McKinsey & Company Mobile Telecommunications Extranet 1

Strategic Perspectives on Mobile Telecommunications: Industry Evolution and Implications

By Francis Deprez, Bernhard Schmidt, Stefan Schmitgen, and Pal Erik Sjatil

After experiencing a decade of stunning growth and profits, the mobile industry has reached an inflection point. Will it see a better-than-expected future, or will it descend into massive value destruction?

The worldwide mobile industry came of age in the decade between 1993 and 2003. Revenues grew by 30 percent each year, subscriptions increased by 44 percent annually, and stock performance – although a wild ride – consistently outperformed the broader market. The mobile industry currently represents more than 40 percent of the total telecom market and is expected to reach 50 percent within three years. Moreover, significant parts of the industry have (in a sense) reached a path of profitable growth, with 2003 global industry EBITDA (earnings before interest, taxes, depreciation, and amortization) margins averaging nearly 40 percent, while capital expenditures as a percent of sales have remained at a manageable 16 percent.

Today, the industry is poised at an inflection point, from which it can either continue to experience enviable profitable growth, or witness extreme levels of value destruction. Industry observers and market analysts today still maintain quite positive outlooks for the mobile market, with subscriber growth forecast to increase by 10 percent annually through 2007, in line with revenue growth projections of 11 percent during the same period. However, it appears that there are numerous clouds on the mobile horizon, which make the future a lot more uncertain than typically anticipated. The structural trends can be categorized in the following terms:

¶ Customer behavior: As existing customers become more sophisticated, their needs begin to diverge, requiring operators to abandon their one-size-fits-all approaches and increasingly differentiate their offerings. The anticipated adoption of non network-based services – mainly focused on mobile data but also on voice (e.g., VoWLAN) – could challenge current customer relationships. Finally, accommodating the "next billion" mobile users could prove to be more challenging than the first billion – the next billion being made up of more customers in emerging markets, who have very different income levels at their disposal.

¶ Technology: The diffusion of alternative wireless access technologies (e.g., WiFi, WiMAX, Flarion, etc.) will challenge the straightforward 2/2.5/3G roadmap. This, combined with the emergence of multi-modal devices and the decoupling of the network and service deployment layers, could make it a lot more difficult for existing operators to fill their networks, keep the customer interface, and to avoid price wars.

McKinsey & Company Mobile Telecommunications Extranet 2

¶ Industry dynamics: A wider range of non-mobile players with disruptive Internet-like business models seem ready to enter the market, and could become attractive substitutes for current mobile customers. Accelerating innovation and product development cycles, coupled with shifts in R&D investment to non-traditional players, could swing industry momentum away from current operators, and challenge the status quo even more.

¶ Regulatory environment: The expected technology neutrality of regulators, with the spectrum being maintained as a scarce resource, could lead to more permissive, more competition-oriented regulation that, again, would negatively impact current players.

These challenges represent substantial threats to mobile operators, exposing industry vulnerabilities in the customer, service, and technology areas and highlight the fact that regulators will most likely do little but enhance competitive dynamics. In order to better understand the upside possibilities and downside threats in the mobile industry, McKinsey & Company's Mobile Telecommunications Practice has developed a perspective that seeks to provide both a "ceiling" and a "floor" for the industry's potential future. This scenario-driven analysis uses the current state of the industry as its starting point and then provides the elements that could make either scenario a reality.

Worst Case Value Destruction

In the worst case scenario, mobile operators would face strong competition and consolidation in a commoditized industry. The realities of such an environment would likely cause operators to:

1. Compete away the mobility price premium for voice service in the event that fixed players partner with third parties in order to roll out fixed wireless and capture indoor calls through VoWLAN. Furthermore, mobile voice pricing could decrease anyway, as signs are emerging that operators around the world are increasingly introducing heavily discounted and flat-rate pricing schemes.

2. Fail in attracting the "next billion" users in the developing countries, if handset vendors continue to focus on high-end devices and decide to not market low-cost products.

3. Lose control of the customer relationship and identity if, for example, other parties from the fixed sector leverage their technology in order to provide the authentication, authorization, and accounting (AAA) systems necessary in offering mobile data services.

4. Be unable to drive data uptake, if content players fail to team up and instead, launch their own services for security reasons (e.g., digital rights management).

5. Generate limited margins for wireless data service, if customers pay only low fixed rates for data services in a fixed/Internet paradigm (such as those introduced in Japan within the last year).

McKinsey & Company Mobile Telecommunications Extranet 3

6. Be restricted in terms of capacity and technology because they face unfavorable spectrum and/or licensing policies.

Mobile revenues would face significant pressure if non-mobile players were to take over sizeable portions of the voice business. For example, in a theoretical case, while revenues in Europe could decline by 41 percent if prices drop to fixed levels, they would decline even more by an estimated 67 percent were a disruptive technology such as VoWLAN to be introduced across the board, thus allowing non-mobile players to commandeer a significant portion of the market. The further revenue reduction would result from the additional price decreases created by the switch to VoWLAN, which could potentially represent up to 60 percent of voice calls.

Revenues would remain flat over the next four years in a worst case scenario (Exhibit 1), instead of increasing by more than 10 percent annually under current forecasts. Such a development would lead to huge value destruction in the mobile industry. The key assumptions behind this value-destroying scenario are not far fetched. For example, if developing-markets subscriber growth averages just 7 percent per year instead of 17 percent through 2007, there would be 30 percent fewer new subscribers in these countries. Such a decline could be driven by a lack of low-cost handsets and infrastructure. Strong competition or regulator intervention could lead to voice ARPU declines of approximately 35 percent instead of the 10 percent currently forecast for the developed markets. Instead of doubling – as is currently anticipated – the ARPU generated by data and value-added services (VAS) could decline by 20 percent as data is commoditized.

Ultimately, EBITDA margins would decline by six to eight percentage points and the industry could forfeit up to USD 200 billion in value. In such a scenario, the winners would include: consumers, who would pay lower prices; mobile virtual network operators and service providers with low-priced offerings; new wireless players, who would acquire parts of the traffic; and Internet players, who would capture the value of VAS.

McKinsey & Company Mobile Telecommunications Extranet 4

Exhibit 1:

BVA-ZZU387- 20040614-he-v613

In a "worst case" revenue growth could be driven down to zero for the next four years ...

* Still conserv ative: Mobile prices decreas ed by ~50% in 6 months in Denmark after Telmor e market entry** 2003 ARP U*** Consider ing d isruption in Western Eur ope, North Amer ica and Asia Pacific (sca led- up bas ed on WE and US)

Source: Gartner, Ovum, IDC, McKinsey analysis

WORLDWIDE ESTIMATES

Mobile rev enue 2003

Growth in data ARPU

Decline in v oice ARPU

Growth in mobile sub-scribers**

Mobile rev enue 2007

Growth in VAS ARPU

644274479

229423

144 42114142314

Current forecasts

"Worst case"

NOT ...

BUT ...

USD ~ 200 billion at risk –zero growth for

the next four years in a pessimistic

"worst case" scenario

• Growth in subscribers till 2007 slows down f rom 17% to 7% in dev eloping markets

• Voice ARPU decline 35% instead of 10% in dev eloped markets vs. 2003*

• Much slower data/VAS uptake com-bined with decrease in pricing (SMS, f lat data fees)

USD billions -revenues

Disruptiv e VoWLAN/ WiMAX uptakeafter 2007 could leadto rev enues <USD 300 bn***

"Favorable Future" Possibilities

Because the worst case scenario is certainly within the realm of possibility, mobile operators must act now in order to avoid this outcome, and thus reach a more favorable future. The key is to effectively resist commoditization by delivering a distinctive mobile value proposition to customers. A more optimistic view on the future mobile industry would require a shift in this direction. For example, mobile operators would offer high-quality access that allows for ubiquitous, spontaneous personalized communication. A large network of companies would also deliver compelling data services and third-party content via standardized open platforms. Operators would offer a trusted, easy-to-use environment (e.g., spam and virus protection) and ensure efficient and secure control of identity data, as well as be able to apply workable charging mechanisms (e.g., active usage payments in the "data world"). In order to succeed, operators must establish stronger relationships with their approximately two billion customers worldwide. They must work to maintain realistic mobility price premiums in a seamless, multi-access world and seek to benefit from heavy demand for data services and the VAS being delivered by mobile players.

McKinsey & Company Mobile Telecommunications Extranet 5

Exhibit 2:

BVA-ZZU387- 20040614-he-v616

Mobile operators who react now could create a significant upside for the industry

* Compar ed to 2007 "as is" modelSource: McKinsey

Main assumptions*

• 25% higher penetration in developing countries leads to 2.3 billion subscribers instead of expected 1.9 billion

• Voice revenues captured by mobile players ~ 30% higher in developed countries than expected assuming strong f ixed to mobile substitution (at price ratio of 2:1) and the reselling of f ixed minutes

• In developing countries voice ARPU is 15% higher than base case 2007 through stronger deployment of mobile infrastructure rather than f ixed

• Data/VAS ARPU is 80% higher than expected for 2007 (275% vs. 100% growth); mobile operators control the entire value chain

• EBITDA margin 4-6 perc. points higher

Continue "as is"

~ 1,150

"Worst case"

~ 750

+50%~ 1,725

"Favorable future"

USD billions - market value

Success could create a significant upside for the industry, potentially boosting total market value by 50 percent from current projections for 2007 (Exhibit 2). The favorable future scenario would generate EBITDA margins 4 to 6 percent higher than those currently anticipated for 2007. Appropriately designed services and handsets should generate 25 percent higher penetration in developing countries, producing 2.3 billion subscribers instead of the expected 1.9 billion. Mobile players should also be able to capture additional voice revenues, which could be roughly 30 percent higher than expected in developed countries, assuming strong fixed-to-mobile substitution and the reselling of fixed minutes. A focus on deploying a more robust mobile infrastructure, which more fully overtakes fixed services in developing countries, would generate voice ARPU that are 15 percent higher than in the base case 2007. In the favorable future scenario, data and VAS ARPU would be 80 percent higher than that currently expected for 2007, with mobile operators controlling the entire value chain.

Forging a Favorable Future

Achieving the favorable future scenario (or at least preventing the worst case scenario from happening) will require both individual company effort and industry-wide action. Mobile operators must defend their businesses from the worst case scenario, while proactively shaping the factors that will enable them to outperform the current outlook regarding the industry's future.

Avoiding the worst case scenario will require a focus on cost containment (e.g., streamlining the organization and implementing lean operations), including strategies for maximizing economies of scale (e.g., consolidation and the establishment of profitable reselling partnerships). It will also compel the industry to develop attractive network products (e.g., integrated messaging service) and to evaluate the cost advantages of

McKinsey & Company Mobile Telecommunications Extranet 6

migrating to next-generation IP networks. In other words, companies should prepare for "hard times" by optimizing their operating processes, increasing scale, and by seeking new network options.

At the same time, achieving the favorable future scenario will mean that firms must leverage customer ownership with an eye toward increasing their "share of wallet", which will require operators to strengthen their customer franchises. Such efforts involve building brand equity and instituting superior customer life cycle management and quality of service processes. Operators must also improve their retail distribution positions and strengthen service delivery to maintain customer satisfaction and loyalty. They must continually innovate in order to offer attractive customer-driven services and (ultimately) embrace new wireless technologies to enable leveraging of the most cost-efficient mix of access networks.

How can a company achieve such objectives? The key enablers of the favorable future scenario require operators to (Exhibit 3):

¶ Manage the customer identity by, for example, leveraging AAA capabilities and SIM in order to create a trusted environment

¶ Establish the precondition for services-based charging principles (e.g., what will be the "active party pays" equivalent in the IP/data world?)

¶ Create open standards for service deployment and guarantee interoperability

¶ Manage seamless access to embrace the most efficient technologies, including roaming and multi-modal handsets.

Exhibit 3:

BVA-ZZU387- 20040614-he-v623

The key enablers for a "favorable future"

Source: McKinsey

Key enablers• Manage customer identity –

leverage AAA capabilities/SIM and create trusted environment

• Create prerequisites for services based charging principles (active party pays in IP/data world)

• Create open standards for service deployment and guarantee interoperability

• Manage seamless accessto embrace the most eff icient technologies, including roaming and mult i-modal handsets

• Customer identity • Charging principles

What can mobile operators

really achieve individually?

Player-specif ic services/applications

OS – neutral service deployment platform

Seamless access integration

GSM GPRS UMTS WiFi?

WiMAX? …

. . .

McKinsey & Company Mobile Telecommunications Extranet 7

There are two ways in which these key enablers can be put into play. One is that companies can simply elect to allow the needed changes to take place around them organically. For example, vendors will set standards for service delivery platforms, Internet players will set standards for access technologies, and SIM card manufacturers will establish identity standards together with players from other sectors. However, allowing other parties to set de facto industry norms will probably cause mobile operators to lose control of critical elements in the mobile value chain.

The other – and preferred – method would be for the players to proactively shape the industry to their advantage. Very large players may attempt to drive standardization by themselves, in the same way that Microsoft did in the personal computer industry. But even large mobile operators may not have the wherewithal to pull off such a strategy. Perhaps a more reasonable approach would be for multiple operators to participate in strong mobile alliances. But even in this case, mobile players must realize that there are key competitors outside of the industry that could blunt the impact of such pacts. Firms can attempt to collectively drive standards via industry bodies and associations, which may be the only option for achieving success in some cases.

The mobile industry will face significant challenges in the coming decade. The "golden" days of full-throttle growth and profitability appear to have passed, as new players utilizing innovative technologies enter the market. Operators must act now to ensure that they are protected from worst case possibilities as well as positioned to take advantage of what could be a very favorable future.

About the authors:

Francis Deprez is a Principal in McKinsey's Brussels office, Bernhard Schmidt is a Manager in McKinsey's Berlin office, Stefan Schmitgen is the European Mobile Telecommunications Practice leader and a Director in McKinsey's Frankfurt office, and Pal Erik Sjatil is a Principal in McKinsey's Oslo office.

Copyright © 2004 McKinsey & Company, Inc. All rights reserved.