Accentuate the positive

Disruption in the UK market got a leg up today, as OFCOM unveiled the preliminary conclusions to phase 2 of its strategic market review. Most of the key elements are along the lines of what BT itself proposed back in February, though a few elements of the fine print lead me to think that this is a fairly tough settlement for BT, perhaps reflecting the company’s desire to cooperate in order to avoid more serious intervention. The stock is up over 4% as I write, and the financial press interpretation is that this is a relief rally as "BT escapes breakup." I'm not sure how many in the market genuinely thought that breakup was a likely outcome, but I guess that following the adage that the market hates uncertainty, some visibility is better than none, even if the picture itself is not that pretty. Both OFCOM and BT are holding calls later today, but at this point, the important stuff is:

• As previously proposed by BT itself, a separate unit will be created within BT for the purpose of guaranteeing equivalence of access. This unit, to be known as the Access Services Division (ASD), will have 30,000 staff, be headquartered in a separate location (I would recommend Coventry), use separate operational and trading systems, and over time will develop its own distinct branding to reinforce its presumed independence from BT. Importantly, OFCOM has insisted that Access Services personnel’s bonuses will be determined on the basis of success in achieving the goals of the unit (i.e., fostering competition), rather than those of BT Group (or the performance of BT shares, which may be inverse to the success of this unit).
• To achieve greater separation between Wholesale and Retail units, BT will agree to segregate product teams in its Wholesale unit managing products where BT is deemed to have significant market power (SMP). These product management teams will have financial incentive schemes similar to those promised for ASD employees.
• OFCOM has put in place clear compliance and enforcement mechanisms, including a five member Equality of Access Board (three of whom will be independent, versus two under BT’s February proposal), and a financial penalty of 25p per line per month if BT fails to deliver its targets for Wholesale Line Rental process improvement by 31st December 2006. Moreover, by agreeing to today’s measures in lieu of action under the Enterprise Act, OFCOM will have the power to take BT to court for non-compliance, and members of the BT board of directors will bear personal responsibility for ensuring compliance with the rulings in any court cases which may arise out of this process (a fact which Cable & Wireless seems to like).
• The 21CN network must be structured so as to support unbundled access for third parties to key bottlenecks, and 21CN retail services may only be launched after equivalent wholesale products are available. Moreover, wholesale and unbundled access pricing for 21CN must reflect the greater cost efficiencies of the new network. (This is what I would have expected OFCOM to say, though BT has previously only referred to "fair access" to 21CN.)
• BT will cut the annual rental on fully unbundled local loops by 24%, from £105 to £80, effective from 1st August. This goes £5 farther than we had expected in terms of absolute decline, and is significantly sharper than what BT was suggesting in February (around 8%). OFCOM has taken the additional step of barring BT from cutting the rental price of its wholesale DSL products until such time as the number of unbundled lines reaches 1.5m (from only 59k at the end of May).
• If OFCOM concurs with BT's view at some future date that the WLR product and processes are functioning properly, then there may be scope for BT to increase monthly line rental, however I note that a piece on broadband regulation is also due from OFCOM next week, and I would bet 50p that it will include some serious consideration of naked DSL.
  

Judging from share price performance today, clearly the market is relieved at what it sees as the removal of an “overhang” issue regarding BT’s future. However, it seems to be ignoring to some extent that the structural complexities involved in setting this system up may be great. We are talking about a new headquarters, structure, IT systems, etc. for 30k, as well as the cultural upheaval which the ringfencing of parts of Wholesale is likely to cause. These are not trivial issues. Additionally, the dramatically lower full ULL rental charge is a green light to Wanadoo, AOL, Tiscali, Bulldog, et al, while BT's ability to mitigate this impact by lowering wholesale pricing is frozen until ULL is well-established.

UPDATE 1: OFCOM's conference call slides are here. The call itself was not hugely informative beyond what we already know from today's statement, though it added some context around OFCOM's thinking. There were a couple of interesting facts which came out. Once the 1.5m lines benchmark has been achieved and the freeze on wholesale pricing removed, the national average decline in IPStream pricing will still be kept to below 3%. Asked about how OFCOM will measure success, Stephen Carter remarked that he expected that once a genuinely level playing field with attractive margins had been created, competition would flow into various segments of the market, ranging from ULL through to innovative voice packages (for which read VoIP). On the ULL issue, I couldn't determine whether he meant DSL service provision over ULL, or in infrastructure itself. The analysts seemed to be focusing on the retail service provider space (which is a given in my view), but I am aware of at least one new company which is looking to compete head to head with BT on the infrastructure side. It is interesting to ponder the additional complexity that this might add to the market, and I wonder how many have contemplated its implications.

UPDATE 2: BT's call was fairly upbeat, at least in the sense that management sounded relieved to have removed uncertainty. In terms of additional information which came out, Clive Ansell, head of regulation, remarked that there is actually a backstop date in 2007, when BT will be allowed to lower wholesale prices, even if the 1.5m threshold has not been reached. Financial impacts were quantified thus:

• "Several tens of million pounds" over a couple of years to set up the Access Services business.
• A £12m hit from building in the 10% margin for competitors on WLR (on the basis of a 10% margin on 1m WLR customers over 12 months), though this figure is obviously going to rise as WLR grows and the next incremental cut in WLR pricing is made.
• Impact from ULL of £30 - 40m, based on 1m lines. This was clearly a back-of-envelope exercise on BT's part, and seems to represent a central case. For example, management said that if we assume that all ULL growth is driven by market growth, then it's a net positive. If all growth is churn-related, I come up with something like negative £45m impact at 1m customers, if they're all fully unbundled lines. Clearly neither of these scenarios is likely to dominate growth in the market in such an absolute manner.

Another indicative forecast was 5m unbundled lines by 2010, but this was stated as just one scenario. Drastic, yes, but better than seeing defections to cable (by the way, have a look at NTL's £9.99 offer for 12 months). Something tells me this market's about to go off like a rocket.