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Winning in Wireless
Winning in Wireless
Winning in Wireless
Winning
in wireless
Scott Arnold • Byron G. Auguste
Mark Knickrehm • Paul J. Roche
T
HE ONCE COZY US
comfortable by the day. New players are entering the market, capacity
is expanding at a breakneck pace, and prices are set to tumble. Most
players take comfort in the belief that demand will rise as prices fall, but
not everyone is likely to achieve enough growth to oƒfset plummeting prices.
As growth stalls and revenue per user declines, profits will become
increasingly elusive.
* The wireless industry includes both analog and digital cellular telephony and the newer digital
personal communication services (PCS).
We would like to thank Maisie O’Flanagan for her contribution to this article.
Scott Arnold is a principal and Paul Roche is a consultant in McKinsey’s Silicon Valley oƒfice;
Byron Auguste is a consultant and Mark Knickrehm, executive vice-president and CFO at the
wireless messaging vendor Paging Network, is a former principal in the Los Angeles oƒfice.
Copyright © 1998 McKinsey & Company. All rights reserved.
Many executives are only now recognizing the magnitude of the change
facing their industry. Our analysis suggests that net earnings for some players
could shrink to between 25 and 30 percent of revenue over the next three to
four years – a far cry from forecasts of nearly 45 percent by industry players
and Wall Street analysts as recently as last Fall. Large incumbents such as
AT&T Wireless, Bell Atlantic NYNEX Mobile, and AirTouch Cellular will
need to make radical changes if they are to succeed in the new environment.
New attackers entering the wireless market in the wake of the recent
bandwidth auctions pose a threat to which incumbents must respond swiƒtly,
while there is still time. They will have to improve their operations and
restructure their business systems to remain profitable as prices fall. They
will have to adopt managerial and leadership approaches appropriate
to the new competitive environment. And they will have to introduce inno-
vative products and services to make their oƒferings stand out to the most
attractive customers.
The game in those days was to increase demand for wireless by expanding
from segments where mobility was a necessity to segments where it was a
luxury. As Exhibit 1 demonstrates, the strategy succeeded: penetration rates
increased from 6 percent of the US population in 1993 to 18 percent in 1997,
although both minutes of use and average revenue per user declined during
this time (Exhibit 2). What made the economics work were higher prices for
lower-usage segments and increased operational eƒficiencies that more than
Exhibit 1
1991 1992 1993 1994 1995 1996 1997 1991 1992 1993 1994 1995 1996 1997 1991 1992 1993 1994 1995 1996 1997
Source: CTIA; Strategis; McKinsey analysis
The good old days came to an end when the Federal Communications
Commission, the US telecommunications licensing authority, began
auctioning wireless spectrum in 1994. These auctions, which continued until
1996, enabled new entrants – whether established telephony players such as
Sprint or competitors new to the industry such as Omnipoint – to join the
market. Wireless incumbents such as AT&T, AirTouch, and Bell Atlantic
Nynex Mobile also purchased spectrum, and became attackers in regions
where they had not previously competed. And Nextel’s national digital
network upgrade to high-quality wireless telephony created another
competitor for attractive business segments.
These auctions have had the eƒfect of increasing the number of players in
some regional markets (such as Los Angeles) to five. Other new entrants,
successful bidders for the three new blocks of spectrum auctioned oƒf early in
1997, are waiting in the wings.
In addition, new digital technologies now being adopted use spectrum three
to six times more eƒficiently than analog networks, allowing more customers
to fit into a given spectrum block. They include GSM (global system for
mobile communications), the dominant digital technology in Europe; CDMA
(code division multiple access), the dominant digital technology in the United
States; and TDMA (time division multiple access), an alternative digital
standard. All PCS (personal communication services) networks use digital
technology, and most cellular incumbents in urban areas are upgrading their
networks to digital, expanding their capacity as they migrate subscribers from
the analog network.
Exhibit 3
Thanks to the new spectrum and
Prices must fall…
new digital technologies, most urban
Cents per minute, estimated
markets will experience an eƒfective
60
wireless capacity increase of 10 or 12
50 Price times 1996 capacity by the end of
40 1999. This capacity explosion will far
30
outstrip the increase in demand in
the next two to three years. This can
20
Fully loaded incremental cost*
mean only one thing: prices will fall.
10
Marginal cost†
Look out below
0
1993 1994 1995 1996 1997
For the past two years, the price per
* Average per minute cost to operate network, including
depreciation of required capital expenditure over the minute of wireless calls has averaged
long term
† Average cost to provide an additional minute on an already between 40¢ and 50¢. Our estimates
built-out network (assumes 70% of costs are fixed)
Source: Industry literature; DLJ; McKinsey analysis suggest that average marginal costs
in the industry are between 3¢ and 7¢
Exhibit 4 per minute, and between 10¢ and 12¢
… and fast per minute when long-run incre-
Average price per minute (cents) mental expenses for expanding cap-
50 acity are included. The experience of
other industries suggests that this
40
Projections kind of disparity between price and
30
marginal cost is unsustainable in a
20 five-player market with high fixed
Worst case*
10
costs (Exhibit 3).
0
1997 1998 1999 2000 2001 2002 The high barrier to exit, at least for
* Assumes 15% retailer margin on top of long-run incremental cost of 12¢ spectrum, only makes things worse.
per minute of use by 2000; flat thereafter
Source: Strategis; McKinsey analysis
PCS operators that have already fully
developed their network have large
Exhibit 5 amounts of unconstrained capacity,
Discounting to attract profitable customers and need to generate enough revenue
Percentage discount offered by entrants on prices of incumbent
to cover big debt payments. They
cellular providers
have a strong incentive to encourage
10
usage, even at prices at or near mar-
0 ginal costs. Even if they were to go
–10 bankrupt, their networks’ capacity
–20 would not be eliminated from the
–30
market; rather, someone else would
buy it and return to the fray with a
–40
lower cost basis.
–50
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
1,0 0
00
15
25
35
45
55
65
75
85
95
10
20
30
40
50
60
70
80
90
a long way, and fast (Exhibit 4). Attackers entering these markets have
reduced prices by between 15 and 30 percent on average, with bigger
discounts and flat-rate pricing aimed at the most profitable customers
(Exhibit 5). In a few cases, discounts aimed at specific segments have been
as high as 70 percent.
A temporary blip?
Many in the industry hope that the worst of the price wars will be over when
new entrants conclude their initial promotional assaults. But they are deluded.
New entrants will continue to arrive in waves over the next two to three years,
and market economics will dictate further price falls as attackers and
incumbents battle for first-time price-sensitive customers and for the higher-
usage established customers that all providers will chase for their best
margins. There is no getting around it: the US wireless industry is in for a
nasty fight. Smart contenders will start preparing now.
Three implications
The coming battle will have three main implications for wireless providers.
The first, a likely increase in total usage, will be positive, although the benefits
will be mitigated by falling prices. The second will be an increase in churn as
customers defect to take advantage of deals oƒfered by new entrants. And
the third will be a substantial drop in industry profitability as competition
intensifies.
Growth in usage
New entrants need subscribers to oƒfset the heavy cost of their network build-
outs. Looking to gain customers quickly, they are oƒten tempted to oƒfer
favorable deals in the form of flat-rate plans oƒfering hundreds of minutes
for a fixed monthly rate. Sprint has oƒfered 1,000 minutes for $100, and
Powertel 300 minutes for $30. Such deals allow customers to use their wireless
phone much more oƒten at little or no extra cost.
lighter, have more features, and run for longer, and network eƒfects that make
owning a wireless phone more valuable as more people become users.
While estimates vary, most suggest that annual subscriber growth will slow
over the next few years. It was approximately 30 percent in 1996, but analysts
expect it to be between 7 and 12 percent in 2001. Even at these lower rates,
though, penetration will more than double in the next five to seven years.
Increase in churn
Customer turnover in the wireless industry has always been high, at 25 to 35
percent a year. It is likely to increase as new entrants in regional markets bring
low introductory prices, substantial advertising and marketing programs, and
all-digital networks capable of providing advanced services such as voicemail,
integrated one- or two-way messaging, and call forwarding. Factors like these
attract price-conscious, dissatisfied, and leading-edge customers.
As more entrants arrive in the market, it is far from clear that customers who
have defected will return to incumbent players. Cellular operators will have
to fight to lure them back, and should be preparing now to track their
defecting customers and launch “win back” programs as new PCS networks
go through their teething pains.
Reduction in industry profitability
Falling prices and rising customer churn will mean reduced profitability for
incumbents. Most are ill prepared for the scale and pace of the change. Their
networks are predominantly analog, and years of limited capital spending
have leƒt them capacity constrained. The expected increase in subscribers
and usage will push up their network operation, maintenance, and customer
service costs in absolute terms.
2,500
High customer acquisition
costs that were supportable 2,000
500
Leading companies also face
slowing revenue growth as 0
1985 1987 1989 1991 1993 1995 1997
their pricing model collapses Source: CTIA; DLJ; McKinsey analysis
Our estimates suggest that incumbent providers that do not move swiƒtly to
take strategic and operational actions are likely to experience a drop in
EBITDA (earnings before interest, tax, depreciation, and allowances) margins
of 25 to 35 percent (Exhibit 7).†
Earnings will fall even faster than EBITDA as increased capital spending
translates into higher depreciation. For the independents, this decline in earnings
is likely to result in a large reduction in market capitalization because of
price/earnings ratios that have yet to reflect the coming changes in the industry.
Exhibit 7
Pressure on earnings
Normalized income statements, estimated
1997 2001
Revenue
100 139
Operating expense
15 30
Customer maintenance
12 17
Acquisition
25 48
G&A
6 7
EBITDA*
42 37
EBITDA margin 42% 27%
* Earnings before interest, taxes, depreciation, and amortization
Source: Strategis; DLJ; Everen; McKinsey analysis
• Achieve consistent national and regional brand awareness for both cellular
and PCS oƒferings, taking care to manage conflict between their own brand
and co-brands (such as Cellular One, a brand owned by several competitors
whose stakes vary from market to market)
Product integration is likely to take three forms, with cost, complexity, and
value increasing in line with integration:
Integrated products do, however, have clear benefits for providers. They
increase share of wallet, help in diƒferentiating market positioning, cut the
cost of acquiring customers via cross-subsidized marketing and acquisition
programs, and reduce the operating cost per customer (because billing is
cheaper, the joint administration of accounts produces savings, customer call
centers can be shared, and synergies can be derived from shared network
elements). Given their long-distance, local, and Internet access businesses,
the regional Bell operating companies and long-distance providers may have
an advantage over the independent wireless providers in developing and
bringing to market innovative integrated products.
But direct product integration is only one of the ways in which providers
must diƒferentiate themselves from the pack. They also need to envelop their
integrated products in service oƒferings that are attractive to specific customer
segments. All elements of the customer oƒfering from acquisition to retention
must be tailored.
These will be diƒficult challenges for any company, but the threat attendant on
increased competition leaves incumbents little choice. Management teams
that take quick and assertive action in response to changes in the environment
will outperform the competition. Those that fail to see the threat or execute
ineƒfectually will suƒfer as their results fall well below the expectations of
corporate parents or investors.
one-third of current levels. The managerial challenges this presents will cut
across almost every business area. Incumbents that succeed in transforming
themselves will be well placed to capture a profitable stake in the coming
boom in wireless telephony.