TORONTO – The realities of the wireless market in Canada and globally continue to tell most people that no matter what the federal government tries or what anyone says, chances are slim that a fourth viable wireless player in Alberta, B.C. and Ontario will find success.
Add BMO Capital Markets telecom, cable and media analyst Tim Casey to the chorus of those who believe the federal government has muddled and mishandled the wireless file and that there doesn’t seem to be a way forward to its stated political goals. Noting that Industry Minister Christian Paradis has been on record several times saying he wants a fourth wireless player in every market and that he has said he “will not hesitate to use any and every tool at (the ministry’s) disposal to support greater competition in the market,” Casey assumes by that, the minister means Alberta, B.C. and Ontario, since there are four players in the other regions (except the far north).
Are there tools the minister can use? Can he create conditions that will prop up a fourth player in those three provinces? “We don’t like his chances,” wrote Casey in a note to investors today.
The big three incumbents of Rogers, Telus and Bell all have so much going for them beyond owning 90% of the Canadian wireless market; the stable, lucrative wireline businesses which enhance bundling capabilities chief among them. In fact, notes Casey, the fourth players in Saskatchewan (SaskTel), Manitoba (MTS), Quebec (Videotron), and the East (EastLink) all have wireline assets and bundling capabilities. The other “wobbly” newcomers, Wind, Mobilicity and Public Mobile, do not, and are suffering, as has been repeatedly documented.
“The financial shortcomings of the independents reveal another rock and a hard place for the Minister. Financial backers of the three new entrants made their investments with an exit strategy if commercial operations stalled: selling to the incumbents in five years. The Minister’s denial of the Telus-Mobilicity deal, and his opaque language regarding other sales of AWS spectrum to incumbents (Rogers/Shaw and Rogers/Videotron) may open up legal recourse,” writes Casey. “The government accepted investors’ capital on the way in, but may have changed the rules four years later. It isn’t exactly an ideal precedent to have hanging out there when you’re trying to attract a billion or two of capital, again, to finance the fourth player.”
The more natural fourth wireless player would have been Shaw Communications out west, but the company decided even though it spent about $300 million on spectrum and some initial network preparation that being a fourth place provider in a very high cost business was too risky. “Shaw is widely regarded as an astute allocator of capital. There’s information in their reluctance to pursue the wireless opportunity in spite of the (seemingly) natural fit,” said Casey’s report.
What the government needs to fulfill its vision is a white knight – and soon: “a large, well-capitalized, patient operator willing to consolidate the existing pure-play new entrants, purchase 700 MHz spectrum, build out a 4G LTE network AND sustain years of operating losses and negative free cash flow. We think the foregoing is easily a $2 billion ticket. Time is not on Mr. Paradis’ side. Initial down payments for the 700 MHz auction are due September 17 and the auction begins on January 14, 2014. Count us among the many sceptics surrounding press speculation that Verizon is interested is coming to the rescue. We think they’d buy Telus if allowed, not mop up the new entrants.”
Casey’s report presented a list of options available to the government, should it choose, a few which Casey (and others) will be deployed and most he finds unlikely.
FUNDING RELIEF
1. Introduce flexible payment options for upcoming spectrum auctions. In the AWS auction, bidders for “set aside” spectrum paid over $1.5 billion and upfront payments represent a significant financial burden for new entrants. Letting bidders spread the license payment out would help alleviate pure-play new entrants’ financial liquidity pressures and incentivize their participation in the upcoming spectrum auctions, writes Casey. “It would not surprise us to see the government introduce flexible payment options for the upcoming 700MHz (2014) and 2.5GHz (2015?) spectrum auctions… We think this has a high probability of implementation.”
2. Return 2008 AWS spectrum auction proceeds. Wind, Mobilicity and Public Mobile would get an immediate cash injection of $442 million, $243 million and $52 million, respectively and that move would significantly ease new entrants’ financial liquidity pressures and incentivize their participation in the upcoming auctions. However, given a federal government with financial needs and fiscal objectives and the difficulty in applying it only the pure-play new entrants in certain regions and not Quebecor, EastLink and Shaw, “we see virtually no chance of implementation,” says Casey.
3. Give away the 700MHz spectrum at the reserve prices or, alternatively, at no cost. The reserve price for paired 700MHz spectrum in Ontario, B.C. and Alberta are $79 million, $14 million and $12 million, respectively, for a combined total of $105 million, notes Casey’s report. It would be a big win for the pure-play new entrants and negative to incumbent stocks, but under this scenario, the government would likely want to first see just one consolidated entity in Wind/Mobilicity/Public as there are only four prime blocks of 700MHz spectrum. “We think it has a relatively low probability outcome,” he adds.
4. Inject capital directly in new players (like the German government has with Deutsche Telekom or Saskatchewan into SaskTel for that matter) or nationalize the newcomers into a Crown Corporation. Government support or a full bailout and purchase are rated by Casey as “extremely unlikely” and “virtually no chance”, respectively.
There are some operating conditions which Industry Canada could impose on the wireless business in Canada to try and make sure a fourth player succeeds, such as:
1. Introducing forced network sharing or mandated, artificially low roaming rates to provide pure-play new entrants with a significant operating cost advantage and an opportunity to grow market share through relatively lower prices. “However, if implemented, we expect the incumbent carriers would immediately slow network investment, which would ultimately lead to network congestion and higher prices,” says Casey. “It is hard to overstate the negative implications of slowing network investment given the tsunami of data consumption over the next five years… It seems unlikely that the government would pursue such an agenda of interventionist policies.”
2. Prohibit multi-branding or flanker brand marketing (forcing the chatr, Koodo, Virgin, and Fido brands out). New entrants have argued that the plethora of brands in the marketplace have created an illusion of competition and incumbent carriers have been highly effective at competing against the pure play new entrants with these flanker brands in the low-end prepaid segment of the market without cannibalizing their more lucrative, high-lifetime-value subscriber base in the postpaid segment, says the research. However, the legality of this measure is questionable under the purview of IC, unless it is tied to a condition of license.
3. Prohibit bundling of wireless services. Bundling multiple services means a “stickier” customer, higher revenue per customer, cost advantages from network effects, etc. “We believe this gives integrated wireless carriers (Rogers, Telus, BCE, MTS, SaskTel, Quebecor, EastLink) a key structural advantage over the pure-play wireless carriers (Wind, Mobilicity and Public Mobile) and wireline carriers in the business segment that lack a wireless service ( Allstream, Cogeco, Shaw),” says the report. However, these plans are very popular with consumers with most wireline carriers reporting triple-play penetration through 50%. “We see little chance the government would pursue this measure based on the complications of unwinding existing, entrenched business practices that are popular with consumers,” writes Casey.
4. Mandate tower asset divestitures. In Canada, wireless towers are largely owned by the incumbent carriers and have been highly strategic assets in protecting the oligopoly, says the report. New entrants decried the ineffective mandated tower sharing rules introduced with the 2008 spectrum auction and Industry Canada introduced tighter controls regarding tower regulation in 2012. In the U.S., tower assets are owned and leased to carriers by third-party operators like American Tower, Crown Castle and SBA Communications, who are incentivized to have more tenants than less. It is worth noting, says Casey, that most cell sites in urban areas are located on rooftops, so this measure would have limited implications in the most lucrative wireless regions. Moreover, unless it is outright expropriation, the incumbents would receive compensation for their assets in a divestiture (tower companies in the U.S. trade at ~18x EBITDA). “We view this as a low probability and modest negative event for incumbents.”
So, to review, it’s a $2 billion bet (consolidation + spectrum + network) plus years of operating losses, to be the fourth player in a four player market in Ontario, Alberta and B.C.
“In short, our analysis suggests this is not a compelling investment opportunity,” says Casey’s report. “It implies a $2 billion investment for a notional $400 million EBITDA profile in, say 2020. Free cash flow would be half that given ongoing capex requirements (at 15% of revenues, minimum) and financial charges.” (Ed note: So why, then, would a company the size of Verizon, or any other large, established foreign brand, want to spend that kind of time, effort and money when it is already earning over $60 billion in revenue and $30 billion in annual EBITDA, is what most are asking.)
“Given the government’s willingness to change the rules of engagement so far, one wonders what an appropriate (internal rate of return) would be for a new entrant. Based on our analysis, assuming most of the $2 billion goes out in years one through three, and notionally $200 million in free cash flow comes back in year six, we still get a negative IRR. And this is a scenario that we describe as optimistic. In conclusion, and as we inferred at the start of this report, we don’t like the odds of turning a sow’s ear into a silk purse.”
