Wednesday, May 10, 2017

Selling our Telecom position

Several people on twitter and some in person have asked me for an update on my very bullish position on Verizon - especially since the results were not as good as expected last quarter.

I promised I would be forthcoming - but that I wanted to spell it out to our clients first. This is an extract from a client letter.

I want to start with the original bull thesis.

The original thesis

The original thesis came from watching Randall Stephenson (the CEO of AT&T) talk at a Milken Conference in 2012. The original recording is here. The relevant portion of the video starts at about minute 18.

Randall Stevenson tells a story of the iPhone’s introduction. The introduction of smart phones ran the company out of capacity in parts of country. [Apple offered the iPhone exclusively through AT&T in the USA.]

In New York the problems were intense. The complaint in New York was that the iPhone was a great phone so long as you accepted you could not use it as a phone. Jon Stewart mocked the coverage with unusual brutality on the Daily Show (link).

AT&T solved this by more and more capital expenditures. At the time, capex ran at around US$20 billion per annum. AT&T was – other than the government – the single biggest capital spending entity in the US.

Stephenson (speaking in 2012) said that the same problem would recur as usage continued to grow massively. But this time Stephenson argued it is different. He asserted that AT&T would not be able to solve this problem by more capital equipment. Spectrum congestion was inevitable.

He saw this as apocalyptic, but we saw potential pricing power and improving profitability.

We were doing simple arithmetic and getting very large numbers. Most Americans if given a choice between their pay-tv provider and their smart phone would choose the smart phone, but they currently pay more for their pay-TV.

We figured that if there were a shortage of capacity then the phone companies would get a lot of pricing power. Our figuring was that with $10-15 per month of extra pricing power Verizon would wind up as a very good stock indeed. And we did not see a reason to stop at $10-15. [It wasn't hard to develop a model where Verizon wound up worth more than Apple.]

This of course led us to do a lot of research into telecommunications technology to see if we could verify Mr Stephenson’s claim of inevitable shortage. And as we discovered nothing in this space is ever as simple as Mr Stephenson’s blanket claims.

So – at the risk of offending people with deep knowledge of how mobile telephony works – we are going to give you a crude understanding of the issues. We do it by simple analogy.

Imagine us in a very large room (say a big indoor stadium), you with a receiver and me with a transmitter flashing a red light.  
I could flash you a signal. Morse code would do.  
With Morse code I could flash things to you at a maximum rate of about five characters per second. That is not very fast. 
Alternatively I could use a computer to control my flashing light and you could use a computer to read it.  
I could then flash signal to you at about the intensity of a CD player. It’s quite a lot of information. More than enough for you to run the internet at a reasonable speed.  
The first and most important way in which we have got more capacity is by using better and better signal encoding and decoding. In mobile telephony, we refer to the generations of transmission technology as analog, 2G, 3G and 4G (namely LTE). It was our assertion that this trend had reached its natural limit.  
Now imagine there are 10,000 people in this room. I could flash a signal to all of them with my red light. And if I equipped all of them with a smart decoder (say a little computer built into your phone) then I could flash the signal encrypted – and they could decrypt it, pick out their bit of the signal and discard all the rest of the signal as white noise.  
The problem now is that my red-light is shared between 10 thousand people and whilst it is very fast if used for one person it becomes quite slow when used for 10 thousand. 
There are multiple potential solutions. 
One solution is to beam my red light to every person individually – say using a laser. This is effectively what is done in a fiber-optic cable. The laser in the cable goes to me, and a different laser goes to you, and they are not mixed because they go down different fiber-optic cables. This offers anyone on the end of a fiber optic cable almost unlimited capacity. The problem is that you have to be connected to the fiber optic cable - and we use these things mobile.  
There are possibilities of beaming radio-waves to people too, though for the most part this is laboratory stuff, not stuff already implemented by phone companies. [That said – it is said by some that the reason that AT&T wants to buy Straight Path is that their spectrum was good for beam forming.] 
Another more realistic solution for most purposes is cell division. Instead of using one big red light to signal everyone in the stadium, I could instead build hundreds (maybe thousands) of small transmitters each beaming a low intensity beam to small groups of people or even individuals.  
There is no real limit to the amount of cell division if I make the power of the antenna low enough. That is, in part, what WiFi does. The power of a WiFi transmitter limits its range to about thirty meters. This means my WiFi transmitter does not interfere with your WiFi transmitter because they are more than say sixty meters apart. The amounts of information that can be carried on WiFi is enormous precisely because the transmitters are so low powered and so numerous.
When someone says that they are going to “run out of spectrum” they are in some sense kidding you. One can always produce more capacity by cell division. The only problem is that it rapidly becomes enormously expensive. To cover America with WiFi one would need to build billions of transmitters. 
Cell division is expensive. Really expensive. 
Then there is another alternative. A cheap one. Just use another colour to transmit. Transmit to one person using red light and someone else using blue light. If my colours are far enough apart on the spectrum chart then they will not interfere with each other. 
Using another colour is another word for using more spectrum. 
Spectrum is an alternative to cell division and hence capital expenditure. 
Spectrum has value if it allows a carrier to avoid capital expenditure.

This leads us to the three ways phone carriers (like AT&T or Verizon) have managed to carry more wireless data:

a). Advances in encoding technology (from 3G to 4G, for instance),
b). More cell division (deploying more equipment) thus shrinking the number of users sharing a single cell,
c). Deploying more “colours”, also known as more spectrum.

We then spent a lot of time researching the limits to each approach, and we focused on spectrum because Randall Stephenson led us there.

Not all spectrum is equivalent. Some can go through walls (low frequency radio). Some cannot (eg visible light). But going through walls is important if I want to use my mobile phone inside.

It turns out that to a rough approximation light can go through an object half its wavelength thick. (The physicists will pick objections to this statement.) But light at 600 MHz will go through the walls of most buildings but light at 5000 MHz (where upper-band WiFi is located) will not.

This makes 600 MHz spectrum much more useful for mobile telephony. It is sometimes called “beach front spectrum” for this reason.

There is a lot of high frequency spectrum available, but it does not have good propagation characteristics. Sprint – the US carrier - is unlikely to ever run out of such spectrum. There is, however, a limited amount of “beach front spectrum” available which has very good propagation characteristics.

Thus the high frequency players like Sprint or T-Mobile in the US tend to offer cheap unlimited packages (because they have a lot of spectrum) but have lousy coverage.

By contrast low frequency players (AT&T and especially Verizon) tend to have limited capacity (as there is limited low frequency spectrum) but great coverage (because it propagates well).

In this sort of market we wanted to own the low-frequency players, as they own what is limited and valuable. But the low-frequency players do not have unlimited pricing power, because customers might jump to high-frequency players offering a cheap – albeit inferior – product.

We purchased positions in shares in low frequency players who we believed would own increasingly valuable spectrum. We figured all we needed to do was wait.

And the data was largely supportive. Verizon Wireless revenue grew quite quickly, even when the fixed line business was declining. Here is a slide of Verizon Wireless revenue from the 2013 Q4 Verizon earnings presentation (slide 7):





Note eight percentage points of Wireless revenue growth – and very fast EBITDA growth.

You could not see this in the Verizon accounts because the landline business was declining, but our logic was that the landline business would stop declining and the wireless growth would continue.

The thesis was reinforced when very high and increasing prices were paid for spectrum in recent auctions in many jurisdictions in the world.

We went so far as to download from the Federal Communications Commission a list of spectrum ownership by county in the US and match that with the population data from the census. We used spectrum prices that we saw being used by major parties in big auctions. Prices are usually considered in dollars per MHz per head of population. We concluded that Verizon offered the best valuation and that using this model owned $500 billion worth of spectrum. If the spectrum prices that we observed being paid were rational then Verizon in particular was really cheap.

The Verizon position had an additional advantage: the penalty for being wrong appeared low. After all, if we were wrong, then we owned Verizon, a high-dividend paying “grandma” stock.

AT&T’s behavior

One fly in the ointment of our thesis was the continued bizarre behavior of the major carriers – especially AT&T. If the spectrum story was as good as we thought, then if you ran a telephone company you would not dilute your stock under any circumstances. You would largely use spare cash to buy back your stock and would bide your time until the loot flowed in from rising prices.

If you believed Randall Stephenson’s story that is what you would do.

Instead AT&T purchased DirecTV – a large satellite TV company.

At one stage we had a large AT&T position. Their behavior convinced us to sell. Besides Verizon was better on the spectrum valuation model described above.

Still this irked us. Perhaps we were wrong…

The thesis broke

There were several things that, should we observe them, would tell us we were wrong. These were:

a) The price of spectrum at major auctions or major transactions not continuing to rise;
b) Verizon, in particular, or low frequency carriers in general offering increasingly large bundles at lower prices; and
c) Wireless revenue growth slowing.

We were unconcerned about price competition for small data bundles (say 2GB of data per month) because we figured there was enough capacity to offer everyone a few GB of data. But we were very concerned if discounts were offered on large bundles of 10GB or more. Most importantly we did not want to see the reintroduction of unlimited bundles.

Alas our thesis broke pretty rapidly on all three criteria over the past six months. The incentive auction (that is the recent US spectrum auction) produced much lower spectrum prices, Verizon reintroduced unlimited bundles, and revenue growth slowed--and then slowed some more (it is still positive, but only just).

The entire position was sold.

Obviously the engineers at Verizon think they can handle all the extra usage that will be piled on what we thought was their limited bandwidth.

When the thesis is wrong it is time to sell.


How bad could it get

We actually think it could get quite bad at the carriers. The world’s worst business is one with high fixed costs, low marginal costs, and lots of competition. In that case the competitive forces will drive prices down to the low marginal costs – and it will be impossible to recover fixed costs.

When the fixed costs are debt financed, bankruptcy often follows. That is precisely why the airlines have been bankrupt many times. The marginal cost of filling the otherwise empty seat is very low – and competition at times drives prices to those very low marginal costs.

If wireless telephony capacity really is unlimited and the carriers insist on price wars then the future is bleak indeed. (For shareholders, if not for consumers.)

We have gone from thinking the carriers were exceptionally good longs to believing they might be good shorts. We are not there yet: we would like to see falling wireless revenue first. But if spectrum
isn’t truly scarce this could get ugly.






John

25 comments:

Anonymous said...

"We went so far as to download from the Federal Communications Commission a list of spectrum ownership by county in the US and match that with the population data from the census."

You should have just taken a look at the chart.

Anonymous jackass said...

The lack of beachfront spectrum is not a big disadvantage anymore, as people move from voice to text as the primary mode of communication. If I have one bar, it may mean a poor quality call, but WhatsApp still works fine.

Also, with almost all technology, cost and convenience win over quality. CDs sounded better than MP3s, which sounded better than streaming.

Nice printed photos looked better than jpegs on your phone.

Landlines still sound better than mobile most of the time.

There are probably thousands of more examples of this.

If you want to see a case of spectrum limitations in action, look at the case of India, which had an insane system for allocating spectrum (maybe still does). Prices fell and fell and the operators lost boatloads of money buying spectrum (look up Vodafone India).

John Hempton said...

We got much more with the download. Firstly it was in a spreadsheet...

Anonymous said...

I may be completely wrong, but one thought which comes to mind with regard to bandwidth to users is that there's a lot of capacity here for people to be *clever*. Invent a new technique, some new hardware, modulate data in yet another way, cut a signal down from 10 MHz to 5 MHz, etc, etc... ...it's a bit like Moore's Law. You can keep improving. Maybe there's a law like that for bandwidth over radio.

Sam Viskovic said...

John, like your work.
Respectfully submit that technology in generally is fraught and not a suitable place for the contrarian tribe.
The only time I will invest is when I know physical limits have been hit, i.e I know oil cost more than $60 U.S per barrel to make as 100 years of draining it has found the cheapest first.
As to the value of wireless spectrum, perhaps we are better served to admit we have NFI how smart people can get in terms of transmitting data.
Fantastic engineering = terrible investing.
In fact investment returns are generally inversely proportional to social utility.
GLTA

Anonymous said...

Read The Master Switch by Tim Wu.

Cheesehedge said...

"The world’s worst business is one with high fixed costs, low marginal costs, and lots of competition. In that case the competitive forces will drive prices down to the low marginal costs – and it will be impossible to recover fixed costs."

Does this not describe the oil majors- ExxonMobil, Chevron, BP, Shell etc. - in the shale era? I suspect those may prove more promising shorts in the long run than T or VZ. The telecom market does not need Sprint however. I do think Sprint eventually goes bankrupt, with significant repercussions for the high yield bond landscape.

Forrest Wilson said...

Consolidation would change the math a bit wouldn't it?

It sounds like owning DISH or another spectrum asset could still be profitable if you can stomach the volatility?

Anonymous said...

If I'm a sinister mustache twirling super exec and I own the most valuable spectrum, and scarcity is what gives it it's value wouldn't I want to force my competition and users to use as much of it as possible in the short term? I just don't see how that behavior is inconsistent with the original thesis.

Ben said...

Wait until T-Mobile and Sprint merge, things will get better for all. Just look at the Japanese wireless business once it consolidated down to 3 players.

Anonymous said...

Any thoughts on DISH US and value of its spectrum?

Adam Sharaff said...

John,

If we're heading to a future of autonomous driving or even semi-autonomous, won't our cars need to have a mobile subscription to enable the telematics necessary to function? If so, and considering how data intensive the needs of these cars would be, could this represent a meaningful source of new revenue for those able to provide the low frequency high propagation signal that our cars will need? I know we're many years from this becoming a reality, but maybe it starts to build into the factors we consider when valuing spectrum.

Best,
Adam

Joel said...

I think the first warning sign should have been when T-Mobile started successfully acquiring 700Mhz band 12 spectrum in the private market at reasonable prices. This happened before the 600Mhz auctions.

I think you also didn't account for how much improving technology would not just improve bandwidth, but would also improve coverage. If you follow Sprint they have laid out that as the handsets advance they plan to use their limtied low frequency spectrum for upload and 2.5Ghz for download. The range of spectrum is at a particular power, so a high power cell tower 2.5Ghz has just as good of range as 700Mhz from a low power phone. Today the cell phone has to send and receive at pairs of frequency blocks in the same range, but as that changes with discontinuous band carrier aggregation you stop needing low bandwidth frequency for download. Other technologies like increase levels of MMIO increase effective range of phones as well.

I also think people under-estimated that the congestion would only occur in high population areas and thus infill with smaller cells makes economic sense supported by increased paying subscribers in these areas.

In support of your original thesis Verizon's "Unlimited" plan is capped at 22GB. So it isn't really unlimited. Same with T-mobile. It's just a metered data plan with a larger base amount of data under a different name. We also have seen Verizon's average speeds drop since they started offering these plans, indicating that the network is getting congested.

As for AT&Ts purchase of Dish, I saw this as a bet against net neutrality being enforced. If they can zero rate Dish video it's essentially a pay to play contract within the company. You can see it as Dish paying AT&T for access or AT&T charging Dish for access, only less explicit than if they had made that deal with an external company and come under scrutiny for doing so. You can see Verizon trying to do the same thing by acquiring content providers like Yahoo.

To me the industry is far from easy to analyze. If the players can monetize access to content players, either by charging them directly or acquiring them and favoring acquired companies, that could be quite profitable. I don't think the spectrum scarcity or even the low frequency spectrum scarcity scenarios are turning out to be true, but it's still worth monitoring.

Anonymous said...

John, As a telecommunications enthusiast, I feel compelled to share some research that may be of further interest to your community. Verizon has recently embarked on deployment of artificial intelligence technology to monitor and manage the risks to negative customer experience around the network. More here in this youtube video (https://www.youtube.com/watch?v=PlBWd3E3uTQ ). More information on the technology available from forums on the web. Furthermore I know of at least one expert who has fine tuned a large Global mobile telecommunications network (HQ in the UK) for optimisation of investment to ensure video of mobile network throughput. They have recently moved to the US to focus on US mobile telecommunications. The I.P. on how to solve this problem was developed by research labs in Europe and with support from a closed proprietary and global expert community. I am not bullish on Verizon or any company associated with it. I am not certain if I have an open position on Verizon ( I entrust my fund managers decide that for me on my behalf!).

Anonymous said...

Engineer here... grey haired in electronics & communication.

There *are* limits to the amount of signal you can shove into a given amount of spectrum, and off the top of my head I don't remember them or even if the current systems are close.

Trouble with shoving more down the same amount of spectrum (or in the jargon, how much data bandwidth you can get into a given amount of RF bandwidth) is that you need to change to new coding schemes. The coding scheme is used to turn the data into something that goes over the air, and recover it at reception. Coding schemes can get horribly complex, need lots of compute power, etc etc. In general though, new coding schemes require new physical hardware - that is new equipment in the cell towers. That's also why your 3G phone won't work in 4g mode with your local 4g base station: old hardware can't do new stuff.

Some of the newer software defined radios *might* allow software-based upgrades, but that's still limited by cost and the skill of the designer and their ability to foresee the future.

So, TECHNICALLY, it might all go further, it might not. And if it does, there is expected to be a significant capital cost to update the cell towers, yet again. And possibly the back-haul, and so on.

What's not been considered is that perhaps the bundles, pricing, etc, are not technically driven decisions. It's quite possible that this is a commercial "grab market share" decision, where the installed technology and assets are pushed and pushed until there are customer complaints about lousy performance. (Remember Vodafone in Australia? Once upon a time their network and service was very good.... then the wheels fell off.)

Telcos need not be run by engineers - these days the techs are usually the unloved and unseen guys who come along after the clever commercial people to patch up or sweep up the mess. Maybe that's happening here.

Even if thats the case, the time for it to turn bad enough to need a big patch up could be considerable, possibly years. Selling out seems rational, and the performance of the technology may well be a secondary consideration.

Joshua Goldblatt said...

just curious if you think the original thesis might have been abandoned prematurely in light of the price paid for STRP (as well as the fine print limitations on "unlimited" plans).

Gary said...

At the global level, the telecom industry has never ever recovered wacc. Not once.
Sure you can find exceptional markets (eg Middle East, Switzerland) and exceptional players (illiad), but it's like saying airline is terrific cos SouthWest.
So to go long Verizon you need to argue Why the end of history.

See PwC research on Telco Capex for the data (yes I was the author).

Roger said...

"The world’s worst business is one with high fixed costs, low marginal costs, and lots of competition."

Isn't that per definition the situation in many capital-intensive, strong cyclical industries? Does that mean all these industries are loss leader over a whole cycle?
I don't think so, but you should buy cyclical branches at an acyclical timeframe.

Think about offshore oil producers or sipping companies - cyclical industries that are actually unpopular for their hugh losses. If they survive, there shares may explode...

Anonymous said...

Since at least a decade are the telcos paranoid about becoming bit pipe providers with no pricing power. With number portability and calls between networks not a factor anymore most of the stickiness is now in the app/ecosystem layer (Apple and to a lesser extent Google). They are now forced to compete on utility level and pricing is limited.

There are two video related capacity levers not yet mentioned:

- time shifting. By storing the video on a mobile device when on a high capacity wifi link. Now possible both with Netflix and Amazon.
- variable bit rate. People do care about video quality but they tend to tolerate lower quality as long as the sound is ok.

It is also very hard to measure network quality for the individual consumer. They have an idea but then their perception is also shaped a lot by marketing.

Cheesehedge said...

Just read about the bidding war that has broken out between T & VZ for the 5Ghz spectrum owned by Straightpath communications. Literally in 1 week T&VZ bid this formerly undesirable high frequency block up from $200 million to $3 billion as it may play a key role in future 5G networks. PErhaps this validates your original thesis?

Brian said...

What do you make of the Straight Path bid frenzy? Does it change your thinking at all?

Anonymous said...

Today morning - Sprint, SoftBank Said in Informal Deal Talks With T-Mobile
https://www.bloomberg.com/news/articles/2017-05-12/sprint-softbank-said-to-start-informal-deal-talks-with-t-mobile

3ppm said...

What about the MVNOs? I used to be a Verizon customer but got tired of their price-gouging contract plans. I switch to Page Plus Cellular (the only (?) MVNO that piggybacks on Verizon's superior infrastructure) and have been very happy since 2013.

Jake Walsh said...

The spectrum rush reminds me to some extent of the fibre rush during the 2000s boom.

In this case I think people are underestimating the gains to be made by cell division, in particular the deployment of small cells to high use areas (office buildings, sports complexes, university campuses), greatly relieving the need for spectrum elsewhere.

https://www.thinksmallcell.com/images/articles/2016/Rethink_Research_Small_Cell_Forecast_Jan_2016.jpg

I think select semiconductor companies could end up being winners here at the expense of the telecoms.

Ben S said...

My data plan provider just informed me that they are bumping me to 8gb/mo of data, gratis, from 5gb previously...

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.