Virgin Mobile and Mvnos September 2004 [2004-33]

Virgin Mobile and MVNOs September 2004 [2004-33] Executive Summary MVNOs have attracted much interest recently, both because of the completion of the long-awaited IPO of Virgin Mobile and the success of a number of ‘discount MVNOs’ in some smaller European countries. In this report we look in detail at the drivers of the success of Virgin Mobile and its prospects for the future, and determine what clues this might give for the potential success of discount MVNOs in the UK and other larger European countries. Virgin Mobile got off to a fairly slow start in the UK, reaching less than 700,000 subscribers by the end of its first full year against its publicly stated expectation of 1 million. This was during a period when the UK pre-pay market was experiencing its peak growth. At the time, its strategy interestingly resembled that of a more modern discount MVNO: direct distribution only, pre-pay offering only and focusing on SIM-only products with an emphasis on simple cheap tariffs. This strategy did, however, rapidly evolve. Virgin Mobile first expanded its distribution to general retailers and then to the mobile specialists (such as Carphone Warehouse) which it had previously criticised as having outmoded business models, and from which it now receives 50% of its new subscribers. Its sales rapidly increased, with the company gaining 10% of market gross additions in 2003 (over 30% of net additions), and reaching 4.2 million subscribers, or 7% market share, by June 2004. Its focus to date on lower ARPU pre-pay customers has however left its revenue market share at just under 3% in 2003. It still dominates the UK MVNO sector, with all other MVNOs having a combined subscriber market share of just 1.4% by our estimates. The company now looks much more like an incumbent mobile operator than it once did, offering a very full range of handsets through all the major distribution channels, having a surprisingly uniform market share across different age groups and offering a modest price discount, preferring to market itself more on its tariff features than their overall level. The company has however retained a ‘funkier’ brand image than the other operators, and prides itself on its market leading customer service. The company’s economics are impressive given its scale disadvantage to the incumbent operators: its underlying cashflow margin of 14% is just two percentage points below that of mmO2 and T-Mobile. Looking at its cost structure in detail, it does suffer from diseconomies of scale in SG&A and particularly in marketing and advertising costs, which are 9% of service revenues compared to less than 3% for the larger operators. It gains significant margin in network-related costs, however; we estimate these at just 19% of revenues compared to 25-30% for a network-based operator. This is a direct result of its airtime deal with T-Mobile, who is charging Virgin, we estimate, an average of 2p a minute for carrying voice calls (although total direct Mobile James Barford 020 7499 1581 [email protected] Virgin Mobile and MVNOs September 2004 costs, including call termination, average about 5p per minute). When the deal was first signed, T-Mobile (or One-to-One as it was) was in a land-grab mode and was desperate to fill an empty network. By the time the deal was renegotiated in January 2004, Virgin had achieved substantial scale and bargaining power. We very much doubt that a new MVNO today would get anything like this price, especially an MVNO which openly threatens to destabilise overall market pricing. We believe that Virgin Mobile’s overall prospects are strong; its growth in the pre-pay market may have peaked, but it is planning the launch of a contract product that will likely at least double its addressable market. The contract market is one that newer operators generally find harder to penetrate; distribution channels have to be strong, handset supply must be good, and the brand must be well-trusted. Virgin Mobile has probably reached this point in its development though. In terms of its margin development, there is the risk that it would suffer relative to the network-based operators from a sharp decline in retail tariffs due to its fixed per minute/text rate with T-Mobile, but we think this risk to be slight: price competition in the UK has been gentle of late, with promotions and targeted handset subsides more the focus of most operators. It will almost certainly gain, however, from economies of scale should it continue to grow, which is likely to outweigh the latter factor in any case. While Europe’s largest MVNO in subscriber terms is in the UK, their proportionate success has been strongest in the smaller northern countries such as Denmark, the Netherlands, Sweden and Norway; countries which – not coincidentally – also have strong consumer-orientated regulators and/or intense competition between the network operators. The most successful of these is Telmore, a company that achieved close to 10% market share in Denmark before being bought by the local incumbent earlier this year. Telmore achieved success by offering a SIM-only product exclusively through its website, supplying all its customer service online, not spending on advertising and giving customers very low voice and text rates. This success was very much helped by the ban of SIM-locking in Denmark (SIM locking is allowed in the UK), a mandated maximum six month contract length there and mandated low airtime costs and termination rates. Telmore’s new parent company TDC and Stelios Haji-Ioannou’s easyGroup have recently signed a deal to launch a Telmore-like easyMobile in the UK and up to 11 other European countries. Will easyMobile replicate Telmore’s success? We doubt it. The Virgin Mobile experience points to strong distribution, sustained marketing, good customer service and an extensive handset range as all being key to success in the UK. Telmore had a number of regulatory advantages in Denmark that are very unlikely to be repeated in the UK or any other large European market. UK customers have already shown that they prefer to buy from a physical shop and that they also want a new handset when changing operator. The only real economic advantage of being a ‘no frills’ mobile operator is the cost saving from offering online customer service, and we estimate this saving to only be about 5% of service revenues (in any case, easyMobile appears to be planning on offering telephone support). We do expect more MVNOs to be launched in the UK and the rest of Europe, but the sustainable models are likely to be those that make use of an existing proprietary sales channel, such as Tesco Mobile in the UK. These businesses are by their definition likely to be niche, and are very unlikely to create pricing pressure for the rest of the market. 2 Virgin Mobile and MVNOs September 2004 CONTENTS Executive Summary 1 Virgin Mobile: A Brief History 4 Virgin Mobile: Current Positioning and Prospects 7 • Handsets and tariffs 7 • Demographics 9 • Customer satisfaction and churn 10 • Distribution 11 • Prospects for growth 13 Virgin Mobile: The Economics 15 Discount MVNOs 18 3 Virgin Mobile and MVNOs September 2004 Virgin Mobile: A Brief History Virgin Mobile was launched in November 1999 as a joint venture between the Virgin Group and One-to-One (now T-Mobile), the fourth largest GSM network operator in the UK. The company was the UK’s first MVNO; the distinctions between service providers and ‘true’ MVNOs are somewhat blurred, but Virgin Mobile buys wholesale network capacity by the minute (or text message), sets its own tariffs and does its own billing, while sourcing and subsidising the handsets itself. This contrasts with traditional UK service providers who bought operator-branded tariff plans at wholesale prices and received a bonus for signing up customers, and generally made much lower margins on airtime (15%-20%). It originally launched with distribution only through Virgin-owned shops (which numbered 300 at the time) and direct channels (call centre and their Internet site). Their initial approach had many of the characteristics of a discounter, encouraging SIM-only sales and making a merit of avoiding the ‘commission hungry middle men’ such as Carphone Warehouse, describing Charles Dunstone in a press release from November 1999 as “bumptious” and his company as “outmoded”. Table 1 Virgin Mobile subscriber growth millions 4.5 4.2 4.0 3.7 3.5 3.0 2.4 2.5 2.0 1.4 1.5 1.0 0.7 0.5 0.1 0.0 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Jun-04 [Source: Enders Analysis based on company reports] Unfortunately this approach resulted in a slow start; the company had gained less than 700,000 subscribers by the end of 2000, versus a target of 1 million – and during a year that the pre-pay market grew by over 10 million. Direct channels in particular disappointed, accounting for only 25% of their modest first year sales; UK consumers did, and still do, prefer to buy their mobile products face-to-face, especially if they are buying from a relatively new entrant to the market. The company wisely changed tack quite quickly, distributing through its first non-Virgin owned channel in October 2000 (J Sainsbury, a supermarket chain), and eventually signing with the large specialist chains, Carphone Warehouse in October 2001 and Phones4U in March 2002 (Carphone Warehouse had by then become a company that “shares the same entrepreneurial spirit as Virgin”). Since then the company has performed very strongly, rising to about 4.2 million reported subscribers at the end of June 2004.

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