Opinion Paper

Managing the Profitability of

Eastern European Mobile
Telecommunication Carriers

2010 / 03

We make ICT strategies work

 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

Contents
1 Executive Summary ...........................................................................................3
2 Current Market Situation ....................................................................................4
3 Benchmark Results............................................................................................6
4 Strategic Measures .......................................................................................... 10
5 Potential Detecon Support ............................................................................... 11
6 The Authors .....................................................................................................12
7 The Company ..................................................................................................13

Opinion Paper 2 Detecon International GmbH

 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

1 Executive Summary

1
Nearly all major European telecommunications carriers have stakes in Eastern Europe .
Against this background, Detecon performed a benchmark study on the financial
2
performance of Eastern European mobile telecommunications operators in late 2009 in
order to learn more about the subsidiaries’ value contributions to the groups as a whole and
to highlight strategic measures for those charged with governance.

Our scope included 22 countries from Eastern Europe representing around 496 million
mobile subscribers. We assessed the data of mobile operators serving around 350 million
subscribers in 14 countries and benchmarked the results against mature and integrated peer
operators (Vodafone, Telenor, Verizon, AT&T, Telefonica, Deutsche Telekom, France
3
Telecom, NTT DoCoMo). Detecon focuses on three financial KPIs .

The benchmark shows that Eastern European mobile operators are still profitable. However,
this paper emphasizes the need for strict control of financial performance, and Detecon
recommends those charged with governance both at headquarters and within local
subsidiaries to collaborate closely, as this will be the only effective approach to maintain
profitability.

Russia
Estonia

Subscribers in Scope [mio.]

Latvia
496 Lithuania
500
Belarus
400 347
Poland
300
Ukraine
200 Czech
Republic
Slovakia
100 Moldova

Hungary
0 Romania
Total Covered Slovenia
Subscribers Subscribers Croatia Bosnia/
Herze- Serbia
govina Bulgaria
Montenegro
Macedonia Turkey
Albania

Legend:
Greece

Captured Not captured N.A.

Figure 1: Benchmark Scope

1
Even though “Eastern Europe” may be a misleading term, as there are great economic,
political and historical differences between these countries, Detecon decided to assess
them as a group, as it is common practice from a corporate perspective. See also
“Wrongly labelled” (The Economist, 07.01.2010).
2
Financial data has been obtained from the annual reports of the operators as of FY 2008.
3
Key performance indicators assessed: EBITDA margin, EVA®, Operational Gearing.

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

2 Current Market Situation

 Rapid subscriber growth  Increased competition

 Network roll-out  Pressure of the new technologies
 Significant business complexity

Start up Growth Maturity Saturation Restart

Avg.
Life cycle phases of stage
telecommunication
companies Structure the business and
fight with its complexity

Revenue driven Profit driven

 Market saturation, no revenue-

driven growth
 Business inefficiencies prohibit  Business innovations
Market launch further development
  Enter/create new
 License acquisition + Financial downturn markets

Eastern Europe

Figure 2: Market Stage of Mobile Operators in Eastern Europe

US$/month/subs. ARPUs % of population Penetration rates

16 110
100
14
90
12 80

10 70
60
8
50
6 40

4 30
20
2
10
0 0
2004 2005 2006 2007 2008 2009 2004 2005 2006 2007 2008 2009

Aggregate Mobile Penetration

Voice PC penetration
Data Wireline broadband
3G penetration
Source: Pyramid research

Figure 3: Growth prospects remain in data and broadband

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

Eastern European telecommunications markets have matured and are now saturating
(compare figure 2). Operators are facing business inefficiencies and are under pressure from
4
the effects of the financial crisis . Moreover, competition is increasing and the need for
ongoing investments in new technologies remains. Therefore, revenue-driven business
models ought to be replaced by profit-driven ones in order to defend profitability and liquidity.

5
As shown in figure 3, total ARPU has constantly decreased until 2006. Since then,
aggregate ARPU levels are stable. Data ARPU is slightly increasing and has nowadays
reached a share of 20% in the total ARPU. But growth is not yet substantial enough to
accelerate total ARPU growth. Over the same period of time, the penetration rate of mobile
subscriptions has grown nearly threefold.

6
Despite those challenges, there is a set of opportunities for mobile operators :
 Many operators in Eastern Europe have a large number of inactive SIM subscribers.
Those should be either discounted or re-conquered, as happened e.g. in Russia and
Hungary.
 The majority of subscribers are pre-paid; those subscribers should be lifted into more
valuable post-paid contracts in order to ensure continuous revenue streams. Innovative
tariff pricing is key.
 PC penetration is still low, and as a consequence so is wireline broadband penetration.
3G/4G technology could be positioned early enough at the right scale as an alternative to
wireline broadband, e.g. using 3G dongles in bundles with netbooks (similar bundles
have been introduced successfully in Western European markets).
 Experience has shown that data and content VAS services will be taken up by customers
as soon as licence and roll-out issues of 3G have been resolved; VAS services should
be stabilized in order to win higher-value customers.
7
 Another key success factor could be to find a suitable MVNO model complementing the
existing tariff structure – as it is common practice in Western European markets – once
regulatory authorities put more pressure on incumbents.

Our benchmark results confirm that current financial performance is still adequate, but they
also highlight the need for tighter control in order to maintain the current profitability levels
and to cope with the challenges resulting from the described market situation.

4
Compare “Impact of the Financial Crisis on the European Telecommunications Industry”
(Detecon, February 2009).
5
ARPU = Average Revenue Per User per month.

6
Compare telecommunication reports on Eastern European countries (Business Monitor
International, 2009).
7
MVNO = Mobile Virtual Network Operator.

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

3 Benchmark Results

Min Median Max

32% 43% 58%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Min Median Max

29% 34% 45%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Operators in scope Peer operators

Figure 4: KPI 1 - EBITDA8

The EBITDA median of the operators in scope is 43%, this is nearly 10% higher than in the
peer group (34%). On the one hand, this can be explained by the much higher diversification
of the peer operators which provide mobile, fixed, broadband and corporate ICT services. On
the other hand, peer operators have already reached the ‘restart’ market stage (compare
figure 2); a transformation which is yet to be accomplished by the operators in scope. The
large spread between minimum and maximum values at 26% is still much higher than the
16% spread of the peer group, indicating that there are stars and laggards with a wide span
of corporate momentum, whereas the peer operators have become more closely aligned in
terms of organizational development.

Detecon predicts that the more the emerging market players evolve towards the business
models of the peer group, the more their EBITDA margins will deteriorate. Moreover, heavier
price wars, increased regulatory pressure, and maturing markets will put further pressure on
9
margins . Detecon forecasts that in the mid-term, the EBITDA margin’s median of the
operators in scope will develop towards a value of well below 40%.

Since the concentration on higher value customers and advanced services require ongoing
investments in new technologies, the pressure on EBITDA and net profit remains and thus
the value contribution to the groups as a whole in terms of Economic Value Added (EVA®)
remains uncertain.

8
EBITDA = Earnings Before Interests, Taxes, Depreciation & Amortisation.
9
Compare “Adapting to the challenges of a harsh operating environment: operator business
models in Europe” (Informa Media and Telecom, 09.09.2009).

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

Min Median Max

-2% 12% 31%

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

Min Median Max

-7% 5%

-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%

Operators in scope Peer operators

Figure 5: KPI 2 – EVA®10 as of revenue

Comparing EVA® or the value creation for shareholders seems to result in a more distinct
picture. The median value of our assessed mobile operators is still around 12%, while the
same figure of the peer operators equals zero. In line with the EBITDA spreads above, the
spread of EVA® values of the operators in scope is much wider than the EVA® spread of
peer operators: very well-performing operators on the one hand and value-destroying ones
on the other. These findings highlight that Eastern European subsidiaries do not necessarily
generate added value for global players.

Therefore peer operators have to collaborate closely with their local subsidiaries in terms of
tracking and improving key performance indicators. This conclusion gains even more
importance since Detecon expects value contributions of Eastern European operators to
follow those of their peers. This is based on the assumption that firstly, EBITDA is the main
driver for EVA®, and secondly, that capital costs tend to increase in times of economic
11
troubles, as recently happened in Greece . As a consequence of being downgraded by the
rating agencies S&P and Moodys, average capital costs will probably increase, which
subsequently will result in higher capital charges and thus will put further pressure on EVA®.
Nevertheless, our benchmark results show that most companies are value contributors, but
parent organizations should carefully consider divestment options, keeping in mind that the
overall economic situation will need time to improve. Tight portfolio management is
necessary, especially in times of economic troubles and because cash flows are the most
12
important valuation methods for our operators in scope .

10
Economic Value Added® (calculated as net profit after tax minus capital charge).
11
Compare “Papandreou tries to prop up the pillars” (The Economist, 17.12.2009).
12
Compare “Value-based management: an approach for wireless network operation service
companies” (C. Carter in Journal of Telecommunications Management,
Vol. 1 2008, p. 46 ff).

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

But what are the key levers for the free cash flow of telecommunications operators? Capital
expenditures around 10% of revenue are standard in the industry and cannot be reduced
13
considerably when new technologies like LTE are waiting for implementation. That leaves
working capital and operating profit as drivers. From the authors’ point of view variable costs
in the telecommunications industry are mainly interconnection charges and leased lines,
controlled by the regulatory authorities. Finally fixed costs will remain the major cost element
to significantly influence operating profits.

A suitable KPI for managing flexibility in cash flows is operational gearing, measuring the
proportion of contribution after variable costs to operating profits. The lower the operational
gearing, the higher the flexibility of cash flow, which in turn will reduce the company’s
business risk.

Operational Gearing
3.4 Operating Profit
245

240
3.2

Operating Profit in Mio. €

235
Operational Gearing

230
3.0
225

2.8 220

215
2.6 0
77 77 78 79 79
Fixed cost in % as of total costs

Figure 6: Fixed Costs vs. Operational Gearing

Our sample mobile operator in figure 6, which is representing the median company in terms
of operational gearing, is suffering from massive operating profit decreases since the
operational gearing rises disproportionally compared to the fixed cost increase. Apparently
this operator is facing a major business risk if Eastern European mobile markets develop as
Detecon predicts.

13
LTE: Long Term Evolution – a new high-speed air interface for cellular mobile
communication systems.

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

Decreasing cash flow flexibility

Min Median Max

1.7 2.5 3.1

1 1.5 2 2.5 3 3.5 4 4.5 5

Min Median Max

2.9 3.1 3.8

1 1.5 2 2.5 3 3.5 4 4.5 5

Operators in scope Peer operators

Figure 7: KPI 3 – Operational Gearing

For operational gearing, our benchmark results show a median value of 2.5 for our operators
in scope. That is still well below the minimum value of the peer group, indicating higher
flexibility on operational cash flows. Detecon predicts operational gearing for these operators
to develop towards the peers’ value, due to:
 slightly increasing contributions and revenues,
 higher fixed costs for marketing, customer management, distribution and
network quality because of increased competition, and
 continuously high or even increasing depreciation charges, since the recently
seen value decline of “non-euro local currencies” will lead to an effective
increase in the price of network equipment, which is mostly denominated in US
14
dollars or in euros.

Some stars in Eastern Europe have a very low operational gearing and their management is
not yet aware of the rising importance of managing fixed costs; they are still tackling pure
growth problems. Managing fixed costs in growth markets is less important compared to
mature markets, as a higher degree of fixed costs could even result in higher operating profit
15
margins if the subscriber base is still growing . But this is no longer the case in Eastern
European mobile markets. Therefore managing fixed costs and developing appropriate
improvement measures will become ever more important.

So, how to cope with the increasing pressure on financial performance?

14
Compare “Financial crisis hits central and eastern Europe, but telecom operators take
steps to weather the storm” (Informa Research, 19.02.2009).
15
Compare “Influencing cost structures to manage risk return” (C. Horngren / M. Datar / G.
Foster in Cost Accounting - A managerial emphasis, 12th edition, p. 75, 2007).

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

4 Strategic Measures

Maintaining the current financial performance of Eastern European mobile operators will only
be possible by joint efforts from local executives in the subsidiaries and global executives in
headquarters.

Measures for local operators:

 Stabilize existing revenue streams, by turning pre-paid subscribers into more valuable
post-paid subscribers. Introducing innovative tariff pricing would engage customers for
16
such a move, as has been shown in Japan with a post-paid share of 98% . T-Mobile
and Telefonica in the Czech Republic have also shown that it can work.
 Conquer the broadband market via 3G/4G and assess wireline partnerships while
take-up is still low.
 Increase customer’s share of wallet by offering a comprehensive service portfolio
(voice, data, VAS, TV), based on a solid broadband infrastructure.
 Improve operational performance by centralizing functionality, simplifying internal
structures, and harmonising technologies.

Measures at the corporate level:

 Set up a clear portfolio monitoring of Eastern European subsidiaries in terms of value
contribution and operational risk.
 Based on portfolio monitoring, consider divestments of value destroyers. Value
contributors should be further developed to have sufficient cash contributions in the
future.
 Consider local joint ventures in highly competitive markets as Orange and T-Mobile
have done in the UK.
 Define clear corporate-wide roadmaps for technological investments (FTTH, 3G/4G)
and telecommunications services upon these platforms. Invest in group-wide
homogenous platforms to reduce OSS complexity.
 Develop standardized marketing services which should be customized according to
the local cultural environment, as Vodafone is doing with its “live!” platform.
 Develop global content sourcing strategies to benefit from economies of scale for the
local subsidiaries.

16
Compare “Mobile Pricing Innovation” (IDATE, 2008).

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

5 Potential Detecon Support

Detecon is familiar with both views, those of the local subsidiaries and those of group
headquarters. How could Detecon support each of the stakeholder groups?

Potential Detecon support for local operators:

 Developing and implementing market strategies for new products & services and
developing innovative tariff structures, addressing the need to stabilize revenue streams.
 Developing and implementing cost accounting systems to create costing
transparency.
 Developing and implementing programs to improve operational performance, e.g.
for network and customer care optimization.
 Developing and implementing business planning & budgeting processes and tools
to transform strategies into quantified plans of action.
 Developing and implementing wholebuy strategies to enable fixed-mobile-
convergence for mobile-only carriers to sustain revenue growth.
 Optimizing the wholesale portfolio for local incumbent operators.
 Providing regulatory support for interconnection regulation.

Potential Detecon support for global carriers:

 Developing and implementing strategies for managing stakes in Eastern Europe, with
particular focus on corporate governance and synergies.
 Developing and implementing performance management systems to better steer
Eastern European stakes.
 Developing regulatory strategies from a global perspective.

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

6 The Authors

Patrick Braunschweig
Senior Consultant Corporate Finance
Mobile: 0049 151 146 22779

eMail: Patrick.Braunschweig@detecon.com

André Wilbert
Senior Consultant Wholesale Strategies
Mobile: 0049 160 906 39195

eMail: Andre.Wilbert@detecon.com

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 Managing the Profitability of Eastern European Mobile Telecommunication Carriers

7 The Company

We make ICT strategies work

Detecon is a consulting company which unites classic management consulting with a high
level of technology expertise.

Our company's history is proof of this: Detecon International is the product of the merger of
the management and IT consulting company Diebold, founded in 1954, and the
telecommunications consultancy Detecon, founded in 1977. Our services focus on
consulting and implementation solutions which are derived from the use of information and
communications technology (ICT). All around the globe, clients from virtually all industries
profit from our holistic know-how in questions of strategy and organizational design and in
the use of state-of-the-art technologies.

Detecon’s know-how bundles the knowledge from the successful conclusion of management
and ICT projects in more than 160 countries. We are represented globally by subsidiaries,
affiliates, and project offices. Detecon is a subsidiary of T-Systems International, the
business customer brand of Deutsche Telekom. In our capacity as consultants, we are able
to benefit from the infrastructure of a global player spanning our planet.

Know-how and hands-on expertise

The rapid development of information and telecommunications technologies has an

increasingly significant influence on the strategies of companies as well as on the processes
within an organization. The subsequent complex adaptations affect business models and
corporate structures, not only technological applications.

Our services for ICT management encompass classic strategy and organization consulting
as well as the planning and implementation of highly complex, technological ICT
architectures and applications. We are independent of manufacturers and obligated solely to
our client's success.

Detecon International GmbH

Oberkasselerstr. 2
53227 Bonn
Telefon: +49 228 700 0
E-Mail: info@detecon.com
Internet: www.detecon.com

Opinion Paper 13 Detecon International GmbH