Managing the Profitability of Eastern European Mobile ... fileoperators (Vodafone, Telenor, Verizon,...

Opinion Paper

Managing the Profitability of Eastern European MobileTelecommunication Carriers

2010 / 03

We make ICT strategies work

Managing the Profitability of Eastern European Mobile Telecommunication Carriers

Opinion Paper 2 Detecon International GmbH

Contents

1 Executive Summary...........................................................................................3

2 Current Market Situation ....................................................................................4

3 Benchmark Results............................................................................................6

4 Strategic Measures..........................................................................................10

5 Potential Detecon Support ...............................................................................11

6 The Authors .....................................................................................................12

7 The Company ..................................................................................................13



1 Executive Summary

Nearly all major European telecommunications carriers have stakes in Eastern Europe1. Against this background, Detecon performed a benchmark study on the financial performance of Eastern European mobile telecommunications operators in late 20092 in order to learn more about the subsidiaries’ value contributions to the groups as a whole and to highlight strategic measures for those charged with governance.

Our scope included 22 countries from Eastern Europe representing around 496 million mobile subscribers. We assessed the data of mobile operators serving around 350 million subscribers in 14 countries and benchmarked the results against mature and integrated peer operators (Vodafone, Telenor, Verizon, AT&T, Telefonica, Deutsche Telekom, France Telecom, NTT DoCoMo). Detecon focuses on three financial KPIs3.

The benchmark shows that Eastern European mobile operators are still profitable. However, this paper emphasizes the need for strict control of financial performance, and Detecon recommends those charged with governance both at headquarters and within local subsidiaries to collaborate closely, as this will be the only effective approach to maintain profitability.

Poland

Greece

Turkey

CzechRepublic

Estonia

Latvia

Lithuania

Belarus

Ukraine

RomaniaHungary

Slovakia Moldova

Bulgaria

Russia

Montenegro

Serbia

Slovenia

Croatia Bosnia/Herze-govina

Macedonia

Albania

Captured

Legend:

Not captured N.A.

500

400 347

Total Subscribers

496

300

200

100

0

Covered Subscribers

Subscribers in Scope [mio.]

Figure 1: Benchmark Scope

1 Even though “Eastern Europe” may be a misleading term, as there are great economic, political and historical differences between these countries, Detecon decided to assess them as a group, as it is common practice from a corporate perspective. See also “Wrongly labelled” (The Economist, 07.01.2010).

2 Financial data has been obtained from the annual reports of the operators as of FY 2008.

3 Key performance indicators assessed: EBITDA margin, EVA®, Operational Gearing.



2 Current Market Situation

Start up Growth Maturity Saturation Restart

Life cycle phases of telecommunication

companies

Revenue driven Profit driven

Market launch

License acquisition

Rapid subscriber growth

Network roll-out

Market saturation, no revenue-driven growth

Business inefficiencies prohibit further development

Increased competition

Pressure of the new technologies

Significant business complexity

+ Financial downturn

Structure the business and fight with its complexity

Business innovations

Enter/create new markets

Avg. stage

Eastern Europe

Figure 2: Market Stage of Mobile Operators in Eastern Europe

0

2

4

6

8

10

12

14

16

2004 2005 2006 2007 2008 2009

US$/month/subs.

0

10

20

30

40

50

60

70

80

90

100

110

2004 2005 2006 2007 2008 2009

% of population

3G penetration

Wireline broadband

PC penetration

Mobile Penetration

Data

Voice

Aggregate

ARPUs Penetration rates

Source: Pyramid research

Figure 3: Growth prospects remain in data and broadband



Eastern European telecommunications markets have matured and are now saturating (compare figure 2). Operators are facing business inefficiencies and are under pressure from the effects of the financial crisis4. Moreover, competition is increasing and the need for ongoing investments in new technologies remains. Therefore, revenue-driven business models ought to be replaced by profit-driven ones in order to defend profitability and liquidity.

As shown in figure 3, total ARPU5 has constantly decreased until 2006. Since then,aggregate ARPU levels are stable. Data ARPU is slightly increasing and has nowadaysreached a share of 20% in the total ARPU. But growth is not yet substantial enough to accelerate total ARPU growth. Over the same period of time, the penetration rate of mobile subscriptions has grown nearly threefold.

Despite those challenges, there is a set of opportunities for mobile operators6:

Many operators in Eastern Europe have a large number of inactive SIM subscribers. Those should be either discounted or re-conquered, as happened e.g. in Russia and Hungary.

The majority of subscribers are pre-paid; those subscribers should be lifted into more valuable post-paid contracts in order to ensure continuous revenue streams. Innovative tariff pricing is key.

PC penetration is still low, and as a consequence so is wireline broadband penetration. 3G/4G technology could be positioned early enough at the right scale as an alternative to wireline broadband, e.g. using 3G dongles in bundles with netbooks (similar bundles have been introduced successfully in Western European markets).

Experience has shown that data and content VAS services will be taken up by customers as soon as licence and roll-out issues of 3G have been resolved; VAS services should be stabilized in order to win higher-value customers.

Another key success factor could be to find a suitable MVNO7 model complementing theexisting tariff structure – as it is common practice in Western European markets – once regulatory authorities put more pressure on incumbents.

Our benchmark results confirm that current financial performance is still adequate, but they also highlight the need for tighter control in order to maintain the current profitability levels and to cope with the challenges resulting from the described market situation.

4 Compare “Impact of the Financial Crisis on the European Telecommunications Industry” (Detecon, February 2009).

5 ARPU = Average Revenue Per User per month.

6 Compare telecommunication reports on Eastern European countries (Business Monitor International, 2009).

7 MVNO = Mobile Virtual Network Operator.



3 Benchmark Results

10% 20% 30% 40% 60% 70% 80% 90% 100%0% 50%

Min

32%

Median

43%

Max

58%

10% 20% 30% 40% 60% 70% 80% 90% 100%0% 50%

Min

29%

Median

34%

Max

45%

Operators in scope Peer operators

Figure 4: KPI 1 - EBITDA8

The EBITDA median of the operators in scope is 43%, this is nearly 10% higher than in the peer group (34%). On the one hand, this can be explained by the much higher diversificationof the peer operators which provide mobile, fixed, broadband and corporate ICT services. On the other hand, peer operators have already reached the ‘restart’ market stage (compare figure 2); a transformation which is yet to be accomplished by the operators in scope. The large spread between minimum and maximum values at 26% is still much higher than the 16% spread of the peer group, indicating that there are stars and laggards with a wide span of corporate momentum, whereas the peer operators have become more closely aligned in terms of organizational development.

Detecon predicts that the more the emerging market players evolve towards the business models of the peer group, the more their EBITDA margins will deteriorate. Moreover, heavier price wars, increased regulatory pressure, and maturing markets will put further pressure on margins9. Detecon forecasts that in the mid-term, the EBITDA margin’s median of the operators in scope will develop towards a value of well below 40%.

Since the concentration on higher value customers and advanced services require ongoing investments in new technologies, the pressure on EBITDA and net profit remains and thus the value contribution to the groups as a whole in terms of Economic Value Added (EVA®) remains uncertain.

8 EBITDA = Earnings Before Interests, Taxes, Depreciation & Amortisation.

9 Compare “Adapting to the challenges of a harsh operating environment: operator business models in Europe” (Informa Media and Telecom, 09.09.2009).



-40% -30% -20% -10% 10% 20% 30% 40% 50%-50% 0%

Min

-2%

Median

12%

Max

31%

-40% -30% -20% -10% 10% 20% 30% 40% 50%-50% 0%

Min

-7%

Median Max

5%


Figure 5: KPI 2 – EVA®10 as of revenue

Comparing EVA® or the value creation for shareholders seems to result in a more distinct picture. The median value of our assessed mobile operators is still around 12%, while the same figure of the peer operators equals zero. In line with the EBITDA spreads above, the spread of EVA® values of the operators in scope is much wider than the EVA® spread of peer operators: very well-performing operators on the one hand and value-destroying ones on the other. These findings highlight that Eastern European subsidiaries do not necessarilygenerate added value for global players.

Therefore peer operators have to collaborate closely with their local subsidiaries in terms of tracking and improving key performance indicators. This conclusion gains even more importance since Detecon expects value contributions of Eastern European operators to follow those of their peers. This is based on the assumption that firstly, EBITDA is the main driver for EVA®, and secondly, that capital costs tend to increase in times of economic troubles, as recently happened in Greece11. As a consequence of being downgraded by the rating agencies S&P and Moodys, average capital costs will probably increase, which subsequently will result in higher capital charges and thus will put further pressure on EVA®. Nevertheless, our benchmark results show that most companies are value contributors, but parent organizations should carefully consider divestment options, keeping in mind that the overall economic situation will need time to improve. Tight portfolio management is necessary, especially in times of economic troubles and because cash flows are the most important valuation methods for our operators in scope12.

10 Economic Value Added® (calculated as net profit after tax minus capital charge).

11 Compare “Papandreou tries to prop up the pillars” (The Economist, 17.12.2009).12 Compare “Value-based management: an approach for wireless network operation service

companies” (C. Carter in Journal of Telecommunications Management, Vol. 1 2008, p. 46 ff).



But what are the key levers for the free cash flow of telecommunications operators? Capital expenditures around 10% of revenue are standard in the industry and cannot be reduced considerably when new technologies like LTE13 are waiting for implementation. That leaves working capital and operating profit as drivers. From the authors’ point of view variable costs in the telecommunications industry are mainly interconnection charges and leased lines, controlled by the regulatory authorities. Finally fixed costs will remain the major cost element to significantly influence operating profits.

A suitable KPI for managing flexibility in cash flows is operational gearing, measuring theproportion of contribution after variable costs to operating profits. The lower the operational gearing, the higher the flexibility of cash flow, which in turn will reduce the company’s business risk.

3.4

3.2

3.0

2.8

2.6

245

240

235

230

225

220

215

07979787777

Fixed cost in % as of total costs

Ope

ratin

g P

rofit

in M

io. €

Op

era

tion

al G

ea

ring

Operating Profit

Operational Gearing

Figure 6: Fixed Costs vs. Operational Gearing

Our sample mobile operator in figure 6, which is representing the median company in terms of operational gearing, is suffering from massive operating profit decreases since the operational gearing rises disproportionally compared to the fixed cost increase. Apparently this operator is facing a major business risk if Eastern European mobile markets develop as Detecon predicts.

13 LTE: Long Term Evolution – a new high-speed air interface for cellular mobile communication systems.



1.5 2 3 3.5 4 4.5 51 2.5

Min

1.7

Median

2.5

Max

3.1

1.5 2 3 3.5 4 4.5 51 2.5


Min

2.9

Median

3.1

Max

3.8

Decreasing cash flow flexibility

Figure 7: KPI 3 – Operational Gearing

For operational gearing, our benchmark results show a median value of 2.5 for our operators in scope. That is still well below the minimum value of the peer group, indicating higher flexibility on operational cash flows. Detecon predicts operational gearing for these operators to develop towards the peers’ value, due to:

slightly increasing contributions and revenues,

higher fixed costs for marketing, customer management, distribution and network quality because of increased competition, and

continuously high or even increasing depreciation charges, since the recently seen value decline of “non-euro local currencies” will lead to an effective increase in the price of network equipment, which is mostly denominated in US dollars or in euros.14

Some stars in Eastern Europe have a very low operational gearing and their management is not yet aware of the rising importance of managing fixed costs; they are still tackling pure growth problems. Managing fixed costs in growth markets is less important compared to mature markets, as a higher degree of fixed costs could even result in higher operating profit margins if the subscriber base is still growing15. But this is no longer the case in Eastern European mobile markets. Therefore managing fixed costs and developing appropriate improvement measures will become ever more important.

So, how to cope with the increasing pressure on financial performance?

14 Compare “Financial crisis hits central and eastern Europe, but telecom operators take

steps to weather the storm” (Informa Research, 19.02.2009).

15 Compare “Influencing cost structures to manage risk return” (C. Horngren / M. Datar / G. Foster in Cost Accounting - A managerial emphasis, 12th edition, p. 75, 2007).



4 Strategic Measures

Maintaining the current financial performance of Eastern European mobile operators will only be possible by joint efforts from local executives in the subsidiaries and global executives inheadquarters.

Measures for local operators:

Stabilize existing revenue streams, by turning pre-paid subscribers into more valuable post-paid subscribers. Introducing innovative tariff pricing would engage customers for such a move, as has been shown in Japan with a post-paid share of 98%16. T-Mobile and Telefonica in the Czech Republic have also shown that it can work.

Conquer the broadband market via 3G/4G and assess wireline partnerships while take-up is still low.

Increase customer’s share of wallet by offering a comprehensive service portfolio (voice, data, VAS, TV), based on a solid broadband infrastructure.

Improve operational performance by centralizing functionality, simplifying internal structures, and harmonising technologies.

Measures at the corporate level:

Set up a clear portfolio monitoring of Eastern European subsidiaries in terms of value contribution and operational risk.

Based on portfolio monitoring, consider divestments of value destroyers. Value contributors should be further developed to have sufficient cash contributions in the future.

Consider local joint ventures in highly competitive markets as Orange and T-Mobile have done in the UK.

Define clear corporate-wide roadmaps for technological investments (FTTH, 3G/4G) and telecommunications services upon these platforms. Invest in group-wide homogenous platforms to reduce OSS complexity.

Develop standardized marketing services which should be customized according to the local cultural environment, as Vodafone is doing with its “live!” platform.

Develop global content sourcing strategies to benefit from economies of scale for the local subsidiaries.

16 Compare “Mobile Pricing Innovation” (IDATE, 2008).



5 Potential Detecon Support

Detecon is familiar with both views, those of the local subsidiaries and those of group headquarters. How could Detecon support each of the stakeholder groups?

Potential Detecon support for local operators:

Developing and implementing market strategies for new products & services and developing innovative tariff structures, addressing the need to stabilize revenue streams.

Developing and implementing cost accounting systems to create costing transparency.

Developing and implementing programs to improve operational performance, e.g. for network and customer care optimization.

Developing and implementing business planning & budgeting processes and toolsto transform strategies into quantified plans of action.

Developing and implementing wholebuy strategies to enable fixed-mobile-convergence for mobile-only carriers to sustain revenue growth.

Optimizing the wholesale portfolio for local incumbent operators.

Providing regulatory support for interconnection regulation.

Potential Detecon support for global carriers:

Developing and implementing strategies for managing stakes in Eastern Europe, with particular focus on corporate governance and synergies.

Developing and implementing performance management systems to better steer Eastern European stakes.

Developing regulatory strategies from a global perspective.



6 The Authors

Patrick BraunschweigSenior Consultant Corporate FinanceMobile: 0049 151 146 22779

eMail: [email protected]

André WilbertSenior Consultant Wholesale StrategiesMobile: 0049 160 906 39195

eMail: [email protected]



7 The Company

We make ICT strategies work

Detecon is a consulting company which unites classic management consulting with a high level of technology expertise.

Our company's history is proof of this: Detecon International is the product of the merger of the management and IT consulting company Diebold, founded in 1954, and the telecommunications consultancy Detecon, founded in 1977. Our services focus on consulting and implementation solutions which are derived from the use of information and communications technology (ICT). All around the globe, clients from virtually all industries profit from our holistic know-how in questions of strategy and organizational design and in the use of state-of-the-art technologies.

Detecon’s know-how bundles the knowledge from the successful conclusion of management and ICT projects in more than 160 countries. We are represented globally by subsidiaries, affiliates, and project offices. Detecon is a subsidiary of T-Systems International, the business customer brand of Deutsche Telekom. In our capacity as consultants, we are able to benefit from the infrastructure of a global player spanning our planet.

Know-how and hands-on expertise

The rapid development of information and telecommunications technologies has an increasingly significant influence on the strategies of companies as well as on the processes within an organization. The subsequent complex adaptations affect business models and corporate structures, not only technological applications.

Our services for ICT management encompass classic strategy and organization consulting as well as the planning and implementation of highly complex, technological ICT architectures and applications. We are independent of manufacturers and obligated solely to our client's success.

Detecon International GmbHOberkasselerstr. 2

53227 BonnTelefon: +49 228 700 0

E-Mail: [email protected]: www.detecon.com

Managing the Profitability of Eastern European Mobile ... fileoperators (Vodafone, Telenor, Verizon,...

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