Extracting the pith out of Telefonica

Editor's Comments

The headline stats from the Spanish giant don't look good (apart from Germany), but these results are like one of Spain's other great products, the orange: if you peel off the bitter peel and discard the pith, there is some sweeter flesh underneath.

First, to the headlines. Telefonica UK revenues were down 6% for the quarter. Mobile service revenues fell 8.3%, although this was seen as a stabilisation. Operating income dropped 31.7% with margins dropping by 8 percentage points to 19%.

In Spain, revenues dropped 10%, with mobile service revenues dropping by 17% and operating income by 13%.

In Germany the picture was different. Revenues were up 2.5% and operating income was up 13%.

Across the European Group as a whole, total ARPU dropped 13% year on year, with voice and SMS revenues responsible for the decline.

Data revenue growth was up, but other KPIs were under pressure, as they were within Telekom Austria and Deustche Telekom - two groups that also reported this week. Voice ARPU was down 19% overall. Actual voice traffic decreased 9% year on year in the UK, voice ARPU declined 5% in Germany and 19% in Spain. But Telefonica's results contained one key underlying difference - which we'll come to in a bit.

Telefonica didn't actually break out its SMS figures, but with some extrapolation we can see the effect that declining SMS revenues are having within the business. Overall data revenues were not up by a great deal in the key businesses. In the UK, non-SMS data revenues increased 17.3% but total data revenues grew only 1.2%. SMS revenues still account for over 50% of data revenues in the UK, so any decline in SMS revenues will have an amplified effect on overall growth.

In Spain total data revenues only grew by 2.7% year on year, despite non-SMS revenues growing 17%. In fact, in Spain the data revenue mix is very different than in the UK - with only 18% of all data revenue accounted for by SMS revenue. I think we have to assume that, for whatever reason, SMS revenues are in a steepish decline within Telefonica  Spain.

In Germany, as we have seen, there was a happier picture, yet with non-SMS data revenues up 41.8%, and overall data up 24.8%, we can see that SMS revenues are again restricting overall growth.

One key aspect of Telefonica's business in Spain and UK is that it is phasing out, or has phased out, handset subsidies. This has led to reductions in net additions, as customers have headed for deals from operators who are still subsidising strongly. But it has led to a rise in device sales revenues, with device sales revenues up 19% in the UK and up 6.5% in Spain. Of course, with O2 doing €200 million in device sales and €1.5 billion in service revenue, the device income line is still a relatively minor one.

But taking away subsidies is about more than increasing device sales income. It's a strategic shift in Telefonica's operating structure that means it doesn't have to spend so long a period in a contract recouping its subsidy. That means it can either bring down its cost of customer acquisition, or can offer better tariffs designed to attract and keep customers.

To put that another way. If an operator subsidises a handset to the tune of €250 and puts a user on a €25 per month contract, it's 10 months before the operator even breaks even on its handset subsidy. This is without taking into account the other overheads and costs of supporting that customer.

That's basic stuff but it's difficult to pull off when your competitors are offering your potential customers shiny new toys on a "pay later" basis. Of course, it puts the burden of the device cost onto the customer, rather than on the operator, therefore limiting its addressable base for that sector of the market. But with Telefonica saying that is has seen an increase in customer satisfaction, and historically low levels of churn, its strategy is clear: "we're done with buying customers for ££££, it's unsustainable".

For the moment, though, the operator is sacrificing both net additions and margin, while it restructures its cost/profit base. This is partly because capex in Germany and the UK is up 18% or so, to finance refarming of 900MHz spectrum in the UK and LTE rollout in Germany. So it's suffering a bit of a double hit, but it actually puts Telefonica in a different place from the other group operators in Europe - and one that could potentially make it a more flexible operator, with long term benefits.

That is why Telefonica's attitude to "non-core" services is attracting interest - such as its announcement this week of a Telefonica VoIP app for iPhone. It is the furthest down the road in payments, in mobile and location-based advertising and in "telco OTT" type services that exploit network APIs. When you look at this set of results, the easy response is that you can see why it needs to be diversifying, but if you were an investor, where would you rather be. With the opportunity, or managing the legacy? Pulping the pith, or squeezing the juice?

Keith Dyer
Mobile Europe