Lopez Holdings

Remarks by Oscar M. Lopez
May 28, 2001
Carlyle Asia Advisory Board Meeting held at Island Shangri-La Hotel, Hongkong

When I last spoke before this group last year, I was still somewhat cautiously optimistic that the telecommunications sector wasn't going to be the headache it turned out to be. I knew that we had serious problems -- mostly related to the overbuilding of facilities in the go go go era of the 90s before the new economy bubble burst. But now that the American economy has started to decelerate and the NASDAQ is a shadow of what it was, our problem with over capacity seems to have taken the form of a world class migraine for telecom companies in the region.

Of course the intensity of the problem is largely determined by the state of the region's various national economies. Outside of the tiger economies, the rest are still recovering from the adverse impact of the Asian Economic Crisis of the late 90s. Debt denominated in US dollars used to finance the build-up of telecom networks suddenly doubled in magnitude in local currency terms. Yet, the purchasing power of the local population did not increase and may have even decreased in many cases. Suddenly, what seemed like a no brainer sunshine industry, which we thought the telecom industry was, became a heavy white elephant unable to support itself, much less deliver the expected profits.

I want to present our experience in the Philippines, which should be typical of what happened to other countries in the region outside of the tiger economy states. To begin with, liberalization of the industry in the early 90s attracted huge investments in Philippine telecom. It was a virgin field, with phone density ratios so low, everyone thought you couldn't make a mistake investing in it. Pent-up demand for phone lines seemed so high that government carved the country into 11 service areas and allowed an equal number of new telecom companies to operate in competition with whomever was already there.

When the investment bill was totaled, telecom operators in the country invested some billion from 1992 to 1997. That is a lot of capital for a developing country struggling from a heavy foreign debt burden dating from the years of the Marcos dictatorship. Well, fixed line capacity jumped from 500 thousand in December 1990 to 6 million in March 2000.

That's the root of the current problem. Today, only 42% of that capacity is utilized. Yet, the total installed capacity of 6.8 million only brings up the phone density ratio from less than 1.0 in 1990 to 9.12 today. We are nowhere near the ratios in the tiger economies such as Hong Kong with 66.7, Singapore with 50, and South Korea with 47.6.

In other words, it turned out that our market was relatively smaller than we thought, in spite of the size of our population, which is 76 million today. The question of affordability became key. This fact was dramatized even more when the economic crisis came and forced a significant number of new subscribers to disconnect because they could no longer pay their service bills.

And as if that weren't enough, the operating environment also rendered some of the assumptions in the regulatory infrastructure invalid. For example, when the industry was liberalized and the players were required to invest in network expansion, it was thought that long distance revenues, particularly international long distance, will help pay for the investment. Technology and competition have caused international settlement rates to fall to the point of negating the initial regulatory assumption. In addition, the cost of calls using voice over Internet protocol (VoIP) will be convergent with the cost of regular local calls.

Philippine industry players also had to manage fierce competition for that segment of the population that could afford the service, mostly in large urban centers. The intensity of competition can be seen in the number of players: 76 for local exchange carriers (ETPI, PT&T, Digitel, Globe, BayanTel, PLDT, PAPTELCO members), 6 for cellular (Globe, Express Telecom, Islacom, Digitel), 11 for international gateway (Philcom, PLDT, BayanTel, Globe), 7 for satellite (Domsat, Philcomst, Capwire), 10 trunk radio (Contel, Nextel, Liberty Broadcasting) and 15 paging (EasyCall, Pocketbell, Piltel, Nextel).

Consolidations are now underway in the effort of industry players to remain viable. The number of cellular operators, for example, have declined and paging companies found their services overtaken by technology, notably the short message service (SMS) of major GSM cell phone service providers.

This brings us to the so-called wireless revolution. In the Philippines, the cell phone is literally revolutionary, having played an important role in People Power 2 that toppled Joseph Estrada from the presidency of the Republic and installed Gloria Macapagal Arroyo. On the late evening hours of January 16, 2001, the nation was shocked by a vote in the Senate impeachment trial of Mr. Estrada, which prevented the opening of a sealed bank envelope containing more evidence of Mr. Estrada's ill-gotten wealth.

By midnight, a crowd of people gathered at the EDSA Shrine protesting the Senate action and denouncing Estrada. Many thousands of the people in the shrine received a 'text' message via cellphone to be there. Throughout the 4 days of vigil at the EDSA Shrine, 'text' messages kept people informed on developments, amused at the irreverent jokes about him and inspired them to stay on until power was peacefully transferred to the new president. One cell phone service provider had to station a mobile antenna to handle the large volume of 'text' messages during the 4 days of protest. Over 90 million messages were processed, twice the daily average which is already the highest in the world. People Power 2 might just have been the first people's revolution that overturned a government with the help of the latest telecom technology.

These 'text' messages are actually known in the industry as SMS for short message service. Together with prepaid service, 'text' messaging spurred the strong growth in the mobile sector in the Philippines. I understand that we process more 'text' messages in the Philippines a day than the whole of Europe. Growth of the cell phone segment is phenomenal. At around 5 million, there are now almost as many cellular as fixed line subscribers.

There is an important lesson to be learned in the consumer response to cellular. Not only is it convenient, the use of the prepaid card made it affordable. No wonder it caught on among young Filipinos and those with limited disposable income. But despite its phenomenal growth, the market penetration of cellular in the Philippines remains at a low 6.5%.

There are however, many important business applications the cell phone service providers can tap. Just last month, we, the Lopez Group, bought into a company that will provide real time tracking service using the Global Positioning System (GPS) and the cell phone. The company known as FindME.com, can locate a truck, a person or any moving object within a geographic area. With services like this, telecom companies will fight fiercely for the top tier market to widen the margins that are not possible with just the basic service of voice and 'text' messaging.

Where does this leave the traditional fixed lines business? In the Philippines as elsewhere in the region, the local exchange carriers are turning to data services to enhance profitability. The Philippine data market is expected to double in annual sales from P4.5 billion in 1999 to P9 billion by next year.

The growth of the data side of the business is accounted for by the increased migration of corporate entities from private networks to shared networks. This is obviously the way to go given the lower connection costs. Frame relay services are 20% cheaper than equivalent leased lines. International bandwidth costs are also falling. Current applications include automated teller machines, point of sale equipment, inventory management, accounting, administrative systems and Internet access.

Internet is still the most exciting part of the business. While the penetration of Internet is also largely affected by affordability, it shows plenty of promise. Despite low ownership levels of personal computers, Internet access is still the fastest-growing segment of the data services market. There were just 1,500 dial up ports in 1996 and it now estimated at 12,500. There were less than a dozen Internet Service Providers in 1996 compared to the 220 now. Internet accounts were less than 10,000 in 1996 and this has ballooned to 300,000. But there is a long way to go still.

Current problems with affordability notwithstanding, we see a bright future for broadband services in the country. In this regard, cable television offers a potential platform for broadband services. About a million of the current 10 million television households are now cabled. About 3 million homes are passed by cable making a tripling of cable homes possible in the short term. At present, cable TV has penetrated close to 2/3 of households with high disposable incomes.

Right now, cable TV companies are beset by high capital costs for infrastructure development. Most of the cable companies built their networks in the mid 90s and upgrades to HFC (hybrid fiber and copper) are estimated to cost between to per home passed. Royalty fees in foreign exchange terms to program providers have also added to the burden of cable operators on account of 100% currency devaluation of the Philippine peso from Ps26 in 1997 to Ps50 plus to one dollar today. Our own SkyCable, the market leader by far, is in the final stages of merger negotiations with Home Cable, the second largest operator and affiliated with dominant telecom company PLDT. With this merger, we expect to enhance the valuation of the combined entity and make it an attractive investment opportunity for interested strategic and financial investors from abroad.

The merged entity will have a nationwide share of 50% - 60% and either a dominant or sole provider position in the specific cities where the joint venture company operates. This improves pricing flexibility and the ability to rationalize product offering and market converged services.

From an operating expense standpoint, the merger will enable the joint venture company to realize operational synergies by reducing manpower and overhead expenses. Importantly, the merger strengthens the company's negotiating power with program providers leading to reduced programming costs.

From a capex standpoint, the merger will enable the company to rationalize build-out, expansion and upgrade. This should ultimately result in improved network coverage and enhanced technical capabilities to provide value-added services like Internet access and video-on-demand.

The joint venture company will initially be owned 50% / 50% by the Benpres and the PLDT groups. Because of SkyCable's significantly bigger share than HomeCable, the Benpres Group will hold another excess convertible instrument in the joint venture company. The plan is for the Benpres Group to sell this convertible instrument to a strategic or financial investor which will then own 33% of the joint venture company. This will happen by July or August of this year after both parties had done their due diligence and signed the merger agreement and a business plan of the merged company had been finalized.

For the benefit of those interested parties, and Carlyle is one of them, let me say, by way of a soft sales pitch, that the joint venture company is one of the few remaining opportunities to invest in a dominant cable operator in Asia. Relative to Asian peers, investors can enter at an attractive valuation. Importantly, there are significant synergy potentials due to the existing distribution networks and content assets owned or soon to be acquired by the domestic sponsors, PLDT and the Benpres Groups. End of sales pitch.

Developments in local media have been largely influenced by technological advances in telecom. Given the high cost of broadcast air time, there is also the trend toward narrowcasting, creating market niches for selected content. This is how the ABS-CBN News Channel, the Philippines' first 24-hour news channel, came to be. In fact, ABS-CBN Foundation and Sky Foundation have created their own niche in educational television. Sky Foundation maintains The Knowledge Channel, the only cable channel that supplements curriculum-based education in the country.

As more households connect to cable, there should be a growth in this segment of media. However, for a country like the Philippines, the problem of the digital divide looms large. All these exciting developments in technology such as those available in cable and in satellite broadcasting are unaffordable to a large majority of our population. This explains why there is fierce competition in a very small upper segment. This limited market adversely affects the viability of these developments now and for the foreseeable future.

The challenge to us, therefore, is to harness technology in media and telecommunications to help alleviate poverty that is prevalent among our people, perhaps by creating jobs and increasing their buying power. In this regard, we see ourselves in a very good position to provide a broad range of remote services.

We see the Philippines in a unique position to take advantage of opportunities offshore in remote services. This is one aspect of this industry that is most relevant to our people because it will open up jobs. For one, the cost of skilled labor, including IT professionals in this country is very competitive. English is used widely as a second language. Our location provides us the ability to adopt a "follow the sun" strategy to operate 24 hours a day, 7 days a week for call center services.

This is why the Lopez Group itself created a new business that will provide remote services for offshore companies in the area of customer interaction. We call this new company C cube.

In closing, we in the telecom business in this part of the world, share the lessons learned by our counterparts in the United States and elsewhere. Like them, we are victims of our own irrational exuberance that made us over invest in network capacity, which is now only less than half utilized. For those of us in developing economies, we made the additional mistake of over-estimating our population's buying power. In hindsight, it makes no sense to build it and think the customers will come. As it happened, they did want to come but they could not afford the price of the ticket.

While there is nothing that could be better than competition to assure efficiency and best terms for the consumer, there is also such a thing as too much competition. This happened in the Philippines where a small market was divided among close to a dozen players. The other aspect of this competitive situation is the matter of wasting scarce capital resources, especially for a developing country. Maybe high capex networks can be shared, with government regulators stepping in actively to assure access and fair access charges. Something as simple as a new player's inability to gain sufficient interconnection can severely damage a business plan.

In the light of day, we are like most telecom players the world over. We are wondering how we got into this irrational exuberance mode and into our present hole. But then again, the fast tempo of technological growth as well as stiff competitive pressure gave us no alternative but to be irrationally exuberant. For us in the Philippines, we will in time use up these excess capacities. The only question now is, how fast will our economy move forward and how equitably will it distribute its gains among our people. Our economic survival as an industry, and as a company depends as much on social equity as it does on technical and business savvy.

Thank you and a good day.

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