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Wednesday, February 07, 2007

KPN: When in a hole stop digging

KPN continue to be super confident about the performance of its overseas mobile operations in 2006. However, I have believed all along that their strategy is fatally flawed, only has a limited lifespan and now I believe that closing time is nearly upon them.

Basically back in 2002, BASE in Belgium was a complete basket case and losing money. KPN decided to slash costs, develop a wholesale and multi-brand offering and compete on price in the prepaid market. There can be no doubt that this has been successful: BASE is now making reasonable margins, but still it has only 15% market share in a three player market. The problem for BASE is that the price conscious prepaid market is only of a certain size and typically exhibits the lowest loyalty of any market segment.

KPN admit they need to look at new areas of growth in Belgium and are targeting the SOHO segment: unfortunately this segment requires a lot of investment in the distribution channel and also a lot of investment in handset subsidies. This goes “contra” to the original “keep it simple” approach of BASE that delivered the turnaround. This is also exactly the same market segment that the second mobile player, Mobistar, plan to target in 2007. I think that BASE are rapidly running out of steam.

It is interesting to compare the BASE strategy to the Telfort strategy in KPN’s home market of Holland. In 2003, O2 sold the Dutch basketcase, Telfort, to private equity for €25m. Telfort then proceeded to pursue exactly the strategy in Holland as BASE in Belgium. In 2005 having slashed costs, acquired the bargain hunters as customers and caused more than a little pain for the major players, Telfort was bought by KPN for around €1bn.

The interesting part of the story is that the private equity behind Telfort realized that moving to the next stage required a lot more money and the bigger value was for an existing player to buy the traffic and realize further economies of scale through the network effect.

In nearly every mobile market in the world, the challenger is nearly always more aggressive on pricing than the larger player, but faces a floor in pricing and that is roughly when prices equals termination rates. However, larger players can go further down the pricing curve, because of the amount of on-net traffic carried. On-net traffic obviously does not incur termination rates.

The BASE team moved onto the next basketcase in the KPN portfolio: e-plus in Germany. To the surprise of nobody, they basically repeated the strategy of BASE and the turnaround in e-plus figures are evident.

The difference is that Germany is the biggest mobile market in Europe and contains two of the biggest beasts in the mobile world, T-Mobile and Vodafone, who do not like to be humiliated by upstarts. Both T-Mobile and Vodafone have begun the fightback lowering prices and playing the bundle card. It is extremely difficult for marginal players to match the bundle, again because of the amount of off-net traffic they carry.

Also, a minority in Germany such as the Turkish community would represent a majority in other markets and therefore becomes more appealing for a major to target; especially when they own a Turkish network and can again offer deals that e-plus will just not be able to economically match. I expect a lot of this to occur in 2007, Voda and T-Mobile targeting the e-plus niches. T-Mobile are also playing this strategy developing products which deliberately target and cause pain to the other player o2 with its T-Mobile@Home aimed directly at the o2 Genion product.

To draw a comparison with the UK, the four majors (Voda, O2, Orange and T-Mobile) were drawn into a bloodbath in defending their shares against the newcomer H3G UK. At the start of 2007, it appears that a bloodbath is developing in Germany with Voda and T-Mobile fighting their corner against O2 and KPN. Six months ago, I would have said that the only conclusion would have been for H3G UK to be sold in the UK and O2/KPN merging in Germany. However, in the UK it appears that H3G UK has completely changed its strategy and the other operators are desperately trying to reduce distribution and SAC costs to restore UK profitability to European norms. Of the four operators in Germany, KPN is the least able to withstand a bloodbath, especially given most of its base is now made up of ultra-price conscious segment. O2 now has a parent with deep pockets, experience of bloodbaths in Latin America and more importantly is deploying a strategy based upon differentiation through the brand and innovation rather than price.

My conclusion is that KPN needs to sell up fast in both Germany and Belgium to realize some value for shareholders. They could then use that money to turnaround two other European basketcases that they are sniffing around: Sunrise in Switzerland and Connect in Austria. However, I seriously doubt whether KPN will follow this strategy, they are more likely to buy Sunrise and Connect and at the same time keep e-plus and Base. This is the beginning of a Pan-Intraeuropean Subscale Strategy. This is exactly the type of strategy they followed with the investment in pan-European altnet KPNQwest in the bubble years. That investment ended in tears for KPN shareholders.

Personally, I don’t think KPN have learnt their lesson and the KPN shareholders will pay the price for the folly of corporate strategy.