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Fitch: Network Operators are Key to the Smartphone Ecosystem

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Fitch Ratings says that whilst much industry debate at the recent World Mobile Congress in Barcelona centred on value creation in the 'smartphone ecosystem,' it largely ignored the idea of value being directed to the operators, despite their heavy investment in networks and handsets.

Fitch estimates that operators invest between 20% to 27% of annual revenues (including network spend and handset subsidies) on sustaining what is an increasingly data heavy mobile communications network. As a result, the agency understands the operators' call for a two tier pricing structure, whereby the content providers (ie. Google, Apple, mobile advertising, web TV platforms ) that are expected to derive most value from data heavy content traffic should pay a premium to drive traffic across the operators' networks.

However, regardless of the outcome on future pricing structures, Fitch continues to expect carriers to sustain network investment and aggressively build smartphone subscriber bases with the long-term objective of driving higher service revenues. The agency notes that as the largest debt funded constituent in the whole debate, it is important for investors to understand that the operators' cash flows will in the near term remain under pressure, but that longer term the aim is to protect and monetise the value created by this burgeoning of data traffic. Continued operator capex investment has enabled smartphone and tablet computing technologies to evolve rapidly, resulting in a richer experience for the end consumer, which for the best in class operators should allow them to raise data tariffs.

"Whilst carriers generally have good cash conversion and revenue visibility, cash flows over the next couple of years at least will continue to be pressured by high network investment, spectrum acquisition, handset and commercial costs. However, the long term aim for the most efficient and best provisioned networks remains to drive data traffic and eventually allow the operators to monetise this traffic, given that consumers will ultimately migrate to the best quality networks," says Stuart Reid, Senior Director, in Fitch's European TMT team. "Consumers will be prepared to pay for the network that best allows them to exploit the capabilities of smartphone and tablet devices" Reid added.

The Barcelona congress included a lot of discussion around ecosystems which centred on software developers and content providers, such as Google and Apple, applications ("app") platforms, the device manufacturers, applications developers, revenue share models, mobile advertising, location based and contextual services. An obvious example of carriers' exclusion from the value chain is their absence from app revenue share agreements. Here, Fitch notes that the relationships that have been discussed publically allude to a majority share of revenues going to developers and the balance to the software licensees such as Apple or Google. Therefore, near-term commercial advantage is inevitably being driven to the portals, software and applications developers, and, to a lesser extent, the handset vendors, while the operators are providing a large addressable audience for these services.

"The popularity of applications such as social networking, gaming and content streaming will however, in Fitch's view, ultimately drive customers to the best network, leading to some pricing power for the owners of these networks over the medium to long-term. Although at this stage there is limited visibility of how this will translate into incremental operator cash flows, the industry's movement away from unlimited data plans and introduction of tiered access fees for the consumer are a start ," Reid continued.

Fitch is modelling 13% - 15% capital intensity (capex to sales) across its European portfolio of rated carriers over the next two years (including spending on fixed, mobile and spectrum investment). Less easily quantified is the investment that operators make each year in subsidising handsets and commercial incentives to attract new customers and perhaps more importantly, retain existing customers on their networks. Operator subsidies are enabling consumers to upgrade to a highly sophisticated piece of mobile technology that would otherwise retail for GBP300-GBP400. Device subsidies and commercial costs will remain high but should reach an inflection point as smartphone chipsets become more affordable and the smartphone becomes increasingly mass market. Fitch estimates phone subsidies and commercial incentives are likely to cost the carriers a further 7% - 12% of revenues or lost margin. A combined 20% - 27% of revenues spent on supporting the evolution of the smartphone ecosystem is therefore a significant investment.

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