Expertise in margin squeeze Introducing Analysys Mason

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Expertise in margin squeeze Introducing  Analysys Mason Powered By Docstoc
					Introducing Analysys Mason

Expertise in margin squeeze

James Allen


Margin squeeze analysis verifies whether there is enough
economic space for alternative operators to compete effectively
 A dominant firm is abusing its market power if it sells products in different parts of the value chain (upstream and downstream
 markets) at prices that mean that alternative firms cannot compete due to too low a margin between these prices

       This would over time lead to the ousting of competitors

 National regulatory authorities (NRAs) face two opposing goals when regulating these tariff differences

       Ensuring margins for alternative operators are not squeezed by too low a margin between the incumbent’s retail and
       wholesale tariffs (and by extension, ensuring a particular wholesale service does not squeeze another wholesale
       alternative (e.g. local loop unbundling could be squeezed by low wholesale tariffs for bitstream)

       Allowing incumbents to compete fairly with low retail prices – to the benefit of consumers

 Reaching a satisfactory compromise between these two goals requires a very good understanding of the economics of the
 services under examination and their likely evolution over the future years

 Alleged squeezes can relate to specific routes, services (e.g. national calls), customer types (e.g. residential), cohorts (e.g.
 customers joining in 2010), geography (e.g. rural customers)

 Disputes can arise either from too low prices of outputs or excessive pricing of wholesale inputs

       For a margin squeeze test to fail, the retail price does not need to be predatory and the wholesale price does not need
       to be excessive

       Margin squeezes could still exist even if one of the prices is regulated

            Source: Analysys Mason

There are many different forms of margin squeeze test

 Depending on the nature of the service and the status of the                                                Illustration of outcome of a
 market, a static or a dynamic margin squeeze test may be a                                                dynamic margin squeeze model

 more appropriate choice
                                                                                              60                                                            10

                                                                                                                                                                 Cumulative units (GBP millions)
       Static models are, in general, appropriate for mature

                                                                Annual units (GBP millions)
       markets                                                                                40
                                                                                              30                                                            5
       Dynamic models (cashflow) are appropriate for
       early-stage markets or markets under significant                                       10
       change                                                                                  0                                                            0
                                                                                                    2004    2005      2006        2007    2008    2009
          –   An appropriate time horizon is needed                                           -20
                                                                                              -30                                                           -5
 It is also essential to determine whose costs need to be
                                                                                                     Revenues      Opex + capex     FCF    Cumulative FCF
 taken into consideration

       Those of the incumbent (leading to the ‘equally
       efficient operator test’)

       Those that an alternative operator can realistically
       achieve (the ‘reasonably efficient operator test’)

 The cost of capital is another key parameter

              Source: Analysys Mason

A margin squeeze analysis needs to be accurate and often needs
to be undertaken rapidly
 With margins for most telecoms services being low,          Our skills and experience help with the need for both
 margin squeeze models need to have a high level of          accuracy and speed
 accuracy if used for setting margins                              We provide relevant benchmarks and support on
       Small differences in margin could potentially be            the determination of key variables for the design of
       significant                                                 the margin squeeze test

       Too high a margin, if imposed by regulation, can            Our experience in business planning and
       lead to undesired effects just as much as too low a         international benchmarking places us in a excellent
       margin                                                      position to complement and cross-check cost

 To be able to rapidly and accurately assess the available         information provided by operators

 margin, a detailed understanding is required of the costs         Our models generate a number of critical outputs,
 of the competing operators (wholesale inputs and own              including
 network costs)
                                                                     –   Overall profitability and profitability split by
 This is further complicated by the fact that often more                 service and customer segment for greater
 than one wholesale product can or has to be used to be                  visibility of results
 able to provide an equivalent retail service – which is
                                                                     –   Minimum gross margin required to achieve
 often the case for broadband services
                                                                         economic break-even (including return on
                                                                         capital employed)

Our approach ensures both the technical and commercial
requirements of the services under consideration are properly
The margin squeeze test requires comprehensive                                   From the commercial side, the margin squeeze test
modelling of the technical requirements of the service                                demands full understanding of all retail costs

  Accurate modelling of the                                                                                  Advertising and
  efficient usage of the                           Costs along the value chain to be                         acquisition costs
                                                 considered in a margin squeeze model*
  wholesale services                                                                                         (including discounts and
  on a forward-looking basis               Wholesale               Own infrastructure                        subsidies) – need to
                                           products (provided      and other               Retail costs
  Understanding alternative                by incumbent)           technical costs                           consider the competitive
  technical architectures                                                                                    environment of the
                                        COGS on                 Switching               Advertising
  that may be employed                  consumption                                                          specific retail market
                                                                Transmission            Acquisition
                                        basis (per
  capex and opex                        subscriber, per         Backhaul                Commissions          Start-up costs may be of
  requirements associated                                       O&M                     Distribution         relevance in the case of
                                        COGS on
                                                                Software                Billing
  to each alternative                   capacity basis                                                       recently liberalised
                                        (per port, per                                  Post-sale service
  Potential economies of                point of presence)      International                                markets or markets that
                                                                                        Customer care
  scope associated with                 Activation fees
                                                                                        Bad debt
                                                                                                             require demand building
                                        Complementary                                                        actions on the side of
  the provision of
  complementary services                products                                                             operators

              *Source: Analysys Mason

Some of our high-profile margin squeeze assignments are
presented in the following slides

    Case studies   Client type               Summary

    Case study 1   Incumbent operator        Design of new broadband access offers that meet regulatory
                                             conditions, including margin squeeze test

    Case study 2   Grouping of competitive Impact of pricing proposals by France Telecom on the business
                   organisations           case of alternative operators at all positions in the value chain
Case study 1                                                                                                                                                           7

    Design of new broadband access offers that meet regulatory
    conditions, including margin squeeze test
    Business challenge

      Our client was intending to lower its Internet access service prices. As such, it sought to develop robust economic and regulatory documentation to
      pre-empt potential complaints from its competitors, which were trying to demonstrate that its offers were squeezing them
      Analysys Mason was asked to provide economic elements to demonstrate that the offers from the incumbent were not anti-competitive

                                                                                             List of cost inputs provided for squeeze test
       Provided advice and cost inputs relating to the
       development of a margin squeeze test, which aimed
                                                                                             Network costs                              Other costs
       to show that our client’s offers could be replicated by
       an alternative operator in a profitable way                                   DSLAM              Service platforms               Customer care
       Carried out a detailed international benchmark of
                                                                                                                                         Billing and
       broadband offers to assess the position of incumbent                        ATM routers            Leased lines
                                                                                                                                        debt collection
       Internet service providers (ISPs) in comparison to
       their main competitors                                                     ATM switches            Co-location                      Bad debt
               This benchmark was used to demonstrate that
               in other European countries the prices of the                     Ethernet switches          IP transit               Sales and marketing
               incumbent operators were close to the prices
               of alternative operators for similar services                      GBIC modules             Dark fibre                        G&A

                                                                                                          Broadband                       Subscriber
                                                                                    IP routers
                                                                                                         access server                    acquisition

    Benefits and results
      The results of our work were used by our client to design its offers as well as prepare the dossier to be used in front of the regulator and other competition
      Our inputs allowed our client to gain regulatory approval for its offers

                     Source: Analysys Mason
Case study 2                                                                                                                                                      8

    Impact of pricing proposals by France Telecom on the business
    case of alternative operators at all positions in the value chain
    Business challenge
      The French regulator was in the process of reviewing and validating the evolution of wholesale tariffs. As such, the members of the AFORST* wished to
      obtain a robust and objective reference tool for modelling the various tariff options for France Telecom’s broadband DSL products. This tool was intended
      to form the basis for a healthy and incontestable discussion of these tariff options
      Analysys Mason was commissioned to help alternative operators and the regulator appreciate the impact that the evolution of the incumbent’s retail and
      wholesale DSL prices was having on the DSL market

                                                                                           Output from economic models developed (extract)
      Given the AFORST members’ different positions, a broad approach was
      required – for some members, the ‘squeeze effect’ of changes in certain
      specific tariffs was of critical importance; others were more interested in an
      analysis of France Telecom’s costs with the consequent possibility of a
      general reduction in tariffs
      To reflect these varying concerns and priorities, we developed a set of
      robust economic models, for use by the operators and the regulator, to
            Analyse the business case of operators at all positions in the value
            chain (such as infrastructure-based operators, retail ISPs and
            vertically integrated operators)
            Investigate the possibility of the existence of a margin squeeze
            Calculate the long-run incremental costs incurred by France Telecom
            in offering wholesale DSL services

    Benefits and results
      Our methodology made it possible to respond to the needs and concerns of all AFORST members. The results of this study were presented to the French
      regulator, which took them into account when evaluating the price evolution requested by France Telecom
      We developed a parametric model that could easily be set up to represent the business model of various OLOs/ISPs (infrastructure based, simple reseller
      etc.). Our models have been used by several operators in their responses to regulatory consultations on broadband markets

                     Source: Analysys Mason
                     *Association of French Service and Telecoms Network Operators

Other recent examples of margin squeeze projects

Country           Client type   Project scope                                         Our achievements

Greece            NRA             To review the costs of the different actors in        We developed a calibrated model based on a theoretical
                                  the Greek retail and wholesale market. The            OLO and used costing and network data from the OLO
                                  goal was to determine the margins in order to         and the incumbent. The results were used to set
                                  see if the regulated IX and retail tariffs needed     remedies for ensuring proper competition in accordance
                                  adjustment                                            with the country’s laws

South East Asia   NRA             Evaluation of margin squeeze between retail           The outcome of our study was a report and Excel model
                                  and wholesale DSL and cable access products           which are being used by the NRA to inform its thinking
                                  in order to determine whether anti-competitive        on future regulation to be imposed in the broadband
                                  pricing was occurring                                 markets

Western Europe    Incumbent       For a major Western Europe incumbent, we              We conducted an international benchmark of similar
                                  provided regulatory assistance to the launch of       offers and prepared pricing and margin squeeze tests to
                                  new voice packages for the residential market         present to the regulator. We also assisted in preparing
                                                                                        meetings with the regulator. Our client appreciated our
                                                                                        responsiveness during the process, which contributed to
                                                                                        getting the offers approved

Europe            NRA             For a regulator, we provided regulatory               We developed a calibrated model based and used
                                  modelling assistance                                  costing and network data from the entrant and the
                                                                                        incumbent. The results were used to set remedies for
                                                                                        ensuring proper competition in accordance with the
                                                                                        country's law

Europe            Incumbent       Mobile margin squeeze test                            We helped prepare a wholesale price list for mobile call
                                                                                        origination and SMS services
                                                                                        We carried out tests to ensure that the proposed pricing
                                                                                        did not generate a situation of margin squeeze
                                                                                        compared to the company's retail prices, as requested
                                                                                        by the regulator

Other recent examples of our margin squeeze projects - 2

Country               Client type       Project scope                         Our achievements

Europe (UK)           NRA (Ofcom)         Review of margin squeeze model        For Ofcom, we carried out an independent review of the
                                                                                margin squeeze model used to set the margin between
                                                                                incumbent IP and ATM-based wholesale broadband
                                                                                access products. Our findings were presented to
                                                                                alternative operators in order to help build their
                                                                                confidence in Ofcom’s model, and a summary of our
                                                                                conclusions was published as part of Ofcom’s decision

Europe                NRA                 Broadband margin squeeze model        We developed a margin squeeze model to help
                                                                                determine appropriate pricing. We considered the full
                                                                                range of retail DSL products offered by the incumbent
                                                                                and a variety of possible wholesale products including
                                                                                DSLAM access and access at a high level of the
                                                                                The client appreciated our ability to develop the model
                                                                                quickly and efficiently, and to populate it with reasonable
                                                                                initial parameters based on our experience in other

We have also related experience, not summarised here, in the areas of
         Cost modelling to support retail minus and cost plus price control
         Testing for predatory prices

      James Allen, Partner
     Tel: +44 (0)845 600 5244
    Analysys Mason Limited
 St Giles Court, 24 Castle Street
    Cambridge CB3 0AJ, UK
Registered in England No. 5177472

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