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Sunday, January 14, 2007

TalkTalk: The £680m Carphone Gamble

An alternative format of the TalkTalk customer numbers shows how difficult Carphone is finding it to grow the base organically. The big leap in customer numbers at the end of 2005 was due to an acquisition of 1.336m customers from Onetel and Tele2 for a combined £142.8m. The big leap in 2006 has been caused by the acquisition of 1.523m (excluding narrowband customers) from AOL for £370m.


Basically, TalkTalk has three product offerings: voice, data and double play.

Approx. 50% of TalkTalk’s Double Play customers are coming from the existing voice customer base, which means net around 215k voice only customers have left TalkTalk since broadband was launched in Mar ‘06. Carphone never mentions in any presentations the dreaded “c” word that bedevils telecoms profitability, but it looks to me like the pure voice business is starting to suffer from churn. As far as I’m concerned this puts a huge question mark over the £143m acquisition of Onetel/Tele2. Carphone already wrote-off below the line in the 0506 accounts £35.2m in costs, if churn continues on the present scale than more write-offs are inevitable.

Also, of note here is the 850k base on the Wholesale Line Rental (WLR) service which is a zero margin product designed to reduce churn. This is a £100m per annum turnover business which is basically a collection agent for BT.

The profitability of voice-only customers remains a mystery; Carphone only reports profitability at the “contribution” level which is a meaningless metric. In addition, Carphone never publicly discloses ARPUs, SACs or Churn figures and therefore reasonable analysis is impossible. I am totally surprised that the analyst community lets Carphone get away with it. In 2004 through 2006, TalkTalk UK Residential reported revenues of £30.2m, £159m, £306m and contributions of (£11m), £2.3m, £24.3m which gives in the first three years a turnover of £495m and a contribution of £15.6 – this is before support costs, depreciation and the £35m write-off in 2006.

Basically for all the talk of market share and acquisitions, I’m almost certain that Carphone has been losing money on “voice-only” services since day one in Feb 2003.

Carphone launched broadband in April 2006 and everything is claimed to be going to plan at least financially. The customer service issues are well-documented and it is not worth repeating them here. It is apparent that the rate of customer signup has sharply dropped in the last quarter, which is hardly surprising given the bad publicity. Post-Christmas, Carphone are starting to re-market the product again and is offering a 30-day trial period before the 18-month contract kicks-in. This is obviously a ploy to allay fears about poor service, however it could be extremely expensive, because I seriously doubt that Openreach will perform the LLU tasks for free.

This year was always forecast to be heavily loss making for Carphone with a cash investment of £110m in broadband. The key will be next year when broadband (before the AOL impact) is forecast to make £30m at the EBIT level (which is a very reasonable metric and I look forward to them publishing this) and the first 18-month contracts start to expire and therefore churn may or may not start to be material in Q4.

The AOL transaction is important is de-risking the LLU capacity issue – most of the original 1000 unbundled Carphone exchanges will now have a lot more than 250 customers which is the breakeven point for LLU deployment. This is incredibly good news and should not be underestimated. However, AOLs strategy was only to partially unbundle (ie still have voice on a BT line) which TalkTalk admit themselves is far less profitable than a fully unbundled line.

Carphone plan to communicate with all AOL customers at the end of January offering a transition to the TalkTalk almost-free-broadband offer or “some extra value” on the current package which almost certainly means a discount. Carphone would only be offering a discount if churn was material. This is the next problem in that the AOL brand is much stronger than the TalkTalk brand. I don’t believe that Carphone will continue to invest in the AOL brand in marketing promotions. If Carphone is not careful they could quite easily see a steadily declining AOL base. £380m is a lot of money to pay for a declining base.

In short, Carphone faces severe problems in all three residential divisions: voice (from churn), ex-AOL (from potential churn) and Unbundled Double Play (getting the process to work and starting to make money), personally I don’t envy their situation even before the impact of competition.

The key feature in recent history of telecommunications since privatisation (25 years) has been of a hugely capital intensive business where waves of innovation mean that returns from investments are difficult unless the company has huge scale. The investment in LLU has hardly begun before Carphone competitors are layering new features to the plain vanilla service Carphone is offering. The first bunch is the mobile operators, including Orange and Vodafone, who are bundling fixed and mobile service together in a way that Carphone can’t and causing tension with Carphone in their profitable retail business. BT, Sky, Tiscali and Orange are offering video services which Carphone could replicate with more investment. Any this is before Carphone’s most important retail customer, O2, enters the market.

The point is nine months on from the original TalkTalk not-so-free-broadband launch it is not standing out any more as particularly cheap, it is certainly not the most feature rich service and in every survey I’ve seen comes bottom of the list in customer service metrics. 2007 is going to be especially difficult for TalkTalk in the marketplace.

All told I guesstimate that Carphone has invested approximately £680m in Residential Communications (£142m for Onetel, £380m AOL, £110m Broadband and around £48m in Voice Capex and Losses) and that is before the investment in Opal Telecom of £85m and the various small investments in the business-to-business market over the last four years. This £680m is also the net debt position of Carphone which adds around another £35m of interest costs annually. I just can’t see the UK network being worth anywhere near the sums invested in it. Also, if things are going slightly wrong this year, I can see Carphone making another acquisition at Christmas next year to keep up the appearance of growth.

As I see it, this is a big shame because the retail side is really outperforming the market and is probably being held back by TalkTalk.