Iliad: The Storm Before The Calm

Jul.25.12 | About: Orange (ORAN)

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 (NYSE:VIV), and Bouygues (OTC:BOUYY). 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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