The Other Bubble

This is the story of the other Internet bubble. Not the dot-com crash, but the potentially more devastating collapse of the race to roll out third-generation, or 3G, mobile phones in Europe. What distinguishes 3G mania is the size of its victims and their ambitions: they are not little start-ups, but the world's major phone companies and manufacturers. They are not building pets and toys dot-coms, but a communications channel still arguably as crucial to this century as roads and railways were to the last. And they were egged on to spend more than they could afford not only by California venture capitalists, but, wittingly or not, by the supposedly responsible states of Europe. This was a bubble built on greed--and government policy.

The other bubble already has its poster company: British Telecom, which spent extravagantly on 3G and is now crumbling under a debt of £27.9 billion. This fallen star of British industry split in two last week, spinning off the wireless division that until recent months appeared to be its hope for the future. The only thing that dampened the shock was the battering venerable British Telecom has already taken in the 3G storm. In recent weeks, BT had accepted the resignation of longtime chairman Sir Iain Vallance, and started selling off its empire abroad, from Spain to Japan. Vallance had envisioned BT as a dominant global player on the mobile Internet. Now, his successor, Sir Christopher Bland, is merely trying to save what's left of the old British phone company.

At the heart of the BT debacle is a crisis that has thrown a pall over the European telecommunications industry. A crucial moment for BT came last Monday, when it postponed Europe's first trial run of 3G technology. The delay of BT's widely watched test on the Isle of Man was only the latest global setback for the "phones of the future." Powerful enough to provide high-speed Internet access, video on demand and countless other whiz-bang features, 3G was billed as a "revolutionary" advance for communications, and a financial savior for an industry facing falling revenue from traditional phone calls. Soon, the 3G prophets had predicted, we'd all pay our bills, watch TV, locate restaurants (even lost pets and children) and chat with one another face to face over 3G phones with built-in video screens.

Now, high rollout costs, software glitches and a shortage of handsets have delayed the launch of 3G services from Japan to Britain. But nowhere is the crisis as bad as in Europe. Over the past year, carriers across the continent have paid a mind-boggling 110 billion euro to buy rights to the radio spectrum reserved for 3G. Industry experts say they'll have to spend at least twice that to build the networks of special radio towers required by 3G, and market their services. That puts them more than 300 billion euro behind even before they've sent the first 3G phone call. On top of the debt piled up by many operators in the 1990s, the troubles with 3G are feeding a real crisis. Tens of thousands of jobs and hundreds of billions of dollars in market value have been wiped out in Europe's telecommunications industry. The fear is that telecoms in Japan and the United States, which have spent less wildly on 3G rights, may now be in position to dominate the wireless world, whenever it does finally arrive.

How did this happen? The story begins in the early 1990s, when European governments were parceling out rights to the radio spectrum for the second generation of mobile phones. Nobody had any idea what the spectrum was worth at first, so governments began doling it out at a relatively minimal charge through "beauty contests," picking companies with the business propositions more likely to succeed. By the late 1990s, the second-generation Global System for Mobile (GSM) communications was an unprecedented success. By 2000, two out of three Europeans had a mobile phone. Europe thought it had finally found a high-tech arena in which it could outplay the United States.

Meanwhile, America was already cashing in on spectrum auctions. From 1994 until now, the U.S. government has received spectrum bids totaling more than $41 billion. Envious of those numbers, and inspired by its own success with GSM, Europe got into the auction game. In 1997, the British government hired game theorist Ken Binmore, a London University economics professor, to help design a 3G auction. The professor's credentials suggested a certain ruthlessness. (He had once advised that public hospitals should bid for beds.) He had a knack for poker and Monopoly, and his auction scheme had a Vegas-like charm. Contestants submitted bids daily by fax for any one of five licenses. Top bidders in each round were required to stay out of the contest until outbid. Results were posted daily, complete with jazzy graphics.

When the hammer finally came down in April 2000, the dot-com bubble was already bursting in the United States. But 3G hype was peaking in Europe. Five licenses sold for an incredible 36.8 billion euro. It was a figure that left even the free-spending mobile industry breathless. "Everyone started shivering after the U.K. auction," says Gert Hofsteenge, manager of business development for the Netherlands-based KPN Mobile, which nabbed a piece of the British market by acquiring a 15 percent stake in Hutchison 3G UK Holdings for £9 billion. "Nobody expected to pay so much." Binmore himself hadn't expected the total bid to top £5 billion. But many in the industry think the British government knew better. "We hired game theorists, and so did they," says an insider at one British mobile operator. "They knew how it would stack up."

The Germans may have known, too. In August 2000, their auction was held under complex rules that stoked a bidding war between Deutsche Telekom's T-Mobil and Vodafone-Mannesmann, and left both bidders in major debt. The total take for the auction was a record 50.5 billion euro, and some corporate rivals suspect that Deutsche Telekom--then 70 percent state-owned--might have driven up bids to benefit the state treasury. Maximilian Ardelt, CEO of the German mobile operator VIAG, which paid 8 billion euro for one license, says the auctions were unfair because of DT's conflict of interest, and has called on the government to refund part of the cost. Germany's Mobilcom has threatened to sue the government for discrimination, claiming it's unfair that German licensees had to pay so much more than those in Sweden or France. "It's the operators who put in the bids, not us," responds chief telecoms regulator Matthias Kurth.

Indeed, what is wrong with a fair auction fight in a free market? Critics say the British and Germans saw what they wanted to see in the American experience: big money. They apparently ignored the result. Of the $41 billion bid in the States, only $14.4 billion was ever paid, because beleaguered operators couldn't raise the funds, or wound up tangled in litigation. In Finland, director of networks and competition Antii Kohtala says the government studied the fallout from the U.S. auction--and chose to go with a beauty contest instead. Similarly, Sweden chose to tax winning companies 0.14 percent of their revenue from 3G. Lower upfront costs for operators mean that when 3G finally arrives, it may well do so first in these Scandinavian markets.

Outside Scandinavia, chaos reigns. The Spanish government had conducted a beauty contest in March, but grew envious of the British and German auction riches and decided to increase a tax on contest winners. In October, the Italians staged what Gartner telecoms research director Nigel Deighton dubs a "Machiavellian auction." The losers in a beauty contest were allowed to bid their way back in. The pressure was too much for some bidders. A consortium involving BT fell apart, and in the end there were only as many bidders as licenses. "If sex, fear and greed are the major motivators of man, you had two out of three in the 3G auctions," says Deighton. "The governments must have realized as the bids went past 4, 5 or 6 billion euros that the operators were paying too much."

Before the U.K. auction launched this mania, Small Business and E-commerce Minister Patricia Hewitt declared, "By holding the first 3G spectrum auction in the world, the U.K. is maintaining its lead in the global telecommunications and information markets." Viewed over the wreckage of British Telecom, the statement now seems ridiculously smug. But governments are right: no one forced operators to bid so much.

What was going through their heads? First, they thought the auction winners would control the industry. "It was the last chance to step into a new world," says KPN's Hofsteenge. Spain's Telefonica Moviles, which initially showed some restraint by pulling out of the British auction, eventually laid down nearly 5 billion euro for a German license. "We had to be a global player," says Conchi Gutierrez, a 3G program manager for Telefonica Moviles.

Many operators saw 3G as a miracle cure for threats to their businesses. Most Europeans already have mobile phones, so the market is near saturation. Consumers expect falling prices, so revenues from voice traffic are expected to decline in Western Europe after 2002. Customers are fickle: 40 percent of mobile users regularly dump their service for a better deal. In short, telcos are desperate for new revenues. The solution: 3G, which promises a huge jump in data traffic--including potentially lucrative new mobile markets like e-mail, music clips and videos.

Enter handset manufacturers like Nokia, Ericsson and Motorola. To watch videos on your phone, you of course need a new phone. No one promoted 3G more aggressively than these companies. As recently as April 10, Nokia was insisting that skeptics were wrong: there would be no slowing the arrival of 3G. "The Viking hordes of businessmen swept across Europe a few years back, telling everyone how cool 3G would be," says Keith Woolcock, London-based head of technology research for Nomura International. "They convinced everyone that they could boost their revenues by adding all these cool new data services with these cool new handsets."

It's tough to say when 3G will arrive on the commercial market now. Educated predictions range from 2002 to 2004 and beyond, and the difference is critical for companies with big debts, due starting now. They have little leverage left with their banks. And in an industry where manufacturers often extended financing to their best customers, the telephone companies, this incestuous source of loans and bailouts is out of favor. The bursting of the bubble suddenly has everyone on his best fiscal behavior. "We are not a bank," says Mads Madsen, spokesman for Ericsson, which has hinted that purse strings may be tightening. "We are taking a conservative approach."

Left on their own to cope with mounting debt and costs, mobile operators are desperate to raise money. Many players, such as KPN and France Telecom, are selling off noncore assets. A shakeout seems imminent. Forrester analyst Lars Godell predicts that only five major European mobile carriers will be left standing by 2008. Signs of the scramble mounted last week, as Nordic operators jockeyed to pull off a big Scandinavian merger, and several companies hunted for new partners.

Governments, banks, manufacturers and mobile operators are all engaged in a game of musical chairs, trying to protect their own interests as 3G continues its downward spiral. Banks no longer want anything to do with telecom debt. The big phone companies are caught in a trap. The surprise success of new services like customized ring tones or short-text messaging shows how important it is for telecoms to innovate. That takes time and money. Few mobile operators in Europe today have either.

So who will survive? Ironically, the company that bet the most in the auctions, Vodafone, may be in good position to survive the coming shakeout, by virtue of sheer size. Other strong players, like DT's T-Mobil, might try to team up with companies that match their European footprint. Weaker operators, like Mobilcom and BT Wireless, will be in for a bumpy ride. Alliances with companies in Japan and South Korea, both 3G technology leaders, were seen as a key strategic advantage, at least until recently. Then Japanese giant NTT DoCoMo last month postponed its own 3G launch. Thomas Fellger, a wireless expert at Berlin IT consultancy Meta Design, says the DoCoMo delay sent shock and doubt through the European industry as well. "The Japanese are so much farther along with the technology, and if they can't make it, how are the Europeans going to?" says Fellger.

They might start with a business plan. A study released last month by a 3G industry consortium called the Universal Mobile Telecommunications System Forum makes it clear that the 3G industry has not yet figured out how to define 3G "services," much less how to make money from them. Piping voice and data through one handset will require complex new partnerships between phone, Internet and myriad other service companies, but no one has figured out how to share the work, let alone the revenue. (Industry surveys suggest that the telecoms are in fact deeply unwilling to share the revenue.) As yet, there is "no clear business plan," concludes the report. In other words, these giant multinationals jumped into the 3G business with no more of a clue than the barroom ideas of dot-com flameouts.

The savviest operators are now scrambling to make 3G work by finding the right partners and cutting the right deals. Vodafone is creating a multiplatform portal, Vizzavi, with the French media giant Vivendi. Telefonica Moviles has cut deals with Reuters and the Dutch entertainment firm Endemol (producer of "Big Brother"). Orange, an arm of France Telecom, in a burst of spin, is billing itself not as a telephone company, but instead as a "wire-free provider of life services." It is building up sport, financial and music content via its orange.net Web site.

As operators struggle to pay down debt, Brussels is finally waking up to the fact Europe's most competitive industry is in danger of losing its edge. Erkki Liikanen, the EU's commissioner for enterprise and the information society, is disappointed that member states couldn't decide on a Pan-European policy before they began auctioning the spectrum market by market. "There should be a transparent procedure, a European-level decision," he says. Others, like Gartner's Deighton, say a combination of Pan-European and local licenses might have preserved competition while spreading spectrum between large and small players.

In an effort to dig Europe out of the mess, the EU issued a paper at the end of March outlining the challenges faced by the mobile industry, and advising that governments come up with ways to ease the burden. Swedish companies already have a plan to share a network of mobile radio towers, and that idea is suddenly catching on for 3G operators who had planned to build competing networks across Europe. Even in Germany, a country with a notoriously freewheeling telecom market, competitors may be allowed to cooperate more closely to cut costs. Telco regulator Mattias Kurth admitted recently, "We do feel a certain responsibility for the operators' high costs." The concern is no doubt appreciated. But it doesn't make up for the massive loss of jobs and wealth left by the collapse of Europe's other Internet bubble.