By
Morningstar
:
By Allan C. Nichols, CFA
Iliad ((ILD.PA)) had the fastest start on record for a fourth
entrant into a wireless market, demonstrating the risk that this
fledgling firm poses to France's existing operators France Telecom
(
FTE
), Vivendi (
VIV
), and Bouygues (BOUYY.PK). In its first quarter of existence,
Iliad added 2.6 million subscribers. France's Big Three wireless
firms prepared for Iliad's aggressive launch by offering SIM-only
plans and reduced pricing, but their results still were dwarfed by
Iliad's.
However, while this performance was exceptionally good, it is
not reflective of what we expect to see going forward. The SIM-only
business--in which a customer pays for a SIM card to get service
only, bypassing the cost of a new phone-- accounted for less than
5% of the entire French wireless market at the end of the first
quarter. While we expect this segment to grow faster than other
wireless divisions, the other operators' market shares still
dominate. We think the market is too focused on the SIM-only aspect
and not the total share held by France Telecom, Vivendi, and
Bouygues. So despite recently reducing our fair value estimates on
these three incumbent operators (to EUR 19, EUR 22, and EUR 43,
respectively), we continue to rate them as buys, with France
Telecom remaining our favorite.
The Mobile Numbers Game
The amount of requests for transferring carriers has increased
steadily since mobile number portability was introduced in France
in 2003, but Iliad's entrance in January produced a giant
spike--jumping to more than 2.6 million in the first quarter from
the previous high of 1 million just a period before. The mobile
number portability system was overwhelmed by the requests and the
system didn't catch up until mid-March. We believe there was
significant pent-up demand waiting for Iliad's entrance (it had
been announced for two years) and this caused the jump in transfer
requests. All three operators reported that transfer requests had
returned to near normal by mid-March and have stayed that way
since. With that initial demand complete, we expect transfer
requests to continue receding toward the previous trend line.
However, with four operators rather than three, the request rate
likely will stay a bit higher.
Roughly one third of Iliad's subscribers were new wireless
customers, which increased the French wireless penetration rate.
The rest were taken from the existing operators, and to a lesser
extent the mobile virtual network operators (MVNOs). This was split
between contract and prepay customers, with France Telecom and
Bouygues losing more contract subscribers than prepaid ones, while
Vivendi went the opposite way.
However, there have been some comments in the French press
regarding poor quality at certain times from Iliad's network, and
we expect some customers actually will transfer back to the
existing operators after trying out the new service. The majority
of Iliad's calls are currently being carried on France Telecom's
network, but the contract between the two specifies that Iliad's
customers are not to jeopardize France Telecom's subscribers. Thus,
when networks become congested, Iliad's customers are cut off. We
think customers who need reliable networks--and generally produce
the highest average revenue per user ((ARPU)) -- will not transfer
to Iliad.
The Switching Season
Seasonality exacerbated the existing operators' subscriber
losses. Historically, the fourth quarter has the largest subscriber
gains because of the Christmas selling season.
This is followed by a weak first quarter as some customers choose
to switch carriers after initial contracts and incentives expire.
While Iliad's launch missed the Christmas season, the company
benefited from the number of customers with expiring contracts,
which enables easier carrier switching. In our opinion, this is the
biggest risk to the existing carriers as contract customers
generate significantly higher ARPUs than those who prepay. So, even
if margins can be maintained on customers taking up the new
Internet offerings (we actually think margins are lower on these
offerings), the contribution of earnings before interest, taxes,
depreciation, and amortization (EBITDA) will be much lower.
The three incumbent operators have been pushing prepaid
subscribers to move to contracts, which enhances ARPU and reduces
churn. All have lost prepaid customers and gained contract
subscribers during the last six years--increasing the percentage of
customers on contracts. Despite the lost customers in the first
quarter, the existing operators continued to increase the
percentage of their subscribers on contracts.
Au Revoir MTR
One issue that has been hurting all wireless carriers in Europe:
mobile termination rate cuts.
However, MTR cuts are further along in France than in most other
European countries, and we don't think the market is appreciating
this. On July 1, MTRs dropped from EUR 1.50 to EUR 1.00 and will
decline to EUR 0.80 on Jan. 1, 2013. They can't go below zero, so
at most there will be one more meaningful cut beyond the first of
the year. After that, any cuts will have a limited effect. MTR cuts
have been hurting wireless revenue for seven years, so after they
are gone, the French wireless business once again has a chance to
generate positive revenue growth.
Revenue and Margins Will Get Worse Before They Get
Better
Vivendi's EBITDA at its wholly owned French telecom subsidiary
SFR held up particularly well during the first quarter, actually
increasing by 0.8%, though this includes success with its
fixed-line business. Bouygues' EBITDA declined by 8% year over
year, as the company was hurt worse by MTR cuts once the premium it
had been allowed to charge ended. France Telecom doesn't break out
EBITDA by division during the first and third quarters, but we
anticipate that EBITDA for all three firms will decline further
during the rest of the year for two reasons: First, the
first-quarter year-over-year comparison was relatively easy due to
the change in value added tax last year, which hit the first
quarter particularly hard. Second, the operators have now lowered
pricing on their core wireless offerings, not just their SIM-only
Internet accessible offerings that compete directly with Iliad. As
contract customers roll off of their existing contracts, renewals
will be at lower rates, which will pressure revenue and margins for
the next 24 months.
Big Three Still in Buy Territory
We think the market fears that the first quarter was not an
aberration and Iliad will continue to take huge market share. This
is a mistake, as evidenced by the much lower number of customers
switching carriers since mid-March. However, we do think Iliad's
success has driven the existing operators to cut pricing for their
core customers more than we initially projected, which flows
through to lower margins. This is the reason we have reduced our
fair value estimates on the existing operators, but even with these
cuts, the stocks are still trading at huge discounts. While it may
take some time for sentiment to change, we expect these stock
prices to recover eventually.
We continue to prefer France Telecom
because of its partial hedge from reselling capacity to Iliad.
Initially, France Telecom expected up to EUR 1 billion in revenue
over six years from Iliad; it now expects at least EUR 1 billion in
the first three years from Iliad. If Iliad is more successful, that
amount would increase.
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