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Friday, October 12, 2007

Carphone Trading Statement: iPhone & Distribution

After an overseas business trip, I’ve finally got round to listening to the Carphone Trading Statement and I found the only interesting parts to be the comments on the iPhone and distribution in general. The real key for the broadband side of the business is the profitability which wasn’t disclosed.

Carphone securing some of the UK iPhone distribution rights was a huge feather in their cap and was not a total surprise for me. Personally, I think that Carphone will sell a lot more iPhones in their stores than either o2 or Apple; retailing is the core strength of Carphone and I think no-one doubts that Carphone are far more advanced and successful at phone retailing than anyone else in the UK market.

Charles Dunstone remained very tight lipped on the commercial details of the deal, but provided a few clues about the process. As in the US, activation of the IPhone will not be done in-store, but instead via the net at home. This effectively means that Carphone will not be performing any credit vetting at the Point of Sale and the transaction will be relatively simple to complete in store – Charles Dunstone himself compared it to a Prepaid sale.

How Apple and O2 are going to ensure the phone is going to be activated on the O2 network and not unlocked is unsure, but it seems that Carphone will play little role in this activity. Also, how O2 and Apple will deal with people who fail credit checks is unsure, but again it appears that Carphone will play little role. It looks as if Carphone liability ends with the person walking out of the store.

The net effect for Carphone will surely be a lower margin for an iPhone sale than a traditional contract sale. In FY07, Carphone made a gross profit of £26 on prepay sales and £99 on subscription sales. I would be very surprised if Carphone was making more than average prepay margin on iPhone sales. However, there are other opportunities for Carphone to make margins – I think the insurance angle could be particularly lucrative.

The overall impact of the iPhone on the Carphone gross margin depends upon on the degree of cannabilisation of “normal” Carphone contract customers; Carphone will be hoping that iPhone buyers will be people who normally buy contracts direct from the operators and not from their stores. It is very simple to play with the variables: for instance 1m iPhones sold in the UK in the next 12-months, Carphone selling 50%, Cannabilisation 60% and loss of margin £75/sale (versus a gain of £25 on the 40% of new business) gives a loss of gross margin of £17.5m for Carphone.

The Distribution business made an EBIT of £141m in the FY07 so this scale of margin loss would have a impact on the overall business. It will take a lot of insurance policies, accessories and extra footfall (ie other non-iphone sales) to make up this shortfall. It should also not be forgotten that at first glance it appears to be far better for Carphone to have some iPhone business than none at all.

Whether having iPhone distribution is better than none at all is not only dependent on the gross margins and cannabilisation, but also on the pound of flesh that o2 has extracted in allowing Carphone to become a distributor. If I was in O2 shoes, I would have definitely looked at reducing my two biggest nightmares: churn and cashback.


The churn on O2 contract base (diagram from Voda) is much higher than Vodafone at 21.5%, furthermore the gap has grown despite the Vodafone exit from Carphone and the introduction of 18-month contracts. Vodafone is also outselling O2 on contract customers. Obviously, incentivising Carphone to reduce churn on O2 contracts will be seen as a current priority for O2.

The easiest way of doing this is to reduce the upfront cash commission and increase the share of on-going revenue. This not only moves the risks from O2 to Carphone but also alters the cash flow especially given that Carphone will pay for the handset cost upfront. There will become a point on the mix of upfront and ongoing commissions that Carphone effectively just becomes a Service Provider on the O2 – a very similar model to Germany.

The downside of Cashback is becoming more and more apparent to all operators. Carphone, especially through its online subsidiary, e2save, is still aggressively pushing cashbacks deals. In fact, its cashback terms are still more severe than the recommendations from operators which have been endorsed by OFCOM.
For example, in relation to a cash back offer, the following terms should be regarded as unreasonable:
  • a requirement that the customer submits their original statements – copies of statements should be acceptable proof;
  • charge for processing a cash back claim;
  • a requirement that cash back claims are submitted within an unreasonably short period (such as anything less than 60 days, for example);
  • terms stating that a cash back payment will not be made if the customer has an outstanding balance on their account.

Basically, the Carphone price match terms currently break every single condition, albeit you only get charged a processing fee if there is an error in your documentation.

I have a sneaking suspicion that the reason that off-the-page contract sales are falling is because cashback is being clamped down upon and therefore the deals just aren’t as appealing or more importantly affordable or it is simply a case of "once bitten twice shy". Probably ex-cashback customers are either returning to the prepaid market or going direct to the mobile operators.

As the Operator backoffice systems are becoming more and more sophisticated, Operators are becoming more sophisticated in retaining the high value customers inhouse and this leaves the average customers connecting via third parties becoming less and less valuable. The big risk for Carphone is that they enter a downward spiral where operators put off their most valuable customers, the remaining customers have a lower average value and therefore Carphone gets less commission.

I feel that this twin threat of shifting the risk to Carphone and the average customer being less valuable is much more threatening long term to the Carphone distribution business model than losing the Vodafone contract business.