ENDERS |ANALYSIS

Iliad – Prospective IPO Of The Parent Of Free January 2004 [2004-02]

Executive Summary

Iliad, the parent of Free, the quirky French ISP that appears regularly in our Internet market reports, is about to launch on Euronext. Iliad held a meeting at headquarters in Paris on 16th December 2003 to showcase the company to analysts. A UK roadshow follows in late January. This company is the most interesting and innovative telecoms service provider in Europe, which is why we cover it so frequently.

Two documents were presented at the meeting: (1) the ‘document de base’ submitted to the Autorité des Marchés Financiers (AMF); and (2) a slide presentation on the company. The presentations by management were interspersed with a demonstration of the TV-over-ADSL product (works very well, including simultaneously with the telephone and PC), a visit to the call centre (one floor of the same building), the development centre (a few desks littered with ‘Freeboxes’), and a visit to a France Télécom (FT) exchange to witness unbundling first hand.

Iliad describes itself as an altnet, utilising its network capability by offering Internet access, VoIP, and TV-over-ADSL via Free, and fixed telephony services via One.tel.1 It has a modest turnover (€203 million in the first three quarters of 2003), but has grown rapidly, and is consistently EBITDA positive (€36.2 million in the first three quarters of 2003). Indeed, Free has been EBITDA positive since 2001, in contrast to major ISPs. It paid a dividend in each of the past two financial years.

Free is the core business of the company. Our interest in Free, as our readers will have noticed, is due to its rather exceptional position on the European telecoms scene. As we reported in LLU in France (2003-49), Free leads other European ISPs in terms of local loop unbundling (LLU), having unbundled 140,000 lines of a French total of 230,000 at 1st December 2003, well ahead of LDCom. We expect Free to remain ahead in 2004.

Free has used LLU to provision DSL connections at incumbent-beating prices and thus take a 15% share of the DSL market, behind first-placed Wanadoo. Free has also launched other communication services – VoIP in August 2003 and TV-over-ADSL in December 2003 – based on its technology of the Freebox, its proprietary ISP. As a result, Free’s ‘Option 1’ DSL subscribers (i.e. those supplied via LLU), that are equipped with a Freebox, enjoy fast broadband Internet access (1Mbps is the minimum guaranteed download speed), free local and national telephony, and multichannel TV service (within two kilometres of the enabled exchange), all for the small outlay of

1 No connection now with the UK reseller of the same name.

Alice Enders +44(0) 1383 881627 [email protected] ENDERS | ANALYSIS Iliad January 2004

€29.90/month. Free’s ‘Option 5’ subscribers (i.e. those supplied via an FT Wholesale DSL connection) pay the same price, but enjoy only the broadband service.

Planned for some time in 2004, the IPO will involve between 10 and 30% of the company’s capital, and valuation scenarios for Iliad range from €600 million to €1 billion.2 Iliad claims it does not really need the funds. To meet its objective of 600,000 Option 1 ADSL subscribers by end 2005 (more than four times the end-November 2003 level of 140,000), the roll-out of its network on the local loop can be fully-funded internally. Additional funds raised through the IPO will be used mainly to accelerate capex on the network. The main purpose of the IPO, Iliad says, is to establish a financial market presence to build the company’s credibility.

The company is lean. Little money is devoted to administration, marketing or consumer research, allowing communication services to be offered at a lower cost to the consumer than alternative providers. The company has achieved brand recognition mainly by generating free publicity. Management also convinced analysts that Free was owner of a valuable proprietary technology in the Freebox (to enable VoIP, TV- over-ADSL and, sometime in 2004, VoD), giving it a six-month to one-year advance over competitors in the double or triple play arena.

This business model has undeniable advantages in the highly competitive Internet marketplace. Free supplies a high-speed broadband access service for a low price (Free has a consistently superior performance rating than other ISPs supplying broadband). Free is well-positioned to attract subscribers in France, which has above- average growth potential (in relation to more mature European markets like the UK or Germany) in 2004-05. While UK household Internet penetration rate is about 50%, France’s is closer to 30%.

Less convincing was Iliad’s story about Free’s future transition to a mass-market DSL operator, although the company has already broadened its base beyond the ‘techies’. There is no migration strategy for its (highly profitable) narrowband base, as Free intends to focus its ADSL sub growth on switchers and new entrants. It has a well- frequented but unexciting portal. Free appears to have no interest in developing software to make the Internet experience more structured or safer for family use (e.g. AOL 8.0 or 9.0).

A question mark also hangs over Free’s DSL subscriber objectives for 2004 and 2005 in the light of the roughly 20% wholesale price cuts from FT on 1st January 2004 and resulting boost to Wanadoo’s competitive positioning. Free took 20% of net DSL adds in 2003 due in part to a €15.52/month price advantage on Wanadoo’s 512k service; as we noted in Wanadoo H1 2003 (2003-34), the European Commission’s ruling that predatory pricing by Wanadoo until October 2002 had prevented the company from reacting to Free’s aggressive pricing policy until FT lowered its prices. Free also benefited from being the leader of unbundling, but LDCom has also become a significant LLU player (Club Internet and 9Telecom are the associated ISP brands).

Following FT’s wholesale price decline, Wanadoo promptly announced price declines on 12 December 2003, lowering the price of the 512k service to €34.90/month, down by 23% from €45.42/month, and €29.90/month on a 24-month contract. Free responded by abandoning the 512k segment, doubling to 1Mbps the minimum guaranteed download speed on the €29.90/month offer. Free thus retains its

2 Shareholders include: management (90.97%); various venture capital funds administered by Goldman Sachs (6.9%) and other institutional investors (0.69%); and staff (2.13%). 2 ENDERS | ANALYSIS Iliad January 2004

competitive advantage of €15/month over Wanadoo’s corresponding 1Mbps service. AOL and other ISPs promptly followed suit.

This sequence of events reveals the vulnerability of altnets, like Iliad, to wholesale price declines from FT. While ISPs may be looking to build supply relationships with altnets to provision DSL at a lower cost or supply VoIP to customers, FT intends to protect its dominance over DSL supply (still over 90% of the total). Not only does FT wish to protect the return from its network build-out, but also to prevent a further new attack on its core fixed-line telephony business from VoIP. The regulator, ART, has placed emphasis on fostering network competition; hence the attractive environment for LLU and the protection provided to altnets during 2003. However, the French Government’s priority is to boost the use of broadband (like the UK Government’s goal of Broadband Britain), where France has lagged other European countries, and thus meet EU-level goals. FT’s wholesale price declines can only help meet this objective. Iliad would be wrong to assume ART’s protection is guaranteed in future.

Will Free’s unique triple play position on the French market provide sufficient basis for subscriber objectives to be met? The VoIP offer is genuinely compelling: 100% free local and national calls to fixed lines. A regular phone just plugs into the back of the Freebox. The user is required to obtain a new telephone number from Free, which is a slight inconvenience, but has not stopped roughly 60% of Freebox-equipped DSL subscribers from taking it up. Callers to a Free number pay local rate on all calls.

The fact that calls to the Freebox are charged at the local rate irrespective of where the call originates – from around the corner or from the other side of France – is among the significant attractions of Free's VoIP offer: the national rate is almost three times higher. In this regard, Free has benefited from a favourable regulatory decision from ART, providing for the regime to continue until mid-2004 at the latest, in order to permit FT and Free to resolve their dispute on the issue. FT, predictably, would like telephone calls to the Freebox to be charged at the national rate in order to dissuade use of VoIP.

We see less of an advantage for Free from the TV-over-ADSL service, at least currently. By Free’s own admission, this is a relatively weak offer in terms of content not likely to appeal to France’s potential and current pay-TV viewers, notably in the key areas of cinema, sports programming and reality TV. Coincidentally, FT and the second leading satellite operator TPS have just launched a TV-over-ADSL service in Lyons that is aimed at viewers who cannot install satellite dishes (Internet access is not included), and Canal+ is likely to follow with an offer of its own. Our view is that Free’s TV-over-ADSL service is akin to Freeview in the UK, and thus provides an advantage, but not an overwhelming one, in the ISP space. This could change in the course of 2004 if Free concludes additional contracts with producers or gains satisfaction from regulatory initiatives to force agreements through, or if VoD is introduced to attract film viewers and permit time-shifted TV viewing.

Lines of Business

Iliad has three lines of business (Table 1): • Internet access: Free and Online (web-hosting and domain names); • Fixed telephony: One.tel, offering Carrier-Preselect-Service (CPS), Kertel, a recently acquired phone card business, and Kedra, a voice call termination business; and • Other: Annu, the Minitel-based directory service.

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Annu is a profitable line of business, but in decline of course due to the gradual replacement of Minitel by Internet-based services. The rate of decline of the Minitel base is10-15% annually.

Table 1 Summary of Iliad’s lines of business, end-November 2003

Share in Share in H1 2003 revenues EBITDA revenue growth Subscribers Comment (%) (%) (%) Internet access 64 56 95 440,000 32% on Option 1 Telephony 28 36 85 200,000 One.Tel Other 8 8 -4.9 n/a Minitel-based Directory service

[Source: Enders Analysis based on company reports]

Internet access and telephony are the two growth segments. Management noted that the two were complementary. They both help achieve good utilisation on the network.

Although this report is focused on the Internet access business, it is interesting to note that Iliad has big ambitions for One.tel. (It was acquired for almost nothing in 2001 from the Paris Tribunal de commerce as a result of the bankruptcy of the Australian parent.) This could eventually have an impact on the way Free positions its VoIP offer, and thus the development of its double and triple play (see below).

Network

Free’s strategy from its inception has been to control as much of its network as is economically possible to reduce the interconnection, line rental and other charges paid to France Télécom. The larger the size of its own network, the lower the level of charges paid. Hence, Free’s current focus on further network deployment through LLU. €77 million was invested in the network in 2003.

Free does not own its 7,135km long fibre optic network. This is almost entirely provided by Indefeasible Rights of Use (IRUs) negotiated with LDCom (94.5% of the total); Free only owns 50km of the network. The IRU with LDCom has a 15-year term running to March 2018. Free has also pursued IRUs that have 10 and 25-year terms with the collectivités locales. These contracts are extremely cost-effective for Free as the local authority has made the investment in a local area fibre optic network to boost economic activity and not to make a return on the network itself.

LLU requires FT to make physical space available to permit the altnet to install its own DSLAMs. Free chose partial unbundling for financial reasons: the line rental charge is half of the fully unbundled line rental charge. Partial unbundling allows the altnet to connect to the end-user via a cable and filter rented from FT. Shared access allows FT to retain the telephony service, while the ISP provides high-speed access.

Each DSLAM is configured to supply a download speed of 8Mbps each to 384 lines. This is far more than the guaranteed minimum supply speed of 1Mbps and allows Free to offer TV over DSL.

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Freebox

The company is extremely proud of the Freebox, currently installed at 100,000 subs out of 140,000 unbundling lines. As demonstrated at the analysts’ meeting, the Freebox allows the end-user to simultaneously use the PC for Internet access, TV- over-ADSL, and telephony (VoIP only). A new slimmer model is to be launched in February 2004, but even still the current box is impressively small.

However, management noted that current configurations do not allow satellite-TV quality transmission of sports events (although the quality is perfectly reasonable). The company expects to deal with this through the new Freebox by allocating 3.8Mbps to the TV-over-ADSL, as compared to 2.8Mbps currently. If the TV-over-ADSL service is on, 2Mbps is available for the PC, which is a slightly limiting factor for multiplayer games but otherwise is sufficient.

Internet Access

Free’s Internet access business has three main components: • Roughly 200 million minutes consumed each month on a PAYG basis; • 235,000 narrowband subscribers with unlimited access up to 50 hours (€14.94/month); • 440,000 broadband subscribers with 1Mbps guaranteed download speed, with VoIP and TV-over-ADSL service for the 100,000 Freebox equipped subs (€29.90/month).

The company thus had a direct billing relationship only with 675,000 subs at the end of November 2003.

Free’s narrowband business appears, on its own admission, to be in decline, partly due to migration to ADSL. The number of PAYG minutes declined by 15%, from 1.3 billion in H1 2002 to 1.1 billion in H1 2003, but the impact on revenues was partly offset by a higher per minute return (from €0.0206 to €0.0217). Revenues were therefore down 10.9% on a year-on-year basis. However, the business remains highly profitable with a margin of 50-60%.

Narrowband subscriptions have been growing, but slowly: from 203,000 at the end of H1 2003 to 244,000 a year later, up 20%, with little change at the end of Q3 2003.

In this context, Free’s main emphasis is on growing ADSL subscribers and thus subscriber ARPU (€19/month at the end of Q3 2003, excluding PAYG). DSL connections are provisioned from FT Wholesale under ‘Option 5’ or, if feasible, on Free’s own network and using ‘Option 1’, or unbundling. As we noted in LLU in France (2003-49), Free accepts subscribers in all parts of France at the same price. In areas when it has DSLAMs it will unbundled the line and use ‘Option 1’. In other parts of France, it will purchase an ‘Option 5’ wholesale DSL product and wait until it has enough subscribers in that area before installing a DSLAM and switching to the more profitable ‘Option 1’. Profitability depends on the share of DSL subscribers migrated onto Free’s own network. From the current level of about 32%, Free intends to achieve 50% migration by the end of Q4 2004, and 60% by the end of 2005 (Table 2).

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Table 2 Free’s ADSL subscriber base, Q3 2003

Q4 2002 Q1 2003 Q2 2003 Q3 2003 30/11/2003 Q4 2005

Broadband 99,100 205,300 275,630 355,250 440,000 1,000,000 - Option 5 95,800 196,530 229,780 268,020 300,000 400,000 - Option 1 3,300 8,770 45,850 87,230 140,000 600,000 - Option 1 (%) 3.3 4.3 16.6 24.6 31.8 60 ADSL market share (%) 7.2 11.5 13.3 14.2 15 n/a

[Source: Enders Analysis based on company reports]

Under Option 1, the total operational cost per user is €4.18/month (line rental, cable + filter), with no cost from with bandwidth usage because the traffic is carried on Free’s own network. In addition, Free estimates subscriber acquisition costs (SAC) of €350 (line activation, Freebox, and DSLAM installation). Amortised over 3 years, this gives a total supply cost of roughly €13.9/month according to our estimates. Free expects the SAC will decline by 30% in 2004 due mainly to lower equipment costs, leading to a total supply cost of €11/month.

In contrast, Free estimated a supply cost of €26.50/month (€15.50 for line rental and €11 for backhaul) for a 512kps connection through Option 5 in 2003. Free however no longer offers the 512kps service, as the minimum guaranteed speed provided for €29.90/month was doubled to 1024Mbps following the French Government’s approval of FT’s new wholesale tariff. Under this tariff, the Option 5 price of the 1MB service has been reduced, and the differential with the 512k service drastically reduced. The precise impact on each ISP of these wholesale price declines depends on the distribution of its subscriber base between exchanges with less than 20,000 lines and those with more than 20,000 due to the way in which FT has structured its tariff.3 Free estimates a largely unchanged supply cost for the 1MB connection under Option 5 in 2004.

In addition, Free estimates a SAC of €100 for each Option 5 subscriber, which it expects to reduce by 30% in the course of 2004. Note that migration of Option 5 to Option 1 requires Free to cease and re-provision the line, which can interrupt the services to the customer for several days.

Management claims no net customer support costs for both Options 1 and 5 as the call centres cover their own costs by generating revenue from calls. Major emphasis is being placed on reducing wait times to no more than six minutes.

Under this cost scenario and assuming stable revenue, Free will experience relatively higher connectivity margins on ADSL starting in 2004 due to increased migration to Option 1 (Table 3). Note that Free has been supplying DSL connections to Option 5 subscribers at a net loss of about €4/month in 2003 and will continue to do so in 2004.

3 Implicitly, FT won approval for ‘de-averaging’, according to which connections supplied at lower-volume exchanges are priced higher than those in high-volume exchanges. The latter tend to be situated in high-density population centers, where LLU has made inroads. The structure thus allows FT more effectively to compete against altnets. 6 ENDERS | ANALYSIS Iliad January 2004

Table 3 Free’s ADSL connectivity margin, 2003-05

Q4 2003 Q1 2004 Q2 2004 Q3 2004 Q4 2004 Q4 2005

Revenue (€/month) 25.08 25.08 25.08 25.08 25.08 25.08 Cost (€/month) - Option 5 29.27 29.27 29.00 28.72 28.45 28.45 - Option 1 14.00 13.25 12.50 11.75 11.00 11.00 - Option 1 (% of ADSL 32 37 42 46 50 60 subscribers) Margin (%) 2.8 6.9 12.0 16.6 21.4 28.3

[Source: Enders Analysis]

One interesting point is that 40,000 Option 1 subs do not have a Freebox, but are connecting with the Sagem modem initially provided to Option 5 subscribers. Apart from the fact that VoIP and TV-over-ADSL are not available, the implications are unclear. The company has to be saving some portion of the SAC associated. The company was a bit vague on what it was intending to do about this. There was some muttering about possibly charging for the upgrade.

TV-over-ADSL

On 1st December 2003, Free launched its TV-over-ADSL offer to DSL subscribers equipped with the Freebox (100,000), but which can only be received within two kilometres of the enabled exchange. Initially offering 32 channels, Free will eventually offer 53 channels, of which 29 are fee-paying (à la carte or by subscription). An expansion to VoD is planned for 2004. Management claims the offer is designed to be entirely self-financing with channels being provided at cost.

This is not a European first. Since 2000, Kingston and VideoNetworks have offered TV-over-ADSL and VoD services in Hull and London, respectively. But the scale is very limited, just 11,000 households in mid-2003 according to the ITC.

Who will be drawn to Free’s TV-over-ADSL proposition? In relation to the pay-TV offers of cable or satellite TV operators, Free’s TV-over-ADSL offer has the advantage of not requiring the subscriber to pay rental fees for the decoder (€8/month), a deposit for the satellite dish (€75), or the installation costs of the cable operator (up to €100).

But no person truly interested in pay-TV would be attracted to Free’s service. By its own admission, Free has a relatively weak content offer in relation to either TPS, Canal+, or the cable operators, especially in the crucial areas of cinema, live sports programming and reality TV, which are the main reasons motivating take-up of pay-TV subscriptions. This means that Free’s charge of €29.90/month is not a bargain in relation to either the €19/month entry-level offer from TPS or €28.50/month from Canal+, as noted in French Pay-TV Update (2003-44), or offers from cable operators.

Free’s 52 channels make the offering sound impressive. But most of these channels have negligible viewing shares, or are terrestrial free-to-air channels (France 2, France 3, France 5 et Arte) that are available anyway. The crucial calculation we have made is that Free’s non-terrestrial channels have a viewing share of 8.2% in all other

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multichannel homes (Table 4). In cable or satellite homes, non-terrestrial channels have a share of about 34%. Free therefore only offers channels with about a quarter of the viewing that goes to non-terrestrial services in conventional pay-TV homes. This makes the service more like Freeview in the UK than a real competitor to pay-TV.

Table 4 Leading channels in multi-channel homes, H1 2003

Audience viewing Distributed by Channel Producer share (%) Free?

TF1 TF1 26.0 No France 2 France Télévisions 14.8 Yes France 3 France Télévisions 11.2 Yes M6 M6 8.2 No C+ Vivendi Universal 3.6 No RTL9 AB 2.6 Yes Canal J Lagardère 1.4 No France 5 France Télévisions 1.3 Yes Eurosport TF1 1.3 No LCI TF1 1.3 No Arte France Télévisions 1.0 Yes TF6 TF1/M6 1.0 No Tiji Lagardère 0.8 No 13eme rue Vivendi Universal 0.8 No TPS Star TPS 0.7 No

[Source: Mediametrie]

Free was unable to conclude deals with the major channel operators by launch date (Table 5), notably TF1, M6, Vivendi, Lagardère and Pathé. Agreements have now been reached with the latter two, which should improve the channel line-up. Management hopes the must-offer obligations under new European Union directives to be transposed into law in France by mid-July 2004 will lead to further improvements in the content offering, notably with respect to C+; Free claims the same regulatory regime should apply as for cable operators. Free has also launched a complaint to the Conseil de la Concurrence alleging abuse of dominant position by TF1 and M6 (owners of TPS) as both producers have refused to discuss a distribution deal.

8 ENDERS | ANALYSIS Iliad January 2004

Table 5 Free’s agreements with TV producers

Audience viewing Number of channels Producers of TV content share (%) distributed by Free TF1 18.0 0 Vivendi Universal 15.0 1 M6 10.6 1 Lagardère 9.9 2 Groupe AB 9.7 17 Disney 4.7 0 Pathé 4.4 0 France Télévisions 2.8 6 (+4 national) Time Warner 2.7 0 Viacom 1.5 6 Other producers 20.7 16

[Source: Enders Analysis based on company reports]

A rival TV-over-ADSL was launched on 18th December 2003 by TPS (64% owned by TF1 and 36% by M6) and France Télécom in Lyons. The offer combines access to TPS content and VoD. The price of the service is €37/month, based on an access charge paid to FT (Ma Ligne TV for €16/month plus €64 in set-up costs), and a subscription to TPS (€21/month plus €40 in set-up costs). Internet access is not included in the service, although it can be obtained separately.

The primary logic is to offer TPS content over copper wires and thus extend the reach of the operator to urban areas where satellite receivers are more difficult to install and operate. The subscription to TPS is for the premium Prestige service, which retails for €35/month when delivered via satellite, slightly less than the €37/month the TV-over- ADSL offer costs; TPS is not offering the full variety of subscription packages, ranging from €19/month to €45.50/month, as described in French Pay-TV Update (2003-44). TPS’s DSL service is thus intended to compete with pay-TV services offered by cable operators, while not cannibalising the existing satellite pay-TV subscriber base of TPS itself. A similar product from Canal+ is said to be near launch.

On the whole, we do not consider Free’s TV-over-ADSL service to be directly competitive with that of TPS or indeed to be directed at competing against the cable operators, all of which offer a richer content. Free is not establishing itself as a pay-TV operator and does not intend to attract switchers from other pay-TV brands. The TV- over-ADSL offer must be regarded as an initial step into the entertainment area that may or may not develop into a full-blown service in the medium-term, when Free will have more fully built out its network .

Telephony

Iliad claims an addressable market for alternative telephony supply of 34 million lines (the total number of fixed lines in France). CPS has had a significant impact in recent years, raising its share of total lines from 17.5% in 2000 to 26.2% (Table 6). With just 200,000 clients, One.tel is however a relatively small CPS player. One.tel has an attractive €0.01/minute offer launched in September 2002 that Iliad intends to market more heavily in 2004 through TV campaigns to attract subscribers.

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Table 6 Development of alternative telephony market, 2000-02

2000 2001 2002 Change

Total lines 34 080 828 34 083 938 33 994 409 -0.2% CPS 5 953 396 8 165 786 8 916 988 +9.2% - Call by call 4 453 936 5 253 053 4 815 465 -8.3% - All calls 1 499 460 2 912 733 3 979 179 36.6%

[Source: Enders Analysis based on ART]

According to Iliad’s own analysis of the telephony offers on the market, the VoIP offer to the 100,000 Freebox subscribers is the most attractive one on most segments: local, national, international and peak time calls-to-mobiles (Table 7). Free offers free local and national calls to landlines from the Freebox on an unlimited basis. Free is thus assuming call termination charges, which it recoups on the high margins made on calls to mobiles. Calls from an FT line to the Freebox (not shown in Table 7), are charged at the local rate, irrespective of the location from where the call is made, around the corner, or on the other side of France. This is another significant attraction of Free's VoIP offer, but is expected to be modified as of H2 2004. Free and FT have been locked in a dispute over the issue since March 2003. Referred to the ART, Free was able to secure a decision requiring FT to charge calls from landlines to the Freebox at the local rate, which is almost three times less than the national rate, until the end of June 2004. This transitional period is designed to allow Free and FT to resolve their dispute over the issue. At the end of the period, we expect higher call charges to the Freebox from FT landlines, which could make use of VoIP less attractive.

Table 7 Tariffs of fixed telephony calls offered by operators, end-November 2003

France 9 Type Freebox One.tel TELE 2 Cegetel Télécom Telecom Local Free 0.01 0.033 0.014 0.017 0.012 National Free 0.01 0.091 0.034 0.041 0.033 International (UK) 0.03 0.059 0.22 0.08 0.084 0.05 Mobiles (Orange) peak 0.19 0.22 0.23 0.22 0.22 0.23 Mobiles (Orange) off-peak 0.19 0.08 0.11 0.08 0.09 0.075

Note: Excluding connection charges (One.tel) and minimum charges (all other fixed telephony operators). [Source: Enders Analysis based on company reports]

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