It’s sad, but true:
communications industry profit margins are continually being squeezed. Revenues
no longer grow at the rates previously enjoyed, and downward pressure on wholesale
and retail prices continues. With profit growth in the near term largely limited,
service providers look for
efficiencies in service delivery costs.
The old expression “Lower the price and we’ll make it up in volume”
assumed that demand would rise sufficiently to both cover original objectives
and also reach new levels of profitability. Certainly this could have been the
anthem of the post-divestiture era as retail prices plummeted. But along the
way, a troublesome pattern emerged: managing the expense stream didn’t
improve.
In the last two to three years, virtually all of the largest U.S. carriers have
suffered flat or modestly increasing cost of services (COS) as a percentage of
revenue. Only one major incumbent, SBC, noted a 4 percent decrease between 2000
and 2001, but that was from an incredible 60 percent COS—not exactly stellar
results when the rest of the herd is running between 36 and 54 percent. The lack
of improvement in the COS figures suggests that service providers aren’t
getting any more efficient at cost control, because as revenues expand, the costs
to deliver the service are expanding at the same rate.
David Bowles, senior manager in the Economic Consulting Services division of KPMG
LLP, cautions that with wireline voice margins as low as 2 percent in some areas,
the need for cost and margin discipline is essential for survival. Even though
profit margins are very high in the residential markets for popular voice features
like call forwarding and call waiting, he says, basic transport is dangerously
close to being under water.
Wireless revenue and profit pressures are just as severe. In a recently released
study, wireless research firm iGillott Research noted that aggressive pricing
from so-called bucket plans will drive consumer ARPU (average revenue per user)
from $41.82 to $36.22 per month through 2006. This will undoubtedly put additional
pressure on margins at a time when wireless operators could well use the added
cash to launch highly touted 2.5G and 3G offerings.
Even Congress has gotten into the act, but to no avail. The economic stimulus
plan signed into law in March, the Job Creation and Worker Assistance Act, contains
provisions for tax breaks from accelerated depreciation of equipment. Many see
this as beneficial for the technology sector, but it is more likely too little
too late, according to Carl Geppert, partner-in-charge for global margin enhancement
at KPMG. “As attractive as the plan may seem, I don’t think it will
have the intended effect,” he says. “You have to consider that in
the last two years, more than $2 trillion dollars of market capitalization has
evaporated from the communications industry. That is huge.
“Given that the depreciation rules are for tax purposes only, it won’t
affect net income, EBITDA (earnings before interest, taxes, depreciation or
amortization) or earnings per share. The reduced tax bills will inject some
cash into the companies making the purchases, but that assumes the company is
profitable, since unprofitable companies don’t pay income taxes.”
What to do? To date, says KPMG’s Bowles, incumbents have tended to use
reductions in selling, general and administrative expenses as their income statement
“quick weight loss” programs. Headcount cuts, travel and training
constraints, and buyout packages for older, more expensive resources granted
some immediate relief. At some point, however—and Bowles believes that
point is now—cutting SG&A has to stop before quality metrics erode.
This leaves COS as the only other major category for boosting efficiency.
From Profit Pressure to Trench Warfare
Cost control isn’t a new idea. Service providers have had revenue assurance
initiatives to plug leaks in disjointed processes and systems for years. Cost
management tools are becoming more sophisticated in reconciling intercarrier
invoice data (see “Data Reconciliation: Service Provider Salvation, or
Just a Back-Office Bandage?,” Billing World and OSS Today, March 2002).
But that isn’t nearly enough, according to Robert Rosenberg, president of
Insight Research. He says that margins are declining in all telecom sectors, including
local, long distance, wireless and broadband. What’s more, Rosenberg says
the matter has never been more urgent, because the signs are ominous for revenues
as well.
He points to Verizon’s 2001 results, which reported a 2.1 percent decline
in the number of installed phone lines. Considering that wireline local service
revenues fuel Verizon’s (and, for that matter, all ILECs’) growth strategies,
and that cable broadband installations are outstripping DSL by 2-to-1, Rosenberg
says, Verizon will have to hustle to make up with revenue in other areas. Verizon
isn’t the only ILEC singing the revenue and profit blues. BellSouth, Qwest
and SBC all recently announced either reduced or “challenging” revenue
and earnings forecasts for the remainder of 2002.
Another distressing figure is the size of the write-downs resulting from new
rules by the Financial Accounting Standards Board effective last September,
which require the recognition of decreases in the value of acquisitions. Verizon
posted a $2.5 billion one-time charge, causing its 2001 earnings to decline
96.7 percent from the prior year. These new rules also caused write-downs at
AOL Time Warner and Qwest to the tune of $54 billion and $30 billion, respectively.
Carriers must “look hard at what they are giving away and consider the
possibility of shedding unprofitable customers,” Rosenberg says, “because
the cash cow [of wireline local revenues] is drying up.”
A Deeper View
In the last several years, service providers have done well in reducing headcount
and increasing revenue per employee, according to John Hanson, vice president
of Mercer Management Consulting. On balance, those one-time measures have not
helped in the search for clues to understanding profitability. Hanson says analysis
to date has been largely limited to individual product cost management, driven
by a product-specific income statement focus. The mandate, he says, is to “shift
from a product-by-product cost analysis to understanding a product-customer mix
profitability picture.” Within each product, he says, “the trick is
to get quite granular about understanding who is profitable on each platform and
what the drivers of that profitability are.”
Another must on the revenue side, says Hanson, is to put more effort behind strategic
price optimization. He points to other consumer commodity providers such as credit
card issuers and grocery chains as examples of companies that carefully evaluate
purchasing behaviors and pricing sensitivities and test market every offer before
broadly deploying them. To do this, he says, one must fully understand the elements
of profitability within an offering, and be careful to structure offers in a way
that is both appealing to the consumer and profitable to the carrier—no mean
feat. Unfortunately, he says, this has not been the typical approach to carrier
product management, and it has resulted in widespread distribution of offers,
some of which have been unprofitable. The warning is clear: you can’t “make
it up in volume” any more.
To understand Hanson’s concern, consider the example of the typical service
provider product manager who wants data on the success of a pricing promotion
for a given product. The results report comes out by the 15th of every month.
It shows a full income statement of revenues, expenses and profits for the month,
as well as year-to-date performance and sales volumes. The problem is this: market
analysis data is often garnered from billing files, long after it’s needed.
This means results reported on June 15 may well reflect bills generated June 1
for May usage on April sales from a promotional campaign launched in March. That
means at least 75 to 90 days elapse before any useful information is made available.
If a 90-day promotional campaign is under the microscope, it’s nearly over
before you can tell if it should be extended. The manager is left with gut feelings
and sales team predictions as decision drivers.
Even more frustrating is the “allocated cost,” a convenient but no longer
meaningful method of prorating large network-centric expenses to product lines
according to a standard metric such as minutes of use (MOU) or number of lines.
Mercer’s Hanson says it prevents the kind of analysis that carriers need
most. At the same time, getting away from simplistic cost allocation may prove
challenging, he says, because it is such an entrenched method. “For all the
good work the carriers have done to try to get the cost out,” Hanson says,
“in 2002 it still tends to be more cost allocation than true cost and revenue
causation.”
These antiquated methods of managing products may have served carrier executives
well enough in the past, says Hanson, but no longer. The data needs to be more
granular to allow assessment of what product managers recognize as “contribution”:
the amount that a given customer or product attribute delivers to profits or costs.
By deconstructing a product’s revenues, expenses and therefore profits into
atomic units and comparing the relative impact that each customer, service feature
or route delivers to the product’s total composition, the product manager
can make informed decisions on what to sell where.
Hanson says this is exactly what’s wanted. “You have to move from
a rote activity-based costing to more of an iterative analysis,” he says,
“where you look at contributions to your most profitable [service offering],
and build up a view, platform by platform by product/ customer combination.”
This daunting task can make even the most stalwart executive swallow hard. “At
the larger carriers, there’s so much data it’s difficult to determine
what’s most
reliable,” says KPMG’s Geppert. Some service providers will argue this
is too microscopic a view, and not easily supported by current IT infrastructure.
Geppert sympathizes, saying, “You have to remember, these systems were not
built to support the needs of product management. Most of them were built to satisfy
accounting needs.” Hanson is quick to counter with strong words for carrier
executives, saying with a twist of sarcasm, “If you are satisfied with your
current margins, then by all means, don’t get bogged down in complexity.”
Scrounging for Pennies
In the wholesale world where margins are razor-thin, having full, effectively
used pipes with customers meeting their minimum guarantees means the difference
between profit and loss on the monthly income statement. Sean O’Leary,
vice president of Internet telephony at international wholesale carrier iBasis,
says that as an industry average, a penny per minute profit on wholesale transport
is the threshold of long-term health for a service provider.
To get that precious penny, looking at the cost of services is just the beginning.
O’Leary and his team around the world consider multiple criteria, including
customer commitments, overseas traffic destinations, quality of service and busy
hour needs. Perhaps even more uniquely, he turns the profit margin lens around
and looks at the profitability of individual customers, rather than just the effectiveness
of an offer to a group of customers. O’Leary says his analysis of margin
considers a customer’s individual overseas destinations, as well as the customer’s
profitability for a group of destinations. He says that this level of sophistication
is the only way service providers, and in particular wholesalers, will continue
to make money.
Get Me Business Intelligence… Stat!
Software vendors are eager to fill the void created by archaic analysis platforms.
Generally called “business intelligence,” their applications connect
the user to meaningful business information extracted from otherwise disjointed
data residing in the service providers’ internal systems. According to
Yankee Group analyst David Hawley, this software generally falls into four categories:
Data warehouses and databases—These encompass both small- and large-scale
products. Larger databases tend to be used for consolidation and are generally
referred to as data warehouses. They can be used to consolidate database systems
across a company. Vendors include IBM, Oracle, Sybase and Teradata (NCR).
Analytical applications and reporting tools—Typically, the vendors of
these are horizontally (multi-industry) focused. They tend to offer some combination
of reporting and analytical (or data-mining) products that allow sophisticated
analysis of the user’s data with the goal of uncovering patterns in company
information. Vendors include Business Objects, MicroStrategy, Cognos and SAS.
Mediation—Once confined to switch-to-bill translation, this group is now
positioning itself as the data arbiter for all OSS and BSS applications in a
carrier’s platform. Vendors include Intec Telecom Systems, Narus, Xacct,
Openet Telecom and Ace-Comm.
Revenue Assurance/Cost Management—Focused heavily on discerning costs
and profitability specific to telecom service providers, these tools reconcile
disparate data across large operational data stores and analyze product profitability.
Vendors include Vibrant Solutions, Lavastorm Telecom, Connexn Technologies,
Emerging Technologies Group and newcomer Black Ink Systems. Many traditional
billing system vendors also offer analysis tools with “bolt-on” modules
that assess customer buying behavior or profitability, such as CSG Systems’
Profit Now module and Amdocs’ Clarify Business Intelligence and Customer
Analytics product.
The first two categories, says Hawley, are horizontal, multi-industry products
that may require significant customization, while the latter two are more narrowly
focused on the telecommunications industry’s needs.
To address the need for real-time feedback for telecom providers, two software
houses are spotlighting profitability analysis as a market opportunity poised
for rapid growth.
Startup Black Ink Systems looked at mature industries selling commodity products,
such as airlines, hotels and financial services. It developed a telecom-specific
business intelligence suite that correlates service provider profitability ingredients
and presents the results on a digital dashboard in real time, allowing the service
provider to make decisions on the fly.
CEO Ed Sefton says the company’s Margin Suite product provides timely updates
on the status of network usage in a manner that imitates the displays found in
other commodity exchanges. By combining network traffic data with customer and
rating data, it provides hour-by-hour status updates on some of the carrier’s
most valued data points, such as route profitability, most (and least) profitable
customers, and top performing service offerings. Special-purpose alerts can also
be triggered by user-specified business rules to signal significant status changes
or threshold violations.
Emerging Technology Group (ETG) also delivers business intelligence for interconnect
route optimization and profitability analysis. The company’s iXTools product
is installed and running at several carrier locations in the United States and
Europe. Much like the Black Ink Margin Suite, it collects data from several
disparate locations and analyzes user-specified key performance data, such as
net margin objectives and cost of sales, either on a gross or customer-specific
basis.
According to CEO Amir Yazdanpanah, the product’s strength lies in the
variety of tasks it can perform. In addition to delivering customer and margin
results to the sales and product management leadership, it aims to improve routing
decision-making, fine-tune variable cost accruals for the CFO, and provide intercarrier
negotiating strength by auditing supplier invoices.
ETG’s Chuck Parrish, vice president of professional services, says the system
is strong in several domains, not the least of which is margin analysis. “A
carrier may have two or three classes of wholesale service, but they have 400
to 700 destinations in each class of service,” he explains. “We give
them the ability to slice and dice down to a very detailed level, so that they
can see margin reporting per customer per destination per class of service, with
margin benchmarks per destination.”
For one U.S. carrier, according to Parrish, iXTools also saves costs by streamlining
the routing decision process. “We take all the traffic information, the cost
data, the pricing information, and on a periodic basis every day generate suggestions
to optimize the cost. We also prioritize the work based on financial impact,”
he says. When routes are performing at sub-optimal levels, an alert is generated
to the user to suggest modifications. Original estimates for annualized savings
from traffic optimization for this carrier ranged from $1.2 million to $ 4.5 million,
more than enough to justify the purchase of the product.
As helpful as these tools may be, results generally aren’t forthcoming without
a lot of customization, says O’Leary at iBasis. His team acquired data mining
tools from Business Objects, had them customized to meet specific needs and then
teamed that output with homegrown tools. He says he is happy with the current
set of tools, but still needs to expand into what he calls “indexed routing,”
the ability to proactively change the way iBasis routes customer traffic, based
on a hierarchy of decision criteria. At the same time, O’Leary seeks a real-time
foreign currency exchange capability that will allow his team visibility into
yet another determinant of profits. ETG claims its product can satisfy both these
requirements; Black Ink Systems has one under development and one under consideration
for a future release.
Yankee Group’s Hawley is optimistic about the prospect for the telecom-specific
sector of business intelligence tools. “I think it pays off pretty quickly,
from what I can see,” he says. “Implementation times are pretty short,
and management of the platform looks pretty simple from an IT perspective.”
Forget About Quick Fixes
Can service providers endure and even reverse the ever-faster plummet of revenue
and earnings? Will any of that lost $2 trillion in market valuation ever reappear?
Perhaps, says Hanson at Mercer Management, but “you’re always going
to have to keep taking out cost, because the prices are going to keep going
down.”
Hawley at Yankee Group adds that carriers must also embrace the notion that
detailed margin and cost analysis will yield results and pursue a vigorous investment
in the people to make the best use of the products. “It may be more psychology
than technology. You can’t just put [the software] in there and have it
figure it out for you,” he says. “You need to have people running
it. The technology is there; it’s whether people begin to change their
thinking.”
The journey out of this stagnant market is likely to be neither fast nor painless.
“If you’re a service provider,” Hanson warns, “it’s
just not clear that you’re going to get a lot of margin improvement in
great big chunks. It’s going to be a ‘sweat the assets’ kind
of play.”
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