WILL BT'S RE-ORGANISATION (NOVEMBER 9TH, 2000) IMPROVE THE COMPANY'S PERFORMANCE?

By Martin Fransman

INTRODUCTION

On November 9, 2000 BT announced the results of its Strategic Review. In April, 2000 BT had announced that the company would establish four new businesses: BT Wireless, BT Openworld (offering mass internet access), Yell (yellow pages information), and Ignite (IP services mainly for businesses). At the same time the company gave notice that it would separate its core network into a wholesale business and a retail business. With Concert, BT's joint venture with AT&T offering services to international companies, this meant that BT would be divided into a total of seven major businesses. The aim of the Strategic Review was to decide in more detail what should happen to these businesses.

WHAT WERE THE MAIN POINTS ANNOUNCED ON NOVEMBER 9TH 2000?

The main points were the following:

• A quarter of BT Wireless and Yell would be sold off to outside investors. (The latter had already been announced earlier.)
• A quarter of Ignite might also be sold.
• BT Wholesale would be established as a separate company called Netco with the possibility of a quarter of its shares being sold to outside investors. Netco, like Rail Track in the railway industry and Transco in the gas industry, would sell its infrastructural services both to other BT companies as well as to outside companies. Sir Peter Bonfield, CEO of BT, made clear the company's hope that regulatory attention would be focused on Netco, leaving BT Retail and the other companies, which he implicitly argued operated under competitive conditions, relatively free of regulation.
• A holding company would be established which would financially own and control the BT Goup's holdings in the individual companies. Little detail was given about the functions of the holding company and its modus operandi.
• BT would abandon its previous ambition to become one of the globally dominant telecoms companies. Henceforth, it would concentrate its interests in Europe and Japan. Assets in the rest of Asia would be sold. One of the aims of this change in strategy and scope was to realise assets in order to pay off at least £10 billion of the company's £30 billion debt. This level of debt threatened BT's credit rating and was becoming extremely expensive to finance.
• At the same time BT announced poor profits.

WHAT HAS BEEN THE IMMEDIATE REACTION TO THE ANNOUNCEMENT?

The reaction may be summarised as follows:

• Generally, the stock market was not impressed with the information received regarding the re-organisation and the poor profits. The day of the announcement BT's share price declined 39 pence to 749. The following day it declined another 49 pence to 700, that is, by 12 percent in two days.
• Reaction by the regulatory authorities: The Department of Trade and Industry, in charge of BT's licence, cautiously welcomed the announcement saying that to the extent that it made BT's wholesale transactions more transparent it would improve matters. Oftel, the regulator, was more guarded. While welcoming any increase in transparency, Oftel, already under public attack for alleged leniency towards BT, noted that the company was subjected to regulatory price controls in part because of the market dominance of BT Retail. This implies that, to the extent that other parts of the company continue to enjoy market dominance, the touchstone for regulatory intervention, BT might fail in its attempt to limit regulation to Netco.

WHAT ARE THE KEY QUESTIONS THAT REMAIN REGARDING BT'S FUTURE?

Will Improved Incentives Improve Performance?

Is there any reason to suppose that this re-organisation will achieve its main aim of significantly improving the performance of BT's businesses?

Take BT Cellnet, in one of BT's key growth areas, as an example. BT Cellnet has been seriously outperformed by rivals Vodafone and Orange. Under the changes announced, BT Cellnet will be part of BT Wireless, a separately quoted company, that will also include BT's other global mobile interests. 25 percent of BT Wireless will be sold off with the BT holding company retaining the remaining 75 percent.

Why should this change improve the competitive performance of BT Cellnet? One argument is that the floating of BT Wireless will allow the company to offer share price-related incentives to managers and allow incentive and performance to be more closely aligned than under the old integrated BT where there was no separate share price for BT Cellnet. In effect, this argument rests on two assumptions.

The first is that the 'extra quantum of incentive' provided by the re-organisation, over and above the incentive that existed previously, will cause 'extra effort', in excess of what was provided before. The second assumption is that this 'extra effort' will result in BT Cellnet bettering its own past performance so as to increase earnings.

There are three difficulties with these assumptions. The first difficulty is the implication that under the old regime managers were not making all the effort that they could have made because of the inadequacy of the incentives under this regime. That is, it is implied that some excess capacity in effort existed. The second difficulty is the implication that extra effort necessarily results in extra performance. Yet it is clear that this outcome may not result.

The third difficulty is that significant improvements in BT Cellnet's performance are only likely to come about, not if the company only improves on its own past performance, but if it improves relative to its main competitors, Vodafone and Orange. The problem, however, is that Vodafone and Orange, operating under their own incentive regimes and the pressure of competition, will also be improving. And BT starts from a position behind that of its rivals. There seems little reason, therefore, to believe that the extra incentive created for BT Cellnet managers as a result of share price-related incentives will result in improvements relative to Vodafone and Orange.

For these reasons it must be concluded that there is little reason for wild enthusiasm that improved incentives per se will result in significant improvements in performance.

Will Improved Focus and Flexibility Improve Performance?

Similar problems exist in the case of improved focus and flexibility. In BT's Annual Report 2000 it is stated that:

"The objective of the restructuring is to improve BT's position in a rapidly changing marketplace, with a sound balance between management focus, the ability to capture cross-business synergies and the flexibility to meet future needs….The separation of the UK fixed-network into wholesale and retail should facilitate more focused management." (p.9)

As already argued in the case of incentives, and for the same reasons, although the re-organisation may increase the focus and flexibility of BT's businesses this will not necessarily result in significantly improved performance.

Why Resist Full Break-Up?

While BT's re-organisation in 2000 amounts to a significant decentralisation of the company, it stops short of the break-up option chosen at the same time, and under similar circumstances, by AT&T. Why?

One major reason is given in the quotation in the last section: cross-business synergies. Evidently, BT believes that by keeping its separately quoted companies in the same BT Group it will be able to reap 'synergies' that would be lost if the companies were completely separated without any pre-determined obligation to interact with one another. How strong is this reason?

Unfortunately, BT does not make explicit what it means by 'synergies', what kinds of synergies it believes will exist between the re-organised companies, or what evidence supports the importance of these synergies. Like incentive, focus and flexibility, synergies become part of the deus ex machina that BT believes will drive improved performance. Without more detailed theoretical and empirical analysis, however, the hypothesised processes that might drive improved performance cannot be further examined. As a result, they hang in mid-air, optimistic beliefs that lack a solid grounding.

Several further points are worth making regarding synergies. The first is that other leading telecoms companies have made great sacrifices over the years in the name of synergies, only to find that they yielded little fruit. A key example is AT&T. It was the belief in synergies that led Bob Allen, then CEO of AT&T, to keep telecom equipment as an integrated part of the company and to make a hostile bid for the computer company, NCR in 1991. It was only in September, 1995 that this belief was implicitly abandoned when Lucent was spun off from AT&T and NCR was de-merged. The company's belief in synergy suffered a further blow in November, 2000 when Michael Armstrong broke AT&T up into four separate companies (although even then he announced that various contracts would be established between the companies so that continuing synergies could be reaped).

The second point is that any benefits that follow from synergies must be weighed against the costs of obtaining synergies. The costs include the efforts and establishment and running cost of the forms of organisation that are put in place to realise beneficial interactions (i.e. synergies) between the various entities. This raises the related question of the role of the holding company and its costs as well as its benefits, discussed in the next section.

Another reason for resisting full break-up has been suggested. This is that full break-up might increase the risk facing those who have funded BT's £30 billion debt and therefore may be opposed by them. BT has not given any indication, however, that break-up is likely once its indebtedness is reduced to more normal levels.

What Role will be played by the Holding Company and how will it Improve Performance?

A key set of questions relate to the role of the new BT Group holding company. As already noted, very little detail was given about this role in BT's public announcements.

For example, will the holding company simply be a passive holder of financial assets in the seven BT companies? If the answer is yes, then it is hard to see why BT did not go the whole hog and opt for the full break-up option. Full break-up would not incur the costs of establishing and running a holding company while, as a mere passive holder of financial assets, the holding company would not add any significant benefits.

However, if the answer is no, that the holding company would play a more active role, then it has to be asked what this active role would involve. For instance, if the holding company were to act as a pro-active investor, rewarding and punishing individual BT companies with the investment and withdrawal of funds, then these companies would face not only the pressures and incentives of the external capital markets, they would also be subjected to financial pressures and incentives from within, namely from the holding company. However, it is by no means clear that this extra set of internal financial pressures and incentives will have an overall positive impact on BT.

However, it may be the intention of BT's leaders that the holding company will also play an important role in constructing overall company strategy, including the realising of cross-company synergies. This implication may be derived from the statement quoted above from BT's 2000 Annual Report. One of the problems that this would raise is the possibility of a contradiction between the desire to give the CEOs of the individual companies the freedom to make their own decisions - and in this way become more focused, flexible, and fast - and the desire on the part of those in charge of the holding company to constrain these decisions when they feel it is necessary in the interests of overall company strategy and perhaps synergy.

Other functions of the holding company might include: appointment, remuneration, and incentives for company CEOs; resolving inter-company disputes; maintaining the BT brand name and reputation; and making and implementing global policy. These kinds of functions, however, will turn the holding company into a significant force to be reckoned with by the individual company CEOs which again may compromise their ability to emulate their more narrowly focused competitors who are less constrained and sidetracked by internal company considerations. It is these competitors - such as Vodafone, Orange, COLT, and Energis - that have proved they are more than a match for BT.

The implication is that it is not at all clear that the holding company will make an overall positive contribution to BT's performance. Depending on its functions, the existence of a holding company may contradict the intention to give the CEOs of the individual companies the freedom to make their own decisions about their businesses. It is, therefore, important for the functions of the holding company to be spelled out and the implications examined. The difficulties that Ron Sommers, CEO of Deutsche Telekom, ran into when he intervened in the affairs of T-Online, the spun-off internet subsidiary some 80 percent of which is owned by Deutsche Telekom, illustrates the dangers that face BT's new organisation. Frustrated that they were not being given the power to run the subsidiary, T-Online's leadership left the company in an acrimonious public walk-out.

What are the Implications of BT's substantially reduced Global Ambitions?

Although BT's scaled-down global ambitions may be interpreted as the company positively coming to terms with reality, and while selling off some of its global assets may allow the company to lock in the profits earned from assets purchased at an appropriately early time, there also are potential problems that might follow from this change in global strategy. To begin with, by scaling down its global ambitions BT is also foregoing to some extent an important potential source of growth. An interesting comparison is France Telecom which, in a far stronger position in its own home market than BT, has increased the priority it attaches to globalisation, now its fastest growing business area.

Secondly, there is little reason to believe that BT will be highly successful in the outside regions to which it has now committed itself, namely Europe and Japan. Although BT has recently increased its holding in Viag, a strong competitor in the German market in both fixed and mobile, to 90 percent, the company still has minority holdings in many European countries. And the embarrassing Blu Affair in Italy in October/November 2000 has pointed rather dramatically both to the potential difficulties of minority holdings as well as to BT's capabilities in managing its foreign partnerships. (In this incident BT fell out with its partners in Blu, the fourth-largest Italian mobile company, when, in the process of bidding for an expensive third-generation auctioned licence, they failed to reach agreement on the proportion of the company BT would own. As a result, Blu withdrew from the auction causing the auction to end since the number of bidders that remained equaled the number of licences. This resulted in a political fracas in Italy since it meant that the government received far less in auction revenue than had been expected.) European markets are being hotly contested but although BT is one of the serious players it is hard to find evidence to suggest that it is likely to be one of the more successful.

Thirdly, BT's position in Japan, the only Asian market to which it will be committed, is rather precarious. BT's main interest in Japan is its 15 percent holding in Japan Telecom together with AT&T that also holds 15 percent. Through Japan Telecom, BT also has an interest in the company's successful mobile subsidiary, J-Phone, as does Vodafone. However, while this investment may yield an attractive rate of return for BT, it does not amount to a strong overall position for BT in the second largest economy in the world.

Finally, with the scaling back of its global activities, BT becomes even more dependent on its global alliance with AT&T. There are questions, however, regarding the success of this alliance. To begin with, the main achievement of this alliance, the Concert joint venture that targets international corporations, has been less successful than hoped, largely due to international competition. Furthermore, the two companies apparently failed in their negotiations to merge their business divisions reportedly in part because of disagreement regarding the value of these divisions. If anything, AT&T has been less successful than BT outside its domestic market and this does not strengthen the alliance's prospects on the global stage.

CONCLUSION

In this analysis questions have been raised regarding the future of BT in the light of its major re-organisation announced in April and November 2000. While the questions have been critical, with the aim of developing a more rigorous analysis of the company's prospects, they do not necessarily imply that BT is likely to fail in its attempts to improve its absolute and relative performance. In arriving at an overall conclusion, however, regarding the effects of BT's re-organisation the questions raised here need to be further analysed.

Martin Fransman

If you would like to make any comments on the above article go to the Current Events Workshop Area