Verizon (NYSE: VZ) is not coming to Canada. Last week the massive American carrier announced that it had little interest in entering the Canadian market. That’s great news for Canada’s Big 3 telecoms – Rogers (TSX:RCI.B), BCE (TSX:BCE), and Telus (TSX:T) – which rallied sharply following the announcement.
The lesson investors should take away from this incident is clear: identifying companies with wide moats is essential for long term investment success.
Background
In June, Verizon proposed a preliminary $700 million offer for Wind Mobile and entered into early takeover talks with Mobilicity as part of an exploratory effort to enter the Canadian market. But it appears a Canadian expansion is off the table for now. “Look, I just have to say that the press made a lot more of our interest in Canada than there was on the fourth floor of Basking Ridge [Verizon’s New Jersey headquarters].” Chief executive Lowell McAdam said on September 3 during a conference call with analysts.
Lowell added “You know it’s something we looked at. We look at a lot of different countries around the world. We continue to do that but it was always on the fringe for us. And as [CFO] Fran [Shammo] and I have looked at the opportunities to push the one Verizon that I have talked about before, those are much better returns for our shareholders than going into Canada.”
And McAdam is probably right. A Canadian expansion wouldn’t be particularly lucrative for a couple of reasons.
First, Verizon would have to acquire one or all three of the smaller carriers. Costs would quickly escalate into the billions. Not to mention the wireless spectrum that would need to be purchased at an upcoming auction if Verizon desired to expand its network.
Second, Canada’s big three telcos command 90% of the market. According to estimates provided by Moody’s, Verizon would have to acquire 15% market share and match the ARPU, or average revenue per user, of established players just to approach breakeven within five years.
Third, due to higher operating costs, Verizon could be easily undercut by rivals.
And finally of course, after the company’s US$130 billion buyout of partner Vodafone, Verizon is probably feeling a little light in the pocketbook.
No case
Even if Verizon entered the market and successfully undercut the incumbents, what then? A collection of price sensitive, low margin customers? That’s hardly a lucrative business opportunity. Joe and Jane Average – the type of customer Verizon would really want to attract – are already bundled with established carriers. They’re not going to switch easily.
The investment takeaway
No new competition is obviously good news for Canada’s Big 3 telecom firms. Hence, the share price rally last week. The fact that a large player like Verizon can’t make a Canadian expansion work is a testament to the power of moats. How many companies can match Verizon’s huge scale or low cost of capital? (Hint: not many)
Canada’s telecom firms have several competitive advantages that make them difficult to attack. Economies of scale act as an effective barrier because existing firms can react swiftly if a new entrant tries to aggressively scale into the marketplace. Incumbents have cost advantages not available to newcomers like the best spectrum and locations. In addition, the capital costs to establish a market presence can be so large that entering the industry is off limits to all but the biggest players. And in the case of Verizon, expanding into the market is so expensive that the opportunity isn’t attractive.
The telecom industry isn’t in the clear yet. Government regulators remains focused on increasing competition within the wireless space. Ottawa has pledged to carry on with the spectrum auction with two of the blocks of the four spectrum blocks reserved for “new entrants”. But even with these subsidies, the business case to enter Canada is borderline at best.
Foolish bottom line
Great investments like Coca-Cola, Procter and Gamble, and McDonald’s are built upon wide moats. After what we saw this summer, we can probably conclude that Rogers, BCE, and Telus are in the same league as these great American brands.
No Verizon is a short-term catalysts for Canada’s Big 3 telcos. But it’s also a powerful testament to their long-term investment thesis as well.
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Fool contributor Robert Baillieul doesn’t own shares of any companies mentioned. The Motley Fool doesn’t own shares in any of the companies mentioned.
