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Thursday, May 10, 2007

Virgin Media Q1 – The Lady Doth Protest Too Much, Methinks

Another quarter, another Virgin Media conference call, another tantrum thrown at Sky. Personally, I think it is all getting a bit ridiculous especially given that most of the current Virgin Media problems are self inflicted.

Balance Sheet

The Cable Industry loves leverage: this has been the case since the early days of US cable and the model was perfected by John Malone at TCI over many decades. The theory goes that the interest payments eats all the profits and therefore no tax needs to be paid over to the government. The cashflows guarantees the debt and the cashflows steadily rise over time given that monopoly rents can be extracted by addiction to the tube. The leverage leads to greater shareholder returns on a percentage basis than a non-leveraged business model, especially as the business is valued on multiples of cashflow.

The corollary of this is that in times of falling cashflows or rising interest rates the equity can easily and quickly be wiped out and the debt holders take over. This is what effectively happened in the UK Cable Industry a few years ago: ntl ran around buying as many cable systems as possible using bondholders’ money and then didn’t generate enough cashflow to keep the bondholders happy. The bondholders effectively took over the company, installed new management, bought the only other UK Cable system of any serious size, bought a MVNO to give it an ultra-fashionable quad play and more importantly a fresh brand.

So at the end of Q1, Virgin Media had net debt of £5,747m with a weighted average cost of debt of 7.9% which equates to around £454m of annual interest charges. Most of the debt is in US Dollars and floating rate, which probably means the skills of the Virgin Media Treasury department in predicting future interest and exchange rates are far more important than any contract negotiations with Sky.

Cash Flow

Virgin Media love to use OCF metrics which they claim is a good measure of the underlying performance of the business. However, I’m old fashioned and prefer to look at the Cash Flow Statement, which shows net cash provided by Operating Activities of £106m, whereas net cash used in Investing Activities is £147.9m. This implies a cash outflow from the business of £41.9m before interest charges of around £110m.

This is really, really important because if things continue as in Q1 Virgin Media will not be around for much longer without generating some cash or changing the capital structure of the business. Of course, the extremely poor Q1 cashflow could be due to seasonal factors, however if we look at Q1 2006 net cash provided by operating activities was £207.3m and capex was lower than in 2007. So Q1 2007 was not a blip.

The Virgin Media capex statement in itself is extremely interesting because it shows that they are capitalizing the cost of CPE or set top boxes. CPE accounted for £62.5m out of total quarterly capex of £152.9m . Another way of looking at this is that CPE costs do not feature in the Virgin Media OCF calculation as they are depreciated below the line. As far as I aware, BSkyB immediately write-off the cost of CPE as part of subscriber management costs and in fact ownership of the box transfers to the customers. It is hardly surprising that BSkyB charge for their HD and Sky+ boxes, whereas Virgin Media give them away like candy.

Even more interesting is that Virgin Media only spent £3.5m on upgrading or rebuilding systems, with an additional £15.4m spent on “scalable infrastructure” – this is hardly the spend of a cable company busy upgrading its systems getting ready for DOCSIS 3.0 and 50meg to the home. In fact, it smacks of a company spending the absolute minimum to keep things going.


Virgin Media appears to have done extremely well attracting TV customers in the first quarter with 36k net adds on marketable homes of 12.7m. BSkyB added 51k TV Customers in the UK and Ireland on marketable homes of 26.8m.

In fact Virgin Media added 75.2k digital TV customers which are more than Sky added in a much smaller addressable area. However, Virgin Media lost 39.1k analogue TV customers. Sky can hardly be blamed for Virgin Media still having 309k analogue customers, even after a decline of 220k year on year.

I would argue strongly that Virgin Media should be upgrading its network and customers and then we could compare apples with apples in the payTV market.


Telephony is an area that Virgin Media are struggling after losing 182k customers year on year. Unbelievably, Virgin Media don’t blame Sky for their problems, but instead focus on Carphone launching the free broadband offer which I think is also missing the mark. Instead they should be focusing on their own actions: to go a full twelve months without reacting and not expecting major churn is more than a little naïve.

I estimate that Virgin Media still have around 398k single play telephony customers which is a drop of around 235k y-o-y (bear in mind some of these customers could have been upsold broadband or TV as well as others churning off the network). Virgin Media were charging these customers £11/month line rental + call charges – obviously there was better deals in the market. These 398k telephony only customers and additionally the 309k analogue TV customers represent the soft vulnerable underbelly of the Virgin Media customer base.


Someone on the call questioned the Virgin Media net adds in on-net broadband being quite low at only 89k as a percentage of the overall market - I’m not so sure. The broadband penetration of homes passed of 26.7% is actually really good and I think cable broadband must be outselling DSL in most common areas. I tend to agree with the Virgin Media Executives that broadband is potentially the Virgin Media ace in hole, but I am a little concerned that they will lose the advantage over time through a lack of investment in capex.

First of all, Virgin is keeping quite mum of the roll-out plans for docsis3, but making lots of noise about 50meg to the home. It seems obvious at least to me that in its current state Virgin Media can’t afford a rapid nationwide rollout of docsis3 technology to the UK.

Second, I am concerned about the recent capping applied to heavy downloaders. In a scenario where there is no capacity constraints no capping would be required and obviously caps destroy the urban myth that the cable network is magically different than the adsl network. To be fair, Virgin Media caps are still probably the least restrictive of all consumer ISPs in the UK.


Business is a very important segment to Virgin Media – representing £163m of revenues in Q1 compared to £637m across the whole of the consumer segment. I was extremely interested that there are murmurs that the business might be up for sale. Personally, I just can’t see how the consumer and business segments could be separated. I also think that Virgin Media have never fully exploited their network assets especially in the SME sector.


Virgin Mobile has effectively withdrawn from third party acquisition and this accounts for the falling subscriber numbers and the increased OCF in Q1. I actually believe this is a very interesting change of approach, but Virgin Media have to be really quick in building their own distribution network and gaining traction on their base. I am currently a total non-believer in the quad play, but if Virgin Media could minimize subscriber acquisition costs, allied to a very good network services contract with T-Mobile and generate enough traffic, I could be converted in the near future.

I am certain that the prepaid MVNO model that Virgin Mobile operated upon previously has a very short life span. The figures published in Q1 imply there is some pain to come in bridging the gap: a drop in prepaid numbers allied to an increase in contract customers should theoretically indicate a jump in ARPU figures. The fact that Virgin Media’s has dropped by 5% without a big drop in prepaid rates implies to me that there is a large number of people with very low activity – in other words there is a big buffer of churners to come.


Despite the well published drop in Sky payments, the division actually managed to increase OCF. Apparently, the increase was all due to litigation - enough said.


Virgin Media was struggling before the partially self inflicted wound of the removal of Sky Basics channels from the Virgin Media TV offering. I personally feel that Virgin Media is using Sky as a convenient scapegoat for its lack of performance in the ultra-competitive UK communications market.

The other problem for Virgin Media is that when you examine the BSkyB recent quarterly results especially when you look at their cashflow performance they are also suffering , but the big difference is that Sky are making large infrastructure investments in developing a triple play.

Another problem for Virgin Media is that when the noise abates and the economists have spent months or years studying the UK communications market, I can’t see how anyone can say that that Sky is a monopolist. In fact, I wouldn’t be surprised if Sky gains more flexibility because convergence has actually reduced their historical market power.

But the biggest problem for Virgin Media is that their balance sheet is based upon the premise of extracting monopoly rents from appreciating assets. Unfortunately for Virgin Media, there is no monopoly in the UK market or even a situation comparable to the US cable companies and neither is there likely to be. Furthermore, I don’t believe that even political and media lobbying of gargantuan proportions will change the situation.