Reality Check: Earnings spotlight on capital spending

Editor’s Note: Welcome to our weekly Reality Check column. We’ve gathered a group of visionaries and veterans in the mobile industry to give their insights into the marketplace.
Greetings from the 4th of July remote location(s) of this week’s Sunday Brief. (Note: if I was in Kansas City writing this, I would tout our status as mobile phone review capital of the U.S. Yes, Brian Maupin, creator of the now famous iPhone vs. EVO video, hails from the City of Fountains). We have a lot to be thankful for, and, while we may grouse about our government, remember – we could have our future inextricably tied to lower performing countries with a co-mingled currency. One day we will all look back on Britain’s decision to keep the Pound Sterling and not join the Euro as one of the soundest decisions of the 20th century. But I digress…
Last week, we looked at consumer data growth across three of the major carriers, and also examined the slowdown in the wireline enterprise and wholesale channels. Given the completion of the Verizon-Frontier transaction on July 1, we should be able to get more insights into the profitability of the remaining Verizon wireline unit on July 23rd when they announce earnings. Meanwhile, Verizon also released the Droid X for reviews this week to complement their Droid Incredible offerings and new reported strongly suggested an iPhone launch in January 2011. And Microsoft killed the Kin, an overpriced device with an outdated operating system. Then on Friday, as most of us were headed off to a long holiday weekend, Apple admitted what we all knew – there really weren’t as many bars in as many places as they thought, and that we would need to rethink the possible wireless signal strength (so much for the argument that the Gizmodo leak negatively affected Apple iPhone 4 sales). Interestingly, Apple neglected to tell us when those bars were going to start telling us the truth. Finally, Verizon (with “Wireless” dropped) introduced a new motto “Rule The Air” with some fairly aggressive ads (one which talks about how you hold your phone).
But those are all fleeting events of the week. We need to continue with the key drivers of sustained earnings. Capital is the lifeblood of telecom. Networks need to be renewed, and, while Chinese equipment manufacturers are ensuring that telecom equipment will go through a deflationary cycle, network cost curves are fairly well established for the industry. Capital, and to a lesser extent access costs from the cell site to the backbone, control the shape of the network cost curve. Where one sits in the spectrum band drives both the concentration of capital (more or less cell sites) as well as signal consistency. We are moving away from constant connectivity (where loss of the circuit results in loss of the call) to “as needed” connectivity (where packet economics, largely driven by simultaneous utilization, drive utilization efficiency).
AT&T, adjusting for the accrual of taxes for health care overhaul, is at a pretty steady $41-42 billion in earnings before interest, taxes and depreciation for the last five quarters. Their interest expense is steady to slightly declining, although, as we have mentioned in the column many times, the lack of debt among the “Four Horsemen” frees up the $3.2-3.4 billion in annual interest expense for other development or increased earnings (@ $80 per hour, this would equate to over 40 million hours of software development or 20,000 full time programmers for a year).
AT&T also pays out about a quarter (23.7% in Q1 2010) of their earnings as dividends. The big use of their cash, however, is capital. As Randall Stevenson, CEO of AT&T, put it to CNBC, “We invest more in our networks than any other company in American business.” AT&T spends about $50 million on capital every calendar day. Even so, not enough can be done to cure data ills, calls are still being dropped, and U-Verse is not quickly overtaking their cable competition.
In a previous column, I estimated the increased costs to upgrade 70-75% of their in-region towers with fiber, as well as the costs to bring their out-of-region access costs up to the next bandwidth level (if DS3 speeds, the costs to bring to GigE). Out of region costs were in the $200-300 million per year range, and capital costs to upgrade their in-region towers totaled about $9 billion. This is incremental spending to current levels.
Now that we have set the framework for AT&T, let’s look at Verizon. As we have discussed in this column several times, Verizon has a stronger commitment to capital spending than any other U.S. wireless company. In fact, for a company with nearly $10 billion less in annualized EBITDA, it’s amazing that they can afford to keep up with nearly equal capital spending to AT&T.
Over half of their free cash flow is consistently going back into capital. That’s commitment. However, interest expense is rising, and dividend pressure is also growing (particularly from Vodafone). Verizon and AT&T are capital machines, together turning out ~$100 million in capital spending on telecommunications infrastructure every day.
Examining capital is important for four reasons:
1. Growth will increasingly have to come from internal/ organic investments as opposed to acquisitions. Historically, Verizon and AT&T have had a mediocre track record of making wise internal capital decisions. The expectations that each capital decision will be a winner is growing.
2. The pressure to pay more dividends, combined with lower capital unit costs driven by the next generation equipment suppliers, will likely drive lower capital spending levels for the next 3-5 years. The carriers (including Time Warner Cable, Comcast, Sprint, and T-Mobile) face a highly deflationary environment in data (see next section). Today, data as a product is fueling EBITDA growth, but as applications grow, so will traffic. Reducing the cost per megabyte is the most important challenge facing the wireless community today and tomorrow.
3. The regulators will attempt to create a “consumer call option” (pardon the pun) on any new investment. This is the most troubling trend – that the Federal Communications Commission and state regulators, in the name of consumer fairness, choose to regulate returns in one part of the market (call this the successful business case) while providing no relief for other areas that may have dragged down overall carrier performance. This caps the upside of the most successful products, and reduces overall returns. The opportunities presented through bit prioritization of both wired and wireless bandwidth are enormous. Technically, Multi-Protocol Label Switching (MPLS) is formed on the basis that all traffic is not created equally. Any future capital deployments and upgrades have to be made on the assumption that there is net neutrality. At this point, there may be better options to enhance shareholder value than pumping more capital into the network.
4. An increasing portion of returns will be made from the applications layer as opposed to the network layer. This is not to say that the investments made will not achieve their business case objectives. However, the growth in handset processing power a
s well as applications sto
res has started to push on the capital spending assumptions made when 3G networks started to be deployed in 2005 (pre iPhone). Of the $100 million spent each day by AT&T and Verizon, only about 3% of that (~$1.1 billion annually) goes toward systems and applications. If this figure were doubled to $2-3 billion annually with the new investment going to VC-based and other start-ups, how might the picture change for telecom? How many new Skypes could be created for an extra $1 billion per year?
Capital drives networks. Wireless will increasingly drive future capital spending. Data will drive future spending within wireless. Can the carriers go the next step, and embrace application development that they do not fully control? Do they have a choice?
Welcome your comments and suggestions for future columns. Next week we’ll start our summer series on applications.
Jim Patterson is CEO & co-founder of Mobile Symmetry, a start-up created for carriers to solve the problems of an increasingly mobile-only society. He was most recently President – Wholesale Services for Sprint and has a career that spans over eighteen years in telecom and technology. He welcomes your comments at jim@mobilesymmetry.com.