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How the spectrum auction could shake up Canada’s wireless industry

Rogers alone accounted for 62 per cent of the auction’s total proceeds, spending $3.3-billion.

Tim Fraser/The Globe and Mail

It took only 24 minutes for Rogers Communications Inc. to launch its investor relations blitz.

As Industry Minister James Moore announced the long-awaited results of its wireless spectrum auction in Ottawa on Wednesday, Canada's largest wireless carrier was preparing to take its own message to Bay Street.

Mr. Moore began speaking at about 5:20 pm ET, stunning industry watchers with the revelation that Ottawa would earn an eye-popping $5.27-billion from auctioning off the 700-MHz frequency – far more than analysts expected and making it the most profitable spectrum auction in Canadian history.

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Rogers alone accounted for 62 per cent of the auction's total proceeds, spending $3.3-billion. Fearing a backlash from investors, the company e-mailed a detailed backgrounder to analysts at 5:44 p.m., minutes after Mr. Moore wrapped up his press conference.

Spanning more than three typed pages, the document was a detailed defence of the company's bidding strategy, designed to nullify concerns that the company overpaid for 700-MHz licences, which are designed to give faster wireless speeds and improve coverage for the 28 million Canadians who subscribe to wireless service.

"Please don't forward, post or otherwise share this," reads the document, which was obtained by The Globe and Mail.

"Rogers won exactly what you'd expect us to go after – which is twice as much prime spectrum as almost anyone expected – and paid prices that are in line with recent and historical 700-MHz [auction] precedents in the U.S." Rogers said its spending came "within a few percentage points of what our valuation models had indicated and were approved internally before the auction began." (Despite those assurances, Rogers shares dropped sharply when the market opened on Thursday morning before snapping back.)

The spectrum auction's final numbers are huge – and so, too, will be its impact on the $20-billion Canadian wireless industry.

Here's what didn't happen in the auction: No large foreign wireless companies showed up with a large cheque and a bold plan to take on Rogers, Telus Corp. and BCE. Verizon Communications Inc., the American giant that seriously considered a Canadian play last summer (and carved billions of dollars off the market capitalization of the Big Three), stayed away. So did most of the private equity firms and other pretenders that flirted with joining the auction last year.

But that does not mean the event lacked for storylines. The auction is considered crucial to the future of wireless service because 700 MHz is considered high-quality spectrum, able to travel long distances, penetrate buildings more easily and handle the vast amounts of data traffic that Canadians use as they stream Olympic hockey games and other video on their phones and tablets.

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Rogers: Searching for momentum

In its e-mail to investors, Rogers suggested that what it paid for the new licences wasn't out of line because other bidders were prepared to pay nearly as much. Under the quirky rules of the federal auction, the winning bidder for each individual block of spectrum actually pays what the second-highest bidder was willing to pay.

The auction format was based on anonymous bidding to curb attempts to game the system, such as driving up prices for competitors. Nonetheless, sources say the telcos were able to use complex algorithms to determine the bidding patterns of their rivals – and to try to push up the amount they would have to pay.

There was plenty of speculation during the auction that Rogers, which ultimately won 22 licences, took a bruising from other bidders for its prized A and B block licences, which cover most of Canada's major markets. In fact, some sources estimate that this type of gaming, particularly during the auction's supplementary bids, resulted in Rogers overpaying for its spectrum by as much as $1.5-billion.

"It was quite intense. There was a lot of jockeying," Mr. Moore said on Wednesday. "Ultimately, Rogers paid what they paid."

The $3.3-billion question will be, is it worth it for the company that still leads the wireless race but has been losing momentum to Telus and BCE?

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"The litmus test on whether they overpaid or not is going to be whether they can successfully advertise that they've got the best network over the next two years," said Greg MacDonald of Macquarie Capital Markets in an interview.

"Because we've seen some litigation on this aspect. So if they can prove enough to avoid litigation and advertise that they've got the best network, then that might lead to some pricing power … That would give some credibility to the argument that you've got some pricing power if you can make that marketing claim. How much pricing power, I think, is a very big question."

Rogers' wireless strategy, much like its incumbent peers, appears to be largely hinged on the explosive growth of mobile video.

"Video already makes up roughly half of our mobile traffic and that number will continue to skyrocket over the next few years. This spectrum deal will give us a competitive advantage to deliver what our customers want long term," Rogers spokeswoman Terrie Tweddle said in an e-mailed statement.

"We've been investing to give our customers the coveted content they want and to deliver the advanced services businesses need. We've now secured prime, beachfront property to significantly enhance the speed, capacity and quality of our LTE [long-term evolution] network to deliver this content and these services to more people in more places on the go."

The company has been investing heavily in content, including its recent blockbuster acquisition of National Hockey League broadcasting rights and its co-ownership of Maple Leaf Sports and Entertainment. Both deals are designed to feed sporting events to its Sportsnet channels – and, with luck, give it an edge in keeping wireless and cable customers. Rogers' wireless churn, or the rate at which customers leave, is higher than that of both Telus and Bell.

Even so, BCE, which is Canada's largest broadcasting company and another MLSE co-owner, only spent $565.8-million for 31 licences in the 700-MHz auction – far less than what Rogers paid. Its Bell subsidiary had 1.2 million mobile TV subscribers at the end of 2013 – 66 per cent more than the previous year.

Vidéotron: Fourth player or phantom competitor?

Despite Vidéotron's emergence as a potential fourth national carrier, some analysts are doubtful about the company's prospects outside of its home market.

Vidéotron won seven operating licences that cover all of Quebec, Alberta, British Columbia and huge swaths of Ontario – key markets that are home to more than 80 per cent of Canada's population – for $233-million. Industry Minister James Moore wasted little time hailing Vidéotron's auction win as proof that his government's competition policies are working. Ottawa's goal is have to have at least four carriers in every regional market.

"I think it's great they're looking beyond their traditional footprint in the province of Quebec to provide my home province of B.C., Alberta and the province of Ontario with a fourth-player option," the minister said.

Not so fast. The spectrum was cheap – so cheap that Quebecor "could not pass up the opportunity to invest in licences of such great intrinsic value in the rest of Canada," said Robert Dépatie, president and chief executive officer of Quebecor Media. But that doesn't mean it's about to leap into markets where others have tried to compete against the Big Three and failed.

"We now have a number of options available to us to maximize the value of our investment," Mr. Dépatie said.

Analysts are skeptical given the uphill battle Vidéotron has faced even in its home province of Quebec, where it has a strong brand and a captive customer base that purchases cable television, high-speed Internet and home phone. It launched wireless service in the province in late 2010 and now has more than 500,000 subscribers.

"It has committed roughly $1-billion of capital [to wireless]. And for all that, it is barely break-even on the EBITDA line ... let alone cumulative free cash flow," wrote Tim Casey, an analyst with BMO Nesbitt Burns. (EBITDA is earnings before interest, taxes, depreciation and amortization.)

Some experts estimate that Vidéotron would need to spend in excess of $1-billion to build a bare-bones LTE network outside of Quebec. Even then, the company would have to build a network of retail outlets, an expensive proposition.

There are also other challenges, including obtaining handsets that would be able to support both data and voice on its newly-acquired 700-MHz spectrum. Vidéotron, like other new entrants, already faces challenges on the device front since it is unable to sell Apple's iPhone.

Another potential stumbling block is the fact that Vidéotron secured only one paired block of spectrum in each service area – making it more difficult to provide the fastest wireless speeds.

Some experts, such as long-time telecommunications analyst Dvai Ghose of Canaccord Genuity, believe Quebecor will simply sit on the spectrum as it examines its "options." The problem with waiting is that smartphone growth will eventually slow in those markets.

Quebecor could get a running start in the rest of Canada by buying struggling new carriers Mobilicity and Wind Mobile, which have a combined 860,000 customers, but those deals are no sure thing. (Vidéotron is offering $200-million to purchase Mobilicity, according to sources, but that amount is insufficient to repay Mobilicity's first-lien note holders, who would have to give their blessing to any deal.)

Others, however, see another possible outcome for Vidéotron's spectrum. The so-called "C1 block" where it won licences is the same as the spectrum owned by Verizon Communications Inc. in the United States.

"This alone does not prove anything, but we reiterate our view that a partnership with Verizon makes considerable sense for both parties," said Macquarie Capital Markets' Mr. MacDonald.

After Verizon pulled the plug on its Canadian expansion plan in the fall, it began lobbying the federal government in November, federal records show. Around the same time, the company's representative indicated to investors at a Scotia Capital conference that it remained interested in the Canadian market, according to sources. Its communications with Ottawa have included the investment review sector of Industry Canada.

Rural Canada: Left out again?

From the outset, the federal government stressed that it wanted this spectrum auction to bring better wireless services in rural communities.

When former industry minister Christian Paradis first unveiled the government's auction plans in March, 2012, he used the rural community of Russell, Ont., about 40 kilometres outside Ottawa, as a backdrop for the announcement. Journalists were told that the sale of this spectrum, a valuable but invisible public asset, would allow carriers to improve the quality of cellular networks in regions that have traditionally been neglected or underserved.

Rural Canada represents a hotbed of political support for the Conservative government, so there is a lot riding on the government's ability to make good on its promise. But despite Ottawa's stated intentions, some regional carriers are questioning whether the format for the 700-MHz auction actually led to the best outcome for rural Canadians.

The auction used what is known as a "combinatorial clock" format that allows carriers to bid on packages of licences. It was designed to ensure that carriers were able to avoid gaps in their network coverage, but critics say it also had the effect of driving up prices for regional carriers with the smallest balance sheets.

"There is an inherent bias in the auction against small bidders," said John Meldrum, vice-president of regulatory affairs for Saskatchewan Telecommunications Holding Corp. "It is because … the auction software, in the end, looks for the highest package of bids. And individual bids can then just get wiped out by the bigger packaged bids."

SaskTel was able to win one block of 700-MHz spectrum in its home province but remains concerned that the overall auction results will not necessarily lead to improved coverage in rural Saskatchewan – at least not in the near term.

It is a multipronged problem. The type of spectrum purchased by SaskTel and other regional carriers (such as Eastlink, Vidéotron and Manitoba Telecom Services Inc.) sits in what is known as the C1 block. It is, generally speaking, the scraps that the Big Three were less keen on, and deployed on its own might not be able to provide rural customers with the best possible wireless speeds.

"We knew going into the auction that there was only one block available in each service area that wasn't going to go to Bell, Telus and Rogers," said Matthew MacLellan, Eastlink's wireless president. "As a smaller bidder, you're left with what the larger bidders don't want." Had a large new entrant tried to buy spectrum in Atlantic Canada with designs on national service, "we would have been left with nothing. We were fortunate."

Eastlink, which recently marked its one-year anniversary of its service launch, provides the largest LTE network in Atlantic Canada. It has long maintained that it is committed to building out service in rural areas that incumbents are less interested in.

"We've invested a lot more, in terms of the technology and the sites, building out rural Nova Scotia and rural Prince Edward Island as compared to somebody like Rogers," Mr. MacLellan said. "Rogers has all the spectrum but we're the ones who have the willingness to build out the rural areas. It is not as important for them to build out Pictou County, Nova Scotia, as it is for us."

There are doubts whether big carriers will ever expand into new rural communities. That's because big carriers only have to deploy 700-MHz spectrum within the footprint of their existing networks – they aren't required to add new service regions.

Given the type of spectrum that they won, regional carriers may also face a handset challenge over the near term. The C1 block forms part of what is known in industry parlance as the "Verizon ecosystem" for smartphones. That means Verizon uses the equivalent spectrum in the United States to support data usage on LTE-enabled smartphones, but its voice calls still default to its older CDMA network.

That's a problem because Canadian new entrant carriers continue to use a different technology to support voice calls – and those networks are incompatible with Verizon's CDMA network. That means smartphones that are made for use on this spectrum can currently support data, but may not be able to support phone calls in Canada for all regional players. The problem is unlikely to be resolved until Verizon introduces new technology that forces smartphone makers to adapt.

SaskTel controls roughly 73 per cent of its home province's wireless market with more than 612,000 mobile subscribers. Still, the company has said the lack of device options for the C1 band means its rural customers may not see any immediate improvement in service from this auction.

Both SaskTel and Eastlink want Ottawa to examine whether the combinatorial clock format is appropriate for future auctions. Sasktel, meanwhile, will also push the government to crack down on spectrum hoarders with a "use it or share it policy" that would force larger carriers to either deploy the spectrum they already hold in rural communities or allow competitors to use it in the interim.

"We're going to continue to push the federal government to look at the unused spectrum in Canada – especially in rural areas – to see that it gets used for the benefit of customers," Mr. Meldrum said. "There is currently a lot of unused spectrum in rural Saskatchewan that is almost as good as the 700 [MHz]."

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