Bringing Wal-Mart Scale Economics to Network Operators

Every competitor wants to be the Wal-Mart of its industry. Wal-Marts ability to scale rapidly from a single profitable unit way past the $300 billion mark in sales is the envy of every company on the plant. For more than 30 years, Wal-Mart has created equity value for its shareholders in ways that its competitors have not. Arguably the company has the most dominate strategic model of any major company in any industry, worldwide. But, in telecom there is no model for scaling quickly and profitably like Wal-Mart. This depresses levels of profit and growth, significantly diminishes opportunities, and drives market revenues into the hands of non-telecom companies, like Apple. Today, network economics do not begin to approach the cost effectiveness of Wal-Marts distribution network. Operators use a highly variable cost structure that increases linearly with network traffic growth. To grow you have to flame off profits. This is the single biggest challenge facing the industry. Failure to overcome this challenge means limits to growth and profitability, poor exit options, and serial financial crises for the foreseeable future. Telecoms linear cost structure inhibits operators abilities to improve margins and capitalize on the explosive growth of bandwidth-intensive applications and services. In the battle for profitable market share between cable MSOs, telcos, satellite companies, and wireless carriers, and media empires, the winner will have Wal-Mart-like distribution economics. The number one priority of C Level management in every carrier worldwide, therefore, is to replace its linear cost structure with Wal-Mart-like scale economics. Wal-Marts supremely efficient distribution network is the single most important enabler of its Everyday Low Prices mass marketing strategy. This White Paper will focus on bringing Wal-Marts peerless distribution strategy to communications carriers so they too can achieve Wal-Marts scale economics, deliver everyday low prices to their customers, and grow and make money while doing so.
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Today we are at the dawn of a dramatically reshaped telecom landscape. When North River Ventures began creating growth models for the telecommunications industry over a decade ago, they observed that the lack of Wal-Mart scale economics would implode first the IXC business and then force consolidation on the wireless carriers and the IECs. This process has unfolded exactly as NRV predicted and consolidation has accelerated throughout 2004-2005 as the strong devoured the weak and repositioned themselves for their next looming battles. WorldCom devoured MCI, collapsed, renamed itself MCI, and was in 2005 acquired by Verizon in an $8.5 billion merger. SBC acquired AT&T for $16 billion and renamed itself AT&T. Sprint merged with Nextel in a $35 billion deal. SprintNextel in turn acquired its affiliates for $6.5 billion. In 2004, Cingular, a joint venture between BellSouth and SBC, acquired AT&T Wireless for $47.5 billion. Almost every penny of that $113+ billion shareholder money was spent to achieve elusive scale economies. Each of these deals was an attempt to position companies against competitors by offering a broader array of seamless services in order to aggregate user demand, gain scale economies, and improve profitability. In effect: become a mass marketer of communications services. In short, the goal is to replicate Wal-Mart economics in telecom. The critical question is this possible given existing business models? As North River Ventures pointed in 1995, Wal-Marts growth engine is so efficient that Wal-Mart doesnt need to make acquisitions. In fact, Wal-Mart acquired nothing until it expanded overseas, and only then once its own management system was so effective that it could easily absorb, and manage, these new operations. In other words, replicating the Wal-Mart model means redesigning the business model first, acquiring later. Getting this backward, as North River has so often pointed out, risks turning a company into a sinkhole for shareholder value. This is exactly what happened to the IXCs half a decade ago and the risks of it happening with todays new generation of integrated carriers is very high. This White Paper is about eliminating those risks, minimizing the potential for acquisition failure, and positioning carriers for profitable growth. Wal-Marts Distribution Model Wal-Marts economies of scale let the company offer the Everyday Low Prices that gain it dominant market shares wherever it operates. EDLP is about much more than price, too. Service and assortment are both important elements in Wal-Marts policy of lowering customers total cost of shopping. Wal-Mart believes its customers want a broad assortment of products under one roof, and expect to find products they want in stock.

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EDLP has been so successful because it reduces the hassle factor for customers and associated costs to itself of shoppingsuch as product stock-outs. EDLP is what differentiates Wal-Mart from the rest of retail. Other retailers have attempted to mimic their model on a limited scale, however Wal-Marts core distribution strategy keeps it the most dedicated and successful practitioner of EDLP. Wal-Marts scale economies have allowed it to transform the shopping experience of its customers, something no one in telecom has ever managed to do. According to Rob Walton, When Dad started the company we operated in rural areas and small towns that were not reliably served by distributors. To get reasonably priced and dependable deliveries, we had to become our own distributor. This gave tiny WalMart a competitive advantage because we were able to lower our costs by bringing distribution in-house1. By reaping the benefits one particular aspect of scale economiesthe aggregation effectWal-Mart could offer EDLP to all of its customers, everywhere. Wal-Mart aggregates and sells as many different items as possible, allowing it to grow revenue over its fixed cost base (more sales out of the same store). This is why Wal-Mart began to sell low margin groceries. As volume increases, Wal-Mart generates incremental contribution toward its fixed costs. The efficiencies generated by Wal-Marts hub and spoke distribution system are enormous and play a large role in its success. Discount Store News reported that Wal-Mart's distribution costs were only 1.3 percent of its sales, compared to 3.5 and 5.0 percent for a major competing discount chain and a major general merchandise chain, respectively. In other words, for every $100 worth of merchandise sold, Wal-Mart spends only $1.30 getting product from the factory to the store. It is not hard to see why retailers less focused on distribution have such a hard time competing price wise when their merchandise must go through multiple layers of wholesalers and distributors.2 Wal-Mart optimized its distribution network on delivered costthat is the total of all costs to source/produce, inventory, sell, and transport product to each customer or customer groups. Wal-Marts distribution strategy is mix of sophisticated supply chain management systems, applications, processes, and communications technologies. Wal-Mart invested billions of dollars to develop these elements of its supply chain capabilities.

1 2

Rob Walton speech, Annual AAI meeting, 2003 Missouri Business.net, Competing with Mass Merchandisers, Kenneth E. Stone, Ph.D.
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However, at a fundamental level, it is Wal-Marts least glamorous distribution assets comprising a network of distribution centers and a large fleet of company owned trucks and trailers that ultimately make its low cost competitive position virtually unassailable. For example, owning its fleet of trucks enables flexible scheduling, cost-efficient delivery to stores, accommodation for peak seasonal periods, night deliveries, and expedited delivery. A company-owned transportation system also assists Wal-Mart in shipping goods from warehouse to store in less than 48 hours. This allows Wal-Mart to replenish the shelves 4 times faster than its competition. Wal-Mart invested heavily in a complex, hard-to-imitate "cross-docking" warehousing system that enabled it to dominate K-Mart on product cost and availability, both critical success factors3. This unique cross-docking inventory system enabled Wal-Mart to achieve economies of scale, which reduces its costs of sales. With cross docking, goods are delivered continuously to stores within 48 hours and often without having to be inventoried. The resulting lower prices eliminate the expense of frequent sales promotions and make sales more predictable. Cross docking gives individual store managers more control where Wal-Mart needs it: with customers. The heart of Wal-Mart's distribution system is its distribution center. A typical distribution center is about one million square feet in size and has the latest in state of the art inventory control and materials handling equipment. A distribution center can accommodate about 150 retail stores located in a circular pattern around the center. Merchandise is delivered to distribution centers and then trucked directly to retail stores daily. As customers make purchases, the electronic scanner checkout system forwards sales amounts and inventory changes directly via Wal-Mart's own satellite system to headquarters and to the appropriate distribution center for reorder. This daily updating of inventory allows distribution centers to send the precise amount of merchandise to the stores to maintain the optimum level of stock. The result is minimum inventory and low stock outages, a balance no one else achieves. According to Discount Store News, about 78% of the merchandise Wal-Mart sells domestically moves through Wal-Marts distribution centers. In comparison its competitors move roughly 50% of sales through their own distribution centers. Wal-Mart has 111 distribution centers in the United States, or roughly one distribution center for every 34 Wal-Mart stores. Among these, there are 30+ general merchandise

Stalk, G., Evans, P., & Shulman, L.E. (1992). Competing on capabilities: The new rules of Corporate strategy. Harvard Business Review, 70(2), 57-69.
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distribution centers, 20+ grocery distribution centers, 8+ clothing distribution centers, and 9+ are specialty distribution centers. The specialty distribution centers ship items such as jewelry, tires, and optical supplies. The remaining merchandise is delivered directly from the factory or through vendors and distributors. Globally, a total of 84 percent of Wal-Mart Discount Stores' and Supercenters' purchased merchandise was shipped from Wal-Mart's distribution centers. Close examination of Wal-Marts supremely effective distribution strategy yields three key insights regarding how its distribution strategy yields competitive advantage: Distribution Operating Leverage Infrastructure Ownership/Control and Flexibility Distribution Ubiquity/Customer Proximity

Wal-Marts distribution fixed cost structure (trucks, store, and distribution centers) gives it high operating leverage. This structure, along with an intense focus on reducing variable costs, enables it to keep total delivered cost low and stabilize margins with increasing volume. Wal-Mart, relative to its less successful competitors, owns more of its distribution channel. Ownership of key distribution assets gives it more control and flexibility than competitors. Whether its Digital TVs or diapers, Wal-Marts distribution system is flexible enough to respond in real time to the dynamics of the market. Finally, Wal-Mart built its retail stores around the distribution hubs to make sure merchandise was as close to the customer point of sale as possible.
Diagram of Wal-Marts Distribution Delivery System
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Physical Infrastructure Trucks, Stores, Distribution Centers, Warehouses

From e-Business to Services: Why and Why Now?, By Ravi Kalakota, Marcia Robinson, CFN Analysis
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U.S. Carriers and Wal-Wart Compared, 2000-2006 CFN asked North River Ventures to revisit its 1995 findingsthe company tracks WalMart closelyto show our clients the state or risk today. Their findings, on the next two pages, are illuminating. Nothing shows how much the lack of a Wal-Mart model for growth and earnings hurts carriers that to compare how Wal-Mart and the big U.S. carriers stacked up in 2000 with how the stand today. The following data uses North River Ventures telecom growth model that was designed around the Wal-Mart challenge by North River a decade ago At the turn of the century, carriers were growing, though much of this growth, as in the cases of Verizon and AT&T, was built on acquisition, not organic growth.

But, by 2006, the situation had changed dramatically. The rate of telecom expenditure as a percent of GDP stalled, indicating a shift user behavior, and organic growth among the majors turned to decline.

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Wal-Marts growth rate, by contrast, actually increased during this period, demonstrating that a company that was already huge at 95% the size of the top five common carriers combined, could use a bricks and mortar strategy to accelerate, if distribution economics were understood. Today, the same five carriers that, combined, were almost Wal-Marts size only a few years ago, are collectively 59% its size today, and this gap is growing. Without a doubt, the top priority of common carriers, and all their suppliers, is to solve this problem and get growth back on track. Without such a solution, there is no shareholder value engine in the U.S. common carrier business, with serious consequences for the entire sector. CFN will provide that solution. Implications of Wal-Marts Scale Economies for Network Operators Like Wal-Mart, to survive and prosper all wireline and wireless operators worldwide must continuously improve the unit price performance curve for every bit transported and delivered to and from the customer base ($/Mbps). Whether the bit is voice, JPEG, MP3, or video, there are at least three competitors in every market offering essentially the same services to the same customers. An example more like retail is hard to imagine. As todays content-rich environment unfolds, broadband connectivity margins, whether wired or wireless, are being squeezed as value is migrating from infrastructure towards content, applications, and services. This is similar to trends throughout the information technology.
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In traditional wireless, ARPU has been falling steadily with price competition and a proliferation of minute bundles. With voice-over-IP making sharp inroads in telephony, the economics of voice and broadband combinations have significant downside, driving blended EBITDA towards broadband connectivity margins (Exhibit 5)5.

Infonetics Research: Service Provider Plans for IP, MPLS, and ATM: North America, Europe, and Asia Pacific 2006

Despite the margin pressure, total network traffic is increasing at double-digit rates. In 2005, digital music sales reached a record of 352.7 million digital tracks, representing a 150% increase over 2004. Similarly, digital album sales leapt 194% from 2004, with 16 million-plus units sold. Just to stay in the game, therefore, carriers need to expand network capacity to satisfy end user demand and deploy multiprotocal technologies while reducing network access expenses. In other words, in telecom services, the more you sell, the lower your margins.

Telecom War of the Worlds Part II, i2Partners

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To reverse this margin squeeze, improve the price-performance of their services, and gain control over scale economies, carriers are trying to exploit the capabilities of multiprotocol technologies and bypass ILECs. Carriers are using packet-based transport technologies and broadband wireless to upgrade their networks with higher transmission speeds at ever-lower costs. Wireless operators are in various stages of deploying next-generation data networks such as EDGE, UMTS and 1XEV-DO, to attract large numbers of enterprise and consumer data subscribers. Fixed wireless and/or 2BaseTL (Ethernet over copper) lets carriers bypass the incumbents last mile networks. Bypassing provides IXCs, CLECs, and wireless carriers the ability to save channel termination charges imposed by the LEC and to capture the benefits of improved price-performance offered by broadband services delivered via these technologies. In 2003, IXCs, CLECs, and wireless carriers spent roughly $14 billion on access facilities with incumbent local exchange carriers such as Verizon, BellSouth and SBC. Access facilities (aka special access) encompasses the dedicated circuits carriers use to connect their networks to their customers via the ILECs. Indeed, pre-merger, network access costs are AT&T and MCIs single largest expense at 38% and 51% of revenues respectively. Mergers between AT&T/SBC and Verizon/MCI will reduce but not eliminate these access expenses. For wireless carriers, backhaul costs can be up to 4060% of total network operating expenses. Some 95% of backhauled cell sites use expensive, tariffed ILEC services, mostly T1 links.6 Roughly 80% of these costs are concentrated in the top 20%or 5,000of the 25,000 local serving offices (LSO) nationwide. Due to the asset base and traditional operating models of the competitive access providers (CAPs) such as MFS, Teleport, and Brooks Fiber, which were acquired and integrated by the IXCs, the IXCs have largely continued
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Telephony Magazine, FiberTower Targets Backhaul, pg 14., March 14, 2005

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the focus on total LEC bypass, deploying local access connections directly from the IXC point of presence (POP) to the end-user customer site, typically a commercial office building. As a result large IXCs such as AT&T and MCI have amassed direct fiber connections to some 6,000 buildings each, while only deploying fiber connections to some 500 or so LSOs each. While the Telecom Act of 1996 enabled, and the current regulatory environment continues to support, collocation for the deployment of multiplexing and access to unbundled network elements, the IXCs continue to purchase these access services from LECs rather that taking these costs in house on their own platforms. This highly inefficient approach builds costs, rather than diminishing them, making carriers less like Wal-Mart and more like its less successful competitors.
Pre-Merger Analysis AT&T and MCI Collocation Presence

25,000 LEC COs

MCIs Converged Packet Access services are limited to On-net via MCI's fiber-lit buildings and Off-net in select locations

The top 5,000 central offices drive over 80% of ILEC special access traffic and revenues 95%+ of client locations are not candidates for fiber / building connectivity and thus require LEC T1-T3 tail circuits Leasing virtually unlimited capacity at the LSO level locks in the access cost curve eliminating most of the variable cost impact from increasing transport volumes Expanding LSO collocation reduces IOF and MUX costs while creating the opportunity for further expense reductions through channel termination (CT) substitution (DSL, Ethernet) LEC collocation and managed CTs are a key enabler for multi-service packet platforms and delivering innovation and improved service through NextGen IP based service

80% of business customer buildings

Collocations by IXC**
*Telcordia research **NPRG 2004 CLEC Report

CFN Services believes attacking these inefficiencies is one of the largest areas of post merger cost savings and synergies available to both wireline and wireless carriers. In the post consolidation environment, most carriers are undertaking a strategic review of their access cost structure and launching initiatives aimed at improving margins by significantly reducing these costs. We believe that customer-to-POP total costs (local access plus backhaul transport cost) can be cut fast by leveraging third-party multi-modal technologies to optimize local access and transport infrastructure. The legacy AT&T operation spends roughly $4.5 billion annually on local access transport services, historically 38% of top line revenue. This is huge. While the merger with SBC will mitigate a portion of these expenses, significant costs will remain in nonlegacy SBC LEC territories such as Verizon and BellSouth.
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Additionally, the Verizon/MCI merger places new competitive pressures on local access prices, the maintenance of which is critical to profitability from the full suite of AT&Ts enterprise services. Worse, this pressure will cut into the potential for expanding these services into the small and medium sized business (SMB) market. In other words, because of structural inefficiencies in its distribution network, the merger of AT&T and SBC could cause the company to lose margin rather than gain it. AT&T will continue to compete with the legacy MCI for enterprise business in markets such as New York, Washington, and Boston, where each has traditionally had a similar local access footprint via on-net LSOs. MCI, by contrast, will have a significant competitive advantage in those markets with ubiquitous LSO coverage of Verizons access networks. CFN Services believes that by leveraging third-party multi-modal technologies to optimize local access and transport infrastructure, these market asymmetries can be solved, giving AT&T, in this example, an opportunity to grow profitably post merger. Based on its analysis of wireless and wireline access costs and footprint, CFN Services believes strategic access optimization initiative can yield savings in the range of 20-25%. Getting to Wal-Mart Economics The CFN Service platform brings Wal-Mart scale economies to telecom services. We use an off-balance sheet strategic platform to optimize off-net to on-net local access transport, giving our clients a clear path to profitable growth. Our platform uses broad-based LSO expansion and collocation for implementation of multiplexing services and access to unbundled network elements for the deployment of multi-modal alternative access technologies such as H/VDSL and Ethernet over copper. Additionally, our platform leverages fixed wireless technologies for cell site mobile backhaul access and broadband Ethernet access expansion. This approach integrates seamlessly with existing carrier local access transport infrastructure, while supporting key initiatives for expansion of converged packet and Ethernet services, and ensuring high-end enterprise services. A platform-based approach to local access transport optimization will reposition wireline carriers strategically for long-term competitiveness in the enterprise market, while also positioning for expansion in the SMB markets. For both wireless and wireline providers, our approach shifts and flattens the access cost curve from a linear growth curve to an incremental growth curve, where unit volume and/or bandwidth growth drive continually decreasing unit costs across the platform, as in the core network.

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CFN is rewriting the telecom services business model in its entirety. Leveraging expert resources and tools developed specifically for local access transport optimization analysis and platform deployment such as FiberSource and FiberMAP, CFN Services performs a strategic analysis of carriers access costs. Incorporating the extensive base of deployed fiber and facilities in over 120 markets nationwide, our analysis identifies opportunities for the extension of existing local access network platforms and implementation of new metro fiber-based platforms in new markets. Our analysis incorporates customer metrics for ROI, and other critical business case measures.

CFN Services FiberMAP (Fiber Metro Access Program)

Gather Multi market Access Cost Data

Perform Analysis and Mapping

Map/Engineer Optimized Network(s) Design

SBC Be llSouth Ve rizon Electronic CD Rs Paper Bills Forecasts Interco nnect agre eme nts

CSX FN Carrier Carrier Demand Demand Data Data

Cost , Inventory, Traffic

Circuit Circuit Inve ntory Inve ntory Da ta Da ta

FiberSource
CSX FN Inve ntory (fibe r, fa cilitie s, a nd re la tionships)

Prioritized roll out based on savings opportunities and strategic priorities

Tra ffic Tra ffic a nd Ne twork a nd Ne twork Da ta Da ta

Ta riffs Ta riffs NEC A NEC A LERG LERG

CSX FN optimizes, POP locations, collocation facilities and/or desired connection points via proprietary analysis tools

While our platform conservatively delivers 20-25% in annual access cost savings to carriers, it does not require significant investments of capital or expansion of internal operating costs. The dilemma for carriers without CFNs Wal-Mart-style economics is that the more they expand, the less likely they are to achieve long-term competitive advantage through network differentiation. To solve this, future infrastructure investments must be toward the edge, where more of the intelligence increasingly lies, and away from vulnerable commodity pipelines.
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Carriers must shun assets with long payback periods and/or table-stakes capabilities. Yet, carriers cannot improve margins if their cost structure is highly variable and they must buy LEC access circuits by the drink.

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Communications Access and Transport Networks v2.0 Since carriers cannot easily duplicate Wal-Marts in-house distribution dominance they must use other means. Wal-Marts distribution model allows it to compete on price and secondarily on product variety. Wal-Marts capital investments reinforce this strategy as seen in its recent focus on RFID technology which is projected to eliminates as much as $7 billion in costs from its annual logistics expense. By contrast, Target, which has been extremely successful in the last five years, focuses first on product, with a strong emphasis on trendy items, and has a secondary focus on price. Target has built its supply chain to be nimble and responsive to its fashionable, fickle customer. To support its strategy, Target embraces third-party logistics providers (3PL), thus avoiding capital investment risk in new technologies and facilities. Targets 3PL arrangements provide a cost structure that is more fixed than variable and give Target control over capacity. Targets decision to selectively outsource gives the company an off balance sheet way of increasing its distribution capacity. CFN Services does the same thing for wireless and wireline providers. CFN gives carriers a quick and cost effective means to build out needed infrastructure without investing precious capital. Our approach delivers flexibility on a market-by-market basis, enabling carriers to leverage existing preferred vendors and relationships, while taking full advantage of platform economics. More importantly, our approach frees up staff and capital to focus on core activities such as marketing and next generation service deployment. Our outsourced platform approach provides carriers economies of scale, third-party expertise, at a shared services cost. In short, we provide carriers control over transport infrastructure without the burden of owning the assets. CFN has the capability to optimize transport network infrastructure and to deliver a managed network including headcount resources, operations and maintenance, collocations and equipment. Since carriers needs are custom, CFN Services can offer all or portions of these services that fit best with their strategy. Let us put on a webinar for your team. You will be simply amazed at the cost advantages that are simply lying around waiting for youor one of your competitorsto pick up. Call me today. (Put in name and # ad e-mail)

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