Fighting a giant: little guys face Slim leviathan on telecom battlefield.

Wrestling even a meager slice of the Mexican telecommunication pie away from Telmex and Telcel, has been a tough and, in some cases, fruitless pursuit, especially for foreign-backed players.

With over 95% and 75% control over their respective fixed-line and mobile fields, the two sister companies in the Carlos Slim empire rule Mexico's burgeoning US$12 billion telecommunications industry much to the detriment of their competitors. Having invested billions, Vodafone and Verizon earlier this summer sold their Mexican venture, Iusacell, for a pittance. Alestra (backed by AT&T) and Avantel (back by Worldcom) have both hit financial woes.

Is the Mexican market made only for the incumbents? Maybe not, but survival for the rest is going to be a tough business.

Like Microsoft's control of the software operating system market, Telmex and Telcel's single-handed domination of their sectors has given them huge advantages over their rivals. Their enormous market caps (currently US$20 billion for Telmex) and their reasonable debt levels and torrential cash flow (US$2.8 billion in 2002 for Telmex) provide them with financial physiques that are the envy of their telecom peers around the planet. In Mexico, they enjoy unequaled economies of scale and market reach.

"I would say that their only real competition is each other," noted Ernesto Piedras, a telecommunications specialists at CIDE, a Mexican think-tank.

REASON TO BELIEVE

Yet despite the burned fingers and tough competition, the other operators offer three good reasons to believe they can survive in the Mexican phone business.

First, most agree that Latin America's biggest economy is ringing with potential. About 3%--and rising--of Mexico's GDP is now being spent on telecoms. By 2008, mobile phone subscriptions are expected to reach nearly 45 million from today's 26 million.

Fixed lines are tipped to increase by 6% or 7% for the next five years, adding an extra million or so lines this year to the 17 million currently installed. Although no operator expects to reach par with the incumbents in the near future, they all hope to grab a significant piece of the action in this incremental market.

Secondly, the non-incumbent players claim that much of their current woes stem not from operational weakness but from their dire financial problems. Having committed to large and costly infrastructure rollouts in the 1990s, they are now weighed down by debts that have become too heavy to handle. Yet, they advertise that underneath their debt-laden exteriors lie reasonably healthy businesses.

Alestra, for example, reported a 377-million peso loss for the first quarter of 2003 but a positive Ebitda (earnings before interest, taxes, depreciation and amortization) at 302 million pesos.

Several have made moves to ease their debt burdens. Expansion plans have been reduced and costs cut, with the proceeds going to the banks. Furthermore, Alestra and Iusacell are currently in the process of restructuring their debts. In June, Unefon renegotiated a disputed US$350 million financing debt with its Canadian equipment provider, Nortel Networks.

Financiers may find such restructuring hard to swallow, but their debtors have a strong hand to play. For example, Ricardo Salinas, who is a formidable negotiator and Iusacell's new owner, is likely to win substantial terms.

"We think delaying tactics could force creditors to spend at least a year gaining effective control of Iusacell if they choose to go that route," pointed out UBS Warburg analyst Stephen Graham in a research note. "That would be time enough for Salinas to let the company's value deteriorate to near zero. So if Salinas insists on a 50% debt haircut, the creditors may have to go along."

Their final reason for optimism is that in the last two years the regulatory environment appears to have improved. In the years following the government's opening of the market to foreign competitors in 1997, the new entrants spent much of their time suing Telmex for monopolistic practices.

"In those days, telecom operators used to be called lawyers' firms who sold phone lines," quipped one industry insider.

So in January 2001, Avantel, Alestra and Telmex had a major powwow to settle some of their differences. Since then, the number of lawsuits filed by operators has reduced considerably.

The single biggest issue to be resolved was the expensive interconnection tariffs that Telmex was charging its competitors to terminate and originate calls over its last mile of copper wire to the customer. Alestra and Avantel subsequently claimed they were unable to effectively compete in the long distance calling market. Thanks to this meeting--in which Telmex agreed to reduce its interconnection fees--tariffs are beginning to fall.

Yet those reforms were driven by the operators themselves rather than by government. Mexico's telecommunication watchdog, the government agency Cofetel, remains impotent. A new telecommunications bill, which was to furnish it with more powers to judge and fine miscreants, has been held up in Congress. The legislation, which many expected to pass at the end of last year, appears to be going nowhere. Some have suggested that the influence of Slim, Telmex's boss and Latin America's wealthiest individual, may have been in play.

So, will these factors allow the smaller telecommunication operators to find enough critical mass in order to prosper? Or will they just lengthen an already inevitable demise under the hegemony of the incumbents? To make an assessment, it is worth looking at the fixed and wireless sectors more closely.

PROTECTED TELMEX

The only way to understand Mexico's fixed-line telephony market is by understanding Telmex. The firm enjoys astronomical Ebitda margins of 50% and is considered the big kahuna of the Mexican economy. As an incumbent, Telmex, which before 1990 was owned by the government, is a natural-born monopoly. In 1990, the government realized public coffers could no longer sustain the vast expansion Telmex was undergoing.

Therefore, it was released into the private domain. It then enjoyed seven years of free reign before the market was opened up to competition. Yet, foreign ownership in fixed-line operators is still capped at 49%. Thus Telmex remains shielded from the most serious of competitive threats.

Private control has improved Mexico's fixed-line sector markedly. Efficiency has increased significantly and phone line penetration has doubled. But, some say, this only reflects the sorry state of Telmex when run by government bureaucrats and should not be seen as exemplary performance by the incumbent.

STILL COMING UP SHORT

Critics point out that despite its proximity to the United States, its buoyant economy and its being only the second Latin American nation to deregulate (Chile was the first), Mexico is lagging behind the rest of the region in terms of its telecommunication performance.

According to World Bank research, in 1999, Costa Rica, Colombia and Uruguay all boasted superior indicators despite the fact that their operators remained publicly controlled. Within two years of privatization, Brazil was able to leapfrog Mexico. This poxy performance stems from two major failings: teledensity (the penetration of phone lines per capita) and tariffs.

Of the larger Latin American nations, only Peru and Venezuela fall behind Mexico's fixed-line penetration of around 14.6%. Jeffrey Noble, a telecommunications analyst with BBVA Bancomer, attributes this to Telmex's reluctance to spend on infrastructure in areas where the return-on-investment maybe lower or negative. As the firm expands into poorer, more remote rural regions, the average revenue per user (ARPU) declines. According to the firm's own numbers, nowadays only 45 % of their customers spend more than the basic line rental.

Fixed-line tariffs are also a major issue. Talk may be cheap but not for Telmex customers. Although installation fees are below average, rental and local call charges remain high. And, as any customer who calls abroad knows, long distance calling tariffs are bordering on robbery. A ten-minute call to London costs 145 pesos plus value-added tax. The same call made from an internet telephone costs around 5 pesos.

In the past, the World Bank has charged Telmex with "being less constrained in exercising its market power than the dominant carriers elsewhere in Latin America." Yet it would be wrong to label Telmex as a complete malefactor. It is the only operator willing and able to make large-scale investments in the sector. This amounted to US$1.1 billion last year and is expected to be the same for 2003.

"Even though everyone likes to complain," said Noble of BBVA, "I simply see Telmex as the best placed to improve telephony services in Mexico."

STRATEGY FOR SUCCESS

So where does this leave its diminutive rivals? None are in any position to mount a direct challenge to Telmex. Instead, they are scaling down their operations (Avantel, for example, has cut its capital expenditure from US$250 million to US$60-70 million for 2003) and are operating only where they can find sustainable returns.

"We believe companies that want to survive should focus on niche markets," said Luis Balderas, the head of telecommunication research at the technology consultancy firm IDC Mexico.

Alestra and Avantel continue to attack the consumer long distance market as well as dedicated services for businesses. Without any capital expenditure, the pair will be unable to expand, analysts say. Yet they are expected to hold onto their existing market share.

Piedras of CIDE cites Maxcom and Protel as examples of healthier niche players. The former has gained an 8% market share in Puebla, and nationwide it now boasts 130,000 fixed-line residential customers. The latter has only 240 employees yet had revenues last year of US$280 million thanks to its strategy of focusing on smaller residential areas.

In short, those who want to enter the fixed-line game, are advised to do so below Telmex's radar.

MOBILE MOVEMENTS Unlike their fixed-line cousins, cellular players are showing a little more chispa. Current sector revenues exceed US$5.5 billion (see chart). By 2008, subscriber numbers are expected to swell from today's 26 million to more than 45 million. Although Telcel still enjoys stalwart leadership with 75.8% of the market, the competitive landscape in the mobile sector is beginning to heat up.

Two noteworthy events have helped stoke the flames: Iusacell's sale and Telefonica Moviles merger with Pegaso.

A knee-jerk reaction to Verizon and Vodafone's sorry departure has been to cite it as another example of foreign investors getting burned in Mexico. Admittedly the sale does show a catastrophic failure--they purchased Iusacell in 2000 for US$1.2 billion and US$980 million, respectively, and Salinas took on the troubled operator and its US$800 million worth of debts for a paltry US$10 million. However, industry insiders agree that the wreck was as much caused by a strategic bungle as by adverse market conditions.

This was marked by its decision to focus on the high-end post-paid sector, while Telcel marketed heavily its post-paid Amigo service, reaching at the far larger lower-income bracket. Iusacell realized its mistake too late and was left floundering.

A MAGNATE'S CHOICES

As mentioned earlier, Ricardo Salinas, a Mexican magnate who also has interests in the media group TV Azteca, the electronics retail chain Elektra and mobile operator in Unefon, is expected to initially revive Iusacell's prospects by renegotiating its finances.

From there, he has three options. First, he could make a quick buck by reselling Iusacell after its refinancing. However, no potential suitor home or abroad seems probable. Secondly, he could run it as an independent entity within the group. But, as Noble of BBVA points out, this would be a highly inefficient way to run a firm, when there is another operator in the same family.

Thus, it is most probable that Salinas will merge his two cellular plays. This would make technical sense because both use the same CDMA infrastructure. Furthermore, Unefone's low-end focused operation could complement Iusacell's posher business. The main concern is that Salinas will not invest a single dollar in the operation.

"This will severely impact Iusacell's expansion and network upgrade plans," said Gabriela Baez, a telecommunication analyst for Pyramid Research.

A far more potent competitor has recently emerged in the shape of Telefonica Moviles (TEM) which purchased Pegaso PCS. The Spanish-controlled operator had spent the last few years lurking in a few minority territories in the north of the country. Unfettered by the limitations of foreign ownership that exist in the fixed-line market, TEM now possesses a respectable 9.1% of the cellular space as well as national network. TEM, which has aspirations to be the world's dominant provider in Latin America, has some very aggressive ambitions in Mexico.

In March, it announced the rolling out of an all-new national GSM network. The new infrastructure will provide TEM with not only the coverage and capacity to reach a large proportion of the Mexican market but the ability to offer next generation (3G) services, such as broadband Internet access. The operator will be investing US$1.5 billion in the project over the next three years. TEM has been tight-lipped about its strategy. It is most likely that it will follow Telcel into the prepaid space, since that is where the lion's share of the untapped market is.

Despite the consolidation, Telcel is moving from strength to strength. Although it is expected to lose some market share to its aggressive rivals, the incumbent should continue to show top-line performance. As well as possessing the widest territorial reach of all the operators, it also is investing aggressively in a new a GSM network.

Its first-quarter results of 2003 prove its resilience. After a new tax was imposed on all calls above 3.5 pesos/minute, Telcel reduced its standard local call fees for its prepaid customers from 5 pesos to 3.48 pesos. Despite the reduction in ARPU, it was able to announce a quarter-on-quarter Ebitda rise of 3.8%.

In short, a dose of hot competition is doing wonders for the Mexican mobile market. And that can only be good for the punters. As a result, there may be bigger-than-expected migration from fixed line to mobile. And that can only be bad for Telmex.

MEXICAN CELLULAR OPERATORS, 2002

                 Revenues (in US$millions)    Subscribers (in millions)

Telcel                         4212                         20.87
Telefonica Moviles              552                          2.40
Iusacell                        499                          2.09
Unefon                          331                          1.35
Nextel                           45                          0.05
Total                          5642                         26.42

Source: IDC Mexico

Rawdon Messenger is a Mexico City-based freelance writer and columnist for the Evening Standard of London.