Telecoms.com periodically invites expert third-party contributors to submit analysis on a key topic affecting the telco industry. In this piece Stefan Zehle, CEO of Coleago Consulting, reviews the recent collapse of UK mobile phone retail chain Phone 4u and looks at the broader implication for the UK’s mobile sector.

In September 2014 Phones 4U Ltd entered into administration. The company had more than 700 outlets and 5,600 staff and did rather well at an operational level.  However, management had no choice after it became apparent that it would be unable to continue as a going concern following the loss of its distribution agreement with EE and Vodafone. Having seen consolidation of the UK mobile industry at network level with the merger of Orange and T-Mobile to form EE, we are now witnessing consolidation at retail level.

Over the years UK mobile operators have increased their high street presence significantly. Consistent with this strategy, EE has also announced that it is taking over 58 stores from Phones 4U, while Vodafone intends to take on 140 outlets.

Retailing mobile services in the UK and many other European countries is a precarious business. Profitability is almost entirely driven by activation commissions, with prepaid tops ups and accessory sales accounting for a small part. There is nothing new here.

In Europe, the licencing of competing mobile networks and the growth of GSM took place in parallel with the liberalisation of the fixed network. The EU Terminal Directive (1988) introduced the separation between the fixed telephony service and terminals. The fixed network service ended in a standardised socket and end-users were free to purchase phones and other terminals independently. The design of GSM mirrored this, in as much as the service ends in the SIM and hence the mobile phone could be purchased from any retailer.

When Vodafone and Cellnet (now O2) were licenced as mobile network operators in the UK in the mid-1980s, the terms of licence stipulated that they could not sell the service directly but had to sell through “service providers”. Around 20 such service providers emerged in the UK. Similar two tiered structures were mandated in other EU countries.

By the time the two 1800MHz operators, One2One and Orange, started service in the UK in the early 1990s, the requirement to sell through service providers had gone – the rationale being that with four operators there would be sufficient competition. Prior to launching, One2One commissioned me to implement a study to determine how to retail the service. Having obtained the accounts of all service providers in the UK (information publicly available at Companies House) and analysed their balance sheets, I found that almost all of them were insolvent. That is their liabilities (creditors) exceeded their current assets.  The creditors were the two existing mobile operators Vodafone and Cellnet, meaning that service providers were beholden to the two operators – independent service provision was effectively dead.

At the time UK service providers relied on activation bonuses paid by Vodafone and Cellnet and a margin made on monthly bills.  Service providers used most of or even the entire activation bonus to subsidise handsets and capitalised rather than expensed handset subsidies. The rationale was that customers would stay with the service providers for many years, allowing them to earn a stable margin from their monthly bills. Typically, capitalised handset subsidies were amortised at 25% per annum. However, annual churn turned out to be higher than 25%. The practice of capitalising handset subsidies meant the cash outflow did not show in the profit and loss account. Hence service providers were profitable, but they did not generate sufficient cash and eventually became insolvent.

In some European countries (Italy, Finland and Belgium) there was a de-facto or de-jure prohibition of bundling of mobile services and handsets. These rules later lapsed. In a bid to reduce churn operators offered bigger subsidies in exchange for two or even three year contracts. This of course was identified as anti-competitive and in some countries maximum contract lengths became subject to regulation, for example six months in Belgium. The European Commission in the 2013 “Connected Continent: Building a Telecoms Single Market” document (September 2013), proposed that consumers should have a right to cancel mobile service contracts after six months.

Regulation is the enemy of profit. Following the introduction of the six month right to cancel, contract customer churn increased significantly in Belgium and also impacted negatively on EBITDA margins. UK operators may be exposed in this regard. Although the SIM only segment is growing, most post-paid customers purchase a subsidised phone as part of a service contract. Vodafone customers can obtain the Samsung Galaxy S5 for free for example with a 24 month contract for £34.50 per month, including 1Gbyte and 600 minutes. The equivalent 1Gbyte SIM only plan costs £16.50 per month with unlimited minutes. By implication, £18 (52%) of the £34.50 bundled payment is deferred payment for the handset. In other words, a very large part of Vodafone’s and other mobile operators’ business in the UK consists of financing phones rather than running a mobile network.

In the context of potential regulation and the continued dependence on bundled offers, the vertical integration of the UK mobile phone industry does not come as a surprise. However, the increased high street presence by UK mobile operators absorbs cash. One way of reducing the negative cash flow impact is franchising. EE, for example, is looking to franchise some of its shops.

The life of mobile operators is not made any easier by the fact that consumers increasingly make handset choices rather than operator choices. The balance of power has shifted from the operators to Apple and Samsung who operate on a global scale. In some markets, operators have separated monthly payments for a phone from the payment for the service. In the UK, O2 already clearly shows the 0% financing arrangement when purchasing a phone with a contract on its website. This introduces a high degree of transparency and keeps operators out of the regulatory firing line with regards to unfair contracts.

The improved high street presence of UK mobile networks could be seen as a defensive strategy because it ensures that mobile operators’ brands continue to be top of consumers’ minds. It enables them to interact with their customers to sell new services delivered via fixed broadband connections, such as EE’s new TV offering.

Stefan Zehle is an expert in telecoms strategy, including marketing and forecasting as well as business planning and modelling. The scope of Stefan’s work encompasses mobile and fixed telecoms services and telecoms and IT products. Coleago Consulting Ltd is a boutique specialist telecoms management consulting firm staffed by highly experienced industry experts, advising telecoms operators and regulators around the world.