30 lines
10 KiB
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30 lines
10 KiB
Plaintext
The smartphone wars: There’s dross in them thar hills!
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<p>Ken Burnside emailed me an interesting tip about a boring financial fact that I think is absolutely fundamental to understanding the smartphone wars. Turns out there’s no gold in them thar hills; the return on investment of wireless networks is <em>negative</em>.</p>
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<p><span id="more-2839"></span></p>
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<p>Exhibit A for this proposition is a ZDnet article titled <a href="http://www.zdnet.com/blog/btl/broadband-networks-returns-on-invested-capital-stink/43040">Broadband networks: Returns on invested capital stink</a>. They cite a research note indicating that the ROIC (return on invested capital) in wireless broadband is 0.3% over the last decade. That’s not a year-over-year average, it’s the ROIC for the <em>entire ten years</em>.</p>
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<p>Sounds pretty bad, yes? Wait. It gets worse. Ken also points out, quite correctly, something the article’s authors missed. The annualized inflation rate from 2000 to 2010 – including the mini-deflationary cycle from 2008 to 2010 that we’re just now exiting – has been about 0.5% per year. So the inflation-adjusted returns to the carriers have been <em>negative</em>.</p>
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<p>This is a more robust result than it looks like. Inflation of 0.5% compounded over 10 years is about 1.6%; this means for constant-dollar carrier returns to the carriers to be positive, the ROIC figures would have to be low by a minimum factor of over 5. Another way to look at this is that the carriers have been losing money to the tune of about 1% of ROIC, but with the losses largely masked by inflation. </p>
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<p>Yes, I realize the ZDNet article doesn’t say whether the 0.3% was adjusted for inflation; it might have been. But an optimistic assumption about that turns out not to get the carriers out of their hole; the ZDNet authors argue real returns have been negative, though they don’t say by how much, because of huge and botched acquisitions. So the losses may not mount as high as 1%, but there doesn’t seem to be any way to slice the numbers that doesn’t indicate at least slightly negative ROIC.</p>
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<p>This has a number of fascinating implications.</p>
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<p>First: Markets are working. Despite the carriers’ oligopolistic behavior and obnoxious customer-control tactics, wireless users have captured almost all the gains from the infrastructure buildout.</p>
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<p>Second: The carriers have a pretty convincing case for resisting further regulatory takings (including “net neutrality” rules) even given that their FCC licenses make them creatures of government fiat. There simply aren’t any “excess profits” to be taxed or socialized away.</p>
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<p>Third: Google’s strategic direction looks smarter every day. They’ve put themselves in a position where they profit from the buildout without having to eat negative returns. Same goes for Apple, but Google’s advertising profits will probably scale better with network usage volume than Apple’s hardware sales.</p>
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<p>Fourth: The carriers have to be playing a long game, hoping they can amortize their buildout costs and move into net profitability before something disruptive happens. </p>
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<p>Fifth: The carriers are <em>desperate</em> to cut costs and drive up margins. But not symmetrically; they’ll tend to favor cost-cutting, because the causal link to better ROIC is both more direct and easier to demonstrate to investors.</p>
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<p>To understand that last point, you have to understand how net-present-value accounting works. When firms do their capital-allocation planning they apply a discount to future profits because money has time value – that is, having money now is better than having money later. Below a threshold positive ROIC it’s better to keep your capital in your pocket. If your ROIC is negative it’s <em>much</em> better.</p>
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<p>Taken together, all these do a good job of explaining some otherwise puzzling features of the smartphone wars.</p>
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<p>The big one is why the carriers have fallen into Android’s honey trap. They’ve traded cost-cutting in present time (by the amount of <a href="http://en.wikipedia.org/wiki/Non-recurring_engineering">NRE</a> they no longer have to use on in-house software development) for future loss of control over their customer base. If their ROIC were positive enough, this would be crazy. But now we have good reason to think it’s slightly negative – and if you’re underwater and using net present-value accounting, it’s difficult to construct a scenario in which foregone future profits matter more than cutting costs to get into profitability now.</p>
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<p>For exactly the same reason, Windows Phone 7 is a no-hoper. Windows licensing fees are not just like NRE, they’re actually worse because they’re a recurring expense that will come right out of per-unit margin on sales <em>and</em> bring with it all the strategic problems of losing control of your software layer. It would take seriously bad drugs to get a carrier CEO to buy that combination.</p>
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<p>I’ve predicted before that carrier skinning of Android wouldn’t last long as a business tactic, and indeed it seems to have been in decline since T-Mobile shipped the unskinned G-2 in October. Giving it up is a similar trade; reduced software-development costs now for loss of customer control later. What I didn’t get was how brutal the cost-reduction pressure on the carriers is. Even in a positive-ROIC situation, it’s likely that carrier skinning would fail the net-present-value test as consumers caught wise to how much it sucks. Since carrier ROIC is actually <em>negative</em>, the relative value of unexpended capital goes way up and there’s basically no hope that the NRE spent on carrier skinning pays off. The only thing sustaining it has been mental habit and irrational territoriality.</p>
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<p>(OK, you in the back there waving your hand frantically. Yes, I know about deals like the NASCAR/Sprint tieup. NASCAR pays Sprint to skin phones as a marketing move. Yeah, you’re right, this is a different business case from carrier skinning. The problem is that NASCAR has to pay Sprint’s <em>entire</em> NRE for the NASCAR skin or the deal is worth less than nothing to Sprint. In fact, it’s worse than that because NASCAR also has to pay Sprint for taking a time-to-market hit and afterwards being stuck with a down-version build of Android that Google is teaching consumers not to want. Those costs pile up fast, so tie-ups like this don’t have a bright future. We might already have seen the last one.)</p>
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<p>It’s also easy to see why carrier marketing is pushing the smartphone transition so hard – they’re chasing sales of higher-pricepoint, higher-margin handsets. They’d do this anyway, but the negative ROIC on their buildout makes it panic-urgent. Android exploits this urgency; if the carriers had enough positive return, capital spent on in-house development of their own smartphone OSes or Windows Phone 7 licensing fees might still pass the net-present-value test. </p>
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<p>The most interesting question though, is what’s going to happen and how much blood is going to be spilled when investors figure out out just how utterly hosed the cell carriers are. Negative ROIC right now plus Google successfully commoditizing their future equals get the hell out while you still haven’t lost your shirt. Where are the carriers’ profit margins going to come from a decade hence?</p>
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<p>I think it’s actually time to ask a more radical question: will the carrier oligopoly still exist in ten years? And I’m inclined to think the answer is no.</p>
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<p>To see why, let’s start from the ZDnet analysis. They think carrier ROIC is negative because the carriers have been wasting crap-tons of money on stupid acquisition deals. Empirically it’s hard to argue that the acquisitions haven’t been stupid, but there are deeper questions here. Like: <em>why</em> are these acquisition deals stupid? And: Is that stupidity essential, entailed, or is it plausible to imagine a history in which the carriers played smarter and kept their ROIC positive?</p>
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<p>To answer these questions we need to go back to the basic Coasian theory of the firm, in which corporate scale is driven by the difference in communications and transaction costs between the interior of the firm and the exterior; the higher that difference, the more internal diseconomy of scale you can tolerate and still win. Now consider a business environment in which that difference is steadily dropping (because faster, cheaper communication is lowering overall transaction costs). The optimal competitive size of firms drops with it. </p>
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<p>So, why are the carriers huge? Because large capital concentrations both demand and reward heavyweight management structures. During something like a huge infrastructure buildout, you need capital concentration and the smart move is to merge your lump of capital with as many other lumps as you can as fast as you can, because the biggest lump is likeliest to win the infrastructure race. Thus the big stupid M&A deals – strategy sound, execution poor.</p>
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<p>But what happens when the buildout is done? You’re stuck with the diseconomies of scale from bigness, but your massive lump of capital isn’t so much help any more. This is exactly the situation the cell carriers are in.</p>
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<p>I hear you boggling. “Huh?” you say, “There’s lots of the U.S. and the world where the cell coverage sucks.” That’s right; it’s because there isn’t enough expected volume and return from extending coverage to justify the capital cost. For years now the carriers have only been extending their networks to avoid losing market share against each other, not to increase overall coverage. From the financial-minimax point of view, the cell buildout is <em>done</em>. We won’t see dramatic coverage improvements before a technological break that dramatically lowers cost per square mile covered.</p>
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<p>But while this is going on, communication/transaction costs are still dropping, so the diseconomies and penalties of being large enough for the buildout phase are still rising. </p>
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<p>My conclusion: eventually, investors will bail and the carrier oligopoly is going to disintegrate. And I mean dis-integrate – lose the vertical and horizontal cohesion it now has. Maybe Google will buy the towers up cheap at the going-out-of-business sale.</p>
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