Rising reserve prices in mobile spectrum auctions are a cause for concern for all

Ever since the Federal Communications Commission began auctioning spectrum rights in the mid 90s nearly all regulators around the world have relied on market mechanisms, such as auctions, to allocate and value spectrum. Regulators recognised that mobile operators themselves were best placed to value mobile spectrum and that the role of the regulator was to design an auction that encouraged operators to reveal their valuations and allocated spectrum to those that valued it most highly. Such an approach should yield a, close to, economically efficient use of spectrum which is a common objective for policy makers. Regulators would however set a reserve price which represented the minimum price they were prepared to accept for the spectrum. The conventional wisdom was to set a low but “non-trivial” reserve price in order to discourage “frivolous bidders”. During the 90s, the Dot Com era and in most recent auctions the actual prices paid have been determined after many rounds of competitive bidding and the final prices were higher than the reserves. However, there is a noticeable trend amongst regulators in auctions for new spectrum such as lots in the 2.6GHz and Digital Dividend frequency range as well as for existing spectrum such as 900MHz and 1800MHz to set a much higher level of reserves than in previous auctions. Specific examples of high reserves compared to historic levels and other auctions include the proposed auctions in Ireland and Switzerland as well as the current auctions in Spain. The trend towards higher reserve prices is a concern for all.

Regulators continue to rely on spectrum auctions to value and allocate spectrum and indeed in some countries, such as Germany, the use of auctions is written in law. However, their confidence in the effectiveness of auctions is being shaken by low levels of auction participation – especially in the case of renewal of existing spectrum

holdings. For spectrum auctions to generate economically efficient outcomes they rely upon competition amongst bidders. However, when the number of bidders matches or is less than the available spectrum such competition will be absent and the spectrum will be sold at the reserve. The absence of excess demand and competition is

increasingly likely as markets mature and potential new entrants recognise the typically higher valuations placed on spectrum by incumbents compared to Greenfield operations and may decide not to participate. This was exactly the experience of the Singaporean and Norwegian regulators in their auctions of existing 900MHz spectrum holdings in 2008 and 2004 respectively. As regulators may expect to only receive the reserve price the level of reserves is receiving a much higher level of attention.

Regulators may have amongst their objectives the goal of capturing for society part of the private value of a  natural scarce resource such as spectrum. With auction prices failing to reflect operators’ private values due to a lack of competition regulators are seeking to estimate the market value for themselves. A typical approach for regulators is to use benchmarks from previous auctions however benchmarking is generally a blunt instrument and the results are heavily influenced by whether the high 3G prices achieved during the Dot Com book are included. As a result regulators are considering developing their own bottom-up valuations to supplement any benchmarking evidence. Indeed at a recent workshop on spectrum valuation in Brussels the majority of the participants were regulators. The task of valuing spectrum is a role that regulators have historically accepted they are poorly placed to perform.

If spectrum is likely to be sold at reserve and regulators are seeking to estimate market values in order to set reserves then this should be a cause of concern for all. Spectrum valuation is a challenging exercise even for the operators who are best placed to conduct the activity. If reserve prices are set too high in error then the spectrum may be left unsold and this will lead to a significant loss of economic efficiency. High reserves may also deter participation in the auction which only serves to reinforce the lack of potential competition within the auction and in subsequent downstream markets. If spectrum prices are based on reserves and spectrum is allocated to the incumbents then the process effectively becomes an administered approach and could suffer from a lack of transparency.

Regulators should make every effort to encourage participation in an auction and if the auction is expected to be competitive they should set low but non-trivial reserves. However, if an auction is unlikely to be competitive then regulators should question the value of holding an auction at all and consider introducing other measures such as

Administered Incentive Pricing to ensure economic use of the spectrum. As with the use of AIP in markets like the UK and New Zealand, if spectrum is going to be priced based on an administered approach then the approach should be inclusive, transparent and involve those that understand the value of spectrum the best, the operators.

By Graham Friend, Managing Director Coleago Consulting

Does the law of supply and demand apply to the mobile telecoms sector?

The recent Annual EU Spectrum Management Conference, at which Neelie Kroes the European Commissioner for the Digital Agenda provided the key note address, saw speaker after speaker present, the now familiar, forecasts of mobile data demand quickly outstripping the available supply of mobile capacity. In most markets the laws of supply and demand would suggest that when demand exceeds supply, prices should rise so that demand falls until equilibrium is reached. Indeed the invisible hands of the market described by the economist Adam Smith should ensure that that a spectrum “crunch” can never exist or at least not persist for long. However, public policy objectives such as affordable broadband for all seem to have resulted in one of Adam Smith’s hands being tied behind its back. The only solution to excess demand it seems, if the views of many conference presenters is anything to go by, is to increase the supply of spectrum available for mobile services. The normal workings of the law of supply and demand seem to have been suspended in the case of the mobile market.

Even if additional spectrum can be prized away from the broadcasters, the military and other users and made available to mobile operators there is still the issue of persuading the operators to invest in the infrastructure to realise the capacity benefits. For an operator to invest it needs to expect to make a reasonable return on that investment. One of the key drivers for the exponential growth in data is the prevalence of unlimited mobile data tariffs. If unlimited tariffs remain the norm then any investment in incremental capacity may largely be swallowed up by customers on unlimited tariffs generating little incremental revenue benefit for operators. When incremental revenue expectations are low developing a business case which generates expectations of a reasonable return on significant infrastructure investment is challenging.

Many studies have shown that mobile is often the highest value use of radio spectrum and that mobile telephony is an enabler of wider economic growth. Policy makers are therefore right to consider making more spectrum available for mobile services. However, policy makers should also recognise that they are reliant upon the business cases and resulting commercial decisions of mobile operators to realise the benefits of additional spectrum. Policy makers may have to accept that even if more spectrum is made available then mobile broadband prices may still have to increase to persuadeoperators to invest to help close the gap between supply and demand. Perhaps the law of supply and demand does apply to the mobile sector after all.

Written by Graham Friend, Managing Director, Coleago Consulting

How to participate successfully in a spectrum auction

Surging mobile data growth and network congestion have created demand for additional spectrum. Governments seeking to reduce national borrowing are anxious to auction additional spectrum to raise revenue whilst also promoting access to broadband services. Mobile operators have little choice but to participate or potentially suffer a loss of competitive advantage.

The last time spectrum was at the top of the sector’s corporate agenda was 10 years ago when governments auctioned 3G spectrum. For most companies the experience and knowledge of the 3G auctions of 2001 has long since been forgotten and many companies must learn how to navigate a spectrum auction all over again. Based on our experience from over 40 spectrum awards we present the keys to successful spectrum auction participation.

Lobby, lobby, lobby: Operators should be proactive in lobbying for an auction design and associated rules, such as those relating to spectrum caps, which best serves their needs. Arguments should be presented in a language that regulators understand such as economic efficiency and promoting competition.

Valuation, valuation, valuation: Bidders must have a clear view on the value of the spectrum lots being auctioned – not only individually but also the value of any synergies arising from geographic combinations, combinations of blocks providing wider channels to benefit from technologies such as LTE or optimal combinations of low and high frequency spectrum which together offer both coverage and capacity benefits.

Clear auction objectives: Economists and auction designers assume that all mobile operators only seek to maximise shareholder value but such assumptions are seldom shared fully by boards. Auction objectives are often couched in terms of obtaining pre-defined blocks of spectrum as cheaply as possible or avoiding any adverse differentials in price for similar lots compared to other bidders. The bid team requires a clear and unambiguous statement from management as to its objectives in the auction.

Know your limits: Economists also assume that mobile operators have unlimited access to funds and are not budget constrained. Few, if any operators are in this luxurious position and management will wish to impose bid limits on the bid team. The bid team need clear guidance on bid limits and how they relate to auction objectives and interact with the valuations of spectrum lots and combinations of lots.

The devil is in the detail: Auction design has improved significantly in the last 10 years which should have made developing bidding strategy more straightforward. However, auction designers are being asked to achieve an ever broader range of auction objectives such as encouraging new market entry, increasing or maintaining competition, promoting investment in rural coverage and ensuring contiguous spectrum to promote efficiency. As a result the use of multi-stage auctions, 2^nd price rules, caps, eligibility rules and linkages to spectrum usage fees for existing spectrum holdings have made developing bidding strategy more challenging. Operators should pay close attention to the detailed auction rules especially if they do not have a pure shareholder maximisation objective and are budget constrained to ensure they have a robust bidding strategy.

Know thy enemy: In some auction formats there is scope for strategic bidding (not bidding “honestly” and “sincerely” based on your valuation) or no choice but to bid strategically (as is the case in some sequential and first price sealed bid auctions) and in such auctions estimating accurately the value of spectrum to your competitors and the their bid limits is as important as knowing your own valuation.

Practice, practice, practice: A bidding strategy is only as effective as its execution Auctions involve high stakes and can be highly pressurised occasions and bid teams need robust protocols and procedures, including disaster recovery, to ensure they can execute the bidding strategy effectively. With some auctions requiring the entry of large numbers of bids (such as the proxy stage of a combinatorial clock auction) or the constant adjustment of valuations to reflect synergies (such as in the case of regional auctions) the bid team is well advised to have developed and tested auction support tools to automate these processes prior to the live auction.

Be prepared to walk away: Successfully participating in an auction may involve walking away with nothing if prices rise above the company’s valuation. It is better to walk away and to have avoided destroying shareholder value than to pay a price above the value of the spectrum.

The $8.5 bn paid by Microsoft for Skype may not be silly money

The $8.5 bn paid by Microsoft for Skype may seem extravagant when looking at Skype as a stand-alone business. However, as anyone involved in valuing M&A deals knows, what matters is the value to the acquirer of the combined business.  Microsoft has a market capitalisation of around $ 211 bn. Microsoft’s business planners will have carefully analysed the deal. A small tweak in one of the drivers of future cash flow will result in a substantial swing in the valuation of Microsoft and the deal could easily be justified on this basis. What immediately springs to mind is the potential of deep integration of Skype with Windows Mobile, potentially lifting Microsoft’s market share in the smart phone operating systems market from its current low level.  Microsoft’s recent tie-up with Nokia provides further leverage in this context. While in the PC operating system market, Microsoft’s dominance lead to regulation limiting bundling (e.g. the EU regulation concerning the bundling of MS Internet Explorer with the operating system), given Microsoft’s small market share no such limitation exists in the mobile operating system market. There is huge scope to integrate Skype in simpler phones aimed at highly price sensitive emerging markets where saving pennies on domestic and international calls matters a lot. Mobile operators are probably watching the acquisition with some trepidation.

Swedish spectrum prices provide a new lower benchmark for Europe

By Graham Friend

The auction for 800MHz spectrum concluded today in Sweden and provides Europe with a new and lower benchmark for this key spectrum band. Spectrum in the 800MHz band, sometimes referred to as the Digital Dividend, is attractive to mobile operators due to its superior propagation characteristics which makes it ideally suited for providing 4G services such as LTE in rural areas and greater in-building coverage in urban areas.

The winners of the spectrum were the four incumbents HI3G, TeliaSonera and Net4Mobility, a joint venture between Telenor and Tele2. The formation of the joint venture may well have reduced competitive pressures in the auction as bidders were capped at a maximum of 2x10MHz allowing for the three blocks to be shared equally amongst the three bidders representing the four incumbents. Two other bidders participated in the auction, Com Hem and Netett Sverige, but as new entrants their business cases would have been weak by comparison with incumbents and very unlikely to exceed the blocking value that the incumbents would have included in the their valuations for keeping out a new entrant.

The result of the auction was a benchmark of US$/MHz/Pop 0.58 which is 63% of the value achieved in Germany and only 32% of the value achieved in the Hong Kong auction which also concluded today. Both the German and Hong Kong auctions faced much higher levels of competitive tension.

There were also interesting results at the operator level in Sweden. HI3G secured its spectrum at roughly 50% of the prices paid by Net4Mobility and TeliaSonera. This outcome is particularly interesting as HI3G may well have had one of the highest valuations for the spectrum as HI3G, prior to the auction, did not hold any sub 1GHz spectrum. This represents another good result for HI3G as the company secured 2x10MHz of 2.6GHz spectrum in the Danish auction at a fraction of the prices paid by other bidders on a per MHz, per Pop basis.

Hong Kong 850MHz spectrum auction prices reflect the advantages of in-building coverage of low frequency spectrum

By Graham Friend

The Hong Kong auction of spectrum in the 850MHz band concluded today with
operators Hutchison and SmarTone securing 10MHz each of paired spectrum for $250
million. The auction, which concluded after 4 days and 41 rounds, saw the winners
outbid China Mobile Hong Kong, CSL and PCCW as well as local fibre network
operator Hong Kong Broadband Network. The 15 year licence includes a 50%
coverage requirement and will allow the winners to deploy 4G technologies such as
LTE in the band.

The price paid generates a benchmark of US$/MHz/Pop 1.78 (the standard measure
for spectrum valuation.) There are relatively few recent benchmarks for sub 1GHz with
which to compare, however two of the most relevant recent examples are Germany
and the USA. The average in Germany was US$/MHz/Pop 0.92 and in the US the
figure was 1.18. The winning bids in Hong Kong look expensive when compared to
Germany however Germany’s auction included reverse roll-out requirements requiring
the operators to cover rural (and therefore less commercially viable regions) first which
would have depressed the price and weakens the value of Germany as a benchmark.
Hong Kong also looks expensive when compared to the US average but Hong Kong is
one of the most densely populated countries in the world. With a population of 7 million
people and a population density of 6,571 people per square kilometre Hong Kong
ranks as the third most densely populated country in the world and sits 165 places
above the US in the world rankings. Many parts of the country are also characterised
by tightly packed sky scrapers providing a topography which can be described as
super dense urban. It is the topography that gives some clue to the value attached to
the spectrum. Sub 1 GHz spectrum has superior in-building coverage characteristics
and in the case of Hong Kong this will have contributed significantly to spectrum
values. Indeed, SmarTone, commenting on the auction result said “at the 850 MHz
frequency band, the lowest frequencies available to mobile operators in Hong Kong,
SmarTone-Vodafone will be able to provide even better in-building radio coverage to its
customers.” Whilst determining the level of in-building coverage from a radio planning
perspective is relatively straightforward and objective, determining the marketing
advantage and how this translates into spectrum value is highly subjective.

Few countries have the same topography as Hong Kong and so those contemplating a
future auction for sub 1 GHz spectrum will be able to draw little insight from the auction
results. If Germany provides a lower boundary of 0.92 and the top 20 cities of the US
(with greater population density) provide an upper boundary of say 4.17 this represents
a wide range of potential outcomes. The Hong Kong benchmark of US$/MHz/Pop 1.78
does not appear completely out of line with the limited benchmarks that already exist
but the prices paid will reflect a much higher degree of subjectivity over valuation and
further variation can be expected when in-building coverage is sighted as a key driver
for spectrum values.

UK to open extra mobile spectrum

The UK used to be at the forefront of mobile communications deployment. The announcement by Chancellor George Osborne that 2.6 GHz spectrum and digital dividend spectrum will be auctioned in 2011 or 2012, now puts the UK well behind Scandinavia, Germany, Austria and other European countries in terms of mobile technology deployment. UK mobile users will have to wait for LTE for another 2 years whereas commercial services are already in operation elsewhere.

However, from the operators’ perspective this is not bad news. Capital expenditure for the acquisition of spectrum at auction and the subsequent deployment is also delayed. It is likely that mobile broadband demand will remain strong and existing capacity would not be sufficient. Operators may be able to increase mobile broadband prices which would help to improve not only UK mobile industry EBITDA margins – which are among the lowest in Europe – but also increase free cash flow. This should delight shareholders.

As regards auction design, the fact that the announcement was made by the Chancellor who is primarily concerned with raising revenue for the government, must be worrying for operators. It is likely that the auction will be designed to maximise revenue.

Canada preparing for spectrum auction

The regulatory authorities of Canada have recently announced provisional plans to release additional spectrum in the 700MHz and 2.5GHz bands. The most recent spectrum auction took place in 2008 when the release of AWS spectrum. The auction resulted in a dramatic change to the competitive landscape with new regional and national players entering thanks to the decision by the authorities to reserve some spectrum specifically for new entrants. The proposed auction for 2012 is likely to be less dramatic.

Recent auctions in Europe for 2.6GHz spectrum suggest that the 2.5GHz band will not attract high levels of bidding however the 700MHz band will be of much greater interest. This time around the auction of spectrum is unlikely to result in new market entry. However, the new entrants currently only hold spectrum above 1GHz and as radio signals at higher frequencies do not travel as far providing coverage is costly. This is particularly significant in Canada due to the sheer size of the country – only Russia is larger. The incumbents Rogers, Bell and Telus all hold spectrum at 850MHz and Industry Canada is likely to impose spectrum caps to ensure that the new entrants are able to gain access to sub 1GHz spectrum in order to improve their competitive positions. In the absence of caps the incumbents would almost certainly out bid the new entrants to maintain their monopoly of sub 1GHz spectrum. Any caps will increase competition amongst the incumbents as less spectrum will be available which will drive prices higher.

Industry Canada is correct to be concerned about the ability of some operators to pay – whilst Rogers recently reported a 20% increase in 2nd quarter free cash flow and both Bell and Telus enjoy positive cash generation the financial performance of 4th players in mature markets has not been impressive and the new entrants will be cash constrained, especially in the current financial climate. Easing the rules on foreign ownership would certainly increase the options for new entrants in relation to raising funds for any auction.

Austrian 2.6GHz spectrum auction results show some consistency with previous auctions but the picture is still confusing

The Austrian regulator RTR concluded the auction of 140MHz of paired spectrum and 50MHz of unpaired spectrum raising proceeds of €39.5 million from the four incumbent operators Telkom, Hutchison, T-Mobile and Orange. The benchmark for the paired spectrum of approximately €0.04 is at a similar level to the results from the German auction which also saw the 4 incumbents secure spectrum but 4 times lower than the Danish auction, another market with 4 existing operators. Whilst relative levels of spectrum supply relative to operator demand is often a significant determinant of spectrum prices achieved at auction it is clearly not the full story.

Austria has one of the most competitive and developed mobile broadband markets in Europe and the need for capacity should have pushed prices higher. However, unusually the RTR attached roll-out requirements to the 2.6GHz band requiring 25% of the population to be provided with coverage with a downlink of 1 MBit/s and 256 KBit/s on the uplink by no later than December 2013. This represents an onerous requirement for operators as it will require them to deploy LTE sooner than perhaps they might have preferred. The coverage requirements will have depressed auction prices. Attaching coverage requirements to the 2.6GHz spectrum is unusual as coverage is usually addressed through lower frequency spectrum bands such as 900MHz and 800MHz as the propagation characteristics of the lower bands are more suited to providing coverage. The mix of strong demand and onerous roll-out conditions mean that the auction results provide little additional insight for regulators and operators who have yet to auction the spectrum.

The relative prices for paired and unpaired spectrum also remains confusing as Hutchison paid less in total for its paired and unpaired spectrum (a total of 65MHz) compared to T-Mobile which only acquired 40MHz of paired spectrum. This outcome is however more likely to be due to the algorithm (effectively a second price rule) used by the regulator to determine the final prices.
The use of second price rules, where the highest bidder wins but only has to pay the amount of the 2nd highest bidder, tends to result in more economically efficient allocations of spectrum but it can lead to interesting variations in price for similar lots. For example Telkom paid 20% more for the same amount of spectrum as Hutchison and T-Mobile paid 40% more on a €/MHz/Pop for its 40MHz of paired spectrum than Orange paid for its 20MHz and the difference is unlikely to be explained in full by differences in spectral efficiencies of LTE in wider bands
As countries such as Switzerland, Spain and the UK prepare to auction spectrum in the 2.6GHz band the Austrian auction provide some insight into the potential value of the spectrum but considerable uncertainty remains.

Heretical thinking: New spectrum may not add value

Hardly a day goes by without a new forecast of mobile broadband demand being published predicting exponential growth in data volumes. This is then translated into a requirement for additional spectrum allocation over and above the digital dividend 700/800 MHz spectrum and the “LTE spectrum” in 2.6 GHz.
Speakers at the 5th Annual EU Spectrum Management Conference in Brussels in June 2010 and the GSMA Spectrum Workshop in the following week articulated a need for more mobile spectrum and urged regulators to make more spectrum available through auctions. Because of the explosive growth in mobile broadband demand, spectrum is deemed to be very “valuable”.

These mobile broadband forecast use the term “demand” when talking about the growth in data volumes. However, incremental demand in the economic sense means incremental revenue, i.e. users must be willing and able to pay for it. Certainly we are not seeing exponential revenue growth. In the mature markets of Europe and North America overall mobile industry revenue is not increasing, and in many cases declining. New revenue from mobile broadband barely covers lower revenues from voice calls, reduced mobile termination rates and lower SMS revenues.

Yet in order to cope with the mobile data tsunami operators buy new spectrum in auctions and subsequently incur further substantial additional capital expenditure (capex) for technology deployment in the new frequency bands and backhaul. In recent years, much to the relief of investors, mobile operator’s ratios of capex to sales had declined and cash flow generation was increasing. Unfortunately, with new spectrum and new technology deployment the trend is again reversing. Shareholders must be asking themselves the question where is the value in this additional spectrum?

On the basis of this analysis Stefan Zehle, the CEO of Coleago Consulting presented a contrarian view at the last GSM Spectrum Workshop, held in London on the 29th of June 2010. In short, once the digital dividend and 2.6GHz spectrum is auctioned, mobile operators should stop pressing for new mobile frequency allocations.

The manner in which mobile operators value spectrum is to work out the additional value that could be generated from owning it. In simple terms it is the difference in the Net Present Value (NPV) of the business with and without the spectrum. If new spectrum is being offered at auction and operator A buys it whereas operator B does not, then operator B would be at a competitive disadvantage in terms of capacity or ease of building mobile broadband coverage. This would translate into reduced cash flow, for example through a loss of market share due to the lack capacity to serve mobile broadband customers. If operator B were to acquire the spectrum, the reduction in revenue would not occur and this “saved” revenue drives the value of the spectrum. Therefore from an operator’s perspective the value of the spectrum is not driven by generating new cash flows but by preventing a reduction in existing cash flows. This leads to the conclusion that if total mobile industry revenues do not increase, new spectrum is a bit like an arms race.
Consider the contrarian case. If no new spectrum is being made available in a country, the industry as a whole in that country may become capacity constrained in terms of mobile broadband. As a result prices for mobile broadband will increase and the return on capital employed will increase. There are no cash outflows to buy spectrum and no new deployment capex. As free cash flow increases, share values increase. Furthermore without new spectrum the threat of new market entry is blunted.

Therefore after the completion of the release of the digital dividend spectrum, the auctioning of 2.6 GHz and re-farming, mobile operators should not press to make more spectrum available for mobile communications. Naturally regulators would be keen to make more spectrum available because this is in the interest of consumers.