Economics and Technology, Inc. -- Views and News, July 2010

July 2010

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Wireless Markets: No Longer "Effectively Competitive"?

The FCC recently released its 14th annual report on Commercial Mobile Radio Service (CMRS) competition – an annual summary of the wireless marketplace and report to Congress. This new edition is similar to past CMRS reports, providing coverage maps, industry statistics, and narratives about the industry. But one aspect of the current report represents a major departure from any of the previous releases in this series: The Commission having repeatedly declared the US wireless market to be “effectively competitive” in each of the first thirteen CMRS Reports, that pronouncement is nowhere to be found in the 2010 version.

To be fair, the Commission doesn’t expressly reverse its previous conclusion by declaring that effective competition is absent from the wireless marketplace. Rather, the Report simply acknowledges that there is a lot of data out there, and a very comprehensive review will be required in order for it to make definitive determinations as to the actual level of competition. While the Report does not explain what would need to be shown to demonstrate that the CMRS market is “effectively competitive,” it does contain specific data that sheds light upon the status and direction of competition in the wireless industry. Indicia such as market share, profitability and contract terms and conditions all suggest that the FCC is on the right track in refusing to declare victory – i.e., that widespread “effective competition” is now present in all wireless sectors.

Market shares

Despite the breakneck pace of adoption of wireless services in the US, competitive entrants have generally had a difficult time establishing themselves. Smaller companies have either folded, or more often, have been acquired by a larger carrier. At the outset of the 2000 decade, the wireless market was made up of six nationwide competitors and a mix of strong regional carriers (often the only ones serving rural areas). Although the national carriers unsurprisingly held the lion’s share of total US subscribers, market shares were reasonably distributed, both among multiple competitors and as between RBOC-affiliated and independent wireless companies.

At the beginning of 2000, there were eleven major wireless carriers each serving more than one million subscribers, and dozens of others offering service in regional footprints. Now, at the end of that first decade of the 21st century, the complexion of the wireless market looks very different. The mergers of Bell Atlantic and GTE and their partnership with Vodaphone’s US properties combined to create the largest nationwide carrier – Verizon Wireless. In 2001, SBC and BellSouth quickly partnered to form Cingular Wireless, then the second largest US carrier.

Despite these consolidations, the marketplace still seemed capable of supporting numerous competitors. By the end of 2003 Verizon Wireless served 24.8% of US wireless phones, while the top four companies together held a 65.7% market share. The two RBOC-affiliated companies (Cingular and Verizon) combined had a lower market share than the independent companies (AT&T Wireless, Sprint, T-Mobile, and Nextel). Regional carriers Alltel and US Cellular had respectable shares of the total US market at 5.3% and 2.9% respectively, and of course higher shares within their specific regions.

However, the mergers and acquisitions did not stop in 2003, and the market dynamics have shifted dramatically. The latest CMRS Report, providing data as of 2008, reveals that on a pro forma basis (reflecting Verizon’s January 9, 2009 acquisition of Alltel) concentration in the US wireless market, as reflected in the market shares held by the largest firms, has risen sharply. Verizon, together with Alltel, served nearly 32% of all US wireless subscribers. AT&T Mobility (the combination of Cingular and AT&T Wireless) was a close second at just under 30%. Together, these top-two carriers, both RBOC-affiliated, controlled 61% of the US market. The top-four companies (Verizon, AT&T, Sprint, and T-Mobile) together controlled a whopping 89% share – even with Sprint’s loss of 3% share from the prior year. The largest regional player, US Cellular, also lost share relative to its 2007 level. The rumored combination of T-Mobile and Sprint would further reduce the number of active wireless competitors serving US customers.

Profitability

It should come as no surprise that wireless profitability has been on the rise consistently during the 2000s as market concentration increased over the decade. Profit can be measured in many useful and interesting ways, although the data necessary to examine wireless profitability on, for example, a service-by-service basis is generally not available in the public realm. The FCC examines overall profitability as measured by EBITDA margin (earnings before interest, taxes, depreciation and amortization). While comparing year-over-year EBITDA data can be tricky (as accounting rules can cause fluctuations in earnings unrelated to actual profits), long term trends in EBITDA make the growth in profitability abundantly clear. From 2002 to 2009, Verizon Wireless increased its EBITDA margin from 39.5% to 46.3%. T-Mobile grew its margins from 9.1% in 2002 to 33.1% in 2009. AT&T Mobility moved from 31.1% in 2005 (the earliest data point available from the FCC) to 38.3% in 2009. Upstart MetroPCS grew its EBITDA margins from 28.9% in 2005 to 30.5% in 2009.

MetroPCS’s entry, as it turns out, serves to demonstrate the limited role small firms play in constraining the market power of the dominant incumbents. According to theCMRS Report, MetroPCS’s market share (as of the end of 2008) was only 2.05%. The carrier has introduced several very aggressive pricing plans – for example, it currently offers a $40 plan providing unlimited voice, texting and data, with the $40 monthly charge inclusive of taxes, surcharges and fees. This price point is substantially below the corresponding unlimited voice/data/texting plans offered by Verizon, AT&T, and Sprint, which vary between $99.99 and $119.99 plus taxes and fees. Notably, the major carriers apparently have not felt compelled to match or otherwise respond to MetroPCS’s pricing initiative, suggesting that they view the small, single-digit share loss to MetroPCS as having a much smaller financial impact than an across-the-board price cut to match MetroPCS’s $40 price point. The growing profit levels coupled with the lack of corresponding price reductions on the part of the dominant incumbents demonstrates the ever-decreasing level of competition in the wireless marketplace as concentration and consolidation escalate.

Contract Terms: Two Year Contracts and Early Termination Fees

Landmark class action lawsuits were brought against Sprint, T-Mobile, AT&T and Verizon, in each instance alleging that flat rate Early Termination Fees (“ETFs”), assessed when a subscriber terminated a long-term contract prior to its fulfillment, constituted unlawful liquidated damages penalties. T-Mobile, AT&T and Verizon all settled these cases (while a California jury awarded plaintiffs $299-million against Sprint) resulting in the carriers ending the practice of charging flat rate ETFs. The lawsuits did not address the fundamental anticompetitive nature of locking subscribers into long-term contracts that would likely be difficult or impossible to impose in a robustly competitive marketplace.

Despite this outcome, the carriers continue to lock subscribers into long term contracts and charge ETFs when the contract term is not fulfilled. The FCC notes that the current (post-settlement) ETF regime imposes a pro-rated charge that declines over the life of the subscriber’s contract. Although this change of practice is undoubtedly a step in the right direction, analysis of the current ETFs, along with new increased ETFs for advanced devices, casts further doubt as to the level of competition actually present.

Both AT&T and Verizon now charge $350 pro-rated ETFs for smartphones, a move that Verizon describes in a letter to the FCC as reflecting the higher costs of providing these more expensive devices at “attractive prices” as well as what Verizon characterizes as the added risks associated with broadband network build out. The specific linkage that Verizon seeks to draw as between ETFs and its overall broadband build-out are indirect at best.

First, so-called “handset subsidies,” to the extent they actually exist for any specific wireless phone, turn out to be considerably smaller than the major wireless carriers claim as the basis for their ETFs, when properly viewed in terms of the carrier’s out-of-pocket wholesale cost rather than its often-inflated “retail price.” Moreover, much of the “subsidy” is recovered immediately via up-front “activation fees” and by the nominal purchase price collected at the point of sale. During the ETF litigation, ETI calculated the average handset subsidy for 2006 at only $14.33.

Second, any handset subsidies being offered are a part of the carrier’s marketing plan to induce customers to subscribe to the wireless service and thus result in a stream of recurring revenue to the carrier. Evidence introduced in the ETF lawsuits demonstrated that the average revenue over the service life of a customer was many multiples of any up-front “subsidies,” even when early terminations are included in such average revenue calculations. Firms in any number of industries have adopted a strategy of sacrificing profits on sales of a “platform” product in order to stimulate demand for an aftermarket product whose ongoing purchase results in a recurring revenue stream. Examples of such practices include razors (which create sales of blades), ink-jet printers (which create sales of proprietary ink cartridges), and Polaroid cameras (which created sales of Polaroid film). In none of these cases was the purchaser of the “platform” product required to make any specific commitment to a minimum purchase of the secondary product.

The FCC acknowledges that the ETF is “...probably the largest quantifiable cost to consumers who wish to switch service providers.” Term contracts and termination penalties unquestionably increase switching costs for consumers, which makes them less available to rival wireless providers. The persistence of term contracts with termination penalties is itself evidence of a less-than-competitive market – particularly in light of the fact that the large established carriers continue to require contracts and impose penalties even though many smaller entrants, such as MetroPCS, do not.

All of this is not to suggest that there are no competitive forces acting in the wireless market. The FCC seems to correctly acknowledge that some areas have become more competitive, while competition elsewhere has diminished. But with concentration on the rise and additional consolidations in the offing, it may still be quite some time, if ever, until the Commission can truly declare victory in its ongoing efforts to foster competition in this key telecom sector.

If you would like more information on this subject, please contact Colin B. Weir.

Read the rest of Views and News, July 2010.

About ETI. Founded in 1972, Economics and Technology, Inc. is a leading research and consulting firm specializing in telecommunications regulation and policy, litigation support, taxation, service procurement, and negotiation. ETI serves a wide range of telecom industry stakeholders in the US and abroad, including telecommunications carriers, attorneys and their clients, consumer advocates, state and local governments, regulatory agencies, and large corporate, institutional and government purchasers of telecom services.