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au 1
#3
19 August, 2014
Selected digestible insights joining the dots between
Socio-economics, Strategy, Transformation and Delivery
The Radar
FINANCIAL SERVICES
CBA results (WBC, ANZ and NAB have Sep Fin Year End and only
provide trading updates. WBC does not report quarterlies)
3 years after Ian Nareev became CEO, CBAs profit is 35% higher
at $8.6B, share price is up 70% from 3 years ago. ROE is ahead
of rivals at 18.7% (vs 16% big-bank average), and it currently
trades at a 15% premium to its peers.
> Some analysts have asked if CBAs best days are behind. The big
picture is that during a period of relatively weak credit growth, CBA
delivered 12% cash profit growth, which is 2x the growth in
nominal GDP. It did this by focusing on IT and productivity.
NAB: still facing UK drag. ANZ: soft revenue growth, stiff
competition for big corporate customers and competitive Asia.
Leadership changes across banks (NAB, CBA, BOQ, Westpac):
CBA exec team reshuffle: hunt for a new Business and Private
Banking boss after incumbent Grahame Petersen announced he
will retire at the end of 2014. Simon Blair, in charge of the
International Finance Services, will step down from his role and
the banks exec committee. He has been replaced by Rob
Jesudason, currently Head of Strategic Development.
NAB Enterprise Services and Transformation exec Lisa Gray left,
replaced by former Chief Risk Officer of BNZ Renee Roberts. She
has been given a less hands-on role than former CBA operations
chief Michael Harte, with NABs CIO David Boyle reporting to her
and the GM for NextGen Steve Collier remaining in his role.
BOQ: surprise resignation of CEO Stuart Grimshaw to join US
NASDAQ-listed pay day lender pawn shop operator EZCorp:
interestingly the AFR flagged Lisa Gray as a potential candidate.
WBC: Former CBA core banking chief Dave Curran joins Westpac
as its new CIO. Westpac NZ chief executive Peter Clare steps
down following a major heart operation.
> Unrelated changes but they seem to paint the picture of a slightly
changing landscape among the leadership of the sector, hence
inevitably creating new dynamics and opportunities.
RBA data shows that retail deposit rates offered by the 5 biggest
banks fell in July14, and have declined markedly since the last
RBA rate cut in Aug13. Market leaders such as UBank and
RaboDirect, which until recently offered deposit rates over 4%,
have both kneecapped their best rates to 3.81% and 3.2% resp.
> This is because funding from bond markets has become cheaper
since the GFC: so banks are cutting rates previously used to attract
deposits as a source of funding when capital markets where more
onerous > This means that many savers and retirees are earning
negative real returns on their cash - historically a rare event.
They are implicitly encouraged by the RBA to chase higher income
with riskier investments like popular ASX listed equity hybrids
An interesting reflection raised by some analysts: With profit
comes pressure for the Big 4 because they form the bedrock of
most SMSFs and retirement savings managed by big super
funds. But questions are being asked about whether or not the
big banks can continue to deliver strong capital gains. High-
profile brokers question whether the banks have passed the
sweet spot in the earnings cycle. Pressures are building on profit
margins, and bad debt charges are at a cyclical low. They say
asset performance can only deteriorate from here as interest
rates normalise and financial stress increases with rising
unemployment: They are amongst the most expensive banks in
the world, based on peak-cycle earnings, the final nail in the
coffin for the sell case is capital if APRA pushes for higher
capital requirements which will have to be met either from
lower payout ratios or dilutive capital raisings, it is hard to see how
the value of these shares could move much higher. A contra
view is that Banks are heading into a period of increased lending
as the economy shifts from mining which was self-funding, to the
non-mining sectors.
> The point here is not to resolve the debate, but to be informed
of those views that provide a valuable insight into the cyclical nature
of our economy
OTHER INDUSTRIES
Data and privacy: Optus has flagged the complexity and cost
(above $200m) of the Federal Govts plan to make phone
companies retain metadata, whilst PM Tony Abbott and Attorney-
General George Brandis said they are working on the hypothesis
that the data is readily available because companies already keep
it for commercial reasons.
> Beyond the political argy-bargy it reinforces the insight that
Data is a strategic asset that businesses, activists and policy makers
are trying to figure-out, creating tensions along the value chain.
What this means for us is that developing a sound understanding of
this governance is as important as developing apps.
Medicare Services outsourcing: Whilst the banks have been
previously shortlisted to take over Medicare's $30 billion Benefits
Payments responsibility, Australia Post looks now well positioned
to take on that role given its network and digital capability. The
outsourcing proposal was a recommendation from the
Commission of Audit and aligns with the Abbott govts pre-
election pledge to streamline the public service.
> A good prompt to keep reflecting on the nature of services in the
context of our Strategy, to draw actionable concepts/ideas: e.g.
what added-value services can augment everyday banking?
After 8 years without a dividend increase, Telstra is this year
taking baby steps to shareholder returns, distributing $4.7B to its
shareholders in the form of a $1B share buy-back and a 15
dividend, taking total dividend payments to 29.5 for the year..
Yet analysts were expecting more from a solid $4.3B profit.
> Even after the payout, Telstra has a free cash flow of $5.1B, which
is signalling it is trying to find the right balance between returning
cash to shareholders and retaining enough cash for future
acquisitions to grow. Indeed, not only all companies now face
pressure to have growth plans compared to the years after the GFC
when the focus was purely on yield, but Telcos are also facing a fight
for their relevance as disruptors like Google Hangouts, Viber,
Facebook and WhatsApp use their global scale to provide services
so cheap that call and texting revenues are disappearing, and whats
left is eaten by these new rivals. Hence reducing Telcos to utilities
providing little more than a network of dumb pipes (see deep dive).
MACRO-ECONOMICS
Not since 2002, before the China-driven resources boom began,
has Australias jobless rate been as high as last months 6.4%.
The concern among analysts is that Australias policy makers are
pursuing Austerity (RBA not cutting rates, govt concern about a
rather manageable budget deficit). Yet between the 2 issues,
deflation currently seems a greater risk than inflation: China is
slowing down with growing alarm about a property slump (-9.2%
home sales in 1H14) in a country already beset by ghost cities.
> This means increased pressure on Australia to diversify the
economy toward growth engines that rely less on China, and with
fiscal policy makers pursuing austerity policies from Washington to
Canberra, the onus seems all the more on central Banks to manage
downside risks.

2
DEEP-DIVE: Telcos and the digital threat (how not to become just utilities providing little more than a network of dumb pipes)

1. Earnings reported this week cant hide that Telstra, SingTel-
Optus and Vodafone are already in the fight of their lives
- Telstra reported a solid $4.3 billion annual profit, and its share
price surged to a 12-year high, but this is masking the threats that
loom over the Telcos.
- They are facing a future in which we are making more phone calls,
sending more messages and downloading more content than ever
before. And yet incumbent Telcos, such as Telstra, that for more
than 100 years have run a deceptively simple business model
building networks which we then pay to use, are increasingly
reduced to utilities providing little more than a network of dumb
pipes.
2. This is because free or virtually free instant messaging (IM) services
- also known as Over-The-Top (OTT) messaging - such as Google,
Viber, Facebook and WhatsApp use their global scale to provide
services on top of the networks so cheap that call and texting
revenues disappear entirely, and whats left is eaten by these new
rivals. Analysts around the world believe the Telcos business model
will be outdated within 10 years.
Indeed voice and SMS that make up a significant portion of the Telcos
revenue started going down a few years ago and its accelerating:
- In 2011, SMS represented 39.8% of worldwide data services revenue,
with MMS accounting for additional 14.2%.
- But then, in 2013, it dropped for the first time ever, as OTT
competition intensified. Last year the Telcos lost about $US25B
globally in voice revenue, $US50B in the case of SMS to OTT. Gartner
predicts that as early as next year the volume of OTT will have
overtaken the volume of SMS, and with that threatening what was
once a great cash generator for mobile network operators.

3. OTT messaging apps are outcompeting SMS for several reasons: they run over data channels while SMS runs over voice. They bypass
mobile networks and roaming because of more pervasive Wi-Fi. On top of this, tablets are becoming increasingly popular and most of
them do not have voice/SMS services, but run data/OTT instead.
4. However Telcos are circumspect: they sees the need to react
quickly but face a conundrum: while data usage has exploded in
volume, there is a long tail of SMS revenue.
While Deloitte expects instant messages on mobile phones to reach
more than double the volume of SMS messages this year 50 billion
IM messages vs 21 billion SMS messages global revenue from IM will
be approximately 2% of SMS: partly because OTT messaging services
tend to be free or cheap (eg WhatsApp charges only $0.99 per user
per year and that's after the 1st year, which is free); but also because
global consumers who don't own smartphones still send text
messages.
5. The reasons for this crash:
- Where a Telco charges 55c to text a picture (eg Vodafone), WhatsApp
and Viber enable phone calls and messages to be sent free of charge
over the internet. So carriers have answered this threat with near-unlimited phone calls and texts. However while this might delay the
switch for some customers, it also shrinks the already falling profits from those services.
- Because internet access is so widespread thanks to infrastructure investments in mobile towers by old Telcos such as Telstra the
costs for tech giants like Google to offer new services have been slashed. This is the Catch-22: it has helped internet usage boom without
a matching rise in the amount of revenue generated by Telcos. E.g. Optus reported a +40% increase in data downloads between 2013 and
2014, yet contributing revenue rose by just 10% as an analysts commented: phone call dollars got replaced by digital dimes.
- Finally, Tech companies dont have the same legacy and workforce costs For instance: WhatsApp had just 55 staff in February 2014;
for every $1 in revenue made by a Telco worker, the average Amazon employee makes $2.

The
Fab Five
are
followed
by even
more
attackers
OTT Services Businesses
Transfer of revenue
Data: 10-15% in 2011
to 25%-40% in 2015
Revenue and Usage
are out of sync
Source: EY

3
6. The battlegrounds and strategic imperatives to transform for the smartphone society
A primal reactions from the Telcos could be to block OTTs, charge or throttle the data: However, retribution appear to be short-term
counter-productive tactics because it triggers higher customer churn and lower data usage, and because it also goes against the principle
of Net Neutrality. Net Neutrality has not had a very high profile in Australia, but has reached High Courts in Europe to the point that
it has even been enshrined into national law in places like France, The Netherlands, Slovenia and Chile.
Instead, the strategic play is about repositioning in the value chain and owning the customer experience. Key dimensions are:
- Personalization of service suites and the customer experience: as services become more complex, being able to tailor the customer
experience is essential. For providers, this means giving users platforms on which they can bundle their apps, information, entertainment,
shopping, communications, and problem resolution.
- Staunch defence of relationships with end customers: The battle for customers will not be won with services alone, but with every
aspect of the ecosystem. Devices have a crucial role to play partly because they often clinch a decision whether or not to sign a Telco
contract. Apple has been showing how this can work with the iPhone. Google is strengthening its position with the rapid dissemination of
Android. Even Amazon has joined the device race with its Kindle Fire Tablet and new Fire Phone.
- Cost-efficient broadband network build-up: When relationships with end customers are eroded, cost efficiency and bandwidth become
critical to remain competitive. Only Telcos that have large infrastructures will be able to survive. All the more that OTTs are increasing
data traffic. By 2020, the OTTs' video offerings will account for more than 50% total data volume. That's why the Fab Five need the
telcos' broadband networks for their business model, who on the other hand must find a way to monetize this exponential traffic increase.
- Realignment and radical streamlining of operating models Roland Berger believes the different infrastructure strategies will leave the
Telco more fragmented. For strategic and financial reasons, they are likely to realign and resize their operating models around network
companies ("NetCo") providing the pipes, customer-centric sales and service company ("SalesCo"), managed by corporate services ("HQ")
setting the strategy.
7. This is likely to lead to 4 plausible scenarios:
i. Clash of the titans: If the addressable market expands but the
industry consolidates, we could expect to see a clash of the
titans' between a few large Telcos and Web 2.0 players eg
AT&T versus Google.
ii. Survivor consolidation: If consolidation without growth
occurs, we could expect a sort of nightmare scenario - huge,
monopolistic operators and stultifying conservatism.
However competition, rather than consolidation, is likely to
dominate. We might see either a "Generative Bazaar" if both
fragmentation and growth occur; or a "Market Shakeout" if the fragmentation persists without growth.
iii. Generative Bazaar: In this scenario, barriers between OTT and Telcos blur as regulation, technology and competition drive open access.
Infrastructure providers integrate horizontally to form a limited number of network co-operatives providing pervasive affordable and
open connectivity to persons or devices, including an expanding class of innovative asset-light service providers.
iv. Market Shakeout: This would happen under prolonged economic downturn: investors would force carriers to disaggregate assets into
separate businesses with different return profiles. Retail brands would emerge to repackage services from disaggregated units.
8. So what
> Firtsly, as a reader of this memo, if you are still paying for
phone calls, especially international, you might want to
urgently consider using apps like viber, Skype, ooVoo, FaceTime
etc..
> Secondly, banks should ponder the insights from the OTTs
as a cautionary tale, and a metaphor: what Over-The-Top
services could plug onto the financial pipes that they run
today?
- When telcos tried to compete with OTTs to create their own
alternative apps, results were almost universally uninspiring.
- Partnerships with OTT services seem a more promissing
avenue (ie not trying to recreate what Tech players do better
anyway): Reliance with Whatsapp in India, Airtel with Facebook
in Africa, Netflix with Comcast, Verizon and AT&T in the US.
- In Australia Telstra has cash ($7.48B) and plans to use it to
stay in the game, even at the risk of partnering with the enemy.
These include eHealth, cloud computing and video platforms.
Eg Telstra spent an extra $US270m to buy online video platform
start-up Ooyala that lets websites host streamed content.
- For several years Telcos have been looking to banks for the
holy grail of internet partnerships. The idea is simple billions of dollars worth of transactions cross their networks every day, from which
banks generate profits, and the Telcos want a taste of the action. But negotiations have gone nowhere fast because both the banks and
the Telcos think they should have the most hand in the relationship. Meanwhile they will likely keep eyeing each other, maybe until a
cheaper payment option Paypal, Amazon or Bitcoins forces a marriage of convenience?

Scenario A
Scenario B
Scenario C
Scenario D
Clash of
Giants
Survivor
Consolidation
Generative
Bazaar
Market
Shakeout
Today
Future Scenarios
Market
Industry Model
Fragmented /
Horizontal
Concentrated /
Vertical
Declining
Expanding
Operator-centric
Bank-centric
Multi-
consortium
Payment network
Example: the evolving models of the mobile money ecosystem