/* ----------------------------------------------- Comment out annoying Snap... ----------------------------------------------- */

Sunday, November 05, 2006

Carphone Warehouse: Struggling to Convince

The whole rationale of the vast army of Carphone Bulls can be summarized by the following three assumptions:
1. Belief that a profitable services business can be built in time;
2. Belief that the distribution business will continue at a minimum maintaining its profitability; and most importantly
3. Belief that the balance sheet can take the strain whilst the services business is being built.

I. Services Business.

I.i. Some Fundamental Flaws.

The biggest problem in running a network business is that everyone thinks it is easy – Carphone has never run a network business before the entry into broadband and I think is falling into the trap of believing it is too easy and underestimating the amount of capital required to build a reliable service. Admittedly, Carphone is not a pure retailer anymore and has good experience of running medium sized service businesses, but this is not a network. Of note is that Virgin Mobile, the biggest mobile service business in the UK opted to sell-out rather than taking the next logical step of building a network.

I.ii. The Big Advantage.

Carphone being a hybrid business with roots in retail is predominately covered by Sell-Side Retail Analysts in the City and therefore it is easier to pull the wool over their eyes of the network side of the equation. You would never see a telco getting away with releasing figures such as “contribution” as the lead indicator of profit. In fact, not so long ago the Financial Times in its Lex column was joking about Hutchison releasing figures of LBITDA before SACs as a barometer of the (lack of) health of its 3G operations. Carphone actually takes this one step further and release “contribution” figures which are actually Gross Profits before support costs and SACs – let alone the network depreciation, acquisition amortization and financing costs – tax is not an issue until Carphone make a profit. Most serious analysts these days look at Free Cash Flow as the daddy of all statistics as they understand the amount of capital required, shortening of asset life cycles and worse of all for Carphone they understand that if not enough cash is not being generated eventually asset writedowns have to take place.

The other operating statistic that is missing from the Carphone result is “organic” growth as opposed to the “acquired” growth. As well as launching broadband, Carphone made significant acquisitions in the voice business of One.tel for £134.6m and Tele2 for £8.2m. Nearly all the growth in UK voice and business can be accounting by these acquisitions.

In fact some older acquisitions, such as Xtra in Spain and the Hutchison Reseller business in Germany seem to have declined in performance. I also noted during the conference call that the whole European Fixed business is under review with the CFO mentioning that it might be more profitable to sell other providers fixed line products in the stores for commission rather than building a service business. Hmmm…This would be a huge retreat, but nothing that we haven’t seen before from other service providers who either has not managed to build scale in various markets or don’t have the cash to support expansion on many fronts simultaneously.

I.iii. Underlying Broadband Business.

The sign-up nightmare for Carphone seems to be drawing to a conclusion and this is without doubt the best news to come of the interims. However, we should never forget that this nightmare was caused completely by design in the launch of the Carphone product. The losses due to the provision of the initial sale of resold IPStream product should not be discounted: again this was a deliberate design with Carphone knowing full well that it was in effect doubling the complexity of provisioning and incurring significant losses. It is therefore really surprising to me that Carphone is getting away with calling these start-up losses exceptional. It is also significant that every other company has taken an alternative path to market.

The looming problem for Carphone is the conversion of customers to full unbundling and currently the general market fault rates are extraordinarily high. Short-term again this will create either a financial black-hole (as customers remain on the loss-making resold business) or another support nightmare as people are without voice and data services. Carphone wants to ramp the conversion up to 20k per week as soon as possible. Once provisioned, people will start to have problems with current home networking equipment, Carphone are already gaining notoriety with only supporting its own routers and not providing assistance if people do not use these routers. Next, Carphone will have problems with customers not getting the 8Mbps speed that they thought they would get. It will be Carphone’s own MSANs equipment delivering the rate adaptive services not BT – at this stage Carphone has basically ran out of people to blame.

This last point is absolutely critical post-LLU conversion: Carphone is building a nationwide broadband network and only renting space, electricity and copper wires from BT. Carphone has purchased Huawei MSAN equipment for placement in each exchange – there is no engineer in the UK with experience of using this equipment in a large scale production environment. Rate adaptive DSL equipment is complex, witness the problems that BT had in launching its max products and this is after months of testing in the BT labs and the army of BT engineers supporting it.

The truly shocking network design component is that Carphone is only leasing a single 100Mbps backhaul circuit from each exchange back the closest of its three main POPs in Irlam, Birmingham and Brentford. It doesn’t take a maths genius to work out that with in excess of 500 customers per exchange (and sometimes up to 2000) that they will not be getting 8Mbps service in peak hours. As I said before, once a customer has been LLued, Carphone has run out of excuses for peak hour bottlenecks.

To make matters worse, these backhaul circuits have absolutely zero redundancy built into them. They go into one of the Carphone POPs and then directly into the Carphone Sonus GSX9000HD (again complex new kit) media gateways for the VOIP service. Losing broadband connectivity due to a connection problem is one thing, losing “999” emergency service is a totally different matter.

Even with Broadband Routers, which are typically either Juniper or Cisco in the UK broadband market, Carphone has taken a risky decision and again gone for Huawei. This could be portayed as less risky because of the MSAN to Router connection is via one supplier, but again the kit is unknown and I’m sure every engineer in the UK would prefer the comfort of the Cisco support levels.

I have no doubt in the long run that Carphone will work out how to build and operate a broadband network, however my big question is whether they will be able to do it at the levels of investment currently in the Capex plans. Capex and Operating Costs is a huge part of the equation in the Telco game (and below the Contribution line), I wonder if Carphone gets in trouble will they have the budget to throw resources at the problem?

We already know how badly Carphone estimated the number of Customer Support bodies required, I wonder if they have done the same with the Technical bodies? As was mentioned in the Call, Carphone realize they do not have a lot of goodwill left with the userbase and if they do not have engineers to send round the country fixing exchanges and connections – huge negative publicity could be generated.

I.iv. AOL acquisition.

AOL is currently a really low margin business generating approx. £2m of profits (according to the acquisition conference call). Carphone have already said they will increase margins immediately by cutting back on marketing efforts. As well as a positive, this can also be seen as a negative as people may churn to other providers. It is obvious from the customer number in the UK Voice business, the old one.tel and Tele2 businesses are experiencing large churn.

The whole rationale for the acquisition as far I can see is that by adding the volume Carphone will get economies of scale to justify the increase in borrowings. I think this is Carphone’s biggest challenge going forward: Carphone will have to move customers from a poor return resold platform onto its own platform as soon as possible. This is in addition to merging two very different cultures.

II. Distribution Business.

II.i. What is the point of the Dealer Business?

As far I can see, the Dealer Business has never made a profit and it continued to lose money in the first six months. This is despite the purchase of one of the UK’s largest mobile wholesalers in the second half of last year and the appointment of the ex-Orange UK Sales Director, Stuart Henry. The legitimate rationale for the business as far I can see is that bigger volumes of handsets and airtime lead to larger discounts from the manufacturers and operators, which creates a virtuous circle with the distribution business. Of course, the reported profits of the Dealer business will contain many accounting estimations of the price of group services. It also makes a lot of business sense for the dealer business to be losing a small amount of money: it helps in the price negotiation with independent retailers; it helps the margin of the distribution business and it helps that no-one apart from the VATman takes any notice of the business. My own personal view is that the Dealer and Distribution business are inextricably linked and therefore should be treated one and the same. The only subtle change that this move would effect is that Operating Profit margins have remained the same rather than increasing slightly.

II.ii. Vodafone Bust-Up.

This all seemed a little bizarre to me:
“We are going to draw up a frame contract for Europe”
“… been speaking to Arun Sarin and we agree we should all be friends and shouldn’t fight”
“Anyway in Spain we don’t sell Telefonica product and look how at connections have growth”
Vodafone will have lots of frame contracts with lots of companies, especially equipment manufacturers and consultancies. What matters is the placing of orders of a given volume of products at a certain price. I suppose the whole idea is to prove that Vodafone and Carphone are still friends and Carphone will not lose the whole of the European Vodafone business.

However, friendship will not help Arun Sarin and Vittorio Colao in their efforts to improve Vodafone’s European business. What will help is lower churn rates, lower SACs, higer customer ARPUs and higher customer numbers: Carphone can definitely help here, but I see nothing changing in the UK – at the end of the day Vodafone thinks it has found a better partner than Carphone. Nothing was mentioned of the fact that o2 and Orange have both publicly asked for lower commissions. Instead was the same story that the operators will always undercut themselves in the drive for market share.

This is the crux of the post-paid distribution story: Will the operators continue to pay the high commissions that Carphone desire?

Carphone certainly have history on their side and have outstanding sales skills. I am still struggling with the Virgin Mobile MVNO paying Carphone huge commissions for its post-paid product, when Carphone are staying out of the market with its Fresh MVNO company (ie Carphone doesn’t believe the Virgin Mobile business model) and where Carphone is investing (ie home broadband/voice) is having a detrimental effect on the ntl parent company.

However, I did laugh a lot when Carphone for the first time published its connections in Spain to Orange and Vodafone: both must now know for certain whose products are being pushed in Spain. Also, I suspect given that Carphone has just signed an exclusive deal with TeliaSonera in the launch of its new network – any drop in Vodafone/Orange sales will be harshly dealt with by the networks at contract negotiation point. Carphone cannot afford its distribution problems spreading to its number one growth market.

II.iii. Prepaid Box-Breaking.

A large part of the retail growth was with the lower margin prepaid business. The reason that prepaid sales are much higher than SIM-free business is that the operators are subsidising the prepaid business and the killer for this business is box-breaking.

It is estimated that 50% of prepaid handset sales in the UK are box-broken. This is a sophisticated business, but something that the operators really, really hate and primarily blame the retailers for. It is noticeable that at this early stage of the Christmas selling season, Carphone is offering prepaid products cheaper than anyone else in the market, including Argos, Tesco’s and Woolworths. Carphone may be taking lower margins or have better deals with the networks and manufacturers. However, it is running a huge risk of being box-broken in a large scale, which will ruin many a network executives New Year Day, so much so that they could develop a painful New Year resolution. Carphone need the volume because of last years mega-success of the exclusive pink RAZR.

II.iv. Distribution Summary.

Despite the couple of negatives above, I think only a fool bets against Charles Dunstone in his core business and I certainly wouldn’t do so. However, the Distribution business can grow, generate cash and still this could not be enough for the voracious cash appetite of building a network business.

III. Balance Sheet.

The Carphone balance sheet is gearing up at a fast pace: net debt at 30th Sep was £411m – a huge increase from £86.5m in just two years. A quick analysis of the balance sheet shows Goodwill increasing by £147m, Intangibles by £108m and Property& Plant by £121m. All this is before the £350m purchase of AOL.

Increasing leverage is actually a really good thing for shareholders if enough cash is generating by the operations to support it. Unfortunately for Carphone shareholders, this is not the case. I reckon Free Cash Out Flow in the first six months was £50m, before broadband of £71m, dividends of £15m, acquisitions of £15m and an inflow from the issue of shares and FX gains of £14m. The overall cash outflow was £138m without any significant acquisitions. The honest truth of the matter is that Carphone is not generating enough cash to fund its capital expenditures. And, this is before the full effects of the interest bill kick-in – post AOL and the increase in debt I just can’t see the position changing.

IV. Conclusion.

This situation is untenable in the long run and I can only see three possible conclusions:
1. increase operating performance to generate the necessary cash. I just don’t see this happening and not just because Carphone have underestimated the capital requirements or a few short term problems in the distribution business. I think it is because the competitors will not let it happen: BSkyB, BT and Orange have people far clever than me looking at the Carphone operations and they have the tools to inflict real pain.
2. sell-up. Again, I don’t see this happening. Carphone has such a rag-tag of assets that I don’t see them appealing to a single buyer.
3. take the company private. I see this as a distinct possibility.