Eurotelcorama 05 300104

DAIWA

DAIWA INSTITUTE OF RESEARCH LTD.

IMPORTANT

Important disclosures are provided on the last page of this report.

Global Equity Research

30

th

January 2004

(No. of pages: 109)

EuroTelcorama

Issue 5: Euro wireline 2004, fragmentation is the name of the game

James Enck

(+44) 20 7597 8455

「日本語可」

james.enck@dir.co.uk

Jacqueline Millan

(+44) 20 7597 8460 jacqueline.millan@dir.co.uk(Priced as at market close on 28

th

January)

We explore emerging issues which we think may drive line loss and servicesubstitution for the European incumbents. We believe current industry and marketforecasts may not fully encompass the range of risks.Among the topics discussed in this report, we examine information service demandand consumption patterns in a number of markets, and also along age, gender, lifecycle and internet experience lines. We attempt to relate our findings to somedifficulties which service providers may encounter as adverse Europeandemographic trends unfold.We also isolate and discuss the developing gap between access and services, whichwe see as being driven by a combination of factors – demographic/generational,technological, behavioral, political and regulatory.In such a complex and uncertain environment, we think stock selection requires adifferent approach, and in conclusion we introduce a multi-factor approach torating, which incorporates many of the themes discussed in this report. As a resultof putting our coverage universe through this process, we have taken the followingrating actions:

•

We are upgrading Telefonica from rating 3 [NEUTRAL] to rating 2[OUTPERFORM], and Telecom Italia ordinaries from rating 4[UNDERPERFOM] to rating 3 [NEUTRAL].

•

We are retaining our 3 [NEUTRAL] rating on BT Group, Deutsche Telekom,Telecom Italia savings shares, and TeliaSonera.

•

We are downgrading our ratings on Portugal Telecom from rating 2[OUTPERFORM] to 3 [NEUTRAL], and France Telecom, KPN and Swisscomfrom rating 3 [NEUTRAL] to rating 4 [UNDERPERFORM].

DIR EuroTelcorama 2

Contents

Section Pages

Executive summary 3 - 4Introduction 51. The state of the sector 6 - 13

Industry revenue appears to be growing ahead of GDP, and average consumer and business expenditure on the PSTN seems to be stabilizing. As ADSL penetration grows, there is a stronger case emerging for its role as a revenuereplacement tool. However, MoU per channel on the PSTN continue to trend downward, and mobile MoU per channel looks sluggish to us. A significant proportion of minutes are simply disappearing.

2. A tale of two markets 14 - 18

An examination of French and UK ARPU reveals striking similarities incomposition despite differing usage patterns. Fewer people have mobile phones inFrance, but use them more on average, though data usage is dramatically belowUK levels. Viewing the mobile and fixed markets as one, it is clear that the number of channels per capita is rising steadily in both countries, but voice usage seems tohave peaked and is trending down.

3. Understanding the customer19 – 41

Internet usage apparently tends to become more practical with greater experience,though average usage does not appear to increase. More mature users and broadband users show a heightened tendency to self-provision services. Many of the most popular applications are wholly independent of the access provider, and generate no incremental revenue for telcos.

4. Europe – the demographic timebomb 42 - 50

The nations of Europe are to see their populations getting significantly older, and in some cases, smaller, over the next 50 years. Europe is also likely to becomemore female. More divorce and less marriage means average household size willdecline, though household creation may increase, with many being single personhouseholds. What are the implications for telcos?

5. Challenges for the telcos – the access layer51 - 73

The telcos face a range of challenges to their position of power in access:technological, behavioral, regulatory and political We highlight in particular therise of Big Broadband, FTTH initiatives driven by governmental agencies and citizens’ action groups, which have goals and investment horizons intrinsically at odds with those of telcos.

6. Challenges for the telcos – the service layer 74 - 95

A range of new applications and social trends should continue to drive a wedgebetween access and services. They include VoIP in all its various flavors, socialnetworking communities and invitation-only communications, and darknets.

7. A multi-factor approach to stock-rating 96 – 109

We introduce an approach to rating stocks which seeks to encompass some of the factors discussed earlier in this report, in an attempt to balance valuation issueswith other less obvious drivers of share price performance.

Acknowledgements

We would like to extend our heartfelt thanks and appreciation to Adam Arndt, Roger Black, Christian Car, Karl Christensen, Lars Hedberg, Chris Hoar, Doug Ross, andMike Tsao, for their invaluable assistance and advice in the preparation of this report.

DIR EuroTelcorama 3

Executive summary

An examination of the state of the European telecom sector in 2003 shows revenuegrowth for the industry above GDP trend, and growing signs of stabilizing expenditureon PSTN services. Operator discipline since the sector collapse in 2000 has yieldedimpressive improvements in productivity, asset efficiency, and cash flow generation.The debt crisis facing the sector two years ago is now firmly behind us, and there is acase emerging for ADSL as an effective revenue replacement tool. The rate of PSTNline loss appears to be under control at present, which is a key issue.At an annual average ARPU of €360 for residential PSTN services alone, minimizingline loss is critical to stability of cash flows from domestic wireline businesses, whichwe estimate will still account for at least 51% of 2010 group cash flow, on average, for the companies under our coverage. The importance of this is underlined by what wetake to be a disproportionate reliance on termination revenues in mobile business units,suggesting that underlying margins in many cases are significantly lower than headlinefigures would suggest.Traditional voice services (both fixed and mobile) are showing ongoing volumesluggishness/decline, and it seems clear that a growing proportion of traffic ismigrating to other uses/behaviors, many of which do not generate revenue for the telco, beyond perhaps the access revenues for the platform over which these uses take place.Consumer surveys seem to strongly indicate a growing sophistication, eclecticism andassertiveness among certain segments of the user base in finding and self-provisioningservices which may enable them to sidestep services provided by the access provider infavor of a more tailored suite of services, some of which may deprive the telco of traditional sources of revenues. In many cases these are younger, higher spendingcustomers, who we believe demonstrate a greater tendency to change suppliers or abandon traditional services entirely. The poor long-term outlook for Europeandemographics may significantly complicate our ability to forecast future demand andeven likely market size.This growing separation of access from services presents the incumbents with a rangeof complex challenges to be met if they are to avoid being gradually relegated to a position of provider of a “dumb pipe,” to be filled with content and services which donot contribute incremental revenue, or in fact drive outright substitution. Conversely,we identify a number of challenges to the incumbents’ positions in the accesslandscape as well. We believe both sides of this equation have the potential toaccelerate line loss and migration of traditional telco revenue streams towards lowrevenue/no revenue applications.The challenges in the access layer identified in this report are:

•

Mobile substitution in access;

•

Regulatory aggression in the areas of local loop unbundling and wholesaleline rental pricing and provisioning;

•

Advances in alternative access technologies, namely Ethernet over cable,viable Wi-Fi meshing solutions, and the growing synergies between VoIPapplications and Wi-Fi client devices;

•

The rise of Big Broadband, initiatives designed to deliver vastly higher levelsof bandwidth to consumers than those currently on offer from telcos, atsimilar or dramatically lower price points. The key instigators of the exampleswe have seen to date include principally local and regional governments aswell as community activist groups, all of whom arguably have goals andinvestment horizons which may inherently conflict with those of theincumbents, who so far have abstained from participation.

Growth and stability reign Love it or hate it, it pay the billsUsage and users are changing, withunforeseen consequencesThe move toward a“dumb pipe”