Nokia Music Centre, Mobile Operators and iPhones/iPods

One of features about the launch of the Nokia Music Centre (NMC) was that the various comments that Mobile Operators had failed in their attempts so sell music. Comments such as the one by Nomura analyst Richard Windsor in MobileToday are typical:

The operators have fiddled and prevaricated for the last three years in terms of bringing the internet to the mobile screen and now the opportunity for them to add value by integrating internet services looks to have been squandered. A utility-like, low margin, bit-pipe future where the value accrues to handset vendors and internet companies looks likely to result.

However, in the 1H 2007 results from Vivendi today owner of the biggest record company in the world, Universal Music Group, show a very different story.

Digital sales of €315m account for 15% of total revenues with 53% from online and 47% from mobile sales

The mobile operators must be doing something right.

The Nokia Music Centre is basically a rejig of the Loudeye/OD2 service with tighter integration on some Nokia handsets. The initial US$60m acquisition of Loudeye/OD2 by Nokia did not meet with universal approval mainly because of the worry for conflict with the mobile operators.

Also, it should not be forgotten the struggles of Loudeye/OD2 before the Nokia acquisition and the struggles of OD2 before purchase by Loudeye. In their last quarterly financial statement (2006Q2) there was a qualification whether Loudeye/OD2 would be able to continue as a going concern without the Nokia deal. In fact the biggest three customers were Microsoft (28%), KPN (16%) and France Telecom (14%), showing that Loudeye/OD2 had a history of partnering with the telcos. Loudeye/OD2 had also lost several of their early important customers such as Coca Cola to iTunes.

I would also point out that NMC appears to be a very much a me-too service with absolutely nothing to differentiate the service apart from the Nokia brand and integration with the handset operating system. I would argue that the mobile operators have been very inventive with pricing and bundling of their music offerings with companies such as 3 including downloads as part of the monthly bundle and Vodafone with its RadioDJ service. I would also add that at least here in the UK, all the operators seem to invest a lot of marketing spending in the music industry especially with sponsorship of live concerts.

There is also some interesting data from a recent OFCOM survey.

11% of mobile users in the UK download music onto their mobile phones. 11% of the mobile market may not seem a high percentage, but with near 100% population penetration, it is a very large number of around 7.5m people. The uptake is roughly tracking the number of 3G subscriptions sold. I wonder if iTunes have that many people actually downloading in the UK rather than ripping and sharing their CD record collections?

And this is before the number of people who are “sideloading” music from their personal music collections on the phones to listen to music. In fact, it is interesting that 34% of people actually see the mobile phone will reduce their use of MP3 players/iPods.

Perhaps, it was Steve Jobs who launched the iPhone from a weak position knowing that the iPod market would eventually be consumed by the locust like multi-purpose mobile device. The mobile phone has already done serious damage to the sale of analogue devices such as watches and alarm clocks in the UK. I actually think it is Steve Jobs brilliance that has allowed him to negotiate such ground breaking deals in partnerships with the mobile operators. Of course, it helps that Apple doesn’t have the legacy of the Nokia model for selling and distributing mobile phones.

I must admit to being totally confused as to why Nokia did not go down the partnership route with the operators. If Nokia were completely confident that the only potential successful path was without the operators, I would have expected them to launch the service in non-subsidised markets, where the operators do not have as much control over the software load on the handset and the moral right to demand preference to their favoured applications.

In summary, I don’t think the mobile operators are as in bad shape as many think, should not be too worried about the bad press in the week generated by the Nokia hype and keep on the current path playing for the long run. I also think on principle the mobile operators should block the Nokia Media Centre on all phones sold with a subsidy unless Nokia agree to a reasonable share of the revenues. If Nokia refuse to block the application, then the operators should have the confidence to not sell the product with a subsidy.

My other major comment is that people expecting huge margins from distributing copyrighted content in general and music specifically are living in cloud cuckoo land. As a real life telco example of a mature service, I would look to the premium call industry, where typically the content owner (eg TV show) gets 90% of the revenue, the distribution channel (eg the phone network) roughly 5% and the aggregator and campaign manager gets 5%. I agree margins are much higher in mobile premium calls than in fixed, but I think this will be only a temporary phenomena. Also, as far as I can make iTunes is a zero profit activity but generates huge profits on the device sales.

The only way someone outside of the record companies will make a lot of money in distributing music is if a fundamental rearchitecting of the music industry takes place.

UK Broadband: Coming Soon - 3m LLU lines

The latest OpenReach kpi’s show that we are currently are at 2,943,414 unbundled lines as of 26th Aug which means that at current run rates we should be at over 3m sometime this week.

The fears that unbundling was slowing seem to been unfounded and current quarter net additions are running at 58k/week compared to 42k/week in Q2. Q3 is already at 519k net adds with a full month to go compared to 513k in the whole of Q2. Even better news for the unbundlers is that the churn rates appear to dropping: I estimate a full 3% in the current quarter to 27% annualised.

I suspect that the players with big ipstream (or BT Wholesale DSL in the graph) bases are very busy moving their customers onto LLU DSL. I’m expecting really good porting numbers this quarter from Carphone (AOL/TalkTalk), Tiscali and Orange.

I’m also expecting that smaller ISPs are really feeling the heat this summer from the cut price unbundlers and I wouldn’t be at all surprised to see further shrinkage in the “other” base. The light at the end of the tunnel for these players is BTs 21CN WBC product and the hope that a specialist wholesaler, such as Entanet, will be able to develop some niche products and aggregate enough demand with the smaller players to make it all worthwhile for everyone.

A cursory glance at the WBC product indicates that some scale is required (ballpark initial guess - a minimum of 100k customers) and therefore a wholesale/retail approach is probably optimal for the "others". In the first generation broadband era, Tiscali fulfilled this wholesale role, but I think second time around Tiscali will be too focused on fighting the behemoths in the consumer segment to make a real go of wholesaling. But then again, I always seem to underestimate Tiscali and remember Tiscali currently has around 300k wholesale customers which is a big chunk of the market.

The stand out offer so far this quarter was the Orange Free (or Discounted) LapTop deal with PCWorld – it seemed to sell out so fast that it is obvious there is huge demand for this type of product in the market. I suspect that Orange are being cautious and wanting to see the returns, fraud, usage rates and support costs on a small sample before committing to a huge investment.

As the graph below shows nearly all home computer users already have the internet and they nearly all have broadband connections. The “Free LapTop” offers have the potential to bring a lot more households into the market quicker than expected.

All the indications are that the AOL Free Laptop will be a huge success in terms of sales especially in the run rate to Christmas. I would imagine that Carphone could easy flog 250k if they were feeling really brave – I estimate that the SAC would be around £270 and 250k would be an £67.5m investment which is serious money for Carphone.

I also wouldn’t be surprised if the initial results of the Orange Free LapTop “Beta test” programme give the UK management enough courage to put a lot of subsidy into the market: £67.5m is a lot of money for Carphone, but a drop in the Bay of Biscay for Orange.

The other recent interesting development is that Be* is back advertising with banner ads all across the net and has revised its tariffs and product specs. I suspect the new owner of Be, O2/Telefonica, are building demand to test systems and processes before a full launch. However, I think O2 will have to do something more exciting than the Be* tariffs to create even a flicker in the market.

The biggest news of the quarter so far is the biggest gossip which is that Sky are getting ready to launch a standalone broadband and broadband/home phone dual play targeting the Freeview homes. This was broken on the non-official SkyUser forum and came about because they recognized that SkyPicnic and variants of it were being registered as domains, unofficial comment apparently from within Sky seem to indicate that the product is a standalone broadband product with a new sexy-looking Netgear router.

While some people are getting excited about this product, I personally will see the launch, if it ever happens, as the first real chink in the armour of Sky. The original broadband business model was all based upon reduction in churn in the payTV business and upsale of new products thereby increasing the ARPU.

Of course, Sky Broadband is nearly one year old and a lot has been learnt about the economics of unbundling since that date – mainly that it will take around 2.5 million customers to make the effort worthwhile and that is with the majority taking both a voice and broadband product.

If Sky launches a Picnic product – the first question that I would ask is Sky worried about reaching the scale from its PayTV customers alone? The next question is whether there is a fall in demand from the PayTV base? It currently seems that Sky has capacity for around 250k additions/quarter. Are Sky adding extra provisioning and support capacity?

I would need a lot of convincing to be assured that a Sky Picnic type product isn’t the first hiccup in the BSkyB master plan.

OFCOM Communications Report: The BBC

A brief look at BBC statistics contained within the 2007 OFCOM Communications Report highlight the following shocking facts:

a) Poor and Young Subsidising the Rich and Old

The flat tax approach of the licence fee has always seemed inequitable; the viewing figures of the main Entertainment channels seem to reinforce this view.

The OFCOM graph show the richer that you are the more likely you are to watch BBC One and Two. The same graph illustrates that the Young are also subsidising the Old. This is especially true when you consider that a household containing just ONE over-75 has its licence fee paid by the general taxpayer. These over-75 households accounts for 4.0m households out of a total of 25.1m license payers or £486.6m out of a total revenue of £3,242.9m.

b) PayTV Viewers Subsidising Analogue only viewers

The higher the programming choice, the less people watch the BBC.

c) Poor Performance Rewarded by Higher Revenues

As audience share declines…

…revenues increase

The only conclusion that can be drawn from the data is the date of reformation of BBC funding is drawing closer.

H3G UK – One Step Forward, Two Steps Back…

Hutchison Whampoa reported last week and the 3G operations seems to have improved significantly on a cashflow basis in general and the UK in particular. The H3G UK & Ireland operations quoted “recurring LBITDA after all CACs reducing by 96% compared to the same period last year”. Hutchison Whampoa do not break out the financial results of the various 3G operations so it is impossible to determine the absolute number of the UK&Ireland outflows but suffice to say it is a vast improvement on the figures from last year.

Over the last twelve months 3UK has radically reshaped its distribution network moving as quickly as possible from a reliance on indirect distribution to direct distribution, whether by owned stores which have increased dramatically in number or by online and telesales channels. 3UK are sufficiently happy with the progress to announce postpaid churn of 2.5% which presumably is a dramatic improvement of churn rates in the past.

The standout headline figure was the reduction in SAC costs by £160m to £212m - some of this will have come from the lower level of contract net adds (139k vs 226k), but there will also be real savings from both the change in distribution strategy and reduction in churn. Whilst this is extremely healthy for 3UK going forward, it will put the independent distribution channels under even more intense pressure going forward.

I also think that the power of the X-Series offer is starting to show in the customer numbers – despite having a severely limited marketing budget and restricted distribution compared to the other mobile networks, the X-Series appears to be selling well. This to me shows the power of word of mouth, especially amongst the tech-savvy community of mobile users. I have yet to hear one person who is disappointed with an X-Series choice.

The prepaid base seems to be going nowhere with revenues only 10% of total H3G revenues of £811m for the half year. The prepaid “active” ARPU figure of £18.82/month and the inactive rate of 75% implies the active prepaid base is somewhere between 600k and 700k customers which is absolutely nothing in the overall scale of the UK market. In my opinion this is hardly surprising given that 3G is a premium service compared to 2G and something that should not worry people too much.

However, allied to the lack of presence in the corporate and fashion sector, it does show that H3G UK is heavily exposed to a single mobile market segment – Mobile Geeks. If another mobile operator wanted to cause H3G UK some serious pain, all they would have to do is to be ultra-aggressive in this market segment.

This really is the first of Hutchison’s strategic problems – how does H3G UK gain scale? Because they are still seriously sub-scale – the first half revenues were probably 50% of the smallest UK operator – T-Mobile and around 33% of the big two – Voda and O2. Hutch can probably halt the cashflow pain but they are never to going to generate a return on capital at current market share.

The second strategic problem is the forthcoming OFCOM termination rate settlement which will knock a huge dent in H3G profitability. The settlement will reduce H3G inbound revenue from around 11p/minute to 6p/minute while not having an associated reduction in outbound fees – this could easily take £100m per annum from H3G’s bottom line. I believe termination rates for H3G is basically a life or death situation and this will mean that every legal and lobbying avenue has to be fought to either reverse or delay OFCOMs decision.

All of which means that H3G destiny is basically out of the UK management control: they can’t attack another segment to gain market share, because which ever operator stands to lose the most will just fight back targeting the H3G geek customers; and although they can delay the imposition of termination rates through the courts, they really need to achieve the impossible by convincing the politicians to overturn the OFCOM termination decision.

For the other operators, they can just sit back and watch: they all know that one of the four buying H3G UK will radically improve the profitability of the overall UK market and they know that the termination rate settlement will probably reduce the value of H3G UK, but they also know that T-Mobile has the most to gain from buying H3G UK. A purchase of H3G by T-Mobile will probably put the UK market in oligopolistic heaven and allow a period of relative market calm and profit maximisation. However, others will be tempted to take a risk and give a little impetus to their UK operations - I can make a case for all of the other three buying H3G UK.

Personally, I suspect the market rumours from last year about a possible China Mobile bid were just an attempt to force the hand of one of the UK operators. Similarly, I expect the current round of conversations about network sharing is also an attempt to force one of the UK operators to get their wallets out. Hutchison seem to be in a bigger rush to say Goodbye to the UK mobile scene than the others are to bulk up their operations.

Virgin Media: Trouble at the Top

Steve Burch has left the Virgin Media building. His ego might be slightly hurt, but I guess a reported US$7.5m payoff will alleviate the pain somewhat. If we add the payoff to the US$11.1m earnings in 2006 and the 125k shares (circa US$3.6m) he received in April 2007 equals a sum total of well over US$20m for 19 months work. I think this is great going for someone whose reign included a quad play loss of share in all core broadband, payTV, fixed and mobile telephony markets.

In an interview with the Financial Times this morning, the Acting CEO, Neil Berkett, said “I’m keen to treat this interim period as if I was chief executive…My focus is to accelerate delivery even more… We’re at an inflection point where we’ve rebranded and weathered the storm of Sky”. Personally, I can’t see any evidence of Virgin Media yet weathering the Sky storm, let alone the BT and TalkTalk storms and that is before the upcoming Digital Switch Over hurricane. Also being a little of a mathematical pedant, I would advise VMED shareholders that an inflection point could also imply things are about to get even worse.

I find it hilarious that The Sunday Times has been dishing out some free advice for the VMED board – more or less saying ignore the Chairman, James Mooney and let the business be run from the UK. I’m sure some VMED people will be thinking that if this is the advice of someone on Murdoch’s payroll, perhaps VMED should do exactly the opposite, which is maybe what Murdoch wants…

The most difficult part of Berkett’s job over the forthcoming months will be to keep the workforce focused whilst any boardroom shenanigans are fought out in private and future leadership is decided. The uncertainty of potential sale of the company will not help matters. The most important task is to keep on the cost reduction path, complete the synergy projects still outstanding from the ntl/telewest merger and find further ways of cutting costs. Regardless it is uncertain whether any of the synergies will ever find their way into shareholder pockets as the storm of competition is currently returning the synergies directly to customers in the form of cheaper cable bills.

Personally, I don’t envy the role of anyone at Virgin Media.

Off on a Break

I'm off to Minorca for a few days Rest and Recuperation so I won't be posting until around the 27th August and I'm not taking my laptop with me.

Unfortunately my planned summer reading, Essentials of Modern Spectrum Management, has had its release date postponed by the publisher and therefore Amazon has not yet shipped the book.

I shall instead to have to amuse myself with the following reading list whilst sipping my San Miguel in the shade:

• Brilliant Orange – nothing to do with the mobile operator, but instead a story about Dutch Football;
• Andrew Marr's – History of Modern Britain; and
• Kieran McCarthy's account of the battle for the sex.com domain.

Carphone: Full Court Press for iPhone Distribution

Mobile Today is reporting that Carphone have opened an Apple store within a Carphone Warehouse store on Oxford Street in London.

Carphone's store staff are gearing up for the opening of the main attraction – the 'Apple house' – which will show consumers the concept of wireless living by displaying laptops, TV screens, iPods and music speaker systems in various rooms. The store offers Apple TV for £250 and the AirPort Extreme Base Station for £119.99, which creates wireless television displays of podcasts, pre-recorded YouTube content, movies, music and photos with an iPod-style menu on screen.

Carphone will basically do anything to convince Apple that it should be a UK distributor for the iPhone. My money is on Carphone winning the debate and making plenty of money out of the deal in the long run. For all their flaws in Telecoms Services, Carphone really are literally streets ahead of the rest of the crowd in retailing.

21CN, Bands and Regional Pricing

Samknows is in the middle of producing an excellent introduction to BT’s mega rebuilding of its core network aka 21CN. Sam is much happier with a compiler than a spreadsheet, yet is immediately struck by some of the pricing differentials on the BT product sets – for example, on a QoS product BT is proposing charging 3x the amount in a rural area compared to suburbia.

To understand what is going on it is necessary to understand the new UK network topology:

Roughly speaking, most serious nationwide unbundlers (Carphone, Sky, Tiscali, O2 and Orange) will eventually unbundle down to the Tier 1 MSAN level at a minimum which is around 1200 exchanges and covers around 70% or 17.7m of the 25.3m UK homes. Again roughly speaking, most of them will backhaul using BT Ethernet products to the MetroPOPs where they will offload traffic onto their own backbones. In other words because of the BT network architecture most of the unbundlers will be using a blueprint which will be very, very similar.

The Tier 1 area is bigger than the UK cable coverage of around 11.8m homes or 47% of total UK homes, but nearly all the cable area will overlap with the unbundled or Tier-1 areas.

In order words without further industry consolidation we have:

• 7 companies fighting for 11.8m homes or 47% of the UK
• 6 companies fighting for 5.9m homes or 23% of the UK
• 1 company fighting for 7.6m homes or 30% of the UK

This is a pretty controversial analysis because it ignores the plethora of resellers currently using the IPStream product who will be transitioned onto the new 21CN products of either IPStream Connect or Wholesale Broadband Connect (WBC). However, it is almost impossible to make money on ipstream in retail given current pricing and churn rates and therefore the only player with any margin is BT through its wholesale revenues or the relatively small number of ISPs who charge a premium for SME products.

I plan on starting crunching the numbers for the new 21CN products after my holidays, but basically I don’t hold out much hope for the non-infrastructure based ISP community and therefore really there is just one company, BT, fighting for the 30% Tier-2 homes or to be more precise the profit on serving the 30%. I suspect all of the BT wholesale pricing will appear competitive in the Tier 1 or Unbundled areas (ie where BT faces plenty of infrastructure based competition) and extremely expensive in the Tier 2 or non unbundled areas (ie where BT faces zero infrastructure based competition)

This equation spells a grim future in the medium term for the rural communities, not only will speed be lower because of higher than average line lengths, but they will be charged a higher price for the pleasure compared to the ultra-competitive urban areas. I think regional pricing is going to be a feature for the next few years.

The only potential beacon of light for these communities, apart from state subsidies, is Sky. After all, Sky probably has lots of high yielding ARPU customers scattered across rural UK where they currently face zero competition from Virgin Media. Here things will start to get really strange because the key ongoing variable cost is the backhaul and in some ultra-rural communities such as North Yorkshire and parts of Scotland there are initiatives laying non-BT owned fibre which will make backhaul cheaper on a wholesale basis and possibly make medium sized remote exchanges economic to unbundle. This will actually encourage Sky to unbundle exchanges where they have a known number of customers already signed up for the payTV service. In other words, Tier 2 or Band 2 exchanges will probably be unbundled on a case-by-case basis which will be all the more confusing to the Great British Public.

As this sub-par broadband future starts to dawn on the 30% of the UK who on average tend to be quite wealthy and politically vociferous, I see huge pressure being applied to the regulator, OFCOM, to do something about the perceived inequality. I for one will be leading the charge that it is not BT’s fault, but OFCOMs and the inevitable outcome of the dodgy settlement at the time of the conception of OpenReach.

40 years ago: Pirate Radio RIP

Fourty years ago on the August 14th, 1967 the party of party poopers, Labour, introduced the Marine Broadcasting Act which effectively banned the offshore pirate radio industry from broadcasting subversive material to the nations youth, thereby handing back a monopoly to the state broadcaster, the BBC. The UK Number One in the singles chart was the seriously subversive Scott McKenzie with San Francisco (Be Sure To Wear Flowers In Your Hair)

The end result was that the BBC, who has never missed an opportunity to keep in tune with and brainwash the future generation of licence tax payers, decided to launch Radio 1 and kicked off on Sept 30th with Flowers in the Rain by the Move spun by Tony Blackburn. The initial line-up of DJs proved to far more destructive to the nations ears than even the wildest dreams of the BBC board of Governors, although a couple, such as John Peel and Kenny Everett did manage to sneak through the interview process.

And so the charade of Radio 1 continues to this day costing the poor beleaguered licence tax payer £42.8m in 2006/7 alone. In the build-up to the Radio 1 40 year anniversary, I expect a whole load of sycophantic nonsense exaggerating its own self importance and role in society. The fact of the matter is that commercial radio would have quite happily provided a similar if not better service than Radio 1 at a far lower cost; comically the commercial sector would even have paid money to use the Radio 1 airwares. The only role that Radio 1 has fulfilled in 40 years is in consuming the oxygen which would have allowed the commercial sector to flourish. Admittedly, they have also provided a free of charge promotion service to the record industry, but I don’t think in the grand scheme of things this is where public funds should be allocated either.

BSkyB / NDS : Further Innovation in the Pipeline

The OFT inquiry into the BSkyB purchase of Amstrad couldn’t be any further wide of the mark in finding the real competitive advantage that BSkyB has over all the other players in the UK TV market. One of the consistent advantages, but not the only advantage, is the innovation that NDS has developed for BSkyB.

Conditional Access is a pretty boring dinner party subject but absolutely core for payTV operations – NDS provides the technology that secures the BSkyB business model. ITV digital found out how expensive it was to make the wrong choice when its cards were cloned and being sold in pubs up and down the UK. A little known fact is that the Virgin Media Conditional Access has also been comprised and limited bootleg versions are available as we speak on the net. NDS has never been cracked and the technology has actually been successfully implemented in Scandinavia and Italy to stop mass pirating of satellite signals.

News Corp was one of seed financers of the businesses when encryption was even less fashionable than it is today. On the back of its start in Conditional Access, NDS has spread its technological wings into other vitally important parts of the BSkyB service.

An important feature of the Sky Sports service is the interactivity. The Red Button feature is designed with NDS technology and still to this day, seven years after launch is not available to Sky Sports subscribers on Virgin Media, a compelling reason for some people to choose satellite over cable TV for some.

Betting on the TV may not be everyone’s cup of tea, but some like it and SkyBet is becoming an useful profit contributor to BSkyB profits. The multiplatform technology underpinning the SkyBet service is from a company called Orbis who NDS acquired in 2000.

Games on the TV have always been part of the BSkyB service even in the analogue days and the key partner is a Danish company called Visionik who were acquired by, you guessed it, NDS in 2002. Visionik themselves in 2006 have since bought another Danish Games developer called ITE.

When interactiveTV was first launched one of supposed key benefits was extra income generated by personalized and interactive adverts. In the first generation these were a complete flop not only because of the early smaller audience size of payTV, but more importantly because of the extra costs of production were not deemed to be justified. Step forward NDS in 2003 with its RapiAd template technology which allegedly allows agencies to build ads from the desktop in under an hour. Quite a few ads these days on BkyB appear with a red button next to them with some sort of interactivity feature.

All of these applications were revenue enhancing to the BSkyB operation, but the next product was such a step forward that it has literally changed TV viewing in the UK forever and is more addictive to the average Couch Potatoe than the Crackberry is to the average City Trader. Yes, we are talking about Sky+ in the UK. I am sure there are hundreds of City Traders whose idea of weekend recreation time is fast forwarding through adverts in the middle of recorded programmes from the week with the left hand whilst simultaneously replying to overdue emails on the Crackberry with the right. Sky+ is an absolute phenomenon and has exceeded all commentators’ expectations and NDS technology underpins it.

Once the Sky+ boxes had been seeded onto the market another new groundbreaking service was launched. Push VOD services into a hidden eighty hours worth of space on the Sky+ v2+ boxes named Sky Anytime and again supported by NDS technology. Currently the content is limited to programmes that have been shown on the Satellite channels, but I don’t suspect it will be too long before Hollywood starts using Sky Anytime as a mechanism for distributing relatively new movies for rental. I can’t think of a cheaper distribution mechanism than using overnight spare satellite capacity to millions of homes.

Assuming a rental price of £4/movie with a 50:50 revenue share with the movies studios works out to be £1.70 revenue/movie share to Sky. Assuming an average 1% take-up per week for the Sky households of 8.5m works out to be £7.23m additional high margin turnover both to Sky and the Movie studios per annum with very little risk of pirating. Sky Anytime could be quite a nice profit centre for BSkyB in the future.

Of course the million dollar question is where the Sky/NDS partnership is heading next.

As with the hidden storage, I believe there is also a chance that a new service will spring to life with the less hidden USB port on the front of the Sky+ boxes. This is only a software download away from being really useful output device for copying content from the hard disk to a portable memory stick which can then be played on other types of devices (eg laptops). Of course, the security will be a concern, but for a company such as NDS with security embedded in its DNA it shouldn’t be too high a hurdle to overcome. I would expect in the future Sky+ boxes to have memory card reader/writers contained within them.

Despite the efficiency of broadcast networks and the capacity of broadband networks, I still believe that reusable physical media has a big role to play in future media distribution. It should be remembered that there is as much innovation going on in physical media as in any other means of distribution – the industry has moved on a lot from the write once unprotected CD’s that have created such anarchy in the music market.

One recent acquisition in Dec 2006 by NDS of Jungo Ltd, brings a lot of expertise in USB interfaces. However, the real reason for the acquisition is the Jungo expertise in producing out-of-box software platforms for home gateways. These gateways are the fundamental means for broadband customers to access the network and are becoming more and more complex over time – not only including the DSL modems, but also routing and firewall capabilities, wireless access points, remote management, storage and print facilities. NDS are pretty open in their belief that support for a hybrid set-top box and home gateway for both ip and broadcast video is the next evolution of their software set and Jungo gets them all the capabilities they require.

This hybrid solution NDS calls the Xspace architecture. It offers fantastic revenue opportunities not only in the long tail of content, but also in targeting ad-insertion and a decent quality return path rather than the current dial-up modem based solution that the current generation of set-top boxes uses.

It is interesting that last weeks acquisition of CastUp provides NDS the capability in the final missing piece of the jigsaw: a CDN. CastUp is not currently on the radar of most industry observers, but it is quite successful in distributing content around Israel, I don’t suppose it will be too long before a CastUp CDN for the UK is built tightly integrated with the BSkyB/Easynet internet backbone.

NDS although quoted on the NASDAQ is majority owned by News Corporation and reported great results for FY0707 last week with revenues of US$709m, Operating Income of
US$160m and Cash Balances of US$593m. Although quoted in the USA, NDS is actually based in West Drayton, Greater London just up the road from BSkyB’s HQ in Isleworth, Greater London. NDS has a lot of other customers worldwide apart from BSkyB and openly markets its software to all cable and satellite companies.

BSkyB derives a lot of its technological advantage through the symbiotic relationship with NDS and only a fool would bet against their view of a hybrid broadband and satellite future. Virgin Media, BT and the other broadband players are going to have their work cut out to keep up with the innovation already on the way.

iPlayer going to be Throttled

The current debate that has started between the ISP Industry and the BBC over the iPlayer highlights a fundamental flaw in the Public Value Assessment (PVA) by the BBC Trust for the on-demand services – it basically ignored the costs of internet video delivery and in fact rather naively stated:

How the networks adjust and how the costs are met is ultimately a matter for the market. Undoubtedly, the BBC Executive may be involved in discussions with ISPs and network providers but we do not consider it appropriate to issue any directions to management on this issue in this approval.

Effectively, the BBC regulator buried its hand in the sand hoping that the “market” and the BBC Executive would come to some sort of amicable solution not realising that a sinister market solution might be deployed. eg mass blocking of the service.

The other major flaw with the PVA was that it built demand forecasts based upon two incorrect assumptions:

i) that the service would be “incrementally” free; and
ii) the service would be available for peak-hour viewing.

A user consuming loads of bandwidth by watching loads of video may have to pay for a more expensive broadband service in order for it to work. In this mornings FT, this is a potential solution proposed by Mary Turner, CEO of Tiscali. Another “nuclear” option was suggested in the Daily Mail where tagging of the BBC traffic and throttling it was suggested.

I’m sure the BBC demand forecasts would have turned out completely different if the question was “If you had to pay your ISP £2/month extra to use the iPlayer would you use the service?” or even “If it took you 48-hours to download the latest Eastenders programme would you still want to watch it on your PC?” or even worse "If it took 48-hours to download a legit copy, would you prefer for a non-DRMed bootleg copy that you could burn to DVD and watch on your TV?"

This is a crucial battleground for the ISP industry and one in which I believe the BBC does not have the moral highground. After all, it pays huge fees to Arqiva/National Grid Wireless to transmit its Terrestrial digital TV signals and it also pays huge fees to Astra to rent satellite capacity for transmission of its content by Satellite – why did it expect to transmit its content for free over the internet?

The ISPs are fighting a Public Sector Broadcaster and the results of the fight will be able to be applied to other commercial video content providers, such as ITV, Channel4, Sky, Google and the rest of the emergent video crowd. It is a vitally important fight that the ISP industry needs to win or at worse get a compromise draw that can be imposed on the rest of the commercial sector.

The BBC Trust has already got its knickers in a twist with the lobbying by the Open Source Community for a non-Microsoft solution, I suspect this time around a more potent force is about to be deployed to strangle the iPlayer at birth. After all, most large ISPs (BT, Tiscali, Orange & Sky) already have video business plans of their own - why should they roll-over, let the BBC solution dominate and ruin their business plans?

Virgin Media – Refinanced in the nick of time...

From the 10-Q SEC filing just released, it looks as if the CFO has refinanced just in the nick of time…

In April 2007, we amended the senior credit facility and borrowed an additional £890 million under a 5½ year bullet Tranche B5 term loan facility and a 5½ year Tranche B6 term loan facility. We used the net proceeds to repay some of our obligations under the Tranche A and Tranche A1 term loan facilities.

After giving effect to the refinancing in April 2007, the principal payments are scheduled as follows:

• March 31, 2009 - £2.5m
• September 30, 2009 - £474.5m
• March 31, 2010 £526.5m
• September 30, 2010 - £579.4m
• March 3, 2011 - £966.0m
• September 3, 2012 - £-2,203.7m
• March 3, 2013 - £300.0m

Even if Virgin Media don't generate the £475m needed to refinance between now and Sept 2009, the credit squeeze will be more than likely over and they can continue limping along.

Q2: UK Mobile Market Wrap-Up

I knocked up a quick chart showing the trends in the UK Mobile Market, but before the analysis a couple of notes of caution:

• 3UK figures are not released yet and these are more important to the UK market than Virgin Mobile
• Voda have stopped recording the inactive numbers, so have a different way of counting the base than the rest
• Voda and O2 exclude their MVNO operations from the subscriber count
• I have assumed all the Virgin Mobile base, both prepaid and contract, are counted within the T-Mobi prepaid numbers. The T-Mobi numbers will also include figures from their smaller MVNOs such as Fresh.
• O2 and T-Mobi only state their revenue figures in €’s and therefore I have converted them using the average exchange rate used by Orange during the quarter.

What is apparent is the speed that O2 service revenues are catching up to Voda's. However with Voda taking much more market share in net adds for both pre and post paid for the half year, I’d be extremely surprised if Voda didn’t finish 2008 still in the lead on the service revenue front.

The promotion of the quarter is definitely the O2 Simplicity deal which appears to be pushing its prepaid base into taking sim-only contracts. Personally, I think this is a great idea and will undoubtedly be copied by the other networks. I think the offer could also be slightly developed and offer tenure-based discounts on new handsets – this will drive traffic into the operator stores and promote loyalty. This is the approach that Sky is taking on flogging HD boxes and every operator in the UK would love for Sky-like churn figures.

The other interesting development in the quarter was the axing of the BT Movio mobileTV service as retailed by Virgin Mobile. Personally, I think this is a shame and is probably an indicator that DVB-H will eventually win out as the standard in the UK. For the other operators, they will be grateful to one less potential buyer of spectrum in the forthcoming L-Band auction.

Virgin Mobile has a new boss, but I think he will have his work cut out to improve margins and the customer base at the company. It is easy to provide a short term impetus to earnings by effectively shutting down a vast swathe of distribution to concentrate on direct sales to the cableTV base. Virgin Mobile is probably facing a long decline in the base unless they start pushing prepaid again.

The big surprise to me was Carphone’s continued growth in distribution despite nearly all the operators claiming direct connections are at a high. All I can think of to explain this phenomena is that Carphone is taking market share from the other mobile retailers such as Phones4U. It just goes to show the continued excellence of Carphone in retailing both on the High Street and Online. I did have to laugh at the Rene Obermann comments about one UK retailer being exceptionally aggressive in the quarter.

T-Mobile are a bit of an enigma at the moment with them cutting the value in the Flext package and also facing the initial wave of Flext contracts from the launch 18-months ago starting to expire. I suppose if things get really scary and they start losing some of the contract base, Carphone will gladly help them out in acquiring new customers at the right commission level.

3UK have also been quite quiet in the marketplace, but I think this is more a feature of the success of the X-Series and them not having to put other offers into the market. The key focus for them is the battle with OFCOM over termination fees, a victory in this is an absolute must.

Virgin Media: Credit Squeeze

Pity the poor Virgin Media shareholders: just as it looked as if the Gods of Private Equity were smiling down on them the credit markets have taken a turn for the worse and the chances of quick exit seem to be diminishing by the day.

Partially soothing the pain, there were a couple of positives in yesterday’s Q2 results: net debt had only increased by £19m in the quarter to £5,786m and OCF grew to £315m from £306m in the previous quarter. People can debate the customer numbers until they are blue in the teeth but these are the most important two figures that Virgin Media release every quarter. This is because the gigantic £4,970m credit facility has certain stringent covenants attached: one of which is the leverage covenant which currently stands at 5.25x – with a rolling 12-month OCF of £1,252m, the ratio currently stands at 4.62x. This gives Virgin Media a certain amount of breathing space – the rolling 12-month OCF figure would have to drop by approx. £150m to breach the covenants at current debt levels. In other words, things would have to get a lot worse in the marketplace for Virgin Media to be in any danger.

However the credit facility has a repayment schedule attached to it and unfortunately for Virgin Media shareholders £237m has to be repaid on 30th September 2007, followed by another £237m in March 2008, followed by another £237m in September 2008 and so on until 2011. As at 30th June 2007, Virgin Media had £277m of cash so can probably make the first repayment in September, but the Mar 2008 payment? I seriously doubt it with the current cashflows and I’m not expecting the marketplace is going to get any easier in the short or medium term.

All this means that sometime soon Virgin Media will have to sit down with the bankers and rearrange the credit facility – not a nice prospect when there currently is a credit squeeze. For sure, the bankers won’t let Virgin Media go under for a second time, but I expect they will want a pound of flesh – interest rates and facility fees are bound to increase.

The only other real option for Virgin Media is to sell out to probably a trade buyer and John Malone, the Darth Vader of the Cable Industry is waiting in the wings and will probably buy any Euro Cable Asset if the price is right. In fact, he is probably the only person on the planet who could give the BSkyB juggernaut a run for its money. Come to think about it, wasn’t Darth Vader and the Death Star on the same side?

UK Broadband Market Summary Q2 2007

I can’t think of anything simpler than counting an ADSL customer: only one company at a time can use a copper pair and the final provisioning is controlled by a third party - either Openreach (LLU) or BT Wholesale (ipstream). However, the Q2 figures almost certainly show that an element of double counting is going on:

As far as I aware, Sky has not declared whether their figures include the UKOnline base which was 32k at the end of Q1. If the figures don’t than Sky net adds are even more remarkable.

BT despite pricing their services at a premium is still attracting a very good share of the overall market. I’m sure that this is not just because of the quality image, but also because competition in the rural areas is a lot less fierce, especially in non-LLUed and Cabled areas.

The Virgin Media share just keeps on drifting and this is despite the “claimed” top end package of 20-meg and the bargain basement £10/month 2-meg service without having to pay a line rental.

Carphone/TalkTalk/AOL appears to held their own during the month. Although the premium priced AOL seems to have faired a lot less well than the competitively priced TalkTalk. With the Free Laptop not kicking in until September and AOL priced extremely high in the non-LLU areas, I expect to see further drift in the AOL base in Q3.

Be is basically going nowhere and needs the brand relaunch by O2 which is due in October. O2 must be burning cash by the bucketload on this operation currently.

The lack of conversion of narrowband customers to broadband must also be a worry for both Orange and AOL. AOL narrowband base dropped 58k in the quarter to 447k and Orange by 124k to 915k. Neither of these drops were mirrored by increases in the broadband base. Remember that the Narrowband customers should be delivering huge margins at this period of their life cycle and it will be worrying the rapid drop off without going onto broadband.

Also, a big worry for the market will be the current lack of scale for Sky. I estimate that Sky need around 3m customers to make economic sense. At a run rate of 250k /quarter, Sky will continue piling the pressure for another 2-3 years and the Sky strategy is one of churning payTV customers from the other networks. Remember the majority of high income payTV customers will probably already be computer users and almost certainly will have some form of internet from another supplier.

With Sky’s strategy and the general dissatisfaction in the marketplace, I will be extremely surprised if overall market churn drops below 30% for the foreseeable future. The Openreach LLU stats show churn at around 30% for the LLU which is incredible give the high percentage which will still be in contract. I dread to think the current ipstream churn but current speculation puts it a lot higher than 30%.

Given the churn and the fact that deep-pocketed players such as O2 and Orange are still seriously sub-scale, I can’t see Broadband margins increasing for the foreseeable future…

Amstrad / BSkyB deal

I must admit to being a little blindsided by the BSkyB purchase of Amstrad. I think the deal makes sense financially, although is probably a lot less of a quantum jump strategically than most people think.

The 150p/share offer values the equity of Amstrad at £125m. The latest published balance sheet information highlighted cash balances of £28.3m as at the interims as at 31st Dec 2006. This would give an Enterprise Value of around £100m. We also have to consider adjustments for other working capital items such as inventories, trade and tax receivables and payables and provisions. Overall, the Amstrad balance sheet looks pretty strong and the EV is probably closer to £90m than £100m at 30th June.

Amstrad itself consists of 3 main parts: the Set Top Box business whose customers are BSkyB and Sky Italia; a marginally profitable (and therefore can be ignored) audio business; and the E-mailer phone business which has ceased manufacturer but provides on-going and declining profits.

In the six-months to June 2006, the email business contributed just over 30% of pre-tax profits with £3.3m out of £10.5m. This will obviously given the business model be highly cash generative but also be declining rapidly. I modelled this business declining steadily over 3-5 years and having cash conversion of between 50% and 80% and I get an upper value of around £9.5m and lower value of £2m. In around words it is insignificant compared to the overall set-top box business.

The next key variable on the deal is the relationship with Sky Italia: turnover in the 12months to June 2006 and 2005 was £18.3m and £24.5m respectively. This is a key relationship and really important to keep production volumes up and help in the economies of scale. Obviously BSkyB and Sky Italia have different shareholders and therefore probably a new mutually beneficial contract will have to b negotiated between the two.

If we use the same analysis of revenues by geographical destination and subtract the emailer revenues we get steady revenue in the UK of around £56m in 2005 and 2006 with BSkyB. Remember Amstrad only supplies currently around 30% of BSkyB Set-Top Boxes. Also, remember the higher end (and therefore more expensive) HD/PVR boxes are supplied by Thomson.

This probably means that with Amstrad Operating Margins of around 20% of Set-top boxes, BSkyB will save around £10m annum on current volumes. Obviously with an inhouse capability, BSkyB might push more volumes into the old Amstrad operations, but I seriously doubt that they would want to go the whole way and single source Set-Top boxes from an inhouse operation. Perhaps, BSkyB could go to 50% which would mean saving of around £15m/annum.

It is very easy looking at the Set-top box equation for BSkyB and adding in economies of scale with Sky Italia to produce a pretty compelling argument for the acquisition merely on a cost reduction basis.

Strategically, I am a little confused as to why BSkyB feels it necessary to add an ODM string to its bow. Currently, BSkyB effectively tightly controls the functionality of all its set top boxes through the issue of reference designs. I’m also sure that Sky keeps tight control of the software loads on the boxes through its key partnerships with OpenTV (Middleware and Interactive TV), NDS (Conditional Access and PVR functionality) and Gemstar (EPG patents). Most of the key (and complex) software drivers will be written not by Amstrad but by its Chipset partners of which the most important is Conexant who seem to provide the crucial video stream processor for the current generation of Amstrad boxes. I’m sure that BSkyB also provides most of the testing of the hardware and certainly periodically updates the software stacks through automatic flash updates.

There is also the risk with the next generation of set-top boxes which will almost certainly include some sort of home networking functionality: connecting all the home PCs and TVs and providing external connectivity whether via cable, adsl, dtt or satellite. This is exactly the market that some of computing giants such as Microsoft and Apple are targeting as well as usual plethora of home entertainment brands (Sony, Samsung and Panasonic) as well as the usual set-top box manufacturers (Thomson, Pace, Scientific Atlanta) I’m not convinced that BskyB can play and win against this crowd in the long run.

Overall, I’m not convinced at all with the acquisition and while it is certainly fickle to suggest so, I suspect the whole deal might be some sort of retirement present for Alan Sugar for all his years of help in building BSkyB into the juggernaut it is today.