Europe's Largest Telecommunications Companies Face Big Revenue Losses

November 19, 2003

By Taska Manzaroli

In Japan and the U.S., firms that provide high-speed Internet access, or broadband, are snaffling business from network operators by sending voice calls via the Web. In Europe, the companies that sell broadband are mostly the carriers themselves; while this could slow the take-up, it won't stop the bandwagon.

It's a development the likes of Deutsche Telekom AG (DT), BT Group PLC(BTY), France Telecom SA (FTE) and Royal KPN NV (KPN) can't ignore as they struggle to reverse revenue declines in their fixed-line business. They'll have to ensure they have products and prices to counter the newcomers as well as resolve internal conflicts in their phone and Internet units as they chase the same customers.

Hailed by some as having potential to sink telecom operators, voice over Internet protocol, or VOIP, turns a voice signal into data and sends it all or most of the way via the Web. As many Internet subscriptions give unlimited access for a fixed fee, VOIP can gift free calls for users with the same software or phone, wherever they are; and it's increasingly being deployed by companies for internal calls.

Telefonica SA (TEF) says a VOIP service it offers German firms can slash communications bills by up to 60%.

"It's a tremendously disruptive technology," said Maury Shenk, managing partner who oversees telecoms at the London office of lawyers Steptoe & Johnson. "The trouble for the big network operators is that while voice revenues are declining, they're declining slowly and remain incredibly profitable. The companies don't want to cannibalize their own sales."

Japan and the U.S. are leading the way in embracing VOIP. Some 5 million people have subscribed to services in Japan with the likes of Yahoo!BB or Fusion, hurting sales at Nippon Telegraph & Telephone Corp. (NTT), analysts say. In the U.S., upstarts like Vonage and the threat from cable firms have forced phone companies to slash prices.

In Europe, activity is intensifying. As well as Telefonica's offering, German broadband provider QSC AG
QSC.XE) says it may sell a service in the future. Vonage, which has 60,000 customers, aims to expand in Europe "early
next year," possibly starting in the U.K., said Lou Holder, executive vice president of product development.

And there's a host of firms that could move in if they spot an opening, including Time Warner Inc.'s (TWX) AOL, Yahoo! Inc. (YHOO), Microsoft Corp. (MSFT), Apple Computer Inc. (AAPL) or Virgin Group (VGN.YY), analysts say.

Gartner Inc. (IT) sees the western European market for VOIP quadrupling to EUR3.6 billion to 2007 from 2002. That would account for almost 4% of total call revenue compared with 1% last year.

"There won't be a massive, immediate slump," said Uwe Lambrette, a consultant in the telecoms practice at Booz Allen & Hamilton, "more a slow erosion of sales over the long term. Slow, but certain."

While rivals can muscle into the patch with relatively little outlay,that's only half the battle. "You still need significant scale to drive profits, as well as a brand," said Blaik Kirby, senior vice president in the carrier and infrastructure business at consulting firm Adventis.

European incumbents have some defenses. In Japan and the U.S., the technology has been used by companies providing high-speed Web access - such as cable TV operators - to grab
revenue. Regulators have played a role in Japan, setting low fees for competitors wanting to access NTT's network.

But in Europe, the former monopolies are dominant in broadband, also known as digital subscriber line, or DSL, giving them some control over developments. Commerzbank estimates European incumbents are taking 50% of new
broadband subscribers; Merrill Lynch says operators have kept a 60%-80% broadband share in most markets, except in the Netherlands and the U.K. where it is 20%-30%.

It's almost impossible to sign up for DSL without renting a line from incumbents, and rival providers usually have to
lease connections from the phone companies, which own the copper wires to people's homes.

"It's very hard to see them losing the wholesale business," said Jawad Shaikh, head of strategy research at the European operations of Cap Gemini Ernst & Young. "In retail, it's a continuation of the trends that are there
now."

New Pricing Models

Prices for the more lucrative corporate clients are already low, analysts note. Europeans also use mobile phones for a lot of long-distance calls, they add.

Paul Lee, director at Deloitte Research in London, said operators could revamp their pricing models to protect against VOIP. Data - charged at a fixed rate - could be sold on a per-usage basis, voice on a flat rate, he
said.

Mindful of the threat, incumbents already offer flat-rate and bundled tariffs, which combine feesfor fixed and mobile. Still, Daiwa Securities analyst James Enck reckons these packages account for just 20% of subscribers, leaving a "large segment of the voice market exposed."

The risks are greatest in countries like the U.K., the Netherlands and Switzerland, where cable firms already compete in broadband and regulators are tough on operators, analysts say. Technological advances, though, could quickly redraw the map in countries like Germany, where infrastructure is in place but needs modernization.

"The cost of upgrading is decreasing," UBS analysts said in a September report on VOIP. "It is increasingly easier and cheaper for a cable network to offer telephony than it is for a telephone network to offer video."

Some services don't rely on an alternative network. Skype has a peer-to-peer service that allows free calls to the users who download the same software - 2.7 million people, according to its Web site. Skype is just as much a threat in Germany as in the U.K.

"Once you give people a broadband pipe, you can't really control them," said Daiwa's Enck.

Another unknown is regulation. The Dutch regulator recently limited KPN's marketing of flat-rate products, stripping it of one weapon to combat VOIP. "Their ability to respond is open to question," Enck said.

KPN reckons it's inevitable that VOIP will spread to the mass market but sees no risk in the short term, spokesman Bram Oudshoorn said. It can counter with tariffs that combine fixed-line and mobile, and can exploit VOIP to provide more services to corporate clients that have their own internal networks, he said.

Investors need to determine which markets are most at risk. For example, owning shares in an incumbent in the U.K. is more risky than in Italy, "as pressure on profitability is more likely to accelerate," UBS said.

Profits are already under pressure. Fixed-line operators had margins of 50% before liberalization about a decade ago; that's fallen to 40%, UBS says. Margins are defined as earnings before interest, taxes, depreciation and amortization, or EBITDA, as a percentage of sales.

Culture Clash

VOIP represents a tricky balancing act for management at telecom operators. Analysts talk of clashes within companies between managers who want to be first to market VOIP products and those who argue against prematurely sacrificing their main, most profitable business.

Deutsche Telekom, for example, could offer voice to Internet unit T-Online International AG's (TOI.XE) 12.7 million subscribers, but that would take business from the company's fixed-line division.

T-Online Chief Executive Thomas Holtrop is prepared to react if the technology takes off, though he doesn't see this now. "We're in wait-and-see mode," he said.

Deutsche Telekom also wants to prevent potential in-fighting between the units from hampering business. Chief Executive Kai-Uwe Ricke said Thursday that broadband is one of six priority areas where it will intensify the
coordination between its four divisions.

In the end, timing will be key. "It's better to cannibalize your own business before someone else comes along and does it for you," Daiwa's Enck said.