The Delta Perspective

February 2011

Reverse innovation in telecoms: The increased integration of developed and developing markets
Authors Victor Font - Group Managing Director Daniel Torras - Associate Partner Tammy Whyman - Principal

OVERVIEW

As the leading Management Advisory and Investment Firm specialised in Telecoms, Media, and Technology within the Middle East, Africa, Central & Eastern Europe and Emerging Asia, Delta Partners believes that the telecommunications industry in emerging markets provides significant product and service innovation opportunities to be adopted in more advanced markets and across other emerging markets.

This white paper explores the reasons why emerging markets are becoming more active as producers of innovation in telecommunications, which are the key innovations, and the implications for operators and vendors from developed and developing markets.

A short history of reverse innovation

In its 2003 almanac, Encyclopdia Britannica listed what it considered to be the greatest inventions of all time. Of these, 90% are credited as either North American or Western European inventions. Now innovations from emerging markets are beginning to have an impact.
EXHIBIT 1: ENCYCLOPDIA BRITANNICAS GREATEST INVENTIONS SPLIT BY REGION (20TH CENTURY INVENTIONS ONLY)

Source: Encyclopdia Britannica 2003 Almanac

After the World Wars, as technology and geo-politics allowed for the opening up of world trade, we entered into a period of globalisation whereas Western inventions reached economies of scale by being distributed on a worldwide basis. Eventually, these products were slightly adapted, or de-featured, to appeal to more segments in emerging markets. This phase of global trade is often referred to as glocalisation. As glocalised products were not originally designed with emerging markets in mind, there were still significant pockets of consumers in those markets who were not served by these products, either due to price or to unattractive product features. Over the past fifteen to twenty years, as emerging markets consumers have gained acquisition power, local firms who understood the needs and limitations of these consumers, and who had access to low cost production, soon began producing hit products for developing economies. These hit products for emerging markets have made many Western firms stand up and take notice, especially as their home markets are stagnating. The process introducing emerging markets innovations into Western markets has been coined by Dartmouth Professors Vijay Govindarajan and Chris Trimble as Reverse Innovation.1 These innovations, when exported to developed nations, have often opened up entirely new product categories that would not have existed if it were not for reverse innovation.
1

How GE is disrupting itself, Harvard Business Review, Oct. 2009

Why emerging markets matter

In the last 15 years, the global telecom market has almost tripled in size. Most of the growth has taken place in emerging markets.

In the period between 1995 and 2010, the contribution of mobile to the global telecom revenue pie increased from 14% to 63%. Emerging markets have been the catalyst of the majority of this growth. While in 1995 mobile revenues from emerging markets represented a mere 2% of global telecom revenues, this figure had ballooned to 28% by 2010. In subscriber terms, the increasing weight of emerging markets is even more palpable. In 1995, only 15% of the worlds mobile subscribers resided in developing markets. By the end of 2010, 79% of the worlds subscribers were in emerging markets. Undoubtedly, emerging countries have been and will continue to be the engine of growth in the global telecom market and the role that market players from the developing world will play in the years to come will shape the direction of the industry.

EXHIBIT 2: GLOBAL TELECOM MARKET EVOLUTION, 1995-2010

Source: Delta Partners, Pyramid Research, Ovum, ITU, WTO

Proliferation of emerging market challengers

At the start of this century, the global mobile market was dominated by a handful of very large operating groups, most of them with European roots, acting as global consolidators. Today, the competitive landscape has changed dramatically.

Following the collapse of the high-tech bubble in 2001, many of the traditional international consolidators from developed markets have been under shareholder pressure to dispose of underperforming and non-core assets and adjust their regional focus. Some of the early consolidators, such as Hutchison Telecom, KPN or NTT DoCoMo, have abandoned or significantly downscaled their global expansion ambitions. In their place, emerging market players such as Russias Vimpelcom and MTS, South Africas MTN, Indias Bharti, Mexicos Amrica Mvil, and the Middle Easts Etisalat, STC, Qtel and Zain, among others, have become true powerhouses, and have built their footprint through aggressive M&A and licence acquisitions. The appearance of these emerging market telecom superpowers is no coincidence. First, these operators were producing strong cash flows from their growing home markets, such as South Africa and the Middle East. Second, the emerging players viewed entry into other emerging markets as less operationally risky, given their understanding of the cultures and business practices of the regions. These factors coincided at a time when greenfield opportunities were abundant and were snapped up by the emerging players. Finally, market fundamentals have added further pressure to the need to build scale. Much of the subscriber growth in the developing world is coming from bottom-ofthe-pyramid consumers and multiple SIM card-holders that generate ARPUs in the low single dollar digits. In addition, intensifying competition has led to aggressive tariff cuts and hefty marketing and network investments, all of which have led to a reduction in EBITDA margins in most parts of the world. In this context, consolidation promoted by or involving operators from developing countries has been driven by the need to build the necessary scale to compete effectively.

EXHIBIT 3: MOBILE OPERATOR GLOBAL POSITIONING MATRIX, 2000 AND 2010

Note: Axis positions are indicative and not absolute Source: Delta Partners

Reverse innovation in telecommunications

Emerging market players in the mobile communications space have been quite successful in building successful regional and even global businesses, often through innovation. But have they been successful at reverse innovation, or at bringing those innovations to the developed world?

In most instances, emerging market telecom innovation has been in the form of new business models aimed at addressing profitably the needs of consumers with low disposable incomes, as well as product offerings designed to stimulate usage of basic and value added telecommunication services.

EXHIBIT 4: BUSINESS MODEL INNOVATION DRIVERS, DEVELOPED VS. DEVELOPING MARKETS

Source: Delta Partners

While developed markets operators have traditionally focused on investing in the most advanced technologies, and have sought competitive advantage by physically owning the entire front- and back-end infrastructure required to provide services (e.g. passive and active network infrastructure, customer care, IT, sales channels, etc.), emerging market operators have taken different strategies. Some operators, faced with much lower ARPUs and a predominantly prepaid (and thus less loyal) customer base, have resorted to outsourcing non-core activities to achieve scalability, and turn capital expenditures into operational costs to better manage cash flows. Other emerging players have been able to successfully skim the barely penetrated markets by charging high price per minute thus maintaining high margins as the business has grown. By adopting new business models, and despite the fairly generalised drop in EBITDA margins in most regions of the world in the past few years, emerging market mobile operators have been able to record EBITDA margins that are on average higher than the margins of their developed market counterparts.

EXHIBIT 5: MOBILE OPERATOR EBITDA MARGINS BY REGION, 2005-2009

(% EBITDA margin)

* APAC region includes some developed markets, e.g. Japan, South Korea, Hong Kong, Singapore, Australia and New Zealand Source: WCIS, Merrill Lynch, Delta Partners

Delta Partners selection of innovations in telecommunications

While not all of the emerging market telecom innovations selected may have the potential for immediate application in developed markets, operators in developed markets should take note of our selection.
The inherently different economic realities of the telecom business in emerging countries have forced operators to look for creative avenues to tap into low revenue generating customers without compromising profitability. In this section, we highlight those innovations that have transformed business models in their markets and beyond.

EXHIBIT 6: SELECT TELECOM INNOVATIONS

Source: Delta Partners

1. Micropayment and remittance transfer by SMART The concept

In 2000, SMART was one of the worlds first to
introduce a remittance (SMART Padala) and micropayment (SMART Money) service aimed at the lowincome market The service expanded the addressable customer base, created higher ARPUs and reduced airtime recharge commission costs Since then, many emerging players have introduced similar services but many are still struggling to gain critical mass

Reverse Innovation potential

With a worldwide potential micropayments market

of ~1.2Bn users and $700-900Bn of transfers by 20142, there is a significant drive for market players (technology providers, financial and telecom players) to attain a relevant position within its value chain Operators in developed markets can create their own micropayment platforms to serve unbanked and lowend segments Micropayment platforms can also replace the need for cash which traditional debit or credit card business models do not allow

2. OPEX and CAPEX outsourcing by Bharti The concept

Bharti pioneered the network outsourcing model in
2004 by awarding IBM a 10-year, $750Mn contract, the scope of which is now worth over $3Bn3 While some operators had outsourced certain elements of their networks previously, Bharti took the model a step further by divesting infrastructure assets, including active and passive elements, which was a first in the industry Since then, Bharti has gone even further by outsourcing the building, maintaining and operating of their networks, which essentially has turned Bharti into a company that buys minutes from a third party

Reverse Innovation potential

Network outsourcing and the divestments of

infrastructure assets can radically shift an operators business model, but caution should be taken when setting up agreements and transferring assets and operations, which is where most attempts tend to fail As more operators adopt the OPEX and CAPEX outsourcing model, mobile broadband networks will be rolled out more quickly due to increased economies of scale, thus precipitating a technology revolution

2 3

Delta Partners The Economic Times, 14 Nov. 2010

3. Freelance sales force by Tigo The concept

In 2006, Tigo Tanzania began introducing a freelance
sales force to fill the gap where distributors did not reach and where an owned sales force was not costeffective. The main focus of freelancers was on street smart agents who would sell mostly voice products. By implementing the freelance model in Tanzania, Tigo was initially able to: - Significantly increase effective presence in target locations - Address a powerful consumer decision driver in operator selection in immature markets, namely the availability of prepaid recharges - Create a dynamic channel, able to capitalise on opportunities and mitigate market trends quickly - Provide competition between direct and indirect channels, leading to overall better channel performance

Reverse Innovation potential

Although a freelance sales force concept is not new to

developed markets, it is often used for more specialised segments such as high end residential or SMEs. Tigos model was innovative in that it targeted underserved geographic regions and led to more visibility on the street

4. Location based management by Econet The concept

A value-based investment method to allocate
investment resources selectively where the pockets of value are located. The overlay of in-depth customer behaviour with network, sales, branding and actual customer service performance data allows operators to prioritise network and commercial investments for specific segments of the market At the heart of LBM is the geo-mapping of customer value against specific network and distribution channel assets (e.g. BTS, stores, etc.)

Reverse Innovation potential

In developed markets, LBM is most relevant for

operators looking to prioritise 3.5G and 4G network rollout and optimise their sales channels In developing markets, LBM is a powerful tool for new entrants that must make trade-offs between CAPEX and time to break even, as well as larger operators looking to improve cash flows and profitability

10

5. Dynamic discount solution by MTN / Ericsson The concept

Named MTN Zone, it is a service designed to optimise
network capacity utilisation by offering consumers a dynamic discount based on the current network load in their coverage cell. Calls during periods when the network is not busy are eligible for discounts of up to 100 percent, which are communicated to customers through cell broadcast Recognised in 2008 by AfricaCom as the Most Innovative New Service of the Year

Reverse Innovation potential

As the amount of data transferred on mobile networks

in the US and Europe explodes and endangers overall network quality, dynamic discounts can be applied for mobile broadband as a way to control peak data usage This is especially relevant as certain types of data (e.g. music downloads) are not time critical and can be scheduled when there is spare network capacity

6. One Network by Zain The concept

The worlds first borderless mobile network, allowing
Zain customers to make calls at local rates across 12 countries using their home SIM card Commenting about One Network in September 2006, The Economist said Celtel [Zains former brand name] has, in effect, created a unified market of the kind that regulators can only dream about in Europe4

Reverse Innovation potential

Creating a one network offer can quickly build a

strong and differentiated positioning for an operator, especially in mature markets where brand strength is the core differentiating element European operators with a large footprint can encourage their customers to continue to use their home SIM when travelling without having to worry about roaming costs. Operators will maintain share of wallet (out of country and upon return) and can build loyalty amongst high value segments

Zain press release, no date specified

11

The future of reverse innovation in telecommunications

While the past has helped us identify certain emerging market innovations which could have the potential to open new business categories in developed markets, what does the future hold?

1. The Asian telecom network vendors are set to become innovation leaders
On the equipment front, it is important to differentiate between the network infrastructure market, pertaining to the manufacturing of access and core network components, and the handset market. Until 2008, the infrastructure market was the larger of the two, as operators were focused on building greenfield networks covering huge swaths of territories, and also overlaying 3G capabilities on their existing 2G networks. In the network infrastructure space, former North American giants Lucent, Nortel Networks and Motorola have been acquired by their European counterparts Alcatel, Ericsson and Nokia Siemens Networks, respectively. The consolidation among North America and Europe-based network equipment vendors of the past five years was an attempt by the incumbent players to defend their dominance in a stagnating global network infrastructure market, and to compete more effectively with the Chinese newcomers. This consolidation, however, has not impeded Huawei from making a significant dent on the market share of the established vendors. The combined market share of ZTE and Huawei in the infrastructure space grew five-fold in the period between 2006 and 2009, from 5% to 26%. Today, Huawei is the worlds third largest infrastructure vendor, and it is breathing down Nokia Siemens Networks neck for the number two spot. Huawei has also been at the forefront of innovation in the network equipment space. Huawei was the first vendor to commercially deploy a software-defined-radio (SDR) GSM/UMTS network in Europe for TeliaSonera in Finland in June 2009 (ZTE, however, claims that Hong Kongs CSL SDR-based HSPA+ network, launched in March 2009 and built by ZTE, was the first of its kind in the world).

12

EXHIBIT 7: NETWORK EQUIPMENT VENDOR EVOLUTION

Source: Bernstein Research, DellOro, Delta Partners

2. Reverse innovation in handsets: A long road ahead

As markets have matured, operators focus has shifted to customer acquisition and retention, and usage stimulation. In this evolving competitive landscape, devices have played a key role as it is one of the major considerations that consumers weigh when making a mobile purchase decision. Furthermore, the rapid pace of technological development in the handset space, with new form factors and enhanced capabilities being introduced at breakneck speed, has helped the handset market outpace the network infrastructure market two-fold in recent years, and surpass it in total sales volume since 2008. Traditional handset makers such as Nokia, SonyEricsson and Motorola have been losing share to the Asian vendors for quite some time. But unlike the infrastructure space where we have not seen any genuinely new entrants for a while, in the handset market, smartphone specialist vendors such as Apple (iPhone) and RIM (Blackberry) have grown from virtually zero to a very respectable size. And if we consider only mobile broadband USB modems, the Chinese dominance is overwhelming. Huawei and ZTE alone account for over three quarters of the market by some estimates.
EXHIBIT 8: MOBILE DEVICE VENDOR MARKET SHARE

Source: ABI Research, Delta Partners

13

The handset space, however, has an important peculiarity that favours developed market vendors: there is a strong trend towards convergence of networks, services and applications. The recent rise of tablets, epitomised by the overnight success of Apples iPad, illustrates how the boundaries between mobile phones, PCs, TV sets and music players are getting increasingly blurry. Companies such as Google and Apple are leading innovators in this space and provide products and services that are software-centric but also include hardware components, in addition to content and social networking utilities. The innovation lead of western vendors in the handset space, however, might be shortlived or at least challenged once again by developing market vendors such as Huawei and others. A simple observation at the amount of R&D conducted and the number of patent applications filed by the leading Chinese and Japanese vendors demonstrates that Asian players are bound to exert very considerable influence in the consumer electronics industry in the years to come.
EXHIBIT 9: TOP GLOBAL PATENT APPLICANTS

Source: WIPO, Delta Partners

3. Indias (and to a lesser extent Chinas) IT outsourcing firms are gaining momentum
In an increasingly commoditised telecom market, ICT services present an opportunity for telecom operators to differentiate, sustain growth and generate new revenue streams. For most of the 90s and the 2000s, North American and European specialised IT firms, many of which were offshoots of telecommunication operators, dominated the ICT space. More recently, Indian firms such as Tata, Infosys and Tech Mahindra, and to some extent also Chinas Huawei, have been gaining momentum, aided by the large and inexpensive pool of human resources available to them in their home markets and their ability to provide world-class solutions to their clients, often via managed services platforms and offshore software development capabilities, at a fraction of the cost of previously available alternatives. However, as long as ICT firms in emerging markets are primarily relying on cost advantage to grow, the industry will contribute few reverse innovations to the market. 14

4. Infotainment will need to be wrestled away from the developed world

As the least mature subsector of the telecom value chain, it is no surprise that much of the innovation observed in the infotainment space has occurred in developed markets. On the Internet front, search engines were originally conceived as directory businesses by American companies (Yahoo!, Altavista, etc.), but it was Google that introduced the now familiar single search box user interface and pretty much wiped out the competition. Google then went on to further organise the worlds information and make it universally accessible and useful with innovations such as Google Maps, Google Earth, Google Docs, Google Realtime Search, and more. Social networking was first popularised by MySpace and later on revolutionised by Facebook and Twitter. In essence, most of the innovation in the area of utilities and infotainment applications has sprung from developed markets. But in many cases developing market players have seized the opportunity and adapted (and in some cases also enhanced) these innovations to meet the needs of their own customers. The Chinese online search market provides a case in point. Despite Googles world dominance in online search, China has proven a difficult market to crack for the American company. Only in large markets with specific language and cultural barriers will emerging content players succeed, but that success will likely be restrained to their home turf.

Wake up call for developed markets

This whitepaper has established that business-transforming innovations in the telecommunications industry are originating more and more frequently in emerging markets, and that many of these innovations have the potential to transform developed markets. Additionally, we have seen that emerging markets players are extending their reach and influence across the value chain and are building their footprint through aggressive expansion strategies. Telecommunication industry players in developed markets, even if their strategy is to focus on their current markets, need to realise that emerging market players will likely be on their doorstep, either as competitors or vendors in their supply chain. One example of an operator who is channeling innovation from emerging markets to its European headquarters is Orange, who has built eighteen innovation centres dubbed Orange Labs, across three continents. With such examples of reverse innovations making their way back into the developed markets, western operators should find a way to embrace the opportunities of reverse innovation before their competition does. 15

Delta Partners is the leading TMT advisory and investment firm in emerging markets. With more than 160 professionals, the firm operates across 50 markets in the Middle East, Africa, Central & Eastern Europe and Emerging Asia. Delta Partners provides three synergistic services: management advisory, corporate finance and investments from its offices in the UAE, Bahrain, South Africa, Spain and Singapore.

Advisory: Delta Partners advisory professionals partner with C-Level executives in telecom operators, vendors and other TMT players to help them address their most challenging strategic issues in a fast-growing and liberalising market environment in over 50 markets.

Investments: As a fund manager, Delta Partners manages an $80Mn private equity fund, targeting investment opportunities in the TMT space in high growth markets. The focus is the Middle East, Africa, Eastern Europe and Emerging Asia. Delta Partners private equity fund leverages the firms unique TMT industry expertise to create value for its investors throughout each stage of the investment cycle, from deal sourcing to supporting portfolio companies in driving value extraction.

Corporate Finance: Delta Partners provides corporate finance services and has been involved in several buy-side and sell-side telecom transactions in the region. As true industry specialists, the firm offers a differentiated value proposition to investors and industry players in the region. Delta Partners actively leverages its close link to its private equity arm to access the investor community as well as top-level financial talent.

Delta Partners delivers tangible results to its clients and investors through its exclusive sector focus on telecom, media and technology, and a unique approach to services, combining strategic advice and a hands-on pragmatic approach.

For more information about Delta Partners please visit: www.deltapartnersgroup.com For a list of all Delta Partners white papers please visit: http://www.deltapartnersgroup.com/our_insights/whitepapers

Copyright 2011 Delta Partners FZ-LLC. All rights reserved.

16