Telkom SA Limited and Business Connexion Group Ltd (51/LM/Jun06) [2007] ZACT 55 (20 August 2007)

[2] The primary target firm is Business Connexion Group Ltd (“BCX”). For the ownership structure of BCX please see a diagram on page 9 of the Commission’s report. BCX is an Information and Communications (“ICT”) company and is listed on the Johannesburg Securities Exchange. The shareholders having more than a 2% shareholding in BCX Group are: Liberty Life Association of Africa Ltd 11.19%; Shareholder Not Within Limit 8.59%; Public Investment Commission (“Stanlib”) 4.77%; Public Investment Commissioners 4.67%; Sanlam Institutional Special Opportunities Fund 3.01%; Public Investment Commission Equity (“ Futam”) 2.64%;Sanlam 2.54%; Deutsche Securities Scrip Collateral Account 2.35%; Business Connexion Technology 2.22% and Comparex Holdings Share Purchase Trust 2.20%.

In terms of the proposed transaction, Telkom intends to acquire the issued share capital of BCX. Other than the BCX shares held as treasury shares, shares held by the Comparex Holdings Share Purchase Trust and shares held by the BCX Share Incentive Trust The proposed transaction will be implemented by way of a scheme of arrangement in terms of section 311 of the Companies Act No.61 of 1973.

BCX is active in the Information and Communications Technology (“ICT”) sector and it provides ICT based services to a broad range of clients, including JSE-listed organizations, government and medium sized companies. BCX describes itself as a “leading integrator of competitive, innovative and practical business solutions based on Information and Communication Technology.” BCX website, hyperlink BCX provides network related IT services, network design and implementation services, WAN management services as well as business applications to large enterprises. It is a CISCO accredited organisation. For more details on BCX’s business activities see its website and the Commission’s Recommendation.

The Commission had recommended that the merger be prohibited. A number of objections had been received. Three parties, namely Internet Service Providers Association (“ISPA”), Dimension Data PLC (“Didata”) and Gadlex (Pty) Ltd (“Gadlex”) were admitted as interveners in the Tribunal’s proceedings. ISPA and Didata were opposed to the merger, Gadlex was in support of it.

The following witnesses gave evidence: Dr Giulio Federico Economist CRA International; Mr Hendrik Arnoldus Matthyser Executive: Business Integration Services, Telkom; Mr Micheal Afred Sewell Group Executive, Outsourcing BCX ; Mr Arnold Esias Van Huyssteen Executive: Product Management-Retail Marketing, Telkom; Mr Peter Anthony Watt Chief Executive Officer, BCX; Dr Angus Hay Executive Head of Strategy: Neotel; Dr Setumo Mohapi Director of Telecommunications: ICT Works (Pty)Ltd; Mr Derek Wilcocks Services Director of Dimension Data; Mr Micheal Brierley Chief Executive Officer: MTN Network Solutions (Pty)Ltd; Mr Ewan Sutherland Independent Telecommunications policy analyst; Mr James Hodge Economist: Genesis Analytics; Professor Emanuele Giovannetti Associate Professor, School of Economics, University of Cape Town and Mr Stephen Bosman Chief Strategy Officer, Gijima AST.

The Commission’s investigation revealed that the transaction has horizontal, vertical and portfolio dimensions. In its analysis of the proposed transaction the Commission found that Telkom and BCX overlap in the market for the provision of electronic communications services in the sub-market for managed network services (“MNS”). According to the Commission, the merger will lead to the removal of an effective competitor, and a high market share for the merged entity in the MNS market, which will enable it to act unilaterally without regard to its competitors’ behaviour. ISPA shared this concern.

Engage in input foreclosure of its rivals in the downstream MNS and ITS markets, who rely on leased lines as inputs, through raising rivals costs, refusal to supply, margin squeeze, frustration of access, quality degradation and delays in installation and fault repairs;
2. Engage in customer foreclosure by influencing customers to divert demand away from Neotel’s Neotel is the newly licensed competitor to Telkom. It was previously known as the second national operator (SNO). infrastructure and PSTS services;
3. Engage in mixed bundling of PSTS, MNS and ITS services which will give rise to anti-competitive effects.

In addition the Commission submitted that the merger was taking place in an industry which had until recently been dominated by Telkom’s monopoly. The introduction of competition to Telkom, in the form of Neotel, was in its nascent period and any accretion of market share by Telkom in the MNS market or any competitive advantage it acquired over its rivals across the three relevant markets would have a substantial impact on an industry plagued by high prices and bottlenecks. The Tribunal was asked to protect the first shoots of competition by prohibiting this merger. ISPA argued that the merger was taking place at a time when the industry is moving towards convergence and that the MNS market was the battleground for convergence. Any enhancement of Telkom’s ability to deter entry or expansion of it rivals– through any of the strategies discussed above - would lead to a substantial lessening of competition. Didata submitted that, through this acquisition, Telkom sought to extend its monopoly into the new converged space as well as protecting its current monopoly in infrastructure and PSTS services.

Gadlex, argued that Telkom no longer had a monopoly in the infrastructure market and that in any event there were technical substitutes for fixed leased lines in the MNS market. The merging parties submitted that the vertical theories of harm raised by the Commission and the objectors would not result in the effects claimed by the Commission because inter alia, they were either not merger specific, were mutually exclusive and would not be profitable for Telkom. They argued further that the horizontal overlap between Telkom and BCX was too small to raise competition concerns. In any event, they submitted, if the Tribunal had any concerns about the anti-competitive effects of the horizontal overlap, they would offer a divestiture of BCX Communications (“BCX Comms”) BCX Communications is a subsidiary of BCX through which BCX offers an IP VPN product., a subsidiary of BCX, as a remedy.

A common thread that runs through the opposing parties’ submissions is that the telecommunications sector has only recently experienced the introduction of competition through the licensing of Neotel and the de-regulation of the industry. However to a large extent, Telkom still remains the de facto monopoly supplier of infrastructure and domestic and international PSTS services. It is also a dominant player in the MNS market. All three parties suggest, in different permutations, that if Telkom were permitted to acquire BCX, this would lead to a lessening of competition in the MNS and ITS markets. In addition it would enable the merged entity to utilize a number of strategies in order to retard Neotel’s expansion into the PSTS and MNS markets and hence retard competition in the telecommunications sector. They do not suggest that the merger will prevent Neotel’s entry into the market, but argue that its expansion and therefore the introduction of competition in the sector, across all three markets, will be reduced or retarded.

It is now generally accepted that the industry is moving towards convergence. This trend towards the convergence of voice and data services, broadcasting and telecommunications, and fixed and mobile services – with a single integrated receiver and number that allows the subscriber to move seamlessly between networks – paves the way for a new complex and integrated value chain of services and service bundling opportunities which has supplanted the classically linear value chain. It is anticipated that in future all services will originate from infrastructure that may be composed of multiple and distinct networks that seamlessly integrate to create a modern information backbone known as Next generation Networks, NGNs. See 2006 South African ICT Sector Performance Review Link Public Policy Research Paper No 8, January 2007. NGNs allow for lower-cost, IP-based services to be transmitted over single platforms. These developments require that any value-chain analysis of operators, services or ICT companies be dynamic, flexible and open-ended.

A major implication arising from these trends is the huge increase in available transmission capacity, historically a scarce resource. This effectively means that the marginal cost of the network capacity that is required to provide carriage services is insignificant and may even be approaching zero. Network infrastructure is increasingly being characterized as a fixed cost. The implication of these trends for the global telecoms industry is that networked business models will increasingly be based on services rendered rather than on basic connectivity. Basic connectivity in the context of convergence is the transmission of bits and bytes and is regarded as a commodity. In conjunction with the changing dynamics of the telecoms industry, to the role of regulation has extended from concentrating on consumer disputes, universal services issues and price setting to much broader role of regulating the sector to enable competition.

An important factor to bear in mind is that while the industry is moving towards convergence it continues to remain a network industry characterized by network externalities. In such industries, initial market leaders – whether these are in technical innovation or in high value subscribers - tend to be favoured. The communications sector, as much is it driven by rapid technological developments still remains a network industry, a factor which seems to have been completely overlooked by the merging parties in their arguments and expert testimony. CRA’s economic arguments and calculations took no account of a dynamic market or a market characterized by network effects. Whether the industry is moving towards an information industry or convergence, driven by changes in technology, the applicable economic laws do not change. Technological advances may result in new markets or require that we define the boundaries of those markets differently, but the basic economic principles in relation to network industries remain durable over time. See in this regard Shapiro & Varian “Information Rules – A strategic guide to network economies” Harvard Business School Press, 1999

In this transaction we have concluded that the merger will result in a substantial lessening or prevention of competition in the MNS market, which has been described as the battleground for convergence. In our view this transaction is an attempt by an erstwhile monopolist to thwart the beneficial impact of de-regulation in the form of greater economies of scale and scope for rival MNS providers and lower costs for customers. It is also an attempt by an erstwhile monopolist to stifle innovation in order to maintain its hitherto monopoly margins in infrastructure and voice services

While we note that the merger, if it had been approved, could have had some detrimental impact on Neotel in it’s entry or expansion in both the infrastructure and MNS market, we signal our concern that the merger is, in part for this very reason, likely to result in co-operation between Neotel and Telkom in relation to warding off the threats posed by the de-regulation of the MNS market and the consequent growth in competition and innovation in that market. We express the concern that the acquisition could have provided Telkom with an unregulated subsidiary through which it would seek to evade regulation.

We turn now to consider the impact of the de-regulation announced by the Minister in September 2004 and some recent regulatory developments in the sector. However as a prefatory remark, we suggest that the word “convergence” be used with a degree of caution. Convergence is the new buzzword and those that are familiar with the ICT industry tend to use it as shorthand for many things, which may not necessarily translate easily into competition law analysis. For example, in this transaction, it was often remarked that the MNS and ITS markets are converging. While there is a technological convergence of voice and data in the telecommunications sector which is resulting in a new integrated offering in the MNS or ITS market, this is not equivalent to saying that the MNS and ITS markets are converging into one market.

The de-regulation of VANS by the Minister is also referred to as convergence, not wholly inaccurately. What is meant here is that the technical convergence of voice and data, which was commercially available previously but was restricted by regulation, can now be deployed. However the sharing, sub-letting, and ceding of infrastructure is not necessarily convergence but is now possible as a result of de-regulation. Convergence of the sector does not necessarily translate into consolidation of the sector, which denotes a specific economic concept in relation to market structure.

Convergence may result in an expansion of the services that constitute the MNS market, and would include services that were previously located in the ITS market, but the markets for purposes of competition law analysis are themselves not necessarily converging. There will always be IT companies who provide equipment and hardware and utility applications but who do not provide MNS solutions to enterprises.
[28] For ease of convenience and purposes of completion, we have included in annexure A a glossary of terms used by us in these reasons.

Telkom SA Ltd started out in 1991 as a state owned enterprise housed in the then Department of Posts and Telegraphs. The Post Office Amendment Act 85 of 1991 provided for the establishment and incorporation of Telkom SA Limited and the South African Post Office Limited. Prior to that telecommunications services were rendered by the Department itself. Under the old Apartheid regime, it provided services to the residential and corporate market on the basis of the policies of that regime. Hence it was rare indeed to find residential telephone services in black townships. The Postmaster General and the Department of Posts and Telecommunications, retained general regulatory functions and continued to regulate the telecommunications industry until the Telecommunications Act 103 of 1996.

After 1994 the democratic government embarked on the formulation of a democratic policy process for the telecommunications sector. This process culminated in the 1996 White Paper and the subsequent Telecommunications Act 103 of 1996 (“Telecommunications Act”) and led to the modernization of telecommunications in South Africa. The government adopted a policy of managed liberalization in which it envisaged that Telkom would be partially privatized and be granted a period of exclusivity in return for universal service obligations. In 1996, 30% of Telkom was sold to the Thintana Consortium LLC (“Thintana”), a partnership between Malaysia Telecom and SBC Communications (“SBC”). SBC is an experienced American telecommunications company which cut its teeth in the AT & T stable. It was spun off as part of the AT& T divestiture which took place on 1 January 1984. Telkom was granted a five-year period of exclusivity in its license with an option to extend it for a further year if certain conditions were met. In return Telkom was under an obligation to roll out a certain number of lines to underserviced areas (which at that stage constituted the vast majority of South Africa) and to make contributions to the Universal Service Fund. In negotiation with the then Minister of Communications, Telkom agreed on a rate regime This was referred to as the Minister’s Determination in the 1996 Act which regulated some aspects of its retail tariffs. As part of the agreement with government Telkom also invested in the SAT-3/WASC/SAFE submarine cable system, which provides increased fibre optics transmission capability between South Africa and international destinations. It also concluded a shareholders agreement with government, the provisions of which are still secret.

In that same year, in accordance with international best practice, an independent regulator, the South African Telecommunications Regulatory Authority (“SATRA”) now Independent Communications of South Africa (“ICASA”) was established to regulate the telecommunications sector. Part of its legislative mandate was to set standards, issue spectrum and service licenses, produce an annual frequency plan, approve equipment (all of which was previously done by the department), arbitrate disputes between licensees and prescribe fees and tariffs for markets in which there was insufficient competition. These are referred to as rate regimes.

The effect of Telkom’s exclusivity rights was that it continued to be the sole supplier of domestic and international PSTS services in South Africa. All other telecommunications operators and service providers were required to obtain their facilities from Telkom and no other licensee could provide local, national and international voice services. The only area of competition (apart from competition in customer premises equipment) was in the provision of value added network services but this was also restricted by legislation.

Value Added Network Service (VANS) was a license category in the 1996 Act. Many services could be provided under this license category, including managed network data services and internet services. VANS providers would purchase infrastructure from Telkom and render services to enterprises over networks designed and constructed by them in accordance with their clients needs. However, in terms of s40(3) of the Telecommunications Act VANS could not provide voice, could not use Voice over Internet Protocol (VoIP), and could not resell, sublet or cede the infrastructure leased from Telkom.

By 2002, Telkom had rolled out some 2.8 million lines but had disconnected some 70% of these. See Telkom Annual Report 2001. While access to telephony had improved for previously disadvantaged South Africans and the country experienced improvements in teledensity, this was largely due to the success of mobile services. At the end of Telkom’s five year exclusivity, South Africa had experienced a net decline in fixed line penetration and internet. Telkom’s pricing structure was considered to be excessive and was widely thought to be adversely impacting growth in the South African economy.

See, William H Melody, Vodacom Visiting Professor in ICT Policy & Regulation, LINK Centre, Graduate School of Public and Development Management, University of Witwatersrand, November 2002, “Assessing Telkom's 2003 Price Increase Proposal”. See also report by Genesis Analytics on behalf of the South African Foundation, April 2005.

In 2002, the Minister issued an ITA Invitation to Apply for a second national operator, a competitor to Telkom. Telkom elected not to extend its exclusivity period. In 2004, Thintana sold its shares to the Public Investment Corporation (“PIC”) which sold onto the Elephant Consortium. http://brainstorm.itweb.co.za/online/ReadStory.asp?StoryID=152675 The licensing of the SNO as it was known then began in 2002 and ended on 09 December 2005.

Neotel has the same rights in its license as Telkom does See the definition of PSTS services in the 1996 Act. but in addition has the right to use Telkom’s infrastructure for a period of two years. In preparation for its entry and to enable it to compete in a market dominated by Telkom, ICASA promulgated a number of regulations which set out rights and obligations in relation to number portability and carrier pre-select between Telkom and Neotel.

In September 2004, several announcements made by the Minister of Communications propelled the industry into probably its most dynamic phase ever. In terms of these announcements, mobile operators could utilise any fixed lines that may be required for the provision of the service including fixed lines made available by Telkom or any other person providing a PSTS. Value Added Networks Services could carry voice using any protocol; they could render their services by means of telecommunications facilities other than those provided by Telkom and the Second National Operator. They and PTNs were now entitled to cede or assign the right to use, or to sublet or part with control or otherwise dispose of telecommunications facilities used for the provision of value added network services. All of these were to be effective on 1 February 2005. The Minister explained that the two important policy objectives driving the announcements were the need to lower the cost of doing business in South Africa and to liberalise the ICT sector. In furtherance of these objectives, she was promoting choice for service providers, efficient usage of bandwidth and growth in the value added network services.

See the Minister’s Announcements dated 2 September 2004.

The Electronic Communications Act (“ECA”) came into effect on the 19^th of July 2006. The ECA repealed the Telecommunications Act. The ECA is part of the new converged regulatory framework for the ICT sector aimed at lowering costs of access to the ICT sector and increasing the efficiency of telecommunications services provisioning in the country. The ECA seeks to inter alia, promote convergence in the broadcasting, broadcasting signal distribution and telecommunications sectors, provide the legal framework for convergence of these sectors, make new provision for the regulation of electronic communications services, electronic communications network services and broadcasting services, provide for the granting of new licences and new social obligations, provide for the control of the radio frequency spectrum and provide for continued existence of the Universal Service Agency and Universal Service Fund.

However, despite the recent regulatory initiatives designed to liberalise the telecommunications sector, we must not lose sight of the fact that, to date, Telkom has a virtual monopoly of fixed line South African subscribers, whether these are corporate or residential. This should come as no surprise since until recently it enjoyed a de jure monopoly status and for all intents and purposes continues to remain the overwhelming dominant supplier of infrastructure in this market, and provider of local, national and international telecommunications in the country. Equally important, and as a consequence of its monopoly status, Telkom has the largest footprint of infrastructure in the country. Its network runs to some thousands of kilometres and it is able to access every small and large town through its extensive local loops. It has been, and still remains, on the one hand the sole supplier of infrastructure and connectivity to other players such as mobiles, PTNS and VANS, and, on the other hand, a competitor of VANS.

WANS are constructed as physical private networks from dedicated leased lines. The infrastructure that constitutes a WAN was obtained exclusively from Telkom, and by far the overwhelming majority are still currently provided by Telkom. The manner in which infrastructure was supplied was also controlled by Telkom. See evidence of Mr Brierley where he explains Telkom’s requirements that VANS submit agency agreements signed by their clients which required details of the customer and installation addresses. See page 1674 of the transcript.

Prior to 1 February 2005, MNS services were provided to an organization in two ways. WAN service providers such as BCX did not provide their services in terms of a VANS licence (they did not provide a network) but provided these services to customers on their premises. VANS was a license category in the now repealed Telecommunications Act of 1996. Service providers rendered MNS services to enterprises on their own networks, which they obtained from Telkom. WAN service providers provided MNS services on a client’s network, which was also constructed from lines leased from Telkom. Such a WAN provider provided both network related and IT services for enterprises in relation to their WAN, as well as other IT services in the form of business applications and equipment. These WANS are referred to as enterprise owned WANS.

The price of the leased line, whether this was an access line or a core network line, was regulated as a retail price to VANS Telkom did not provide them with a wholesale price on the basis they were not public operators but service providers. and constituted approximately 60-65% of the cost of the services rendered by VANS. See evidence of Mr Brierley and Mr Van Huyssteen on page 1203 of the transcript VANS obtained the leased lines from Telkom and recovered the costs thereof from their clients, making no margin on the cost of bandwidth. The cost of leased lines for enterprise owned WANS was borne directly by the client itself. See evidence of Mr Sewell and Mr Brierley.

The manner in which these lines could be utilized by VANS or the clients themselves was restricted by the Telecommunications Act which led to underutilized capacity and high communications costs. Since Telkom owned the infrastructure and to a large extent retained control over it, See evidence of Mr Brierley above. Also transcript page1722 and Hodge’s witness statement on page 41. service level agreements, which regulated the services associated with the bandwidth and dealt with issues of network performance levels, downtime, fault repairs etc, were also limited by the extent of the service levels Telkom would offer together with the bandwidth. VANS provided their clients with a back to back service level agreement, being limited to Telkom’s undertakings and performance.

During this period, organizations obtained their communications services from a number of providers. An enterprise could - and in terms of the restrictions was compelled- to buy different components from different suppliers. All infrastructure and access lines had to be obtained from Telkom (whether the MNS service was provided by a VAN or not), certain services could be obtained from an ITS provider, others such as internet access could be purchased from a VANS provider. In addition other communications needs, such as fixed line voice services could only be purchased from Telkom. If a large organization decided to outsource all or some of its communications requirements, it generally tended to appoint a single service aggregator, who would manage all the other service providers on behalf of it. See for example the AngloGold Ashanti service agreement with BCX which requires BCX to provide a range of services to it, including services sourced from Telkom. See page 3687 of the record

Developments in technology in the VANS segment gradually permitted services to be provided in the form of shared networks. These were provided by VANS providers The technology was known as VPN technology. Virtual Private Network, see our discussion below on the difference between enterprise owned WANS and VPNS The early developments in this technology were legally challenged by Telkom on the basis inter alia that it constituted an infringement of Telkom’s exclusivity and the restrictions that were in place on value added network services in terms of the Telecommunications Act of 1996. See Telkom v Internet Solutions 14 June 2002 and Telkom v AT & T 21 June 2002. See pages 1875-1922 ISPA Trial Bundle 5 In 2002, ICASA ruled that VPN technology was a value added network service, could be provided by a licensed VAN provider and was not in contravention of the Act. Telkom SA Ltd v AT&T Global Network Services 21 June 2002 Despite challenging ICASA’s decision in the High Court and refusing to connect AT&T until a court order was sought against it, Telkom itself launched its VPN Supreme product in 2003. Telkom brought a review application against ICASA in the IS matter. AT&T brought an application in the High Court to compel Telkom to abide by ICASA’s decision and to provide it with connectivity. However, the regulatory restrictions and the unfriendly framework remained in place until 1 February 2005. See Mr Sewell’s evidence on why BCX chose not to enter the VANS space at that time page 881 of the transcript.

The de-regulation brought about regulatory certainty and immediate benefits to enterprises. VANS Which would be classified as an ECS licensee in terms of the ECA. are now able to sublet, cede and re-sell infrastructure leased from Telkom and are also allowed to use VoIP, leading to economies of scale and scope. Organisations can still have their own private network but the costs of that investment could be shared with others. In addition they can transmit voice in the form of VoIP over their network. Obviously the more enterprises that can share a network the cheaper it would be. They would also benefit from the network effects of on-net calls. The consequence of this reduction in costs is that enterprises are more willing to outsource their WAN needs in order to obtain the benefits of sharing it with others.

This has led to a movement away from the strings model of WAN – where each branch of the organisation had to be connected to the other branch and head office in linear fashion - to a cloud model of WAN, ie the VPN. In the cloud model, the service provider builds a core network to which each branch connects to a VANS POP POP stands for Points of Presence, as opposed to connecting directly together. Branches and head office can then talk to each other through the core network. In addition more than one organisation can use the provider’s VPN. Significantly, in addition to all the traditional services that could be transmitted over the WAN, organisations can now transmit voice in the form of VoIP.

It is not surprising therefore that the VPN model is demonstrating phenomenal growth not least because it represents an immediate cost benefit to enterprises long suffering under high communications costs. According to BMI-T BMI-T is a market analyst in IT, Telecom and Banking and arrives at industry reports through data and views obtained from industry participants as well as from reported figures. the enterprise market is ripe for a migration from WAN to outsourced VPN solutions. BMI-T estimates that the VPN sector will grow by 24% annually and that by 2008, will constitute 67% of the MNS market. Migration usually occurs at a time when a company is scheduled to upgrade its legacy network (due to large switching costs involved). The International Data Corporation (“IDC”) IDC is a subsidiary of the International Data Group which collates and analyses data for the ICT sector. estimates that “in the coming years a number of large contracts that drive growth rates sky high in the beginning of this millennium will be renewed”. See BMT-T South African IT Services 2006-2010 Forecast and 2005 Vendor Shares” Item 29 page 1539 Telkom Discovery Bundle File 4 However not all enterprises will necessarily move to an outsourced VPN offering. Some very large enterprises may still desire to maintain a PTN/enterprise WAN or have some measure of control over their network because of security or reliability concerns. See Telkom VPN Supreme Product Plans Telkom’s own staggering growth in VPN suggests that this will be the predominant form of the new WAN, a more cost effective, outsourced integrated WAN.

Furthermore, growth in data revenue and more so now that the convergence of voice and data is legal over the internet, is seen as the future growth segment in the telecommunications industry. Internet access and value added services such as managed data network services continue to exhibit the strongest growth rates, a trend that will continue over the forecast period. See 2006 BMI-T on page 1408 Telkom Discovery Bundle file 4

Since economies of scale can be achieved the cost of bandwidth for enterprises has declined and fewer leased lines need to be purchased from Telkom. Due to this, enterprises are now likely to spend more on their ICT value added services than on connectivity. However greater economies of scale and scope have also improved margins for MNS providers. With declining costs of connectivity and the consequent increase in outsourcing and spend on value added services, MNS providers have had to re-consider their offerings in the market in order to meet the challenges of de-regulation. This has encouraged entry by companies that have been involved in the MNS market into the VPN segment.

Prior to the de-regulation in the MNS market, when an enterprise decided to outsource its communications and data services, such outsourcing took place in various permutations. The enterprise could outsource any component or all of its data communications needs whether this was the network, the management thereof and its IT services. Very large organizations, such as national government departments, would issue a tender in relation to such outsourcing. The more outsourcing an enterprise did, the larger the number of service providers, the more it required the services of a single service aggregator.

The development of an integrated package such as the VPN in the converged market now enables an MNS provider to approach its customers with an offering that would include all of the components of that integrated package. The MNS provider can now offer infrastructure, managed data services, internet, voice and any other number of services that could be integrated into a VPN. A service provider could of course, continue in the same old way and procure or sub-contract those elements in the package which it itself could not provide from others. However such sub-contracting would cut into its margins.

In order for an MNS provider to compete effectively in the dynamic MNS market and to reap the benefits of de-regulation (in the form of lower connectivity costs) it needs to “own the customer” and earn as much margin as it can. MNS providers that have credibility in outsourcing and a closer client-vendor relationship are likely to more easily gain entry to a client’s decision makers. A company such as BCX with its range of skills is likely to win an outsourcing contract and own the customer. However, it would need to ensure that it keeps as much of the margin it can. BCX acquired Bidnet for precisely this reason – as long at didn’t own a VPN network itself it would always have to rely on Telkom or other VPN players to partner with, hence giving up margin that it could otherwise retain.

Needless to say the de-regulation of VANS represents the greatest threat to Telkom, as it does to Neotel. It has created “arbitrage” in the market for fixed line connectivity (bandwidth) and voice. From a review of the Telkom strategy documents, it appears that the word “arbitrage” is used in a number of situations – it is used to describe the fact that a customer can buy a cheaper WAN & voice on a VPN rather than an enterprise owned WAN and fixed voice services; or it refers to the fact that voice services can now be provided more cheaply (in the form of VoIP) than Telkom’s fixed voice services; or that MNS rivals can now provide VoIP over bandwidth that was traditionally bought for data communications or that MNS rivals could achieve economies of scale on bandwidth thus reducing Telkom’s margins. See in general Telkom 2010 Strategic Plan. Also ISPA file 1 pages 332-334 MNS providers can now sell shared bandwidth, VoIP, internet and other data services. The legalization of VoIP has also introduced retail price competition in national and international voice services, which were previously part of Telkom’s PSTS monopoly services.

The combination of a loss, on hitherto extremely high margins on leased lines and voice revenue in Telkom’s most lucrative market See the evidence of Wilcocks in which he explains that all the profitability of in the telecommunications sector is from the top 350 companies. See page 1517 of the transcript. – the large enterprise market – poses a far greater threat to Telkom than the entry of Neotel does. Telkom has been able to assess, on its own calculations, that Neotel is expected to gain some 8-10% of Telkom’s total fixed line market. However the loss to Telkom attributable to de-regulation in the MNS market is is more difficult to predict and would be a function of the number of high value subscribers and the relative network size of its rivals in the MNS market. Telkom also stands to lose revenues in the most profitable segment of the MNS market namely internet services. This is because enterprises, once they decide to migrate to a VPN, and in order to maximize savings, are likely to also migrate to an internet service provided by their VPN service provider. See evidence of Mr Brierley on pages 1682-1683 of the transcript. BCX is already providing internet services. This is also the segment of its business in which Telkom will experience significant retail price competition, Neotel already having indicated that it does not intend to compete with Telkom on the basis of price. See also South African Telecommunications Sector Performance Review 2006 by Steve Esselaar, Alison Gilwald and Christoph Stock page 38

“Telkom’s main reason for proposing the transaction is that the proposed transaction will diversify Telkom’s revenue streams into new revenue streams that Telkom can grow in order to replace voice revenues which are expected to decline as a result of increasing competition. Telkom expects revenue in the IT services sector generally to grow, and that a presence in the IT services sector will enable Telkom to benefit from this. Telkom also believes that there are ancillary benefits to be obtained from extending its range of existing services to complementary services in the IT sector. The proposed transaction will enhance Telkom’s ability to offer its customers end-to-end solutions across the ICT value chain. Telkom’s strength has to date been in voice, managed data networks and internet access, while BCX offers a complementary service offering.” See page 1361 item 4 of the record. According to Telkom the three main ancillary benefits that are expected to accrue to Telkom from providing a broader range of IT services are :The first benefit is that it will enable Telkom to meet the preference of some corporate customers for the convenience of having a single aggregator of their ICT inputs( commonly referred to as “single service aggregation” or “bundling”);the second ancillary benefit is that operating as a single services aggregator will result in delivery of a better service, due to improved interaction between the various providers of the different aspects of the overall service offering. The third benefit is that of efficiency, whereby the total cost of providing the overall service should be reduced through the alignment of functions between Telkom and BCX in order to avoid duplication.

Mr Matthyser on behalf of Telkom, who has been integrally involved in the acquisition of BCX, submits that Telkom anticipates that it will lose revenue as a result of Neotel’s entry, convergence (de-regulation of the industry) and further price regulation of Telkom by ICASA. Telkom estimates that it will lose approximately 10% of its total market share of the PSTS market to Neotel, its newly licensed competitor and needs to diversify and find alternative streams of revenue. According to Matthyser, the acquisition will enable Telkom to plug some of the revenues losses it expects with the entry of Neotel. The loss of revenue as a result of competition from Neotel is estimated at R5bn over 5 years. Matthyser says that Telkom expects to lose more revenue as a result of increased regulation by ICASA but the acquisition of an IT company will at least plug some of the revenue lost. Telkom also claims that many PSTS operators internationally have had to diversify their revenue streams in the face of de-regulation and competition and have vertically integrated into IT companies.

However, throughout the hearing, we were told by a number of witnesses, including the merging parties’ expert witness that the margins in the ITS sector were very low. These low margins were used as a basis by the merging parties’ expert witness to demonstrate why input foreclosure would not be a profitable strategy for Telkom to pursue in the downstream ITS market for which leased line is an input. We were also told by the merging parties and their expert witness that barriers to entry were very low in the ITS market and that the market was highly fragmented.

Given these two factors – low margins and low entry barriers- it is difficult to believe that Telkom couldn’t, with its enormous resources and deep pockets, enter the ITS market organically and why it was willing to pay a premium of approximately 25% for the acquisition of a company for such small margin gain. Mr Matthyser, when asked to explain this, could not provide a satisfactory answer but testified that “even when the deal was contemplated, it was on the basis of covering revenue losses at the acknowledgement of making very little new margin or getting small incremental margin benefits from the deal over three years”. Transcript page 531

Mr Wilcocks on behalf of DD testified that he was not persuaded by the reasons Telkom had provided for the acquisition of BCX. In his view, the ITS industry’s profits constituted only R1.3 billion, and was a low margin, highly fragmented industry. Transcript page 1515 This translated into a fraction of Telkom’s own revenues, i.e. Telkom’s return on sales is approximately 30% as opposed to that in the ITS sector of only 2.5%.

“In my view if Telkom is faced with a reduction in profits that in my view are monopoly profits that is has enjoyed for many years, it really has two choices. One is that it could try and find other profits in other areas, substitutes if you will for this. And my understanding is that Telkom has publicly announced that is the reason why it wishes to acquire Business Connexion to diversify its earnings base. Now from the figures that I submitted previously it would seem to me that that is going to be incredibly difficult to achieve. It doesn’t seem to be a logically coherent argument to me, because if you look at the spreadsheet that shows the company’s earnings you will notice that Telkom’s earnings are about R9.8 billion, Business Connexion earnings in its last reporting period were about R110 million, so even a miniscule reduction in Telkom’s profits can’t possibly be substituted by Business Connexion’s profits.”

Mr Watt, the CEO of BCX did not testify initially, as was expected. He only appeared before the Tribunal after his retirement and resignation from BCX had been announced. In his stead Mr Sewell, testified on behalf of BCX. However Mr Sewell had not been involved in any of the negotiations around the transaction and could not provide us with any firm view of BCX’s rationale for the transaction. At best Mr Sewell could only speculate about the strategic rationale for the transaction.

When Mr Watt eventually appeared before this Tribunal he denied any involvement by the Board in Telkom’s offer to BCX and indicated that this was a direct approach to shareholders. According to him the Board was now simply implementing a decision taken by shareholders. Accordingly he expressed no view about the strategic rationale for the transaction for BCX. However correspondence between Telkom and BCX’s deputy CEO show that Mr Watt, contrary to his evidence, under oath before the Tribunal, had personally indicated his willingness to negotiate a higher offer from Telkom and was familiar with the content of the discussions between Telkom and BCX shareholders. Telkom had made an initial offer of R R7.60 per share which had been rejected by the Board. See Mr Watt’s evidence on page 2308 of the transcript.

A strategic document prepared by the deputy-CEO of BCX indicates that BCX considered three options for its future, in light of convergence which had increased competition in the market. It had the option to go it alone, merge with Didata or go in with Telkom. Whether or not this was presented to the BCX board was unclear. Mr Watt however conceded that “some of those issues had been discussed”. See Mr Watt’s evidence on page 2312 of the transcript

A constant theme that is found in Telkom’s strategic documents is that it seeks to defend its core market against competition and convergence by offering end to end solutions, consisting of bundled products to clients, on a long term basis, at discounts. Its aim is to own the customer and to increase the costs of customers switching to rivals. See page 990 item 6.2.3.8 of the record

“A separate subsidiary will allow for more flexibility in pricing as it will not be subjected to the rules of regulatory accounting and costing. This entity would also not be under close scrutiny from the Competition Commission. This will allow for more room on bundling of products and services.” See Telkom’s 2010 Strategic plan item 7.2.4.3 in page 1021 of the record (Our emphasis)

South Africa: Competition Tribunal

Telkom SA Limited and Business Connexion Group Ltd (51/LM/Jun06) [2007] ZACT 55 (20 August 2007)