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Vocus means businessIn the last two years, four potential buyers have looked, then decided not to buy the Vocus Group.

Last week Australian energy company AGL withdrew its A$3 billion takeover offer for Vocus. This came only two weeks after Swedish private equity firm EQT halted its $3.3 billion transaction.

In 2017 private equity firms Kohlberg Kravis Roberts and Affinity Equity Partners both withdrew bids. In each case, the deal floundered at the due diligence stage.

Bruised Vocus

It’s been a bruising experience for an already damaged Vocus. When AGL walked away from this week’s deal Vocus shares lost a third of their value.

On the surface, the bad news apparent during due diligence means there’s something bad in the financials that Vocus hasn’t disclosed to shareholders. It’s something that well-funded companies are not able to spot before bidding.

Reports in Australian media say that bidders walk away from Vocus because the plan to turn around the business is more complex than it appears from outside the company. There is something in this, but it is probably not the whole story.

Consolidation

Vocus is the result of a number of telecommunications industry mergers. It is a rare example of classic industry consolidation.

Along the way, Vocus acquired other companies. At times it has struggled to integrate the parts. That’s not uncommon in the telco sector.

Vodafone New Zealand acquired a number of businesses. Years later it has still not completely integrated the various back-end systems. Customer enquiries can mean service agents need to reference several screens to answer simple questions.

This Balkanisation is how large companies made up of smaller concerns often operate.

So long as there is plenty of forward momentum those tricky integration issues can be kicked down the road. Over time they can either be fixed or, for one reason or another, they simply stop being a problem.

The big Vocus problem

That’s a problem for Vocus, but it isn’t the big one. Far more serious is that Vocus’ Australian consumer business is losing money.

In part that’s because Australia’s NBN model has flattened the market to the point where it’s hard to turn a buck selling broadband. There’s no clear path to profitability.

AGL looked like a good buyer because it’s a power company. Combining power and broadband sales is a tried and tested strategy. If the AGL bean counters looking at Vocus’ books realised that could turn things around, the problem is worse than most of us thought.

Even though Vocus is, to some degree, a special case, it isn’t that out of line with the rest of the telecommunications industry.

No quick path to profit

All of which says bad things about the state of retail telecommunications. The private equity investors have looked and seen there is no quick path to profit.

More patient, longer-term investors like AGL, who have access to the magic formula of adding power sales to a broadband subscription don’t think it looks viable either.

If you work in the sector you might want to worry about that.

EQT Infrastructure’s A$3.3 billion takeover bid for Vocus Communications could see a new owner for the New Zealand business.

Vocus Group New Zealand includes the Orcon, Slingshot and CallPlus brands along with other assets. It is the third largest telco behind Spark and Vodafone.

The potential buyer, EQT Infrastructure, is a Swedish private equity investor.

Vocus commands good price

EQT’s bid, which became public on Monday, put a 35 percent premium on Vocus Communications’ trading price at the time.

Insiders say the bid is likely to succeed. Although there are other potential bidders waiting in the wings should EQT’s offer fall through. Either way, Vocus is likely to find a new owner soon.

The EQT bid comes only days after Infratil and Brookfield’s successful bid for Vodafone New Zealand. It suggests other telco sector mergers and acquisitions could be on the way.

This is not the first time investors have attempted to buy Vocus Communications. In 2017, private equity firms Kohlberg Kravis Roberts and Affinity Equity Partners, made a bid for the company. That was later withdrawn.

According to the Australian Financial Review, the key to renewed interest in the business is Vocus’s fibre assets.

Fibre infrastructure

Infrastructure is an increasingly popular investment class. The returns are relatively high and, in many cases, it faces little direct competition. Fibre assets of particular interest to infrastructure investors at present, they feel that its owners don’t always maximise its value.

The Australian Financial Review goes on to report it’s likely the buy will sell Vocus Communications’s retail business.

Presumably, this would also include Vocus’s New Zealand retail brands.

Vocus has New Zealand local fibre assets. It picked them up from the former FX Networks business now wrapped into the Vocus Group.

One interesting angle is that after 2022 regulated UFB wholesale prices will be based on network asset values. If fibre becomes a sought after asset for investors, that could put pressure on the regulated price.

fibre-optics

On Thursday Chorus released its proposed unbundled fibre pricing for industry feedback. Would-be unbundlers responded with a noise resembling what you might hear when placing an electric guitar in front of an amplifier: a loud howl.

This was always going to happen.

New Zealand’s telecommunications regulations mean that the fibre networks must, by law, be open for unbundling from the start of 2020.

Unregulated, for now

For now, the unbundling process and the prices wholesale fibre companies can charge is not regulated. The idea is that the industry can hold commercial negotiations. If that doesn’t work, then the regulator will step in.

Unbundling worked well for some ISPs when Telecom was forced to unbundle the copper network over a decade ago. ISPs installed their own hardware at an exchange and paid Telecom a monthly access fee.

This worked well for a number of reasons. First, the service providers could cherry pick the most lucrative neighbourhoods. Second, there weren’t many exchanges and each exchange served a large number of customers. Third, the monthly access fee was regulated.

Bitstream then and now

It turned out that the price was considerably lower than the fee Telecom charged for bitstream access. Bitstream access was, to a degree, similar to the service ISPs now buy from New Zealand fibre companies.

The gap between these prices left ISPs with enough room to offer competitive prices to their customers or take the difference as increased margin.

Unbundling fibre is different. Instead of hundreds of exchanges each serving thousands of customers, there are thousands of fibre nodes each serving a handful of customers.

The other big difference is the way we price fibre services. Today’s layer 2 prices are regulated. Prices depend on the level of service, but typically they run from around $40 to around $65 for a gigabit service. The Commerce Commission based its pricing structure on a fibre company’s costs.

Difficulties

Now, this is where things get difficult for would-be unbundlers. The input cost difference for a wholesaler between operating a layer 2 service and an unbundled layer 1 service is pennies, not dollars. That $40 monthly access fee might drop to $38 or thereabouts if it was regulated along the same lines as a bundled line.

This doesn’t leave an unbundler with enough margin to play with.

Despite the unattractive underlying economics two telcos, Vocus and Vodafone, joined forces to push an unbundling programme.

Since late last year they’ve been showing a demonstration of what the technology might look like. They’ve also been dropping unsubtle hints suggesting that: ‘unbundled fibre had better be cheap’.

Like copper only different

Scratch the surface and its clear their thinking is the difference between bundled and unbundled fibre should be in line with things in the copper world.

Chorus’s proposal is that unbundling service providers pay a monthly access charge of $28.70 per line. This covers the fibre line from the customer to the nearest node, Chorus calls these nodes ‘splitters’. Usually 16 customers connect to each splitter.

On top of that, Chorus wants to charge $200 a month for the connection from the splitter to a central point where the service providers can connect the unbundled service to their own networks.

Unbundling at scale

You don’t need to be good with arithmetic to realise that this only works for a service provider if a lot of customers at any splitter want to buy their connection. A would-be unbundler would need to have more than a dozen connections at each node for prices to drop below the basic regulated bitstream monthly fee.

Although keep in mind here that an unbundled fibre line might operate at a blistering 10Gbps. That’s a service that could command a premium retail price.

To no-one’s surprise Vodafone and Vocus made it clear they don’t like the proposed price. A press release from the pair has the headline: “Chorus machinations could put competitive UFB on ice”.

Maths

In it, a clearly angry Vocus CEO Mark Callendar says the maths just doesn’t stack up. He is right. But the legislation was designed that way. There isn’t enough margin between layer 1 and layer 2 to make an ISP happy.

An access price that would please Callendar, at a previous media function he told me it should be under $20, would leave the fibre wholesale companies under water. They’d be bankrupt in no time and that would put critical national infrastructure at risk.

Back to the release where Callendar says: “…the Commerce Commission will now need to intervene, it’s as simple as that. The UFB network was designed to be unbundled and ultimately is an asset that the government has helped fund.”

The Commerce Commission was destined to be dragged into this row from the moment Vocus and Vodafone first announced an intention to unbundle.

Intervention

If it does intervene and assuming it follows a similar cost-based model, the would-be unbundlers are going to be as disappointed then as they are now. The economics of fibre unbundling mean it is a path that’s not worth the trouble, at least as far as residential customers are concerned.

Now, it’s quite possible that the spat you see on the surface is all there is. Yet there’s something else at play. Since the fibre network started, most of New Zealand’s service providers have raced to the bottom on price. It’s about the only point of difference they feel able to compete on.

As Vodafone CEO Jason Paris has said to me in a previous interview, they have competed away all the profits in the broadband business.

Thin margins

Margins are razor thin. Unbundling had potential to fix that. It’s also an opportunity for two high profile telcos to position themselves publicly as against New Zealand’s telecommunications regime without actually saying they are against the regime. Make no mistake, that’s the real object of their ire. 

In the public statements so far, they’ve poked the finger at Chorus.

There’s something in that. But Chorus is a creation of a telecommunications regime that the previous National government set up. The Labour government continued the same regime. There’s a broad political consensus that our telecommunications market is working as designed.

You could see Chorus as the government’s proxy in these matters. A useful punching bag if you don’t like the rules. 

Equivalence

One part of the disliked regime is something called equivalence. The idea is that Spark, Vodafone and Vocus get exactly the same prices, products and services from fibre companies as a five-person regional ISP working in rural Taranaki.

The big firms hate that. They like to use their clout and economies of scale to negotiate better terms from suppliers. Regulation stops them.

Consciously or unconsciously, Vodafone and Vocus hope the government is listening. That’s why so much of their rhetoric about unbundling uses politician-pleasing words like ‘innovation’ and ‘competition’.

Competition

Unbundling is clearly a competitive1 move, but it’s not really innovation in the sense we normally use the word. Assuming it is doing everything right at the back-end, the only practical option an ISP has to innovate with unbundled fibre services is to remove some of its capability from certain customers.

Remember this as the war of words heats up in coming months and the various parties troop into the Commerce Commission. They’d like to get a lower price for unbundled fibre.2 Who wouldn’t? But what they really want is to take back a little control and restore profit margins.

Disclaimer: Chorus pays me to edit the Download magazine and a weekly newsletter. It didn’t pay me to write about unbundling. Indeed, this post doesn’t reflect anyone’s opinion other than my own, certainly not Chorus’. No one vetted or otherwise approved this. Any mistakes are down to me. Your corrections or alternative opinions are welcome.


  1. Spark has options with its fixed wireless broadband. These should ramp up when 5G arrives. Vodafone ought to be able to do the same, but the local firm isn’t getting the investment it needs from Vodafone Group. Unbundling is a cheaper option. ↩︎
  2.  

  3. I’d expect the Commerce Commission to insist wholesale fibre companies propose a single per-line price in place of the more complex line and splitter tariff. ↩︎

Sky TV launched legal action in a bid to force ISPs to block access to streaming and video download websites.

As you’d expect, the move didn’t go down well with the industry. At least two ISPs say they will fight Sky in court.

Sky sent notice that it will seek court orders for Spark, Vodafone, 2degrees and Vocus — which trades as Orcon, Slingshot and Flip – to block a list of unspecified sites. The date blocking should start is not specified in the letters.

Spark and Vocus seem ready to resist.

The four ISPs account for more than 90 percent of all online accounts in New Zealand. If Sky gets them to block, picking off the smaller players will be trivial.

Pirate Bay

Sky TV’s letter specifically names the Pirate Bay as a site it wants to be blocked.

The pay TV company says it is targeting illegal pirate sites as they are a threat to local entertainment industries and sporting codes.

The timing is curious. Most of the threat from piracy has subsided. The battle is won.

Once were pirates

It would have made sense for Sky to have moved against these websites in the past. But today piracy is only a shadow of its former self.

Vocus consumer general manager Taryn Hamilton says his company’s stats show visits to The Pirate Bay – a popular file-sharing site – is now at 23 percent of its 2013 peak.

Most of the damage to Sky TV’s business was done a long time ago. Today pirates are no threat. Legitimate online streaming services like Netflix, Hulu and Amazon are what is really killing Sky’s business. They have already killed the pirates.

They offer a similar mix of entertainment programming at a fraction of Sky’s price. Netflix is $15 a month, Sky TV is around $80.

Sport is different

Things are different with sports programming. Sky has the rights to the most popular sporting codes in New Zealand, there are no legitimate alternatives.

While determined customers with VPNs can often shop around overseas for a better deal, it’s often too much trouble for most people. And overseas coverage can be inferior,

Hamilton says the idea of Sky blacklisting sites is dinosaur behaviour and something you might expect to see in North Korea.

It is certainly dinosaur behaviour. The fact that Sky names the faded and diminished Pirate Bay as a public enemy is a sign of how out-of-touch it is with the current scene.

Yet blocking websites isn’t restricted to totalitarian North Korea. A number of countries have laws blocking pirate websites. Often after the kind of litigation Sky plans. Web-blocking regimes don’t always work. There are plenty of workarounds for determined pirates.

Fighting Sky

Hamilton says Vocus will fight Sky in court. His company is not alone. Spark says it also aims to fight the injunction. Last time there was a copyright battle, Spark sided with Sky TV.  InternetNZ says it is seeking legal advice. Vodafone, which has a close relationship with Sky, says it will comply with any court order. At the time of writing, 2degrees has yet to commit.

Should the four ISPs co-ordinate their defence, maybe with help from InternetNZ and other interested parties, life could be difficult for Sky, which is already in long-term decline as it continues to fail to adjust to new technology.

Lawyers are obvious winners here. Litigation is likely to be expensive. One problem is there is no precedent in New Zealand for this kind of complaint, the Copyright Act stems from a time before video streaming was practical. Until now most service providers have walked away from pitched battles.

Kodi victory

Around the time Sky sent letters to the ISPs, the company won an interim injunction against Fibre TV which sells the Kodi set-top box. Fibre TV sells the set-top box along with software designed to make piracy easy. The decision was made in the Christchurch District Court and Sky was awarded costs.

It is possible that the Kodi victory spurred Sky TV’s renewed interest in attacking the ISPs. Possible, but unlikely. Fibre TV was small and unable to put up much of a fight. The case against Fibre TV was a slam dunk and there’s not much public sympathy for the company.

On the other hand, the attack on ISPs looks set to be a public relations disaster for Sky. The move is unpopular with consumers.

Criticism of Sky TV

As you’d expect Sky TV has come in for a lot of criticism over its move – not just from the ISPs who are in the firing line.

It is fair to say Sky is struggling to defend an outmoded business model. Yet it is equally understandable that the company wants to protect the value of the rights it has purchased in good faith from movie or TV studios and sporting codes.

It is possible that Sky is acting against ISPs on behalf of rights holders. In the past, the big US-based media companies have attempted similar actions. They or the sporting codes could be bankrolling Sky’s litigation or even pressuring Sky to act as their proxy.

All these protagonists seem out of touch with what’s happening on the ground. Netflix has shown how to make software piracy redundant. It charges what consumers consider a fair price for a decent selection of programming. That becomes a compelling alternative to navigating the dark side of the internet.

Sky needs to find a way to cut its prices to Netflix-like levels. From outside, that looks hard because it appears bundling channels lets Sky subsidise some content by overcharging for other content. If so, it is an unsustainable business model. Moreover, the problem has nothing to do with Orcon customers being able to see the Pirate Bay.

Commerce Commission Monitoring ReportLast week Spark boss Simon Moutter told shareholders at the company’s AGM it is cheaper to win customers through merger and acquisition than through market efforts.

The NBR reports him saying: “We expect to see, and participate in, significant consolidation of the retail broadband industry over the next couple of years.

Give that Vocus NZ is on the market, it’s not hard to join the dots here. We can assume that Spark NZ is interested in buying some or all of Vocus.

If Spark buys Vocus NZ

There are other assets, including the fibre network built by FX Networks. But taking Moutter’s AGM comments at face value, Vocus’s broadband business is in his sights. That’s CallPlus, Slingshot, Orcon and a couple of minor brands.

Let’s assume the price is right and Spark is able to beat any rival bidders. What does this mean for market competition?

It all depends on which market you’re looking at. If we take the total New Zealand retail telecommunications sector as a whole, a Spark-Vocus acquisition would not change much.

A good starting for measuring market share among significant players is the 2016-17 TDL liability allocation determination drawn up by the Commerce Commission.

This is used to work out each telco’s share of the Telecommunications Development Levy. Only sizable telcos pay the levy, their share is proportional to the company’s share of the total qualifying revenue. In effect this number is the company’s share of the retail telecommunications market.

Spark dominates

Spark is by far the largest market player with a 35 percent share of the industry qualified revenue. Vocus is the fifth largest company on the list, but its share is a shade over three percent. Add the two together and the list looks much the same as before.

On this basis there is almost no obvious reason for the Commerce Commission to object to Spark NZ buying Vocus. The market dynamic would be almost the same as before.

The almost in that last paragraph is because the Commerce Commission’s Annual Telecommunications Monitoring report for 2016 shows Spark’s share of fixed line retail revenues as a line item. It has been falling for a decade.

By implication, Spark’s falling market share shows competition is working. If Spark acquired Vocus NZ, this figure would tick up. That may or may not be enough to ring alarm bells. Yet, while the Commerce Commission may not relish industry consolidation, it can’t necessarily stand in the way of bigger-picture market trends.

Broadband market

Retail broadband market share NZ 2016

Things get tricky if the Commerce Commission decides competition is important in the broadband market.

Spark is the largest broadband retailer with a 46 percent market share. Vodafone is number two with a 29 percent share. Vocus is the next largest player with 14 percent of the market.

The three top broadband retailers have 90 percent of the market.

Add Spark’s broadband market share to Vocus and you have a company with 60 percent of the market.

Spark is already the largest and in every respect it dominates. Yet to go from 46 percent to 60 percent would reset the market.

If Vodafone were to buy Vocus NZ, it would still have a smaller market share than Spark. The two would be, in effect, on equal footing.