The ’s proposed acquisition of the AOL UK access business October 2006 [2006-e51]

• The Carphone Warehouse (CPW)’s £370 million acquisition of AOL UK’s internet access business is set to quadruple the size of CPW’s UK broadband customer base, enabling it to become the third largest player in the market after NTL and BT, with approximately 2 million broadband subscribers

• CPW will also benefit from its partnership with AOL for portal advertising, content and other internet-based applications, relatively small but fast- growing value-added services in which CPW has little experience or market position, which will prove important in terms of both customer retention and margins

• However, bulk migration of customers onto unbundled lines has barely started and will be critical to the overall success of CPW’s entry into broadband

We will comment separately on the subsequent announcement from concerning handset distribution.

On 11th October 2006 Carphone Warehouse (CPW) announced that it had agreed to acquire AOL UK’s access business from Time Warner for £370 million in cash. Subject to regulatory approval, the deal is due to be completed on 31st December 2006. AOL will continue to provide branding for the AOL access business and ‘audience’ services, i.e. portal and associated content services. AOL will also manage online advertising sales for the combined CPW/AOL broadband customer base through a revenue- sharing agreement.

Provided it can retain all of AOL UK’s existing customers, CPW will acquire about 1.5 million residential broadband subscribers, about 600,000 narrowband subscribers and just under 100,000 CPS telephony customers, almost quadrupling its current broadband subscriber base to about 2 million, eliminating a major competitor and becoming the third largest residential broadband provider in the UK after NTL/Telewest (3.1 million) and BT (2.2 million excluding B2B).

The acquisition works out at £176 per customer including the narrowband base but excluding tax effects, a dramatically lower acquisition price than that achieved in the sale of AOL France and AOL Germany (€500+ per subscriber). This is a consequence of a lack of competition for AOL UK due to onerous branding conditions imposed by Time Warner.

Telecoms Ian Watt +44 (0)7968 969438 [email protected] Ian Maude +44 (0)7900 698498 [email protected] CPW proposed acquisition of the AOL UK access business October 2006

For CPW, the deal looks good value and is likely to ensure that the company will not find itself at a cost disadvantage to another unbundler in the form of BSkyB or an agglomeration of merged ISPs (for example, Orange/Tiscali) for at least five or so years. The deal has the potential to yield instant scale for LLU at over 1,000 exchanges.

According to Time Warner, AOL UK generated operating profits of just £14.1 million on revenues of £442.1 million in 2005, but we believe there is significant scope for CPW to reduce costs through reduced corporate overhead, headcount and marketing expenditure (AOL has no high street store network).

CPW will also benefit from its partnership with AOL for ‘audience’ services. These will include a co-branded portal and other internet-based applications, relatively small but fast-growing value-added services in which CPW has little experience or market position, which will prove important in terms of both customer retention and margins. AOL will manage online advertising sales for the entire broadband base. Our understanding is that CPW will receive 40% of net advertising revenues, generated from portal advertising to all broadband subscribers, whether AOL UK or CPW. With AOL generating an estimated £75 million in advertising receipts in 2006 and a growing broadband base, this will be a significant revenue stream. Yet-to-be-developed portal- based applications such as video-on-demand (VOD) could add to this.

Following BSkyB’s aggressive move into broadband, residential telecoms in the UK looks set to be dominated by BT, NTL/Telewest and BSkyB, all of whom can be each be expected to have over 3 million residential customers within five years. Up against such a trio, CPW was beginning to look sub-scale, in spite of its 2.6 million strong telephony base. Even if CPW reached its own target of 1.75 million broadband customers by March 2009, it might well have found it difficult to sustain such a ‘second tier’ position in the market. However, the AOL purchase brings with it more than just the usual integration issues.

Most importantly, we estimate that AOL’s customer base comes with an above- average proportion of Sky users. On a pro rata basis, one would expect, as CPW management claimed at the Q&A, about a third of AOL customers to be subscribing to Sky’s satellite pay-TV offer. But given AOL’s position at the premium end of the family market, we are confident that the actual figure is about 50%, or 1.05 million of its total base.

To discourage its pay-TV users from signing up with CPW for telephony and broadband, BSkyB has launched a service which is highly competitive with CPW’s. Now CPW is to acquire the AOL UK customer base, the relative attractiveness of the two offers is likely to become even more significant.

There are several important ways in which Sky’s offer is less competitive than CPW’s. Firstly, Sky’s ‘free broadband’ offer is for a 2 Mbit/s access speed whereas CPW’s offer is for an up to 8 Mbit/s service. Sky’s equivalent offer costs £5 per month, though unlike CPW, Sky does provide a wireless router with both offers. Secondly and most important, CPW’s free offer applies to its 1,000 target exchange areas whether the company has actually unbundled there or not, whereas Sky’s offer applies just to customers on exchanges it has actually unbundled (currently about 500, with 700 expected by the end of the year). Outside its unbundled areas, Sky becomes less competitive still, at £17 per month for up to 8 Mbit/s compared to £10 at CPW. However, all CPW broadband customers must use CPW for telephony including at

2 CPW proposed acquisition of the AOL UK access business October 2006

least a national call package. This is not necessary to qualify for Sky’s free broadband offer, since it is open only to customers taking Sky pay-TV. Sky will also increase the pressure on CPW when it launches line rental at £9 per month in Q1 2007, £2 cheaper than CPW.

The outcome of the battle between CPW and BSkyB for AOL’s Sky households will depend on the weight customers place on these factors and on the relative efficiency with which both players execute. To date, both have damaged their credibility through their inability to meet demand promptly. To Q2, CPW admits to having lost 78,000 applicants, 12.5% of the total, although some of these would have been rejected for technical reasons.

In our view, if Sky executes well, it is quite possible that half a million or so current AOL subscribers could migrate to BSkyB by the end of 2007, particularly if they feel more comfortable retaining their BT line for telephony, rather than taking the plunge with CPW’s bundled offer.

However, even if CPW loses half a million subscribers to Sky and grows its ‘organic’ broadband base according to our own estimate of 1.5 million broadband subscribers (rather than guidance of at least 1.75 million), AOL should still enable it to double this to 3.1 million by March 2007. By our estimates this should be more than Sky and almost as much as NTL and BT, enough to remain reasonably competitive in terms of scale.

With respect to the AOL customers that CPW does retain, another factor is that AOL customers migrating to CPW’s offer will stop paying monthly fees of between £14.99 per month and £29.99 for broadband, although they will start paying £19.99 plus call charges for telephony. CPW claims that such a migration will be margin neutral, but this assumes the CPW offer is provided using LLU. CPW will however be able to continue to migrate AOL customers who do not wish to move to TalkTalk on partially unbundled lines.

An additional complexity results from the fact that AOL UK’s unbundling programme is well under way, with about 160,000 customers in over 300 exchanges unbundled on a shared basis. Although these customers will be able to share backhaul from the exchange with CPW customers, there will be few other network-related scale economies unless such customers opt for the CPW double play offer, migration to which will incur further costs.

If its performance indicators are to be believed, the company seems to have got on top of its provisioning and customer service issues, albeit at the cost of an extra £10 million. Queue lengths and call centre response times appear to be down to acceptable levels.

But CPW’s big problem is that by 30th September 2006, only 20,000 customers had been migrated onto LLU. The vast majority of the rest are on the ‘free’ offer but supplied using a combination of Wholesale Line Rental, Carrier Preselection and IPStream, generating a negative margin in the order of £10 per month, by our estimates. It is easy to forget that CPW currently stands alone in the market place as the only unbundler attempting to mass migrate customers to lines that are fully as opposed to partially unbundled. We understand that there are a range of issues outstanding regarding migration to full LLU, in particular relating to the portability of geographic numbers, and within , a lack of experience among new recruits

3 CPW proposed acquisition of the AOL UK access business October 2006

and a slowness to alert CPW if a migration to full LLU fails and service is lost. This is a far more serious problem with respect to telephony and broadband sold in a bundle than with broadband alone. These issues explain why CPW has unbundled so few lines, in spite of the fact that 846 exchanges have been handed over from Openreach and that CPW’s altnet subsidiary Opal had lit 370 by the end of September. If these issues are not resolved soon, CPW risks damaging Group profitability, even after factoring in the benefits of the AOL deal.

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