Presentation for the Izmir Cullen Conference Implementation of a margin-squeeze test in Macedonia Presentation for the Izmir Cullen Conference ... Difficulty of definition of the REO

19862-64 | Commercial in confidence

Implementation of a margin-squeeze test in

Macedonia

Presentation for the Izmir Cullen Conference

21 February 2013 • Paulina Pastor Alfonso


Copyright disclaimer

Copyright © 2012. The information contained herein is the property of

Analysys Mason Limited and is provided on condition that it will not be

reproduced, copied, lent or disclosed, directly or indirectly, nor used for

any purpose other than that for which it was specifically furnished

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Introduction: About Analysys Mason

Methodology for a margin-squeeze test

The Macedonian case versus the Italian case

Q&A

Contents

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Analysys Mason is uniquely positioned to provide consulting and research to the TMT industry

4 Introduction: About Analysys Mason

Our focus is exclusively on telecoms, media and

technology (TMT)

We support multi-billion dollar investments, advise

clients on regulatory matters, provide spectrum valuation

and auction support, and advise on operational

performance, business planning and strategy

We have developed rigorous methodologies that deliver

tangible results for clients around the world

We analyse, track and forecast the different services

accessed by consumers and enterprises, as well as the

software, infrastructure and technology delivering those

services

Research clients benefit from regular and timely

intelligence in addition to direct access to our team of

expert analysts

Our dedicated Custom Research team undertakes

specialised and bespoke projects for clients

Research

Consulting

Transaction

support

Strategy

and planning Operational

consulting

Procurement Regulation

and policy

Consumer services

Enterprise services

Telecoms software

Regional markets

Network technologies


Contents

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Q&A


A margin-squeeze test checks whether a product has positive margins

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Example of a profitable product

Methodology for a margin-squeeze test • The formula

Source: Analysys Mason

SMP: Significant market power

W/s

inputs

(r)

Net.

costs

(w)

Retail

costs

(d)

Margin > 0

Retail

price

(P)


A number of conditions are necessary to establish a situation of margin squeeze

7 Methodology for a margin-squeeze test • Minimum conditions

Vertical

integration

Dominance on

the upstream

market

Upstream

input must be

essential

Downstream

market not

effectively

competitive

Sufficient

duration

The firm willing to implement a margin-squeeze strategy must be

vertically integrated and/or have control over the key upstream

inputs, while being active on the downstream market

The vertically integrated operator must hold SMP in the upstream

input market

The provided upstream inputs must be ‘essential or key’ for the

provision of the tested downstream service

The downstream market is not effectively competitive: however, this

does not imply that the SMP operator should be dominant in the

retail market

The margin squeeze must be of sufficiently long duration, taking into

account the lifetime of the product


8 Methodology for a margin-squeeze test • Methodological choices

Five methodological choices are to be considered when performing a margin-squeeze test

Item Question to be answered

Level of

efficiency of

the operator

From which perspective will the situation be analysed: from the

dominant operator’s or from an alternative operator’s point of view?

Downstream

cost standard

Which methodology will be used for the downstream costs analysis:

an accounting or an economic approach?

Evaluation of

profitability

over time

Which approach should be used to measure an operator’s

profitability: a period-by-period (PdP) or a discounted cash flow

(DCF) method?

Level of

aggregation

of products

What is the aggregation level of the considered retail products:

product-by-product or aggregated level?

Upstream

input

How must the wholesale inputs be considered:

in aggregate or in a separate way?

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W/s

inputs

(r)

Net.

costs

(w)

Retail

costs

(d)

Margin > 0

Retail

price

(P)

The test can be performed following an EEO and/or a REO approach Two imputation tests may be

considered to perform the test:

the equally efficient operator

(EEO) test considers an operator

whose efficiency level is similar to

that of the SMP operator

the reasonably efficient operator

(REO) test considers a reasonably

efficient downstream operator (i.e.

an operator efficient but not able to

leverage the scale and scope

economies of the incumbent)

The formula items affected by the

approach are w and d

9 Methodology for a margin-squeeze test

EEO SMP operator’s

REO alternative operator’s

Example of a profitable product

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For retail costs, the cost measure is usually chosen according to the information available

10 Methodology for a margin-squeeze test

*CCA: Current cost accounting

Main features of the most relevant cost measures

Fully allocated cost (FAC) Long-run incremental cost (LRIC)

Usually historical assets (can also be

converted to current assets, in this case

being CCA* FAC)

Modern equivalent assets (MEA)

Usually straight-line depreciation

(annuities can also be used)

Economic depreciation

Actual installed capacities Efficient levels of capacity

Actual costs of operation (with CCA, the

costs of operation can be adjusted)

Efficient costs of operation

All costs included Relevant costs only

In summary: ‘Observed fact’ In summary: ‘Modelling assumptions’

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In the evaluation of an investment, four variables must be considered: time, risk, costs and revenues

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Variables to be considered in an investment evaluation


Investment

evaluation

Revenues

What are the total revenues that

will be generated over the

investment lifetime?

Must they be considered as

recognised revenues or as cash

inflows?

Costs

What are the total costs that will

be incurred over the lifetime of

the investment?

Which costs are capex and which

ones opex?

Time

How long must the time horizon

be?

Does it have to be considered as

a whole or split in sub-periods?

Risk

What is the associated risk to the

investment?

How can it be measured?

Will it change over time?

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Comparison between the main features of DCF and PbP methods


DCF and PbP are the two methods most commonly used for the evaluation of investments

DCF Item PbP

▪ Financial Perspective ▪ Accounting

▪ One single value (net present

value or NPV)

Model output ▪ One value for every considered period

(periodification)

▪ Yes (discount of expected future

cash flows)

Time

consideration

▪ No (no actualisation)

▪ Overall timeframe within a

single calculation

Considered period ▪ A single period in the overall timeframe

▪ As a cash flow Investment

consideration

▪ Depreciation along the underlying lifetime

of the asset

▪ Need for estimates (cash flows,

cost of capital and terminal

value)

Potential issues ▪ Misleading about economic value

creation (short-sighted approach)

▪ Constant cost recovery over time for

capitalised costs

▪ Growing/dynamic markets Best for ▪ Stable markets

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Service Product-by-product Aggregated

Access

PSTN access

ISDN PRA access

ISDN BRA access

PSTN access

ISDN PRA access

ISDN BRA access

Voice

Local/national calls

(on-net, off-net)

ISDN PRA access

ISDN BRA access

Local/national calls

(on-net, off-net)

ISDN PRA access

ISDN BRA access

Possible levels of aggregation of retail services


The test can be performed either on a single retail service or on the whole retail portfolio

Best for

Test a new retail offer (e.g. to avoid

cross-subsidisation by other

products at early stages)

Assess the overall replicability

of the SMP operator’s retail

portfolio

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Service Subset of wholesale inputs Mix of wholesale inputs

Access

Local loop unbundling (LLU)

Wholesale line rental (WLR)

LLU

WLR

Voice

Call termination

Origination:

– carrier selection

– carrier pre-selection

Call termination

Origination:

– carrier selection

– carrier pre-selection

Possible levels of consideration of the upstream inputs


The upstream inputs can be considered either separately or as a mix of inputs

Best for

Easiness of implementation

(though several combinations could

be considered)

One-go implementation

(but need to estimate the

weight of each input)

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Contents

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Q&A


We were commissioned to implement a retail price regulation methodology for Macedonia

The Agency for Electronic Communications of the Republic of

Macedonia (AEC) commissioned Analysys Mason to develop and

implement a methodology for price regulation of the retail services

offered by the operator with SMP in the relevant retail markets

The AEC’s Decision published in March 2010 imposed a price control

obligation on Makedonski Telekom at the retail level

16 The Macedonian case versus the Italian case • Market context

Makedonski Telekom is required to submit its proposed retail tariffs

for all the relevant products and services to the AEC at least 30 days

before varying the tariffs for its existing retail offers


Before carrying out a margin-squeeze test, we reviewed the market conditions in Macedonia

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Comparison of the fixed voice markets in Macedonia and Italy

The Macedonian case versus the Italian case • Market context

Source: AGCOM (Dec 2011), AEC (Dec 2010)

Item Unit Italy Macedonia

Incumbent

Fixed voice

subscribers # 14 686 673 322 160

Market % 66.7% 77.7%

First altnet

Fixed voice

subscribers # 2 774 394 50 687

Market % 12.6% 12.2%

Market

Number of

competitors # 4 6

Monthly

ARPU

EUR

/subs 13.5 11.4


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Items for which different choices were made

The Macedonian case versus the Italian case • Implementation of a margin-squeeze text

The different market conditions led to different choices of operator type and upstream input

Item Macedonia Italy Rationale

Level of efficiency of the operator

Both EEO and REO

r: REO

w: EEO with OLO network architecture

d: EEO

Difficulty of definition of the REO (e.g. market share)

The OLO network with the EEO scale is assumed as the ‘efficient’ one

Upstream inputs

Subset Mix Market development stage:

– Italy: mature market, no need to look for a specific ‘supply chain’

– Macedonia: developing market, need to look to the different ‘supply chains’ separately (ladder of investment)

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Items for which the same approach was taken

The Macedonian case versus the Italian case • Implementation of a margin-squeeze text

For the non market-related items, the same approach was taken in both cases

Source: Analysys Mason

Item Choice (both countries) Rationale

Downstream

cost standard

LRIC (application of a

mark-up on the

network costs,

in turn LRIC)

Easiness of implementation, widely

accepted in the industry (by both

operators players and regulators)

Evaluation of

profitability

over time

Both DCF and PbP Margin-squeeze assessment in

different time horizons (DCF: whole

lifetime; PbP: single period)

Level of

aggregation of

products

Product-by-product Assessment of the replicability of a

single retail offer still to be launched

(ex ante) and not of the overall portfolio

of the incumbent operator

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Contents

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Q&A


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Contact details

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Paulina Pastor Alfonso

Senior Manager

[email protected]

Analysys Mason Limited España

José Abascal 44 4°

28003 Madrid, Spain

Tel: +34 91 399 5016

Fax: +34 91 451 8071

www.analysysmason.com

Documents

Presentation for the Izmir Cullen Conference Implementation of a margin-squeeze test in Macedonia Presentation for the Izmir Cullen Conference ... Difficulty of definition of the REO