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Analyst Angle: US and China Lead While Regulation and Competition Policy Impede Europe in 5G

As originally published by RCR Wireless November, 2018

By: Keith Mallinson
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US, China, Japan and Korea are seizing global leadership in 5G with support of coherent and helpful industrial policies in those nations across the entire mobile ecosystem including technology development, spectrum licensing, site acquisition and operator consolidation. All these nations will launch 3GPP standard-compliant 5G services in 1Q 2019, except for the US, that might start sooner, and Japan, where the first launches are expected before yearend 2019. The first 5G smartphones will probably be sold to consumers to be sold to consumers in 2Q 2019.

Digital Single Market policy initiatives, including the 5G public-private partnership (5G-PPP), sought "to put Europe in the lead of the 5G technology race," but the region is significantly hampered by adverse regulation and competition policy with nationally fragmented markets for mobile operators.

5G is indispensable

My previous Analyst Angle showed that 5G deployment will be essential to accommodate the rapid and relentless growth in data demand. 5G is the only way to access spectrum above 6GHz, including mmWave, that is needed to provide most of the 20-fold increase in cellular network capacity required by around 2025. 5G will also be favored at lower frequencies, including what are now regarded as "mid bands" from around 2.5 GHz to 3.7 GHz.

In addition to increasing network capacity, performance and functionality; 5G will also dramatically reduce operators' costs. Verizon's Chairman and former CEO, Lowell McAdam, claimed in a May 2018 interview that "5G will deliver a megabit of service for about one-tenth of what 4G does today." Transitions between previous mobile technology generations have also yielded large cost reductions (i.e., measured in dollars per unit of data traffic carried) with improved spectral efficiencies and with economies of scale that come with bigger spectrum blocks, carrier aggregation and orders of magnitude more network traffic.

While these cost reductions are largely passed on to consumers at much lower prices in due course, operators must make major up-front investments in network equipment and spectrum to achieve those savings. Total mobile operator revenues globally have been in slight decline over the last five years after adjusting for dollar inflation of around 1.5 percent per year. Nominal revenues have increased by only four percent from $984 billion in 2013 to $1,024 billion in 2017, according to GSMA Intelligence. Meanwhile, total data traffic has increased by a factor of six, according to the Ericsson Mobility Report. With data predominating in mobile operators' service plans and pricing these days, operators' revenue yields per gigabyte of data consumed by consumers (i.e., the effective prices paid for data consumed by the latter) have, therefore, correspondingly reduced by a factor of around six over the period. Operator CapEx has averaged 17.8 percent of revenues while falling by 1.5 percent (i.e., $15 billion less per year) over the period. Spectrum costs are typically paid also.

With mobile data prices in the US, for example, more than triple the European average, according to Rewheel's Digital Fuel Monitor, US operators are taking a few years longer to pass on their cost savings to consumers. However, that lag has tended to provide US operators with the stronger earnings and cash flows that justify early investment and secure shareholder approval for 5G. This investment will enable broad network coverage, much bigger capacity and high service availability, as well as even lower prices. For example, according to GSMA Intelligence, the average EBITDA margin for US operators in 1Q 2018 was 40.6 percent, versus only 17.8 percent in Denmark and 28.2 percent in the UK.

Reducing costs makes it inevitable that all operators eventually migrate to the later generations of technology. Radio network equipment has become increasingly multi-standard: including older-generations of standards along with the latest standard. OEMs including Nokia are now producing 5G-capable hardware that can first be used for 4G and then subsequently be software upgraded for 5G use, including spectrum sharing with 4G.

But leaders will reap greatest rewards

It is the economic drivers, industrial policies and regulatory constraints, with respect to competition rulings and spectrum licensing, that are determining where and how rapidly 5G will be implemented.

The need for 5G, including mmWave, is inevitably most pressing in medium- and high-income nations where demand is already most intense, but operators in some of these nations are moving much more rapidly than others. Unsurprisingly, it will be early-adopting nations that benefit most from 5G with greater roles for them as innovators and vendors in the 5G ecosystem, rather than nations mostly being merely 5G-technology users.

As with LTE and 4G from 2010, America is again a frontrunner in 5G with the market heft, money and motivation to prime the global 5G ecosystem including network equipment, devices, applications and services markets. The bold migration to LTE by market leader Verizon was most significant. The large US market has two powerful operators with Verizon and AT&T, and is contemplating consolidation between the other two national players T-Mobile and Sprint. The US is releasing several gigahertz of additional spectrum bandwidth and trying to make it easier and faster for operators to acquire network densification sites. The US is also home to market-leading 5G technology supplier Qualcomm, already with a mmWave antenna modules and 5G smartphone reference designs. Virtually all the early 5G device launches will be based on its platforms with 18 OEMs committed to launching devices in 2019 based on its X50 5G modem.

OTT service providers including Alphabet (Google, YouTube, Android), Facebook and Netflix who have benefitted most significantly from the mobile broadband revolution in smartphones with 4G, are also set to be major early beneficiaries from 5G including eMBB, which will be by far the most important service category driving 5G revenues for at least the first couple of years.

Japan and Korea are also leading implementers of 5G with Olympic games showcases, benign regulation including modest spectrum fees and relatively-easy site acquisition.

While China was very late in adopting 3G, and a follower in 4G, it will be early in 5G including major infrastructure investments and numerous committed OEMs. OnePlus and vivo have been the first to announce their plans for commercial launches of 5G smartphones in 2019. 5G investment in China is being spurred by favorable industrial policy including the nation's "Made in China 2025" initiative, with only three operators across the nation with 1.4 billion population and without the burden of onerous spectrum costs. There is even word that China Telecom and China Unicom might be allowed to merge. With such a large domestic market, Huawei's strong position in 5G is assured.

Ericsson and Nokia are well positioned for 5G because they have succeeded globally with international expansions in technology development through acquisitions as well as in sales. Ericsson and Nokia capitalized on their home Nordic region and then greater Europe, that were the respective world-leading geographies in the adoption of 1G and 2G respectively. The companies have made major R&D investments, maintained strong positions in 3G and 4G and are now set to be leaders in 5G based on their global positions. For example, Nokia now owns America's prized Bell Labs through its acquisition of Alcatel-Lucent in 2016. They are also benefitting from the backlash against Chinese vendors including Huawei and ZTE due to concerns in the US, Australia and now the UK about national security and protectionism including requirements for intellectual property transfer in exchange for Chinese market access.

Conflicted policies in Europe

Market prospects within Europe are not so good in the all-important early years for 5G. Europe has suffered from market failures in the mobile operator sector since the turn of the millennium due to high spectrum costs, fragmented markets and the blocking of consolidation by the EU's competition authority. In marked contrast to Europe's global leadership in introducing 2G in the mid-1990s, its move to 5G will be patchy and relatively slow, as it was in 4G.

Despite national fragmentation with dozens of European nations, visions for the single market in 1992 propelled the region to leadership in 2G with the GSM, that was soon redefined as a global standard. Regulation enabled profitable growth with only two licensed operators in most nations for several years. Services markets remained nationally fragmented, but with tremendous demand growth and benign competitive conditions for operators.

With the introduction of 3G in the early 2000s, European policymakers intensified competition in operator services with additional licensees, while also switching from allocating spectrum for free in "beauty contests," to auctions. The latter was carefully crafted to extract the maximum amount of money from the sector. This $150 billion bounty had the unfortunate side-effect of severely restricting the operators' ability to invest in networks and services. Initial expectations for 3G were too high: technologies in networks and devices were unable to live up to the hype.

Introduction of HSDPA in dongles from around 2006 and in iPhone and Android smartphones from 2008 propelled 3G at the of the decade, but by then Europe was losing its preeminent position. Global handset market leader Nokia was on the brink of its precipitous decline.

Europe was on its back foot with the introduction of LTE. The all-important low band at 800MHz was licensed, nation-by-nation in Europe, typically at least a couple of years later than was the US low band at 700MHz band, which was licensed nationally in 2008. European operators were wary of investing in another new generation of technology following the huge costs and losses incurred in 3G.

Priorities among European policymakers in recent years have been in reducing prices through regulation and promoting pan-European totems. For example, elimination of international roaming charges for voice and data is at the heart of the EU's political objective to eliminate national barriers, but this has deprived operators of what was once most profitable. The European Commission yearns for pan-European markets in close competition. Instead, as is the case in other industry sectors, there is a patchwork of national markets. As indicated in a speech by Commissioner for the Digital Agenda, Neelie Kroes, in 2014, "you face 28 different spectrum systems in Europe. So it's harder to plan and bid across borders."

Antitrust prohibitions have impeded market dynamism and economic efficiency. Despite the relatively small size of European nations, the EU's competition authority has blocked prospective four-to-three mergers in Denmark and the UK. This has stagnated markets with weak financial returns for the incumbents, as quantified above, and made markets less attractive for new entrants. In contrast, Rakuten is set to make market entry with 5G in Japan, which is a relatively large national market with only three operators whose average EBITDA margins were 37.4 percent last quarter. Rakuten will be very disruptive with a low-cost operating model. T-Mobile has also been very disruptive with attractive pricing in the US, to build market share and maximize its position in the hoped-for merger with Sprint.

While the US FCC has reversed its position against the hardline net neutrality rules instigated by the previous FCC Commissioner, Europe remains inclined toward net neutrality, which has favored OTT players, including those identified above. OTTs operate with relatively low capital investments while operators are forced to provide open access to their networks.

European mobile operators are understandably unhappy, as indicated by several speakers including CEOs Timotheus Höttges of T-Mobile and Stéphane Richard of Orange at a recent FT-ETNO conference. European operators' weak financial performance is also reflected in significant share-price underperformance versus other sectors. Several speakers at the above conference expressed concern about the record-high spectrum prices in Italy's recent spectrum auctions. Telecom Italia's CEO Amos Genish has bemoaned "market failure" despite being responsible for agreeing to such payments. Arguably, operators only have themselves to blame in bidding up prices, but they clearly feel they have no alternative when mobile operator concentration is prohibited and when auctions are designed to maximize what they take. Genish intends to pursue 5G to reduce costs, but this will clearly be a struggle.

Economic risks and returns

Opportunities to earn economic rents are vital in the development of risky markets such as with new technologies, services and with major capital investments in 5G. In 1G and 2G, these profits, exceeding operators' costs of capital, were largely captured by mobile operators. Since then, such profits across the broadening mobile ecosystem have reduced through competition among more operators and have increasingly been taken by governments in spectrum licensing fees, by OTT service providers and by one outstanding smartphone OEM. Apple, with a stellar operating profit margin of 31 percent took 78 percent of all smartphone operating profits in 2017, according to Strategy Analytics. This shortfall is most pronounced in Europe where regulators and competition authorities have sought to be short-term consumer champions with measures such as price controls on roaming charges and by insisting on more competing network operators than is economically efficient. Maximizing proceeds in spectrum auctions to spend on other worthy causes, such as social programs, also has popular appeal. But these actions have hurt the European mobile sector and are causing the region to lag in 5G development and adoption.

European operators do not have the financial strength or investor confidence to vie for global leadership in 5G. They will surely follow when technologies are proven, and prices come down. But by then, major opportunities for competitive advantage and value creation in conjunction with partners in the region and elsewhere will have been lost to others.

Keith Mallinson has more than 25 years of experience in the Telecommunications Industry: as a research analyst, consultant and testifying expert witness. Complementing his industry focus, he has a broad skill set including technologies, market analysis, regulation, economics and finance. Prior to founding WiseHarbor in 2006, Mallinson led Yankee Group's global Wireless/Mobile research and consulting team as Executive Vice President, based in Boston, from 2000. Until then, he had overall responsibility for the firm's European division, as Managing Director from 1995. Prior to that he was the European Research Director.

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