Mexico calling; analysis: local telecoms in a bearish new market realities--and a new law. (Cover).

Since the privatization of Telefonos de Mexico (Telmex) in 1990, Mexico has steadily allowed market forces to run the telecommunications industry. Recent events, however, have thrust the government's role in the market into the limelight. A combination of sagging revenues, closed capital markets and the inability of new players to gain market share have stymied the emergence of the strong competition sought by Mexico via privatization and liberalization.

With a number of operators struggling to stay afloat, the country's legislators are going back to the drawing board and drafting a new--but controversial--telecommunications law. But such change maybe too little too late for most new entrants in the market, as the number of players continues to dwindle, now through consolidation, and in the future through bankruptcy.

INDUSTRY IN PERIL

In many ways, Mexico is a microcosm of the woes plaguing the privatization and liberalization of telecommunications markets around the world. In the late 1990s, new market entrants spent billions of dollars acquiring licenses and developing modern networks in pursuit of the apparently high untapped demand of Mexican consumers and businesses for telecommunications services. According to Mexican telecommunications regulator Cofetel, more than US$13 billion were invested in the county's telecommunications industry between 1995 and 2000.

Unfortunately for these new companies, a combination of factors conspired to derail their advance down the road to riches. A worldwide economic slump, punctuated by the burst of the Internet and telecommunications bubble, has closed both debt and equity markets, making it difficult for companies to finance the significant debt incurred during the spending spree of the 1990s. Earnings for operators in fixed-line, mobile and long-distance markets have fallen far short of projections as well. Meanwhile, incumbent Telmex has been able to successfully defend its market share amid falling prices.

In this market, operators have been forced to move from strategies of expansion to attrition. In a game of "last-man-standing," mirror operators (i.e. those that just recently entered the market) are at a distinct disadvantage. This can be seen throughout Latin America, and is exceptionally pronounced in Mexico, where new entrants are struggling to gain market share, often ending up on the block as multinational parents search for buyers.

TELMEX DEFENDS ITSELF

In fixed telephony markets the Mexican experience reflects what has happened around the globe--Telmex has easily fended off attempts by new entrants to gain market share. After nearly five years of open competition, Telmex still holds more than 95% of all fixed-line subscribers in the country.

Local loop competitors like Maxcom and Axtel have found a lukewarm response to their services among mass-market consumers, and have redefined their business plans to focus on corporate markets. Even here, new entrants have found it difficult to convince clients to switch, because switching providers entails a switch in phone numbers, and many companies are unwilling to do so. The initial strategy of Monterrey-based Axtel was to target mass markets. After launching services, the company rapidly changed its focus to corporate markets in a search for a niche. More than 40% of Axtel's 342,000 active lines as of May 2002 corresponded to corporate clients.

Telecommunications companies that hold fixed-line and wireless local loop (WLL) licenses in Mexico are well aware of the inherent difficulties of winning clients over from Telmex. As a result, a number of these operators are simply deciding not to exercise their licenses. Of the 13 local loop authorizations granted by local industry watchdog Cofetel in 1997, less than half are in operation.

The slow growth of fixed-line telephony can be traced to a number of reasons, which by no means are unique to Mexico. Throughout the world's emerging nations, prepaid mobile telephony has effectively cannibalized the fixed-line market. From 300,000 in 1992, Mexico's cell phone subscribers now number more than 23 million. Over the same period, however, fixed-line subscriptions have barely doubled, from 6.3 million to 14 million.

Despite billion-dollar investments and the efforts of the Mexican government and Cofetel to increase fixed-line penetration in poorer segments of the population, the mass market has expressed its preference for pay-as-you-go products that allow consumers to more easily control their spending. As the realization that lower income echelons simply are not consumers of fixed-line telephony products, it has become evident that growth in fixed-line penetration is more a result of--rather than a motor for--economic development.

REVENUE PINCH

Across Latin America, mobile telephony has seen a jump in subscribers, while at the same time suffering from a revenue pinch, and Mexico has been no exception. By unleashing the secret to fantastic growth in cellular telephone subscriptions, Mexico's mobile operators have unintentionally pushed their businesses to the brink. Prepaid mobile and "calling party pays" (CPP) programs have resulted in skyrocketing penetration rates, while adversely affecting overall average revenue per unit (ARPU). Per-user revenue--which peaked well above US$60 per month in the mid-1990s-is now less than US$15 per month across the region, placing profitability beyond the reach of most operators.

The introduction of prepaid programs in 1995 and CPP in 1999 have released the demand for communication services in low teledensity market segments. As of December 2001, close to 23 million Mexicans were mobile subscribers; of these, more than 90% use prepaid programs. As competition has driven down prices, the average number of outgoing minutes per user has fallen from nearly 150 minutes per month in 1994 to a projected 2002 year-end total of 52 minutes per month. The combination of price competition and falling usage has seriously affected operator revenue streams, with some Mexican mobile operators receiving less than US$12 per month per user.

The industry has resoundingly said "no" to a short-term migration toward third-generation (3G) broadband wireless services as a solution to the revenue crunch. At present, only America Movil's Telcel has committed to making significant investments in its network infrastructure, as it migrates to GSM (Global System for Mobile Communication) technology. But even this move is more focused on the increased voice-service efficiencies that the technology offers than the potential road toward rich data services it may eventually provide. America Movil Finance Director Carlos Garcia said, "We recognize that (Mexico) is a voice-centric market, and will focus on that service at present."

MOBILE CONSOLIDATION

As companies continue to suffer from falling margins, even as subscriber growth continues, the mobile industry has entered a stage of rapid consolidation. A year ago, Mexico had nine competitors in the mobile arena: Today, less than half remain. Telefonica Moviles' recent acquisition of Pegaso left Mexico with four mobile operators, all of which are licensed to operate throughout the nation. Beating out Iusacell and Unefon, the Spanish firm is now a distant No. 2 in the market behind Telcel, which controls over 77% of the market.

All eyes are now on Iusacell as the next acquisition target, with regional powerhouses Telecom Italia Moviles (TIM) and BellSouth International seen as the most likely buyers. However, both potential investors have publicly said that such purchases do not figure into their short-term plans, each pointing to their challenges in funding existing operations.

LONG-DISTANCE PLEBISCITE 

When the Mexican long-distance market was opened to competition in 1997, new entrants Alestra and Avantel gained instant market share when Cofetel held a national "plebiscite" in which long-distance subscribers were asked to choose their preferred carrier. Initial migration to new carriers was significant, and raised the question of whether Telmex could successfully defend its market leadership. Over time, however, the market share gained by Avantel and Alestra has given way to Telmex, which now controls more than 72% of all domestic long-distance traffic in the country.

SEARCH FOR CAPITAL

The result of currency risk, economic slowdown, falling ARPUs and major investment in past years is that new competitors in the Mexican telecommunications market are saddled with debt. And such high debt loads could not come at a worse time. As debt has increased, the availability of capital has fallen off sharply. Access to capital across Latin America has dropped over the past year--in real terms as well as relative to other regions, according to the Milken Institute.

The current financing squeeze has forced most market participants to scale back investment plans, sell non-core assets and focus on only their most profitable businesses. The freewheeling approach of just a few years ago has been replaced by an attitude of extreme austerity throughout the industry. Even as operators try to sell off licenses and infrastructure at extreme discounts, few players have the pocketbooks or the appetite to bite.

At the end of the day, industry players have come to recognize that Telmex and sister-company America Movil have retained impenetrable leadership positions in the most important segments of Mexico's telecommunications industry. Instead of competing directly against the incumbents, most operators have retooled their business plans to focus on niche markets.

Particularly hard hit is the telecommunications wholesale business, where oversupply has left many operators below minimum capacity and at bare-bones margins. It is not uncommon in today's Mexican telecommunications market to find long-haul operators working at 15% to 20% gross margins.

San Antonio-based ATSI Communications originally entered the Mexican market as a "carrier-of-carriers," offering national and international network access to other telecommunications operators. The wholesale market squeeze has led the company to focus on the retail market in the form of "telecenters" as a profitable niche. ATSI CEO Art Smith sees the move toward a cross-border, Mexican--U.S. Hispanic product set as a key niche. "We need to move up in the food chain," said Smith.

ATSI is aiming for gross margins of between 50% and 60% with its new market focus, he added.

ENDGAME BEGINS

Niche market opportunities, however, are not large enough to accommodate all of Mexico's players, and a number are already evaluating exit strategies via acquisition by other companies looking to enter or expand their presence in the market.

Most new competitors in the Mexican telecommunications market control network assets that operate in parallel to each other and Telmex's infrastructure. Valuation of such assets has never been lower, and operators are finding that prospective buyers are more interested in the value of client bases. This fact, combined with the reality that most clients belong to incumbents Telmex and America Movil, paints a bleak picture for cash strapped operators. The risk of just "fading away"--going bankrupt without finding a buyer--is very real for such companies.

Perhaps one of the last exceptions to this rule was Telefonica's recent purchase of Pegaso, which provided the Spanish mobile operator with the licenses and infrastructure it needed to be able to offer nationwide coverage. Telefonica paid US$87 million in cash for the embattled mobile carrier, and assumed US$1.2 billion in debt via the transaction.

The case of Worldcom's Avantel, a long-distance operator that entered the market in 1997, is indicative of the general malaise in the industry. The result of its own financial crisis, WorldCom has retained Goldman Sachs to aid in the liquidation of its 45% stake in Avantel, along with its significant share in Brazilian long-distance operator Embratel.

PLACING BLAME

A number of operators asked to comment on the reasons that the Telmex-America Movil team has been so successful refused to do so, saying that silence is a virtue in an endgame. But in virtually all market segments, companies that compete against the two incumbents say--off the record--that ineffective telecommunications regulations are the reason that Telmex has held onto its market position. In the words of one CEO who requested anonymity, "Sure we have complaints, but I don't see any benefit for our company by commenting on that issue given our current condition."

At issue are Mexico's telecommunications laws, which Telmex's competitors say have little to do with what is happening in the market. They say Telmex's ability to set high interconnection rates, place obstacles to network integration and generally run roughshod over Cofetel rules impedes competition.

"I'm disappointed to see that there is still more politics than practicality in Mexico's telecommunications laws. Obviously, the government needs to give more autonomy and enforcement power to Cofetel," said ATSI's Smith.

THE NEW LAW

In a second effort to ensure the long-term viability of competition in the Mexican market, the government has proposed the development of a new telecommunications law. Since late 2001, a telecommunications bill has been slowly working its way through the legislative committee, with more than a little controversy. In May, National Action Party (PAN) Senator Javier Corral accused committee head Jesus Orozco of the Institutional Revolutionary Party (PRI) of representing Telmex's interests. Both politicians subsequently resigned from the committee.

Drafts of the bill that have recently been circulated show that it includes a laundry list of items designed to loosen Telmex's grip on the industry. Proposed changes include increased muscle for Cofetel, as well as requiring dominant operators to unbundle network elements, which could force Telmex to offer network services on a "cost-plus" basis to other carriers, similar to what the Regional Bell Operating Companies (RBOCs) have been obliged to do in the United States since 1996.

All indications point to a heated debate when the bill reaches the full legislative body sometime in the fall of 2002. Most analysts agree that the new law is unlikely to be passed until next year, and that significant changes will most likely be made before the final version is set.

DOMINANT OR NOT?

Although Mexico's revised telecommunications law may still be a year away, Telmex and the government are riot taking a wait-and-see attitude. Central to today's legal and public posturing is the definition of what comprises a "dominant operator." Not surprisingly, Mexico's Federal Competition Commission (CFC) and Telmex differ on this matter. This is an important issue for Telmex, because the current telecommunications law allows for the application of extraordinary rules against dominant operators. As well the long-term implications of such a ruling could impact the unbundling of network elements when new legislation is passed.

In early June, the CFC declared Telmex dominant in five market segments, only to see its decision overturned as unconstitutional by the courts. With this ruling, the CFC was forced to return to square one, and begin to build its case for Telmex's dominance once again, with seemingly endless avenues to appeals for the company. "With these decisions, the interest of a few companies has been able to prevail over that of the Mexican public," said CFC head Fernando Sanchez Ugarte.

Telmex responded that the definition of market dominance is simply an attack on its hard-won market position, and provides a blanket solution to a problem that requires a more reasoned and case-by-case analysis. Telmex Legal Director Javier Mondragon said the CFC's motives are off base. "They should be protecting the interest of consumers, not competitors," said Mondragon.

At play in the current discussion are billions of dollars in investment. The CFC seeks the establishment of clear rules on dominance that will give foreign operators the confidence to invest in Mexican operations. Conversely, Telmex recently announced the reduction of its planned 2002 investment from over US$2 billion to US$1.5 billion, and blamed the cut on the CFC's efforts to impede it. The company says it won't invest in new infrastructure as long as it is uncertain whether it will be the sole beneficiary of such investment.

Too LITTLE TOO LATE?

Regardless of what may come of the new telecommunications law and the dominance debate, attempts to improve competition in the Mexican market may be too little too late. Current financial conditions in Mexico and abroad find carriers on the run, struggling to keep ill-planned investments of the 1990s alive in a punishing capital market. A change in the market's legal structure is unlikely to put Telmex or America Movil's market dominance in doubt.

The way Telmex was privatized over 10 years ago--and the fact that it is a well-run business--made its emergence as market leader nearly inevitable.

In any case, the heated debates continue, and will most likely provide the Mexican telecommunications industry with a legal structure that could have helped create better market conditions, if only it hadn't arrived a decade too late.

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Bruce Sinclair ([e-mail]) is the Technology Industries Director for InfoAmericas, a multinational research and consulting firm specializing in Latin American markets.