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PCS: The race for Brazil
Telecom Investor / October 2000

By Larry Luxner

SÃO PAULO -- About an hour's drive northeast of São Paulo along the Via Dutra highway to Rio, one crosses the Tropic of Capricorn at latitude 23.5° S -- the southernmost limit of the sun's vertical rays.

Continuing along the same highway, another impressive landmark soon comes into view: the sprawling factory where Swedish telecom giant Ericsson manufactures mobile phones and wireless infrastructure for the booming Brazilian cellular market.

In one corner of the 67,000-square-meter plant, production manager Iolando José de Castilho Jr. supervises 100 employees in the assembly of RBS-884 radio base stations. Wooden crates containing electronic components and raw materials are stacked neatly to one side, while Portuguese-speaking men and women sit quietly at their impeccably clean stations, testing equipment and painstakingly soldering printed-circuit boards together.

Every month, Castilho's staff produces 12,000 digital radio channels -- double the production of only a year ago. The radios, manufactured in 10-watt and 30-watt varieties, are valued at $1,000 each. At first, sales were limited to the Brazilian market, but last year, Ericsson began exporting RBS-884s to nearby Argentina and Chile.

And now, says Castilho, "we're making studies to implement production of GSM phones for the Brazilian market."

GSM in Brazil?

Until recently, that particular mobile technology -- most often associated with European manufacturers -- was a rare bird in Latin America, with GSM networks operating only in Chile, Paraguay and Venezuela. But the technology is about to get its first major boost in this part of the world, thanks to the Brazilian government's recent decision to award new cellular licenses in the 1800-MHz spectrum.

Observers say the introduction of PCS into Brazil, a vast country with 170 million people, could blossom into a $10 billion business, less than two years since the breakup of the Telebrás monopoly, the spinoff of its wireless properties and the beginning of competition from the 10 B-band operators in their respective regions.

"This is going to open the doors for a lot of new players to come into the market, especially large European and American players that aren't currently here," says Andy Castonguay, senior analyst for Pyramid Research Latin America. "It's also going to give the mirror companies a chance to participate in these bids directly, in terms of their trying to buy a new license, or expand their coverage through mobile services -- or put them into position where they can lease their networks and make a little extra revenue that way."

On June 21, regulatory agency Anatel announced that it would offer the 1800-MHz rather than the 1900-MHz frequency for new PCS licenses, as recommended by the International Telecommunication Union. In doing so, Anatel is saving the1900-MHz band for third-generation mobile systems (3G) and ensuring the development of GSM in Brazil.

"The strongest argument in favor of 1800-MHz licenses is that this choice allows GSM the opportunity to enter Brazil, significantly increasing GSM's presence in Latin America," says The Yankee Group, in a new report on the Brazilian wireless market. "However, we believe that if 1800-MHz licenses are issued, the price of these licenses will be potentially lower because there will be fewer interested parties."

Going with 1900-MHz would have given carriers the ability to offer seamless roaming domestically, as well as in the United States and Latin America -- the top two destinations for Brazilian travelers abroad. That's not currently possible with GSM.

It would also have had a more positive effect on competition within Brazil, says The Yankee Group, as new entrants would have been able to rapidly expand network coverage through roaming agreements.

"GSM operators will have smaller network coverage in the short to medium term -- interconnetion with current players will not be an option. PCS competition won't be so strong, and penetration growth won't reach its full potential in the first two to three years," says the report, noting that GSM infrastructure will probably be imported in the beginning, making it more expensive than TDMA or CMDA handsets and base stations. "On the other hand, it will encourage new suppliers such as Alcatel and Siemens to invest in Brazil."

One thing everyone agrees on, is that it wasn't an easy decision.

"The Brazilian government has been looking at Europe very closely and hoping they can get big money here," said Mikael Ekman, who is heading up Ericsson's PCS foray into Brazil. "There was a long political debate, where the European factions -- especially Siemens, Nokia, Alcatel and Telecom Italia -- were pushing for the selection of 1800, while Ericsson and all the rest were pushing for 1900. We preferred 1900 because we think it's the best for various technical reasons."

Ekman said the decision to go with 1800 "was not the decision we expected," but that "this is the reality," explaining that "a company like Lucent Technologies has a big disadvantage. They have a good local presence but a poor GSM concept. Then you have Nokia, which doesn't have a footprint here but is good in GSM."

Virgilio Martins, Lucent's public-affairs chief in São Paulo, agrees with Ekman that "the best solution for Brazil would have been 1900, because of the platform that already exists here," though adds that "we are technologically neutral, and we're very well-positioned in the C-band."

With the frequency decision made, Anatel's next big decision is how to structure the upcoming auctions for PCS licenses.

Three weeks after announcing it would go with 1900-MHz, Anatel in July unveiled its plan for divvying up the vast country into three PCS licensing regions.

Region I encompasses 16 states in Brazil's vast north and east, ranging from sparsely populated Amazonas and impoverished Maranhão to economically powerful Rio de Janeiro and Minas Gerais. Region II includes nine southern and western states as well as the federal capital, Brasília. Region III comprises the state of São Paulo, which alone has 35 million people and accounts for 36% of Brazil's GDP.

Analysts say the awarding of PCS licenses will likely drive down cellular prices further, benefitting customers who for years struggled even to get a fixed phone line.

Under the new rules, Anatel has placed no restrictions on foreign ownership of companies or consortia hoping to bid.

Jamila Xible, Brazil program manager at The Yankee Group in Boston, said all of the current players will be allowed to bid, but only CLECs and long-distance operators may purchase a license that overlaps with areas where they currently operate.

"With the new competitive environment, you'll have five players in each area: the two cellular operators who are already there, and three new PCS players," Xible explained. "The C-band will be auctioned off by the end of this year, and the D- and E-bands next year."

Anatel will award additional frequencies for these D- and E-bands, though it hasn't decided what route to take.

"It's going to make a big difference if it's 1800 or 1900," said Xible. "Depending on what Anatel decides, it'll affect the existing players' interests. If, for example, Anatel decides on 1800, then Telesp would have to build a GSM network as well as CDMA in their current area if they want to grow. If they get a 1900 license, it's likely they'll continue to expand the CDMA network."

It appears that the dollar sign will be the overriding factor in determining who wins the new licenses, though Anatel has set some minimal requirements. Among them, C-band license winners must commit to covering at least 80% of urban areas of all cities of 500,000 or more inhabitants, plus state capitals, within 24 months of winning the license. Frequency usage rights last for 15 years, and half of the license payments are due up front; the remaining half is payable in 12 installments.

But this time around, few industry insiders expect the kind of mammoth deals like the $2.6 billion BCP (composed of BellSouth and various joint-venture partners) paid in 1998 for a B-band license to serve metropolitan São Paulo. That's because penetration levels were far lower, pent-up demand was high and prepaid had not yet been introduced.

"Nobody knows how much these auctions will raise," said Ericsson's Ekman. "With the B-band, you had a big chunk of people waiting for a cellular line. At that time, a new line cost $3,500. I would say the market has improved dramatically since then."

Adds Xible: "There will be five competitors in each area, so that'll make these licenses less attractive than before. In some cities like São Paulo, Rio and Belo Horizonte, there is enough demand for five operators, but in others, like Bahia, it's excessive. I doubt they'll be able to sell them all in the first round."

Starting from virtually zero, BCP has been able to capitalize on pent-up demand and achieve a 46.2% market share as of June 2000 -- the highest of any B-band operator in Brazil. The remaining 53.8% of São Paulo's cellular users have opted to stay with Telesp Celular, the mobile operator owned by Spain's Telefónica, which bought the cellular operations of government-owned Telesp as part of the 1998 Telebrás privatization.

As of Jun. 30, 2000, Brazil's 20 cellular companies (one A-band and one B-band company in each of Brazil's 10 regions) provided service to 18,445,170 cellular subscribers. From a vendor point of view, the clear market-share leader was Ericsson, with 38.9% of the pie, followed by Nortel (23.4%); NEC (20.8%); Lucent (12.1); Motorola (4.5%) and Alcatel (0.3%).

"We supply nationwide coverage. If we don't have the A-band in a given region, we have the B-band," says Lars Jehrlander, vice-president of business operations at Ericsson S.A. in Brazil. "We also have a very strong local presence. We've reorganized the whole company two years ago and created key account organizations based geographically very close to our customers. That's a strength we have compared to our competitors. Brazil is a huge country, and you can't run operations from Miami, not even from São Paulo."

Yet Jehrlander isn't jumping up and down with excitement.

"During 2000, the market has been slower than we expected. Our expectations were to go from 14.7 million subscribers to 25 million by the end of this year, but it looks like we'll have a tough time reaching this number," he said.

Throughout Brazil, cellular penetration varies widely, ranging from a high of 18.7% in Rio de Janeiro state and 17.4% in metropolitan São Paulo, to a low of 4.3% in Region 8, which encompasses the vast but sparsely populated northern jungle states of Amazonas, Pará, Piauí and Roraima.

Overall, an estimated 8.6 out of every 100 Brazilians has a cellphone, up from less than one per hundred in 1995. That number is expected to exceed 26.7% by 2005, by which time, says Xible, the country will have 42.9 million wireless users, 27.4 million Internet surfers and 6.8 million people accessing the Internet via their mobile phones, thanks to WAP-based technology.

A big part of the growth in Brazil's cellular market has been prepaid. ATL, the pioneer in prepaid subscriptions, was the only Brazilian wireless operator to launch services with prepaid -- and it was able to grab 64% of net additions during the first quarter of 1999 thanks to its aggressive strategy of selling ready-to-use, prepaid packages via retail, specialty, electronics and company-owned stores.

"Prepaid in the whole of Brazil is a very important growth strategy, because we have people in the lower classes who don't have credit histories or the abilities to pass the normal credit requisites for a postpaid contract plan," said Brian Schicker, the former marketing director of ATL, which has 1.2 million customers in the states of Rio de Janeiro and Espirito Santo. "People want to control their costs and spend only a certain amount of money per month on calls. Prepaid is also a very quick and easy selling transaction, and some electronic goods stores now don't want to sell anything other than prepaid."

Schicker is now chief operating officer at Americel, the B-band operator for Region 7, which covers 14.5 million inhabitants in six states and the relatively wealthy Federal District. Americel, with 300,000 customers (or a 20% market share) is owned by a conglomerate of seven pension funds, with minority participation by Opportunity Bank and two Canadian operators -- Telesystem International Wireless (TIW) and Bell Canada International.

"I don't welcome competition," he said, "but competion does create an increase in demand, and probably we'll all grow and benefit from the stimulation that generally results from new entrants coming into the market."

The Yankee Group says the opening up of PCS licenses will attract three kinds of potential bidders: companies with wireless properties outside the states of São Paulo and Rio de Janeiro that see PCS as an opportunity to enter those lucrative markets (such as TIW/Bell Canada and Telecom Italia Mobile); operators in São Paulo and Rio that want to expand coverage to other regions of Brazil (BellSouth and Telefónica), and foreign telecom operators that have no presence in Brazil and would like to establish one (such as AT&T, Omnipoint and Verizon).

Pyramid's Castonguay adds a few of his own picks, including Deutsche Telekom, France Telecom, SBC, Vodafone, Sprint PCS and Telefónos de Mexico.

"These are all folks that are rumored to have interests," he says, adding that Anatel structured the new licenses in a way that "allows these companies large geographic scope, and whoever wins is probably going to be a consortium between outside players with operating experience, and local players with networks that already exist in some way, shape or form."

Castonguay said it wouldn't surprise him at all if the new PCS bidders include Brazilian electric utilities such as Light or Eletropaulo.

"It's very much dependent on how these folks are able to establish their consortia," he explained. "If they include partners that already have valuable infrastructure in place, they'll be able to bid more, since they'll have less of a need to invest in buildout."

Robert H. Blocker, a leading São Paulo investment analyst who tracks the telecom industry, predicts a shakeout: "Everybody's going to invest, there'll be too many companies, and they'll start to consolidate."

While equipment vendors won't be required to manufacture in Brazil, they would be ill-advised not to. Prohibitive import tariffs imposed in October 1996 on all telecom equipment assembled outside the Mercosur customs zone (which includes not only Brazil but also Argentina, Paraguay and Uruguay) have led just about every major telecom vendor to set up factories locally. Most of them are in the Campinas-São José dos Campos area of São Paulo state, where Ericsson, Lucent , Nortel, Nokia, Samsung, Qualcomm and Motorola all have plants.

"The two main factors which would entice cellular companies to manufacture in Brazil are tariff benefits and the sheer size of the Brazilian market," says BIA International consultant Ed Czarnecki, suggesting that big investors have no choice but to locate their plants in Brazil if they wanted to remain competitive.

"Ericsson produces most of what we sell here. It's almost a necessity, because of rather oppressive import taxes," said Jehrlander.

Lucent's Martins says his company saves 20-30% by manufacturing in Brazil, which he calls "very significant" to the company's bottom line.

Over the past four years, Lucent -- whose strength lies in TDMA and CMDA infrastructure -- has invested $200 million in Brazil, employing 1,600 people at three factories: a radio-base station plant in Campinas, a switching facility in Belo Horizonte and a joint-venture factory in Curitiba (with local company Inepar) that makes power systems. In addition, the company will soon produce fiberoptic cable at its Campinas operations.

It's unclear whether local manufacturing will extend to handsets that have roaming capability in both GSM and TDMA and/or CDMA environments.

"If they demand nationwide roaming from the beginning, they'll need a phone that in addition to GSM can handle digital TDMA and AMPS, and that's a creature no one has really seen," said Jehrlander. "But we understand from Anatel that there's probably not going to be a great demand for this."

However, Montreal-based TIW, which has so far invested $450 million in four Brazilian cellular operations, says that could be a crucial factor in whether or not it bids for the licenses to begin with.

"Obviously, we're an important player in Brazil, and we have expressed an interest in the past," says TIW spokesman Mark Boutet. "Establishing a national presence is an important factor for us, From a business perspective, we're still evaluating the impact of Anatel's decision to use the GSM standard, and introducing a third technology into the market in terms of roaming and the availability of the appropriate handsets."

Assuming the technology becomes available in time, such handsets wouldn't sell for less than R$1,000 (about $540) -- more than three times the local cost of most TDMA or CDMA cellphones currently in use throughout Brazil. That would undoubtedly cut down on the number of potential subscribers, further reducing the value of the licenses.

In September, Anatel will call for C, D and E-band proposals, with evaluation and license awards for the C-band in November or December. The licensing process for the D and E-bands should begin in January 2001, with new PCS operators offering service by July 2001. Anatel also hopes the 3G license process to start by 2002. Actual 3G operations aren't likely in Brazil until early 2004.

Americel's Schicker doesn't take these dates very seriously, however. He calls them rather optimistic.

"Knowing Brazil like I do," he says, "we have dates that are always goals, but very rarely do we meet those goals."

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