will shape the mobile telecom industry over the next decade

?Understanding the macro context in which such large capital allocation may take place is of paramount importance. Past trends may become uninformative, given that forecasts must account for structural moves across the board. I summarize below the key cycles that investors must take into consideration.

?1.1 The global macro-economic cycle:

No one can predict the future of the economy, but there is consensus that we are facing a change of paradigm moving away from “free money” to a more restrictive environment through higher inflation and higher interest rates. There are two thematic implications that should be considered. First of all, the capital allocation process could become more thorough (investors being more diligent in which assets they acquire, demanding more restrictive covenants and being more challenging on the business outlook). Second, a current market hypothesis is that there is a thematic investment shift from growth to value. This should definitely benefit companies that are able to deliver robust financial outlooks supported by high-quality assets, as capital will flow their way.

Put together, it seems that well-performing telecom assets should de-minima benefit from money flowing into value. On top of that, there is a strong secular trend of capital flowing into digital infrastructure assets and this is expected to get stronger in the upcoming decade.

?Implication for investors -> Strong secular trends on top of some macro tailwinds means being first in allocating capital into new Digital Infrastructure assets is key to avoid strong competition. Looking into acquiring MNOs offers a unique opportunity to be first

?1.2 The telecom industry cycle:

Over the 2010s all telecom operators faced strong headwinds across markets and geographies. A decade of decline was made of several cycles combined together. A commoditization of communication products, heavy Capex cycles, the rise of OTTs and the missed digital opportunities. From a top-line perspective telecoms have therefore faced stagnated revenues and being forced into optimizing their operations to sustain margins. Such long-term structural decline seems to be coming to an end.

First of all, while in certain markets there still exists room for price compression it appears that across the board Telcos are avoiding further price wars (with the exception of certain markets).

Second, the Capex cycles are starting to widen lowering the cash stress. Specifically, the 5G Capex cycle is taking longer than the 4G cycle. And extrapolating this to the longer run the 6G cycle should run longer through the 2030s.

Third, a more radical view states that we’ve past the peak of digital products being exclusively the domain of native digital players (except for forefront disruptive innovation). Everyone has catch up in some sense and is able to provide more digital solutions that are fit for some portion of the market. Therefore, the competitive advantage on core digital products is begging to disappear. This means that there may be opportunities for revenue growth in certain market sectors.

Fourth, the regulation cycle for big tech may also weigh in on them and reduce the OTT pressure on telecoms, a strong reversal from the last decade where market regulators strongly imposed net neutrality while the OTTs didn’t face any constraints.

?Implication for investors -> We may be at the begging of a new cycle in telecoms, being first investing in new types of assets within the industry may prove fundamental to maximize returns on these secular industry trends

?1.3 The technology cycle

Moore’s law isn’t dead, at least for the upcoming 5 years. Why so? Well, there is a waterfall cycle that starts at semiconductors, moves into electronic systems enabling digital processing techniques that then power applications. How is that relevant for mobile networks? It is worth noting that 4G was already using extremely efficient spectral efficiency techniques (e.g. OFDM), but the new wave of mobile technology improvements don’t sit at increasing spectral efficiency in that dimension. Increased and more efficient computational power (which is a consequence of Moore’s law) is driving innovations such as massive MIMO, which requires computing efficiency both at the Base Station as well as at the end device. And while it is true that proportionally the throughput enhancements won’t be as impressive as the previous 4G cycle, we still have room for significant improvements (they may be of equal magnitude, but spread over a longer period of time). The current cycle is still exiting! *

*Note:?Other dimensions can be efficiently added to the capacity (supply) side: more spectrum on single antennas, single BB units, more efficient RF modules, integrated stations, etc. All on the backbone of chips!

However, one of the most important and radical changes awaiting mobile networks may come from software, with 5G, OpenRAN and SDNs enabling platform modularity, fluidity and flexibility. This may be a paradigm shift in terms of how we think of these assets! (which becomes a key consideration for players and investors looking to deploy capital).

A last technological remark must be made on the device side, which fulfills the more holistic infra view. Devices have been getting better, but no major leaps have happened over the last couple of years. We could expect another wave of device hardware improvements in the next 5 years, which will require 5G connectivity enhancements, and only when the hardware is ready, the software will appear and on top of it with new disruptive applications.

?Implication for investors -> The current Capex cycle, although longer than the previous one, is still expected to bring important technological advancements that should underpin the next innovation wave in the mobile industry

1.4 ?The organisational cycle

The telecom organizations have been evolving over the past 20 years from being rigid engineering focused companies to incorporate an agile multidisciplinary drive into their DNA. A major factor that has dragged down innovation in telecoms has been its organisational dynamics, with Silos operating independently from each other, fighting for resources and hardly realizing any synergies. Many operators have gone over significant internal transformations over the last couple of years by restructuring their organisations, incorporating agile ways of working and by modernizing their IT architecture and systems.

The combination of an agile organisation with a modern IT backbone has allowed to closed the GAP that existed with “digital native” companies over the last decade. And it could become a major endogenous factor driving competitiveness in digital markets over the next decade

?Implication for investors -> Telecom companies have realized the need to transform their operating model, going for agile ways of working and evolved IT architectures. This is a key ingredient to compete in the next wave of innovation in digital markets. Companies with these characteristics are better placed to capture market upsides

?1.5 The demand cycle:

For an MNO it’s crucial not to forget that its core revenues come from mobile subscriptions. In Western markets we have already reached very high mobile penetrations and subscriptions, with almost every person having at least one handset. ARPU compression has been a major headwind and it appears to be receding at the end of the commoditization cycle of the last 10 years. Demand for mobile services (in revenues) should stay stable over the next decade, therefore giving high accuracy to projected revenues at market level. This is very important for investors, as it gives predictability to the core business meaning stable and predictable baseline cash flows.

The second element that must be considered, is the broader demand for digital products and services. This is where revenues upsides can materialize. The digitalization of individuals, enterprises and institutions still has room to grow. In Advanced Economies there is still further digital literacy room to grow on the laggards (e.g. older demographics, long tail of SMEs and SoHo, Government). For Developing Economies there is even more space due to catch-up vs advanced economies (and with their own dynamics of “base of the pyramid”).

A third element is the nature of digital products. With communications having gone through a commoditization cycle, basic digital products are now thought of as essentials. There is certainly a trend to sustain the digital innovation cycle riding on the back of a more digitalized society that still demands digital products. A growing market for digital products across the board means there will be niche opportunities where MNOs can have structural advantages.

?Implication for investors -> Demand for communications should remain stable over the next decade, providing predictable revenues stream as the backbone of the investment thesis. There is still significant market growth in digital products, and there are niches where MNOs can play with advantage

?[2] A view on how these cycle may interact and materialize in three different scenarios

?2.1 Upside case:

We could imagine the case were 5G platforms deployed over the next 5/10 years foster a strong development of a new ecosystem for both consumers and enterprises. The demand for innovative digital solutions remains as strong as the previous decade. This would mean that a portion of this new market for digital mobile products can be captured by MNOs who develop compelling propositions. Moreover, it is fair to assume that in certain sectors mobile companies could have structural competitive advantages that if supported by the correct Go To Market and product-market fit strategies could result in significant market shares.

In an upside case we could also assume a fair economic return for the communications products, and no price wars nor further commoditization of the base of revenues. In some cases, some form of market repair could also be a safe hypothesis.

2.2 Base case:

?For the base case, the demand for further digitalisation would remain continuously growing for the enterprise segment which would be matched by a continuous development of the technology ecosystem around 5G platforms. The consumer segment growth would remain somewhat weaker, and with characteristics where MNOs may not be best placed to serve such growth (e.g. continued development around connected wearables, where consumer brands are better fit for those markets). The communication market should remain at its current state, with no further commoditization. In some markets, a slow recovery to economic returns could be safely assumed.

?2.3 Downside case:

?In a downside case, the main assumption would be that the growth from digital innovation for both consumers and enterprises would still be captured by digital players. In a general context, it would be structurally difficult for MNOs to play in those upside markets (this wouldn’t rule out the cases for leading MNOs who could figure out leading strategies to capture non-negligible market share). Cycles of pressure on prices and margins on the baseline communication services could be assumed, but still it would be fair to treat them as temporary.

?Implication for investors -> Demand for communication services is expected to remain very stable, and even in a downside case it would only experience temporary pressures. The upsides from digital innovation on 5G platforms will be there in all scenarios, and MNOs who have the right strategies would still be able to capture at least a portion of the upside. This means that investing in the right assets would imply a stable baseline cashflow with a somewhat predictable upside. Put together, all scenarios should yield IRRs that satisfy Private Capital’s criteria for deploying capital if they invest in the right Companies. ?

?[3] The strategic playbook: How can MNOs capture the opportunities and mitigate the risks ahead?

?A critical question is how can MNOs select the right strategies to capture the upsides while still having a profitable management of the baseline. Below I indicate a few selected examples on how an MNO can act:

• Innovation through strong Organisational set-up: having modular, flexible and automated IT backbone alongside an agile organisation would allow to set up tactical command business units that could very quickly create new products and services, test the product-market fit and launch new business lines. This would enable to test where an MNO can compete with advantage and then easily and quickly scale up on the right opportunities
• Playing the upside digital market on structural advantages. MNOs may be able to leverage on certain aspects of their core business that could be beneficial on new business. Examples include a strong brand, a substantial subscriber base, a developed distribution and retail footprint, robust territory technical operations, and others...
• The Capital Asset Business Matching model: MNOs could drive disruption by further value chain separation. A first step has been Towers carve-out, but given that lines will get blurred by the advent of SDN, openRAN and 5G platforms there may be an opportunity to separate network assets from the front-end business and operations. In this case infrastructure companies could absorb the assets with the anchor tenants retaining strong quasi-ownership status through contracts. On the other end separating the consumer from the enterprise business may provide the correct matching between capital and incentives, further strengthening both business lines
• Investing in software defined infrastructure. MNOs can start preparing themselves for the future networks, and by having the right assets in place and operations they could capture upcoming opportunities of capital investing in digital infrastructure
• Playing the convergence game on the back of an asset light strategy. Continuing on the Fixed Mobile Convergence trend, MNOs can play in fixed market with an asset light approach benefiting from the strong capital being deployed in Alt-Nets as well as established fixed network players
• Communications for the underserved. Using the strength of the mobile networks to target the B2B periphery by providing communication solutions as well as digital products
• Ride the ESG wave on the back of strong positive externalities generated by mobile networks that enable and empower digitalisation

?Implication for investors -> There are several strategic moves that MNOs can chose from, which must be optimal in the macro context and their own capabilities. When considering buying an MNO investors must assess what is the optimal way forward and what needs to happen for that to materialize (investment, time and efforts)

?[4] The capital playbook: How should investors approach the capital allocation process and where/how/on-what to invest?

?Investors considering deploying capital in Mobile Network Operators should have specific considerations alongside the typical investment process. Because the investment thesis is new and disruptive extra care, deep expertise and diligence are necessary to test and validate all the hypotheses. Below are some key considerations for investors to build such a robust investment process:

?A - What is the investment thesis? Which angle are you going to play?

Considering all the macro, structural and specific factors discussed in this article investors must come up with a consistent and cohesive investment thesis. Some key questions they must answer are:

• How does the market and geography fit into the macro cycles? In which stage of the industry cycle is the specific market being considered?
• How do you assess the baseline mobile business in such a context?
• What are the market possibilities to execute on the upsides? (Is the market an innovation hub? Does it require to import technology and innovation? Does it have the required in-situ skills for organic tech development? What’s the digital ecosystem look like?)
• What is the regulatory regime? Will it constraint or enable certain strategic plays? (e.g. how will the rules on spectrum usage permit certain types of network carve-outs?)
• How do you assess the market structure and the investment flows? And how will this impact capital allocation and exit strategies (the M&A play)?

?B - What key dimensions should investors assess in target companies?

Beyond the typical due diligence process, special emphasis must be taken on the following key elements:

• How far has the MNO gone in their IT transformation journey? Do they have a leading tech backbone that enables business dynamism?
• How agile is their Organisation? What’s the set up to tackle the digital future on the core business and on the upside opportunities?
• What’s their network technology investment maturity? Are they a leading, standard or legacy player? (e.g. are they considering or deploying openRAN, cloud base band units, SDN, etc.?)
• What’s their core mobile business positioning? How do they play in B2C, B2B and WH?
• What are their network assets and network strategy? What’s their mix of IRU, rent, own across the different network domains from RAN to Core?
• How strong is their HR capital in key departments?

Being behind on some or all of the above elements may present the opportunity to accelerate the transformation path, while being a leading company presents the benefit of a strong momentum to go after the upsides. For investors it’s all a matter of what’s the investment play and how is the timing aligned with the macro context (is there enough time to transform the company and don’t lose key upside opportunities?)

?C - Finally, what is the plan moving forward?

Given that the proposed approach is to harvest upside opportunities on the backbone of a strong cash flow generating business, a key consideration is what will the company’s play be in the upcoming 5 to 10 years?

• Given their stage of transformation and the chosen strategic play: what transformations remain to have all the necessary foundations to have a solid baseline?
• And what transformation programs are needed to tackle the upside opportunities?
• What is the investment needed for these transformations to materialize? (in terms of cash, time and effort)
• What would be the risk management strategy and the continuous strategic adjustment (the feedback loop)?

?Implication for investors -> Developing a comprehensive capital playbook for investing in MNOs requires to articulate three key dimensions: understanding the specific macro cyclical context, expert assessment of the key company’s characteristics and the need to build a coherent strategic plan to go after the upsides. By putting all these elements together an investor can have a leading edge in investing in Mobile Network Operators

MF.