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Tuesday, July 11, 2006

Barriers to Entry for New Cellular Entrants


Whilst reading the Andrew Odlyzko’s latest article in IEEE Spectrum Magazine on valuing networks, I was constantly thinking back of how to quantify the barriers to entrants that cellular networks create in order to ensure oligopoly profits and avoid being “dumb-piped”. I have not included the big two which are the spectrum cost and network build out cost because they are typically transparent to all and factored in. Furthermore with the last big round of EuroLicensing for 3G networks everyone had similar spectrum costs and the new entrants had slightly higher network build costs.

1. Termination Fees

If I own an interconnected cellular network, my incremental marginal costs will be directly proportional to the amount of traffic leaving the network and I will gain addition revenue for every inbound call from another network completed on my network. These fees are normally set by the regulator and are an incredibly important barrier to entry.

Obviously, if I am new entrant my market share is zero and I will be paying termination fees for nearly every call my customers make. I also will be receiving a lot less in absolute term inbound revenue since my base is so small. My margins will be a lot smaller than the incumbents. This “barrier to entry” continues until an equilibrium is reached in the marketplace whereby the new entrant has revenue to cover its’ net termination fees.

It is important to realize that the size of this barrier is proportional both the size of the termination fee and the inbound/outbound call volumes relative to the market for the new entrant. Most regulators frequently try to compensate for this phenomenon by allowing new entrants or operators with smaller market share to have higher termination rates than the operators with the largest market share. It is also important to observe that all customers are not created equal as far as networks are concerned: obviously higher traffic customers are worth much more for incumbents than the low users. Cellular Operators also design plans to keep as much traffic on-net as possible and avoid external costs.

2. Churn

The next most important factor especially in a saturated market is the rate of churn, obviously the lower the rate the longer it is going to take a new entrant to get to equilibrium and therefore the higher the initial operating losses and funding requirements. Quite often the incumbents lengthen the contracts prior to the launch of a new entrant to make the job of the new entrant harder.

3. Customer Acquisition Costs

The new entrant needs not only the capital to acquire spectrum, build-out the network and finance start-up losses, but it needs enough money to acquire enough customers to get to equilibrium. The higher the Customer Acquisition Costs the higher the barriers to entry. A new entrant has no sales distribution network to speak of and usually has to pay existing third party distribution networks more money to acquire customers than the incumbent. This is if a third party distribution network exists at all – new entrants rarely go for the corporate network initially, because it is just too difficult to gain traction and trust in this sector. As well having higher indirect costs, a new entrant also faces the fact that they have to discount beyond the existing operators prices to get people to try the service. Also, cellular operators are the masters of bundling equipment “for free” to higher usage customers – again this adds more to the customer acquisition costs. These Customer Acquisition Costs can sometimes, incredibly, be higher than the cost of the network build.

4. Sarnoff’s Law

As the sale of content becomes more important to the operators revenue base then Sarnoff’s Law will get more important as applied to content distribution. In other words, an incumbent network is worth much more than start-up for a content distributor and theoretically content distributors can negotiate a much better deal than the new entrant. I can’t think of anywhere in the world that this area is currently regulated and therefore expect the big cellular operators to be driving extremely hard bargains in revenue share agreements. Also, in terms of net neutrality the ball is on a different foot this time for the Google’s, Yahoo’s & MSNs of this world: expect to see them paying big revenue share deal to get onto the mobile networks - much, much more than they paid in the fixed line world.

5. Investor Patience

Especially for a quoted company, the most difficult barrier to entry to overcome is investor patience. Just the mention of TeliaSonera entering Spain caused the share price to drop. If anything goes wrong and payback takes longer than expected they could end up with a semi-crippled subsidiary without the investment required to get to “optimal” market share. HWL are more-or-less in this phase with investors applying serious pressure for them not to put anything more capital into the various 3 start-ups across Europe, but 3 desperately needs more market share to make them worth something as assets.


There are a lot more barriers to entry than people may think and new entrants are at a severe disadvantage for the early critical part of their life. This is why I believe we will see in the next couple of years quite a few failures (or sales of sub-optimal networks) as the markets become more saturated.

The challenge for the EuroRegulators is to avoid the temptation to stop the consolidation phase. I can think of nothing worse than a few sick operators being propped up by over-zealous regulators and dying an undignified slow death. Scale matters much more than people realize in the mobile world.