Telcos square off for some spectrum poker

Optus, Telstra and Vodafone have lots to consider when they make their bid, or if they make a bid, for Stephen Conroy's overpriced wireless spectrum. But at the end of the game, perhaps only consumers will lose.

Last week, when Stephen Conroy announced the reserve pricing for the digital dividend spectrum auction to be held next year, he confronted the three big wireless operators with a set of difficult tactical and strategic issues to consider.

The near-unanimous (it may well be unanimous) reaction from disinterested telecommunications analysts is that Conroy has set the reserve price of $3 billion for the 700 MHzx spectrum, or $1.36 per megahertz per population (MHz/pop), at levels that are, by the standards of recent international auctions, way over the odds.

That could have something to do with the Gillard government’s fiscal problems and its promise of a budget surplus but it might also be related to the concerns, even before it made its disinclination to participate public, that Vodafone Hutchison (VHA), wouldn’t participate. That would leave Conroy with only two bidders, Telstra and Optus, and little bidding tension.

Until Conroy set that reserve price the highest price yielded in recent spectrum auctions offshore was in the US, where a 2008 auction produced a price of just under $1.20/MHz/pop. That auction, however, saw Google and a number of cable companies competing with the mobile operators. According to Goldman Sachs, if the Conroy reserve is included, the average price paid for spectrum internationally in the past few years is 80 cents MHz/pop. Exclude the US and Australian prices and it’s closer to 70 cents MHz/pop.

VHA has said explicitly that it won’t participate in the auction next April ‘’under the current terms’’. That suggests it might have a re-think if the reserve price is lowered.

The 700 MHz spectrum is considered critical to 4G or LTE (long term evolution) coverage but Vodafone believes it has an existing advantage in the spectrum needed for 4G (it has a strong position in 1800MHz spectrum) and therefore could boycott the auction without suffering too much competitive disadvantage.

Optus, after the $230 million acquisition of Vividwireless from Seven Group earlier this year believes it has sufficient spectrum for its 4G ambitions (albeit not low frequency spectrum) in metropolitan areas in the near to medium term. Both VHA and Optus, however, would be turning their backs on regional coverage and risking their longer term competitive positions if they don’t acquire 700 MHz spectrum.

For both those groups the decision on whether or not to participate in Conroy’s auction isn’t straightforward and isn’t a decision that will ultimately be made locally. The cost to each operator is probably more than $1 billion and potentially, for Telstra (which is regarded as the most likely to pay up for spectrum) it could be closer to $2 billion.

A decision to pump that much capital into this market would ultimately be made by Vodafone and Optus’ offshore parents – Vodafone and Hutchison Whampoa in VHA’s case and SingTel in Optus’.

All three of those shareholders would have other higher-returning operations elsewhere competing for that capital, with Vodafone and Hutchison probably more concerned about fixing a near-broken Australian business in the near term than what might happen in a decade’s time. They may also not be particularly concerned about competing in regional areas, where traditionally it has been difficult to compete against Telstra and make money.

The first decision for Telstra and Optus will be whether to participate at all. Optus has described Conroy’s auction rules as ‘’unworkable and out of line with international outcomes".

There’s a bit of game theory involved in the decision to participate or not – a version of ‘’Prisoner’s Dilemma’’ – where the smart thing to do would be for both of them to boycott the auction and force Conroy to drop the reserve price but where mutual distrust and the potential for one of them to grab a major and long term strategic advantage will make them leery of that option.

Certainly Telstra could afford to participate and has its network quality advantage and its national coverage to protect.

It also doesn’t have to get permission from a third party to spend big and might well take the view that if Optus is forced to participate it will be capital constrained in future as SingTel seeks to improve returns on capital – and constrained in terms of its pricing of wireless products – while Telstra would gain a massive long term strategic advantage if it acquired spectrum and Optus didn’t.

There are, therefore, both internal strategic issues for the telcos to consider as well as the longer term competitive dynamics of the sector.

There are also, of course, the actual implications for the market if the telcos feel obliged to participate on Conroy’s terms.

If they behave rationally, to the extent that they over-pay, the excess costs will be passed onto consumers and wireless services will, in pursuit of the elusive surplus (that no-one actually thinks is a worthwhile pursuit) end up costing more than the international experience would suggest they should.

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