French Wireless Players Will Adapt Well To Iliad's Entrance

By Allan C. Nichols, CFA

We are excited about Iliad's recent launch of a fourth wireless network in France, as concerns about its entry have been overhanging the market for two years. We have long said that Iliad won't be as successful as management expects and, more important, won't cause as much pain as the market anticipates to existing operators France Telecom (FTE), Vivendi (OTCPK:VIVHY), and Bouygues (OTCPK:BOUYF). We continue to believe that as a fourth entrant this late in the game, Iliad will be less successful than it predicts and will not reach the penetration rates the market expects.

Japan. Like Iliad, Softbank made big claims about disrupting the wireless market when it acquired Vodafone's business in Japan. Softbank founder Masayoshi Son is a self-made billionaire thanks to the Internet, similar to Iliad founder Xavier Niel. Son made lots of statements about cutting prices and changing the wireless world in Japan when he acquired Vodafone's Japanese business in 2006, similar to what Niel has said about Iliad and the French wireless market. However, after initially cutting prices, Softbank later raised them back as it wasn't having much success. It wasn't until Softbank gained exclusive rights to the iPhone in 2007 that it gained meaningful market share. Since exclusive handset deals are not allowed in France, Iliad can't use such a strategy to gain share.

France Is Our Favorite Wireless Market

France epitomized our favorite wireless market: It had only three operators, each with its own network, and all behaved rationally. That changed with Iliad acquiring a fourth wireless license at the end of 2009 and stating its intent to aggressively cut prices. In response, the existing operators have been reducing prices in preparation for Iliad's entrance and have launched separate lower-value brands. Iliad launched service in January with even more aggressive pricing than we expected. However, the other operators responded in kind. An important item to remember is these low-priced brands are only available through the Internet, while most consumers, especially high-value contract customers, want to visit a store.

We believe that the market has overreacted to Iliad's threats and that all three existing telecom operators in France are undervalued. In our opinion, the market is pricing in substantial customer losses and margin declines on earnings before interest, taxes, depreciation, and amortization. After our research into the success of fourth entrants in other countries, we don't think this will occur. Our favorite, France Telecom, derives only about 25% of revenue and EBITDA from its French wireless business, and if Iliad is more successful than we expect, it will need to use more of France Telecom's network capacity. Vivendi and Bouygues also have other sizable businesses that will be unaffected by Iliad.

France's wireless penetration rate is among the lowest in Europe at just above 100%. This is a level similar to several other countries when a fourth wireless operator has launched service. In these countries, the new entrant drove higher penetration rates, but didn't cause the existing operators to lose subscribers. This is what we expect to happen in France. We think Iliad will gain several million customers over time, which will drive the penetration rate in France closer to the European average. However, we expect the existing three operators to maintain their subscriber bases and to continue increasing their percentage of contract customers.

While mobile virtual network operators have grown faster than the market and now account for close to 10% share in France, the existing operators have continued to add customers as well. We expect the latter operators will be able to maintain their size; they may decline some in 2012, but we expect them to recover after that.

French Mobile Subscribers and Penetration Rate

Source: Morningstar, company filings, Arcep, ITU.

MVNOs' success has caused France's existing operators to steadily relinquish share at the low end. However, this has been more than offset by success gained from focusing on more profitable contract customers. We think Iliad will have a greater effect on MVNOs than on the existing operators.

The size within a country matters to telecom companies' profitability. Even in benign France, Bouygues' smaller size means lower EBITDA margins. Bouygues has consistently had EBITDA margins about 10 percentage points lower than France Telecom and Vivendi. Even with more than 10 million customers, it is still well below the other operators' margins, despite having a higher percentage of contract customers. None of Iliad's customers are traditional contract customers, and we expect it to struggle to reach even Bouygues' margins.

Fourth Entrants, Country by Country

Poland. We think the closest comparison to Iliad is Novator in Poland. In four years of operation, Novator has gained about 11% share, far more than any other late entrant, thanks to its more aggressive pricing. However, the existing operators basically have maintained their subscriber bases, while Poland's penetration rate jumped from around 100% to above 120%.

The existing operators' performance was hurt more by aggressive mobile termination rate cuts than by Novator. In 2006, Poland had one of the highest MTRs in Europe. The government aggressively brought that down to the European average in the next four years, with the largest cut of 36% in 2008, which drove down revenue across the board in 2009.

The reduced revenue affected the operators differently. While the lower revenue also hurt France Telecom's margins, Deutsche Telekom managed to increase its margins as it was recovering from disruptive fights for control among its large shareholders. The MTR cuts were exacerbated by Novator's aggressive pricing. France Telecom's prepaid wireless base declined 11.5% during the year, but its contract base grew 7.5%.

Spain. Yoigo and Spain's MVNOs benefited from the country's severe recession. Historically, telecom operators have been fairly immune to downturns in the economy. However, Spain's recession has been so severe, with unemployment exceeding 20%, that customers have been scaling back usage and using lower-priced offerings from Yoigo, owned by TeliaSonera, and the MVNOs. However, the other operators only temporarily lost customers.

Once again we see the importance of size. Telefonica has more than 40% market share, allowing it to have substantially higher margins than even number-two Vodafone, let alone number-three France Telecom. Despite Yoigo's recent growth, it took four years to reach EBITDA break-even.

Italy. Despite gaining 5.6 million customers in its first two years of operation, 3 Italia hasn't hurt the Italian wireless industry. The other operators continued to add subscribers following 3 Italia's entrance, with growth not slowing until the global recession in 2008. Telecom Italia then used the recession as an excuse to clean up its subscriber base, which included large numbers of customers who hadn't used their phone for months. Italy is predominantly a prepaid wireless market, similar to most emerging markets. In these countries, companies tend to be less strict about when they remove subscribers from their rolls.

Fourth entrant 3 Italia only succeeded in reaching EBIT positive for an entire year in 2010, seven years after it launched service, and even then it was due to a one-time EUR 146 million benefit because of the receipt of 10 megahertz of spectrum in the 1800 MHz band. The firm's profitability struggles occurred despite having a wealthy parent, Hutchison Whampoa, with significant telecom experience and a superior network. The firm launched service with its entire network 3G, while most of its competitors were still mostly 2G based. Iliad has significant experience operating a broadband operation, but this can be quite different than managing a wireless business with full responsibility for the network.

Japan. Like Iliad, Softbank made big claims about disrupting the wireless market when it acquired Vodafone's business in Japan. Softbank founder Masayoshi Son is a self-made billionaire thanks to the Internet, similar to Iliad founder Xavier Niel. Son made lots of statements about cutting prices and changing the wireless world in Japan when he acquired Vodafone's Japanese business in 2006, similar to what Niel has said about Iliad and the French wireless market. However, after initially cutting prices, Softbank later raised them back as it wasn't having much success. It wasn't until Softbank gained exclusive rights to the iPhone in 2007 that it gained meaningful market share. Since exclusive handset deals are not allowed in France, Iliad can't use such a strategy to gain share.

Vodafone already had 17% share when it sold its business to Softbank, yet Softbank still couldn't maintain profitability with low prices. If Softbank couldn't succeed starting from an existing number-three position, we don't see how Iliad will be significantly profitable starting from scratch at the number-four spot. As Softbank has increased its prices and until recently benefited from exclusive rights to the iPhone, it has succeeded in increasing its EBITDA margins to KDDI's level. Impressively, eMobile, with its smaller size but focused approach, became EBITDA positive in the fiscal year ending March 2010 and approached Softbank's margins the following year. However, its success hasn't prevented the other operators from adding subscribers and improving their own margins.

Germany. Telefonica entered the German market shortly after KPN. By entering early, Telefonica grew in line with KPN. However, even though both firms began operations when German penetration rates were below 20% and were around for the big spike in penetration rates in the late 1990s, their subscriber bases significantly trailed the size of the two largest operators.

Even more revealing than size is profitability. While KPN has expanded its EBITDA margins to the level of the first two operators, Telefonica hasn't. Telefonica has continually competed much more on price, which has hurt its margins and only recently provided some benefit in market share.

United Kingdom. France Telecom, the fourth wireless entrant in the U.K., became the largest operator by subscribers but couldn't maintain it. For a short time in the early 2000s, the Orange brand became very popular and shot France Telecom to number one. However, the superior networks of Vodafone and Telefonica allowed them to regain the lead. As in Germany, the fourth entrant came to the market early, only a few months after Deutsche Telekom in 1996, when penetration rates were below 12%. This was early enough that they both gained share proportionally with the market during the big runup in penetration rates in the late 1990s. The U.K. picked up a fifth operator, 3 UK, in 2003, whose performance is closer to the fourth operators in other countries.

Like its sister company in Italy, 3 UK didn't reach EBIT positive for a full year until 2010, and again it was due to a substantial one-off gain (GBP 500 million), this time from a revised network-sharing agreement.

Besides five operators until France Telecom and Deutsche Telekom formed a joint venture (Everything Everywhere), the U.K. probably has the most MVNOs and the largest ones. Virgin Mobile, now part of Virgin Media, started in 2000 and at one point had more than 6 million customers. The MVNOs' combined subscriber base peaked above 12 million, or about 22% share. Many MVNOs have been very aggressive on price, which caused initial leader Virgin Mobile to change strategies and focus on more profitable contract customers, allowing its prepaid base to bleed away. All these competitors have driven EBITDA margins lower.

We think the U.K. represents the absolute worst case for France. If French EBITDA margins fell to 22%--about the average in the U.K.--it would knock off about EUR 1.5 billion from France Telecom's EBITDA, EUR 1.2 billion from Vivendi's, and EUR 130 million from Bouygues'. This would lower our total EBITDA estimates for the firms for 2012 to about EUR 13 billion, EUR 7.2 billion, and EUR 3.3 billion, respectively, providing them with enterprise value/EBITDA multiples of 4.9, 4.8, and 3.3. This is hardly expensive and we think it demonstrates the amount of business these firms have that is unrelated to the French wireless market and how much the market has overreacted to Iliad's entrance. We also doubt the margin declines will be uniform or this severe; France Telecom's and Vivendi's margins wouldn't drop as low as 22% even in the worst-case scenario, while Bouygues would probably drop a bit more.

Existing Operators Have Been Overly Punished

France has been considered the ideal market for an aggressive new entrant because of its relatively high-priced service and low mobile termination rates, which at EUR 0.015 are about half of the European average. This means a new operator doesn't have to spend as much connecting its subscribers to the other networks. However, the higher rate comparison isn't a clean one. Rates are also affected by the mix of contract and prepay customers. Contract customers generally use their phones much more and thus have higher rates. France has a higher percentage of its users on contracts than other European countries. Excluding MVNOs, the French contract rate increases to 75%.

The telecom industry's history is rampant with mergers in order to gain scale. In-country scale is particularly important, as the more customers a company has who talk to other people on its network, the lower its costs as it avoids roaming and MTR costs. After a review of fourth operators in other countries, we think Iliad is too late to the game in building the scale necessary to be as successful as management claims it will be--or as the market has assumed, given its stock price. Conversely, we think the market has overly punished the existing operators, which already have scale. While Iliad's more aggressive pricing strategy may attract several million customers over time, we continue to think these will be more price-conscious people who generate lower margins.

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