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FINANCIAL ANALYSIS OF THE SWEDISH 3G LICENSEES

Where are the profits?

Version II

Paper to be presented at the ITS 12th European Regional Conference September 2-3, 2001

Dublin

JOAKIM BJÖRKDAHL WITH ERIK BOHLIN

DEPARTMENT OF INNOVATION ENGINEERING AND MANAGEMENT CHALMERS UNIVERSITY OF TECHNOLOGY

S-41296 GÖTEBORG SWEDEN AUGUST 2001 CORRESPONDING AUTHUOR: ERIK BOHLIN EMAIL: erbo@mot.chalmers.se TEL: +46-31-772-1205 ACKNOWLEDGEMENTS ANDERS BYSTRÖM

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ABSTRACT

There are many different opinions on the prospects of UMTS or 3G mobile telephone systems. Our paper investigates the financial consequences of the implementation of UMTS on mobile operators. Our analysis is limited to the Swedish UMTS market. We analyse the Swedish 3G licensees with a financial model, which shows annual cash flows, net present values (NPV), breakevens, paybacks and sensitivity analyses.

Our results suggest that there will be a substantial profit problem. One of the reasons for the lack of profitability is that the average revenue per user will not increase much more from today’s level, but the operators’ costs will. This is a general finding for all the operators. Besides, more players result in increased competition and less market shares for the incumbents. The green field operators will have the greatest difficulty. However, the set-up costs will not be as large as predicted in the Swedish license applications due to co-operations and network sharing. Instead, the marketing and operational costs will be the largest part of the total cost during a fifteen-year period. Of the costs, content and marketing will increase with the introduction of UMTS, while the operational cost will be on the same level as for 2G.

Future research needs concern fine-tuning of the model to conditions in the European markets. Important considerations there for the financial outcome relate, among others, to the levels of license fees demographic characteristics and likely strategies among the players.

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A. INTRODUCTION ...4

B. BACKGROUND...5

B.1 REGULATORY CONTEXT...5

B.2 SWEDISH LICENSE FRAMEWORK...5

B.3 THE OUTCOME IN SWEDEN...6

C. METHOD AND ASSUMPTIONS ...8

C.1 PROCEDURE AND METHOD...8

C.2 CASH FLOW MODEL...8

C.3 REVENUES...9

C.3.1. Revenues from subscribers...9

ARPU...9 MOBILE PENETRATION...10 MARKET SHARES...11 INHABITANTS...11 C.3.2. Roaming...11 C.3.3. M2M ...11 C.3.4. MVNO...12 C.4 INVESTMENTS...12 C.4.1. Set-up cost ...12 C.4.2. Capital cost...12 C.5 OPERATING COSTS...13 C.5.1. Operational cost ...13 C.5.2. Marketing ...14 C.5.3. Content ...14 C.6 NET PRESENT VALUE...14 D. FINANCIAL ANALYSIS ...15 D.1 COSTS...15 D.2 REVENUES...15

D.3 RESULTS OF THE ANALYSIS...16

D.3.1. Europolitan Vodafone ...17 D.3.2. HI3G...17 D.3.3. Orange Sverige...18 D.3.4. Tele 2 ...19 D.3.5. Telia...19 D.4 SENSITIVITY ANALYSES...20 D.4.1. ARPU...20 D.4.2. UMTS Penetration...20 E. CONCLUSION...22

APPENDIX 1 MOBILE PENETRATION ...23

APPENDIX 2 SET-UP COST FOR THE LICENSEES ...24

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A. INTRODUCTION

There are many different opinions whether UMTS (Universal Mobile Telephony Systems) or 3G (Third Generation Mobile System) will be successful. For example, there are experts that believe in a UMTS migration of 50% by the year 2005 and an average revenue per user (ARPU) above €110 per month. Others are much more pessimistic and believe that it will be delays, low UMTS penetration and an ARPU not much higher than today. At the same time 3G is expected to be a main force of economic growth in Europe. There are however rather few papers which analyses cash flow models of the financial consequences upon the operators. This paper makes a contribution by analysing the financial impacts of UMTS. The paper focuses on Sweden, and analyses each winning license applicant.

The report presents the different analyses and assumptions that the results are based on. Furthermore, a sensitivity analysis is carried out to show the needed ARPU and market share for the licensees to get a satisfying business case.

Accompanying the study is a business modelling tool, that can be used to create forecasts of the new mobile business. This model provides a consistent basis to examine the impact of how the market develops. With the model, we will analyse cash flows, net present values (NPV), breakevens, payback times and sensitivity analyses.

This analysis will be conducted at this stage only on the licensees business in Sweden and costs and revenues generated from the UMTS business. Future work will expand the range of countries and conditions.

The paper is structured as follows. First we provide an overview of the regulatory context in Sweden of 3G, including an overview of relevant actors. The main body of the paper follows next. Here we present the financial model, and conduct an in-depth analysis of the Swedish case on UMTS. Conclusions follow.

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B. BACKGROUND

This part contains a brief summary of the process to implement UMTS services in Sweden, from the regulatory activity in the European Union and Sweden to the framework and the outcome of it.

B.1 REGULATORY CONTEXT

On 14 December 1998 the European Parliament and the Council of the European Union came up with the decision no 128/1999/EC1 regarding the introduction of a third-generation mobile and wireless

communication system in the Community. The purpose of the decision was to facilitate a rapid and a co-ordinated introduction of UMTS/IMT-2000 networks and services in the Community on the basis of the principle of the internal market and in accordance with the commercial demand. In accordance with the third article of the decision the Member States shall take all necessary measures to enable an introduction not later than 1 January 2002. The framework for general authorizations and individual licences in the field of telecommunications services is presented in the EU directive 97/13/EC2.

According to the 4 § Telecommunications Ordinance (1993:598), the Swedish government authorized PTS to state the framework3 for issuing licenses by virtue of 14 § Telecommunications Act (1993:597).

The interest of the Swedish regulatory authority (PTS4) is to increase the competition in the

telecommunications field. Earlier the Swedish network operators could decide which operator that should be able to use their networks and therefore changes in the law were required. The government wanted to force the network operators to offer the excess network capacity to other actors on the market, on terms adjusted to conditions on the market. This amendment entered into force on 1 May 2000. Furthermore, on 17 December 1999 PTS submitted a proposal to the Swedish government about the obligation for network operators to come to an agreement with national roaming, and this

amendment entered into force on 1 July 2000.

The Swedish decision on the choice of issuing process is derived from the Telecommunications Act, where it is described that the licenses permissions should be distributed on grounds of fact. According to the government bills 1992/93:200, 1994/1995:128 and 1996/97:61 auctions or lotteries are not regarded as issuing processes that distribute “on grounds of fact” and the Swedish Parliament agreed upon the meaning. During the fall 2000 one member of the Swedish Parliament submitted a bill, 2000/2001:FP104, to change the Telecommunication Act and enable auction as issuing process. However, the bill was rejected by the Standing Committee on Transport and Communications. In accordance with the Telecommunication Act, Sweden chose a Beauty Contest as the appropriate issuing process5.

B.2 SWEDISH LICENSE FRAMEWORK

There are three incumbent network operators on the GSM market, Telia ( the orginal PTT), Tele 2 and Europolitan Vodafone, despite the fact that PTS issued four licenses. One licensee did not fulfil its engagement and the license was withdrawn. Partly because of that fact, PTS has failed to reach a satisfying level of competition on the GSM market. Therefore, PTS intends to increase the competition both regarding the UMTS and GSM market. Because of this, PTS wanted to issue as many licenses as possible to reach a high level of competition on the market. However, the UMTS services demand a

1 http://europa.eu.int/eur-lex/en/lif/dat/1999/en_399D0128.html, 011101. 2 http://europa.eu.int/eur-lex/en/lif/dat/1997en_397L0013.html, 001101. 3 PTSFS 2000:5.

4 The National Post and Telecom Agency – Post och Telestyrelsen (PTS).

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certain bandwidth, which results in a limited number of licenses that can be issued. Thus, the frequency band was divided into four 2x15 MHz (FDD) + 5 MHz (TDD) to assure the quality of the services and in order not to give competitive advantages to some of the licensees.

The selection of the UMTS licenses was carried out in two phases. The first phase evaluated four parts: 1. Financial capacity of the applicant

2. Technical plan for the UMTS network 3. Business and market plan

4. Experience and knowledge of fixed and mobile networks

The applicants that fulfilled the four parts in phase 1 continued to phase 2, which was independent of the first phase. In phase 2 the applicants got certain points proportionately to how the application fulfilled the criteria that PTS evaluated. The criterions were:

1. The promised geographical coverage regarding surface area, population and diffusion in the country 2. The promises of when the rollout will be completed and when the services will be available

After the valuation the applicants’ points were summarized and the applicants were placed in order of precedence. If two applicants would have had the same total points, the applicant that would have offered the most rapid rollout got the license.

Each license applicant had to pay an administrative fee of €11,100 and the cost for the licenses are an annual fee of 0.15% of the turnover. The licenses last to 2015-12-31, but can eventually be prolonged. The applicants did not need to be Swedish physical and legal persons to apply for the licenses.

However, two companies that were regarded as affiliated could not both receive a license. Furthermore, if the licensees not fulfil their engagements, PTS has the possibility to use certain sanctions.

B.3 THE OUTCOME IN SWEDEN

Ten applicants applied for the UMTS licenses in Sweden, but only four UMTS licenses were issued. The operators that received licenses were Europolitan Vodafone, HI3G, Orange Sverige and Tele 2. Europolitan Vodafone and Tele 2 are both incumbent operators with GSM networks in Sweden. HI3G and Orange Sverige are however new entrants. HI3G is owned by Hutchison Whampoa and Investor while the major owner of Orange Sverige is Orange. This means that the major carrier, Telia partly owned by the Government, did not receive a license. This outcome was a surprise to the public. Telia, Reach Out Mobile and Telenordia appealed against PTS’ decision to the Country Administrative Court. However, the Country Administrative Court left the action without approval and considers that PTS made a correct decision, but criticise PTS on certain points6. Both Telia and Telenordia have

decided not to appeal against the decision7.

The outcome of the licensees’ engagements is that more than 99% of Sweden’s surface area has to be covered by 31 December 2003. The licensees also have to run some part of the network before 1 January 2002. However, since the operators only have to build 30 % of the network by themselves, there will be co-operations between the operators. Firstly, Tele 2 announced that they would co-operate

6 PTS, Press release, 010627.

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with Telia. Despite Tele 2 received the license, Tele 2 and Telia have established a common company that will build and run the network. The agreement with Tele 2 does not involve any charges for Telia to take part of the license and the companies will compete on the market regarding the services. The first idea was to start a separate company with 50% interests each. The license is however tied to Tele 2 and cannot be transferred to another company, but this did not prevent Tele 2 to give a separate company the commission to build and run the network. However, the Antitrust Law will determine if Tele 2 and Telia will be allowed to share the license in this manner.

Secondly, Europolitan and HI3G also declared that they would establish a joint venture to build and run the network8. In this case the companies are tied to fulfil the engagements separately, i.e. each

company has to build at least 30% of the network. Finally, Orange Sverige and HI3G/Europolitan wrote a letter of intent on 16 May 2001 regarding co-operation in the rollout.

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C. METHOD AND ASSUMPTIONS

In this part the method and all assumptions used for the financial analysis are presented. C.1 PROCEDURE AND METHOD

To calculate the expected net present values (NPV), breakevens, payback times and sensitive analyses a model presented in C.2 is being used. First of all a base case scenario is determined, where specific data is taken into consideration. The data is from different sources and own estimates. In our opinion, this base case scenario is the most realistic development for the operators. Thereafter, the output is modulated with other input data to get satisfying business cases for the operators. To study the sensitivity of the business, results are also presented with other scenarios than the base case. C.2 CASH FLOW MODEL

In the analysis, a cash flow model is used where expected revenues, investments and operating costs are used as input data. Figure 1 shows the structure of the cash flow analysis and the needed data. The revenues include subscriber revenues, roaming, M2M9 and MVNOs10. The costs include investments

and operating costs. Investments are divided into costs from amortization on the set-up, interest costs and the set-up cost that is paid by equity. Operating costs includes operational and maintenance costs, marketing and content.

Free Cashflow

Revenues Investments Operating Costs Subscriber Revenues Roaming M2M

Revenues from MVNOs

Operational & Maintenance costs

Content Marketing

Figure 1: The cash flow structure.

We will use this model in two ways. First we are looking at available cash flow from the corporate point of view. This means that we are assuming that all available cash flow is available for future investments. In other words, we are excluding dividends, and we are treating the 3G project without cash demands from the owners. Thus, management has full discretion to do what it wants with the potential

dividends. In this case, however, we assume that management devotes all available cash and efforts into the 3G project. In so doing, the cash flow model is closely connected with accounting based financial statements that the firm would produce for the 3G project. In other words, the cash flow model is

9 Machine to machine (M2M) is communication between machines without human interaction.

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closely connected with the regular accounting based balance sheets and profit statements that the 3G project would produce. This will have the effect that our model is sensitive to the capital structure that the 3G project will have. In other words, choices about debt vs. equity matter here. These choices will be analysed further below, for each actor.

The other sense in which our model will be used is for discounted cash flow analysis. Here we are only concerned about the economic return, and not about capital structure per se. We are only looking at the real side of the project and return earned on it, without explicit regard to capital structure. In a

traditional fashion, we are separating capital structure from real investment decisions. The cash flows included in the NPV analysis are not affected by financial considerations. By implication, we will not be using the interest payments in our NPV analysis (these are modelled in the annual cash flow model). We do not need to do any so-called adjusted net present values11. Instead, we will use a capital cost that

will be charged to each relevant cash flow element. The capital cost will in turn be based on market valuations. In this case, we will use capital costs based on the WACC model, which implicitly takes into account aspects of the financial condition of the firm in question, see more below.

C.3 REVENUES

The revenues are generated from four sources; subscribers, roaming, M2M and MVNOs.

C.3.1. Revenues from subscribers

The subscriber revenues are estimated in three steps; firstly, the ARPU (Average Revenue Per User) is estimated for the operators, secondly the mobile penetration and UMTS penetration is evaluated and finally the operators’ market share is estimated, see Figure 2.

R ev en u e s fro m su b s crib e rs A R P U In h a b itan ts M o b ile P en e tratio n U M T S P en e tratio n M a rk et S h a re = x x x x

Figure 2: Revenues from subscribers.

ARPU

The ARPU will increase with the UMTS business compared to the GSM business, due to more services and revenue streams. Today the operators almost only get revenues from voice and SMS. However, with UMTS the operators can get more revenues from data services, like telematics, M2M, multimedia, email and business data. We can now also see a stabilization of the ARPU and price per minute for voice that have decreased for a couple of years. But the prices will probably continue to decrease when more actors enter the market. However, with a lower price the usages increases and the voice ARPU will not drop that much. Thus, the contribution from the data services will be a significant part of the operators’ revenues and will give an increased total ARPU.

The level of the ARPU depends on the strategy chosen by each operator. In Figure 3 we show how the Swedish operators are likely to position.

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Cost Focus Cost Leadership Differentiation Differentiation Focus COMPETITIVE ADVANTAGE CO MP E T ITIVE S C O P E Differentiation Broad Target Narrow Target Lower Cost

Figure 3: The network operators and their expected strategies in the UMTS business. Source: Authors’ estimates.

Tele 2 has adopted the cost leader strategy on the GSM market and we predict that they will continue to use this strategy within the UMTS business. Tele 2 has a GSM network in Sweden with lower quality than the competitors and the company usually waits until the market gets mature before entering it. Tele 2 has less ARPU than the other network operators, which is a hallmark for an operator with a cost leader strategy. Due to this, Tele 2’s ARPU will be below the average and around €3912. Orange has

used a similar strategy as Tele 2 when to enter the GSM market in Europe, but is more innovative. This is probably the strategy Orange will use when to enter the Swedish market too. Therefore, Orange will have an ARPU that is quite similar to Tele 2’s. In our judgment, Europolitan is likely to continue its differentiation strategy and its ARPU will continue to be high. Today Europolitan has an ARPU of €63 per month, which is almost three times more than Tele 2’s and two times more than Telia’s. The reason for this is that Europolitan has a differentiation focus on business customers and that most of its customers are postpaid. We think that even if it will be more revenue streams within UMTS, it will be hard for Europolitan to keep its high ARPU and think that it will decrease to €56. Finally, HI3G and Telia are assumed to have almost the same ARPU, €44, because they probably will use a combination of Europolitan’s and Tele 2’s strategy. Telia has this strategy today and for HI3G this strategy is our best estimate.

Mobile penetration

We make a difference between mobile penetration and UMTS penetration, the former including all types of mobile standards. There are different opinions about the future mobile penetration, see APPENDIX 1. However, we have used Arthur Andersen’s estimates and believe that a saturation level around 90% is the most likely scenario for the mobile penetration. This because some children and elderly are unlikely to ever have a mobile phone. Concerning the UMTS penetration we have used BCG’s estimates and believe that the penetration will increase until 2011 and thereafter decline due to the entrance of the fourth generation of mobile system13, see Table 1.

12 € 1.0000 = SEK 9.0075.

13 Ericsson among others expect that 4G will be launched 2010. Tele 2 Telia

Orange HI3G

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2001 20012001 2001 2002200220022002 2003200320032003 2004200420042004 2005200520052005 2006200620062006 2007200720072007 2008200820082008 2009200920092009 2010201020102010 2011201120112011 2012201220122012 2013201320132013 2014201420142014 2015201520152015 UMTS Penetration UMTS Penetration UMTS Penetration UMTS Penetration 0% 4% 8% 13% 23% 38% 50% 65% 78% 86% 90% 88% 86% 83% 80% Mobil Penetration

Mobil PenetrationMobil Penetration

Mobil Penetration 70% 74% 78% 80% 82% 83% 83% 84% 84% 85% 85% 86% 86% 87% 87% Table 1: UMTS and mobile penetration during a period of fifteen years. Source: BCG, Arthur Andersen.

Market shares

With the introduction of UMTS, there will be more players on the Swedish market and the competition will increase. This will affect the dominant operators, Tele 2 and Telia, that today have over 80% of the Swedish market. However, Europolitan will not be affected that much. This because the company currently has a market share of 16% and that no other operator expects to adopt Europolitan’s differentiation strategy. Concerning the green field operators, they expect to take a higher UMTS market share the first years than the incumbents. This because they will offer voice services through the UMTS network, while the incumbent operators probably will continue to offer voice services over the GSM network in the beginning. We expect that Orange takes a higher market share than HI3G due to its strategy, see Table 2.

2001 20012001 2001 2002200220022002 2003200320032003 2004200420042004 2005200520052005 2006200620062006 2007200720072007 2008200820082008 2009200920092009 2010201020102010 2011201120112011 2012201220122012 2013201320132013 2014201420142014 2015201520152015 Orange Orange Orange Orange 0% 35% 33% 28% 22% 21% 20% 20% 19% 18% 18% 18% 17% 17% 17% HI3G HI3G HI3G HI3G 0% 30% 25% 20% 18% 17% 17% 16% 15% 15% 14% 14% 14% 14% 14% Europolitan Europolitan Europolitan Europolitan 0% 10% 12% 12% 13% 13% 14% 14% 14% 14% 14% 14% 14% 13% 13% Tele2 Tele2 Tele2 Tele2 0% 10% 10% 12% 15% 16% 16% 17% 17% 18% 19% 19% 19% 19% 19% Telia Telia Telia Telia 0% 10% 13% 16% 17% 19% 20% 20% 22% 22% 22% 22% 23% 24% 24% MVNOS MVNOS MVNOS MVNOS 0% 5% 7% 12% 15% 14% 13% 13% 13% 13% 13% 13% 13% 13% 13%

Table 2: Estimated UMTS market shares during a period of fifteen years. Source: Authors’ estimates.

In Table 3, the UMTS market shares of the total market are presented to understand the small market shares for the operators in the beginning.

2001 20012001 2001 2002200220022002 2003200320032003 2004200420042004 2005200520052005 2006200620062006 2007200720072007 2008200820082008 2009200920092009 2010201020102010 2011201120112011 2012201220122012 2013201320132013 2014201420142014 2015201520152015 Orange Orange Orange Orange 0% 1,4% 2,6% 3,6% 5,1% 8,0% 10,0% 13,0% 14,8% 15,5% 16,2% 15,8% 14,6% 14,1% 13,6% HI3G HI3G HI3G HI3G 0% 1,2% 2,0% 2,6% 4,1% 6,5% 8,5% 10,4% 11,7% 12,9% 12,6% 12,3% 12,0% 11,6% 11,2% Europolitan Europolitan Europolitan Europolitan 0% 0,4% 1,0% 1,6% 3,0% 4,9% 7,0% 9,1% 10,9% 12,0% 12,6% 12,3% 12,0% 10,8% 10,4% Tele2 Tele2 Tele2 Tele2 0% 0,4% 0,8% 1,6% 3,5% 6,1% 8,0% 11,1% 13,3% 15,5% 17,1% 16,7% 16,3% 15,8% 15,2% Telia Telia Telia Telia 0% 0,4% 1,0% 2,1% 3,9% 7,2% 10,0% 13,0% 17,2% 18,9% 19,8% 19,4% 19,8% 19,9% 19,2% MVNOS MVNOS MVNOS MVNOS 0% 0,2% 0,6% 1,6% 3,5% 5,3% 6,5% 8,5% 10,1% 11,2% 11,7% 11,4% 11,2% 10,8% 10,4% Table 3: The UMTS market share for each network operator of the total mobile market, Source: Authors’ estimates.

Inhabitants

From the year 2001 the population is expected to increase with 0,35% per year.

C.3.2. Roaming14

The roaming revenues are estimated from the operators’ roaming revenues today and are expected to be 5%15 of the annual revenues and increase with the UMTS penetration.

C.3.3. M2M

Except for the M2M (machine to machine) revenues generated from the mobile users with handsets there will be other types of machines that will communicate with each other. This revenue source is expected to be 5% of ARPU from the year 2003 and increase with the UMTS penetration16.

14 Roaming is to use other operators network. 15 Interview with Europolitan Holdings, 2001.

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C.3.4. MVNO

The mobile virtual network operators are expected to get an ARPU of €39 per month and take a market share presented in Table 2 (slightly more than 10%). A share of the revenues generated from the MVNOs will go to the network operators, because the MVNOs hire net capacity from the network operators. The share that the network operator will get is expected to be 70% of its total revenue17, and

each network operator expects to take 20% of the MVNO market. C.4 INVESTMENTS

The investment calculations are based on the amount of base stations mentioned in the UMTS applications and the planned co-operations between the operators.

C.4.1. Set-up cost

The calculations of the 3G set-up cost is based on following assumptions: • Approximately €111,000 is the cost to build a new base station18.

• Upgrading/rebuilding of existing sites and base stations for UMTS costs around 30% of the construction of a new site, i.e. around €33,00019.

• An additional cost of approximately 10% will occur, e.g. to make the network faster in the future20.

Operator Base

Stations Existing Sites operation Co- New Sites Cost, New Sites (€million) Cost, Rebuilding Sites (€million) Total cost (€million) Tele 2 10,186 2,300 100% 2,793 308 76 422 Telia - 2,700 100% 2,393 264 89 388 HI3G 20,814 0 70% 11,101 1,225 0 1,348 Europolitan 20,000 1,200 70% 9,657 1,066 40 1,216 Orange 8,365 0 70% 7,366 813 0 894

Table 4: Calculations of the investments for the UMTS network with co-operations. Source: Authors’ estimates.

The distribution of the set-up cost is based on The Boston Consulting Group’s estimates21 and is

presented in Table 5.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

20,0% 38,5% 38,3% 0,4% 0,4% 0,4% 0,4% 0,4% 0,4% 0,4% 0,4% Table 5: The distribution of the set-up cost. Source: BCG.

C.4.2. Capital cost

In the calculations debt facilities for the set-up is derived from the statements in the applications for the UMTS licenses and utterances. Both Telia and the owners of HI3G are solid companies that not need to borrow money for the set-up investments. The investment that Telia will do is relatively small too. HI3G, on the other hand that will do a large investment is owned by Hutchison Whampoa, a big company from Hong Kong and one of Asia’s most profitable, which had an equity of €21 billion at the

16 Authors’ estimates.

17 Interview with a management consultant company, 2001. 18 Interview with Johan Ragnevad, Northstream, 2001. 19 Interview with Johan Ragnevad, Northstream, 2001. 20 Authors’ estimates.

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turn of the year and the investment company Investor. Tele 2 will pay the set-up investment through debt facilities, due to its solidity and an aggressive expansion in Europe. Both Europolitan and Orange Sverige are owned by multinational companies. However, Europolitan’s owner Vodafone (72%) have bought UMTS licenses in Europe for billions. Orange is in the same situation, even if Orange Sverige consists of more companies.

Tele 2 Telia HI3G Europolitan Orange Sverige

Debt Facilities 100% 0% 0% 75% 50%

Table 6: The expected debt facilities for the licensees. Source: Authors’ estimates.

The companies interest rate is based on ratings from Moody’s, except for Tele 2 that is based on its average interest rate 2001 and from own estimates. Each company rating corresponds to a certain bond rate, which is a judgment about firms’ financial and business prospects, see Table 7. Once Moody’s rates a bond, the rating is not changed unless there is a significant shift in the company’s financing or prospects. Since the companies recently have been downgraded due to the uncertainty in the business this is the expected interest rate that the companies can borrow money at.

Tele 2 Telia HI3G Europolitan Orange Sverige

Rating22 - A1 - A223 A324

Rate25 7,54 7,37 - 7,54 7,71

Table 7: Ratings and interest rate for the operators. Source: Moody’s.

In the cash flow the annual interest cost, annual installment and the share of the set-up that not is paid by debt facilities is paid by equity.

C.5 OPERATING COSTS

The operating costs are divided into three major parts; operational, marketing and content. The operating costs are based on the network operators’ costs today, from own assumptions and with help from different sources. Below follow the assumptions.

C.5.1. Operational cost

The operational cost includes costs from network operating, maintenance and personnel cost. In the beginning there are only small additional operational costs for the existing operators, due to the existing organization and small share for the UMTS business. Therefore, the operational costs are expected to grow with the same ratio of the UMTS penetration, i.e. 80% of the operational cost is derived from the UMTS business 2015. Tele 2 and Europolitan have a similar size of organizations and the green field operators are also expected to have a similar size. However, the operational cost for Europolitan and HI3G is expected to be higher than for Orange and Tele 2 due to their strategies. Telia has about twice as large organization compared to the others and an expensive one, which has the affect that its

operational cost is very high in consideration to the others. The operational costs are derived from own estimates, Arthur Andersen and J.P. Morgan26, BCG27 and Northstream.

22 Richard Bloom, Moody’s New York, 010803.

23 The rating is for Vodafone, which owns 72% of Europolitan Vodafone. 24 The rating is for Orange plc, which owns 50% of Orange Sverige. 25 Moody´s daily long term corporate yield, 010801.

26 JP Morgan & Arthur Andersen, Wireless Data report, 2000. 27 BCG, UMTSAffärsanalys, 2001.

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C.5.2. Marketing

The marketing cost includes fixed marketing cost, customer acquisition and handset subsidisation. The marketing cost will increase with UMTS because there will be more players on the market. Moreover marketing is expected to be higher for the green field operators than for the existing operators, because they are new in the game and have to market their brands more aggressively. After the year 2012 the marketing cost expects to decrease due to the introduction of 4G. The marketing costs are derived from own estimates, Arthur Andersen and J.P. Morgan28, BCG29 and Northstream.

C.5.3. Content

The content part, which will be very important in the UMTS business involves both product

development and content acquisition. The content cost is probably the cost for the operators that will increase most compared to the 2G business. It will be more important to offer attracting services to the customers and the product development part will grow overall. Furthermore, the content will be bought from other actors on the market and this part will grow substantially. In the calculations the content costs are expected to be around 15% of the operating costs30. However, the content cost will

be less for HI3G, Orange Sverige and Europolitan Vodafone because they are partly owned by large international companies that will give them advantages like synergy effects. But the content cost also depends on which strategy the operator has.

C.6 NET PRESENT VALUE

The weighted average cost of capital (WACC) is the minimum risk-adjusted rate of return that operators must earn in order to be acceptable to shareholders and owners. The WACC will however not be equal for all operators, but depends on the cost of equity, cost of debt capital and the share from debt and equity. The interest rate paid to debt holders is less than the required rate of return on equity, because debt is less risky. Of course, this does not mean that it is advantageous to have 100% in debt, because of the bankruptcy costs. Thus, the optimal ratio of debt to equity is determined by taking on increasing amounts of debts until the marginal gain from leverage is equal to the marginal expected loss from bankruptcy costs. Another thing is that the cost of equity is higher for the green field operators, due to the fact that these companies enter a new market and are taking a higher risk. Things like these have to be taken into consideration when to estimate the WACC. The different WACC for the operators used in this report is presented in Table 8.

Tele 2 Telia HI3G Europolitan Orange Sverige

WACC 11% 11% 13% 12% 13%

Table 8: The weighted average cost of capital. Source: Authors’ estimates.

Cash flows are calculated until 2015, which is the year the licenses will expire. However, the licenses will probably be prolonged, which have the effect that it will be a value of the business after 2015. To estimate this horizontal value we assume that the annual cash flow decreases with 30% from the year 2016.

28 JP Morgan & Arthur Andersen, Wireless Data report, 2000. 29 BCG, UMTSAffärsanalys, 2001.

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D. FINANCIAL ANALYSIS

The financial analysis presents the licensees’ costs and revenues and the net present value (NPV), breakeven and payback time are calculated for each of them. Furthermore, a sensitivity analysis gives the needed ARPU and market share to get a positive NPV for those with a negative value. Sensitivity analyses with other scenarios than the base case are also presented. The planning horizon is fifteen years corresponding to the license condition.

D.1 COSTS

With the introduction of UMTS the costs will increase for the operators. It is the marketing and especially the content costs that will increase most. The operational costs on the other hand will not be changed appreciably. The marketing cost will increase because there will be more actors on the market, which results in an increased competition and the content due to more services.

The difference between the costs for the incumbent and green field operators is that the incumbents will have less operational costs in the beginning when the UMTS penetration is low. This because the incumbents already have operations in Sweden, and that there will not require much more to run a UMTS network. However, when the penetration increases more of the operational costs will be in the UMTS business. The green field operators will also have higher marketing costs, especially in the beginning, due to the fact that they have not any customer base in Sweden and have to market their brands more aggressively. We are illustrating the effects of the cost elements for each year and operator in Table 9.

Tele 2 Telia HI3G Europolitan Orange Sverige

Annuity Costs (million €) 260 434 530 377 436

Table 9: Annuity costs for the operators. Source: Authors’ estimates.

As can be seen, the green fields will get higher annuity costs than the incumbents. This because of the operational costs that have not a large impact for the incumbents in the beginning. HI3G will invest more in the set-up than Orange and has a more costly strategy, and because of this a higher annuity cost. Concerning the incumbents, Tele 2 and Telia have set-up investments that are around three times less than Europolitan’s. Tele 2 also has low costs overall, which results in less costs than the others. Telia on the other hand has a big organisation and due to this fact it is the incumbent with the highest annuity cost.

D.2 REVENUES

The green field operators have a disadvantage when it comes to the revenues. The incumbent operators have all the customers and the green fields have to offer either lower prices on the services, better services or a combination that is better than the incumbents. Otherwise, the customers have no reason to change operator and the green fields are made to fail. The green fields cannot expect to take higher UMTS market shares than Tele 2 and Telia in the long term due to their disadvantage, and because the market share has a great impact on the revenues the green fields will get less revenues than the

incumbents in the long term. However, the first years the green fields will get higher revenues because they will offer voice services over the UMTS network in difference to the incumbents that will continue to use the GSM network.

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Annual Revenues 0 200 400 600 800 1000 1200 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 year million

Europolitan HI3G Orange Tele 2 Telia

Figure 4: Annual revenues for the network operators during a period of fifteen years. Source: Authors’ estimates.

Generally it can be said that the revenues will increase with UMTS, depending on an increased ARPU. Both Europolitan and Tele 2 will get higher revenues when the UMTS business will be mature, than they have today. However, Telia that will lose a great deal of its subscribers and will get less revenues when the UMTS penetration reaches its saturation level. Concerning the green fields, Orange will get higher revenues than HI3G due to a higher market share.

D.3 RESULTS OF THE ANALYSIS

In this part the cash flow, NPV, breakeven and the payback time are presented for each operator. Furthermore, sensitivity analyses are presented to show how much the ARPU and market shares have to increase to get positive net present values. The cash flow estimates are based upon the model in Figure 1, i.e. including assessments on financial structures. The NPV, however are only based on the real investments taken irrespective of financial strategy. The planning horizon is 15 years and taxes are not included. Note that if the licenses will not be prolonged after the year 2015 the NPV for the operators will be less than the presented in this part, see APPENDIX 3.

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D.3.1. Europolitan Vodafone

In Figure 5, Europolitan’s annual and aggregated cash flow is presented.

Cash flow, Europolitan Vodafone

-400 -200 0 200 400 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 million -2 000 -1 000 0 1 000 2 000 million

Cashflow Aggr Cashflow

Figure 5: Annual and aggregated cash flows for Europolitan during a period of fifteen years. Source: Authors’ estimates.

Europolitan will reach breakeven 2007 and the payback time will be 11 years. Furthermore, Europolitan will get a negative net present value of €1 million, see Table 10.

NPV (million €) Breakeven Payback

Europolitan -1 2007 2011

Table 10: Europolitan’s results of the base case scenario. Source: Authors’ estimates.

D.3.2. HI3G

HI3G’s annual and aggregated cash flow is presented in Figure 6.

Cash flow, HI3G

-1 000 -500 0 500 2001200220032004200520062007 20082009201020112012201320142015 million -2 500 -1 500 -500 500 million

Cashflow Aggr Cashflow

Figure 6: Annual and aggregated cash flows for HI3G during a period of fifteen years. Source: Authors’ estimates.

HI3G will reach breakeven during 2007, however the investment will not be paid off during fifteen years. In consequence to this HI3G will have a negative net present value of €1 255 million, see Table 11.

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NPV (million €) Breakeven Payback

HI3G -1 267 2007 Not within 15 years

Table 11: HI3G’s results of the base case scenario. Source: Authors’ estimates.

HI3G has a negative net present value due to the large set-up investments and a low market share. To get a positive net present value, HI3G has to get an ARPU of €75 per month. In other words, HI3G has to increase its ARPU by 70% to get a positive net present value. Or if the ARPU is unchanged, HI3G has to get an average market share of 27% of the UMTS market.

D.3.3. Orange Sverige

The annual and aggregated cash flow for Orange is presented in Figure 7.

Cash flow, Orange

-600 -400 -200 0 200 400 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 million -1 500 -1 000 -500 0 500 1 000 million

Cashflow Aggr Cashflow

Figure 7: Annual and aggregated cash flows for Orange Sverige during a period of fifteen years. Source: Authors’ estimates.

Orange will reach breakeven during 2007 and the payback time will be 13 years. Furthermore, 2015 will Orange have a negative net present value of €429 million, see Table 12.

NPV (million €) Breakeven Payback

Orange Sverige -429 2007 2013

Table 12: Orange Sverige’s results of the base case scenario. Source: Authors’ estimates.

To get a positive net present value, Orange has to increase its ARPU from the calculated €39 per month to €48 per month or get an average market share of 19% of the UMTS market.

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D.3.4. Tele 2

In Figure 8, Tele 2’s annual and aggregated cash flow is presented.

Cash flow, Tele 2

-200 0 200 400 600 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 million -1 000 0 1 000 2 000 3 000 million

Cashflow Aggr Cashflow

Figure 8: Annual and aggregated cash flows for Tele 2 during a period of fifteen years. Source: Authors’ estimates.

Tele 2 will reach breakeven during 2006 and is the fastest operator to reach breakeven on the Swedish UMTS market. This through a combination of low set-up cost, annual costs and a fairly high market share. Tele 2 will have a net present value of €669 million. Tele 2 is also the operator that will have its investments back fastest, i.e. 2009, see Table 13.

NPV (million €) Breakeven Payback

Tele 2 669 2006 2009

Table 13: Tele 2’s results of the base case scenario. Source: Authors’ estimates.

Tele 2 has a great possibility to get a positive NPV even if the ARPU and market share should not be as high as the estimated. Tele 2 affords to only get €27 per month from their subscribers or can take an average market share of 12% and yet get a positive NPV.

D.3.5. Telia

In Figure 9, Telia’s annual and aggregated cash flow is presented.

Cash flow, Telia

-400 -200 0 200 400 600 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 million -1 200 -200 800 million

Cashflow Aggr Cashflow

Figure 9: Annual and aggregated cash flows for Telia during a period of fifteen years. Source: Authors’ estimates.

Telia will reach breakeven during 2007 and the payback time will be 12 years. Telia will have a positive net present value of €113 million, see Table 14. Telia is calculated to take the largest market share of all

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the operators, but still not the most profitable. This is the result of the high costs that Telia has compared to the others.

NPV (million €) Breakeven Payback

Telia 113 2007 2012

Table 14: Telia’s results of the base case scenario Source: Authors’ estimates.

Telia has not afford to get an ARPU and market share that is much lower than the estimated if it should get a positive net present value.

D.4 SENSITIVITY ANALYSES

There is a lot of uncertainty in the business and different opinions about the development of UMTS. There are no given answers, and therefore it is of interest to see how the results will be changed with different scenarios. However, these results are not as realistic as the results in the base case scenario, but shows how the business case will be affected.

D.4.1. ARPU

Due to the fact that the competition will increase, there is a risk that it will be price wars, which will affect the companies’ ARPU. This scenario is based on an ARPU that is €10 less than in the base case scenario. All costs are left unchanged, the only difference is the ARPU. The results are presented in Table 15.

NPV (million €) Breakeven Payback

Europolitan -525 2008 2014

HI3G -1 792 2009 Not within 15 years

Orange Sverige -1 094 2008 Not within 15 years

Tele 2 -15 2008 2012

Telia -686 2009 Not within 15 years

Table 15: The results of the scenario with a lower ARPU. Source: Authors’ estimates.

As can be seen in Table 15, only Europolitan and Tele 2 will have its investment back before 2015. All companies will also have negative net present values. Since the value of the ARPU has a great impact on the operators’ profitability most of the companies have not afford to see a decreased ARPU from today’s level.

D.4.2. UMTS Penetration

The adoption of UMTS might not be as high as in the base case scenario if there will be delays

concerning the handsets and rollout. There are also substitutes like GSM/GPRS and WLAN that might steal market shares from UMTS. This scenario is based on a penetration that is half of the penetration in the base case scenario, see Table 16.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 UMTS

Penetration 0% 2% 4% 6% 12% 19% 25% 33% 39% 43% 45% 44% 43% 42% 40%

Table 16: The UMTS penetration. Source: Authors’ estimates.

With lower UMTS penetration the marketing costs will decrease for all the operators. For the incumbents the operational costs will also be reduced, because more of the operation will be in the GSM/GPRS business. However, the green fields have only the UMTS business and need to have a

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certain size of the organization to run the business. Thus, this scenario is based on that the green fields not take a part of the GSM/GPRS market. The results are presented in Table 17.

NPV (million €) Breakeven Payback

Europolitan -912 2009 Not within 15 years

HI3G -1 922 No positive cash flow Not within 15 years

Orange Sverige -1 405 2012 Not within 15 years

Tele 2 -214 2008 2014

Telia -639 2009 Not within 15 years

Table 17: The results of the scenario with lower UMTS penetration. Source: Authors’ estimates.

This scenario is the operators’ nightmare, because of the high set-up costs paid by the operators. The UMTS penetration must reach a quite high level if it shall be profitable for them. With the penetration used in this scenario, only Tele 2 will have its money back before 2015. Because of the low penetration the incumbents not reach breakeven before 2008-2009. For the green fields it is worse, HI3G will not get a positive cash flow at all. Orange on the other hand, will get a positive cash flow 2012, but in the year 2013 it will be negative due to a decreased UMTS penetration.

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E. CONCLUSION

With the introduction of UMTS, several experts believe that the operators will increase their profitability substantially. However, our results suggest that this will not be the case. For instance Telia will be less profitable than today. One of the reasons for the lack of profitability is that the ARPU will not increase much more from today’s level, but the operators’ costs will. This is a general finding for all the operators. Furthermore, Telia will lose market shares as there are more license holders. In Telia’s case it is possible that the company will lose up to 50% of its customer base. In the calculations, Telia will not get the investments back before 2012 and the company will only have net present value of €113 million. We are more positive to the other incumbents, Europolitan and Tele 2. Tele 2 will also lose market shares, but because of its co-operation with Telia and the low cost overall the company has a great chance to increase its profitability. Moreover, Tele 2 will have the quickest payback of all the operators, i.e. 2009. Europolitan has in our opinion a great chance to almost keep its market share, due to its differentiation focus, but because of its high set-up cost, there is a risk that Europolitan will be less profitable than today. However, Europolitan will get the investments back during 2011 and almost get a positive net present value.

Concerning the green field operators, it will be even harder for them in the 3G business than for the incumbents, due to the fact that they have not any customer base in Sweden. However, Orange will get their investments back 2013, but HI3G will not get the investments back before 2015 and will lose money on the business. Both companies have also negative net present values, Orange €429 million and HI3G €1 267 million. HI3G must for an example increase its ARPU to €75 per month, which is 70% more than the estimated, to get a positive net present value, which is in our opinion almost impossible.

The set-up costs will not be as large as predicted in the license applications due to the co-operations and network sharing. Instead, the marketing and operational costs will be the largest part of the total cost during a fifteen-year period. Of these costs, content and marketing cost will increase with the introduction of UMTS, while operational cost will almost be the same as with 2G.

If the UMTS technology will be successful with a high penetration it does not mean that it will be a success for the operators. It is very important to understand that Sweden only has a population of 9 million people and the GSM market only contained three network operators. Suddenly it will be five within the UMTS business, including Telia. Thus, with these conditions the operators will not earn significant profits.

The next step in our research will be to fine-tune the model to conditions in the European markets. Important considerations there for the financial outcome relate, among others, to the levels of license fees demographic characteristics and likely strategies among the players.

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APPENDIX 1 MOBILE PENETRATION

The mobile penetration used in this report is based on estimates from Arthur Andersen. Figure 10 presents three different sources on the mobile penetration to show different estimates.

60 65 70 75 80 85 90 95 100 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Year Penetration (%)

Arthur Andersen CIT Publication Ovum

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APPENDIX 2 SET-UP COST FOR THE LICENSEES

In Figure 11, the set-up cost is compared with the planned set-up cost and the investment mentioned in the applications.

S et-up co st for th e licen sees

1 8 7 6 4 0 7 3 3 0 3 5 2 1 7 4 1 0 4 1 2 5 2 7 2 3 2 7 1 0 1 5 4 22 1 3 4 8 1 2 1 6 8 94 0 5 00 1 0 0 0 1 5 0 0 2 0 0 0 2 5 0 0 3 0 0 0 3 5 0 0 4 0 0 0 4 5 0 0 T e le 2 H I3 G E u ro po lita n O ra ng e € million

Investm en t a cco rd in g to th e a pp lic atio n S e tup cost w ith ou t co -o pe ra tion S e tup cost w ith co -o pe ra tio n

Figure 51: The total investment according to the application, i.e. total investment until positive cash flow is shown in the left pile. The investment cost for the set-up without co-operation is the middle pile and with co-operation is the right pile.

In Table 18, the cost savings due to the co-operations are presented.

Licensee Tele 2 Europolitan HI3G Orange Sverige

Cost Saving (%) 59.5% 47.8% 46.7% 11.9%

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APPENDIX 3 NPV AND INTERNAL RATE OF RETURN

If the licenses will not be prolonged after 2015 the operators will get a different NPV than the presented in the report. In Table 19 the NPV and internal rate of return at year 2015 is presented.

Tele 2 Telia HI3G Europolitan Orange Sverige

NPV (million €) 526 -17 -1 337 -126 -542

IRR (%) 20 11 - 11 6

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