Three is the magic number.
Source: Investors Chronicle

Vodafone was out to impress this week. Its annual results presentation was, as usual, accompanied by a demonstration of the latest gadgets and services. But this time around there was some added spice - for the first time, Vodafone was able to show live third-generation (3G) services in action. The assembled journalists and analysts were treated to video downloads, videophones and data services for business users. Here, at last, was proof that all the money spent on 3G licences would result in real services, real revenues and, hopefully, real profits.

But behind the tantalising possibilities of video downloads and interactive gaming, mobile operators' top priority for 3G may be something far more familiar. Voice calls still form the bedrock of the mobile industry and, according to research from telecoms consultancy Analysys, by 2009, voice calls will still represent 66 per cent of mobile revenues.

That's because the number of voice minutes carried by the networks is set to increase dramatically. According to figures from Analysys, mobile voice minutes in western Europe will increase by 57 per cent to over 1,300bn minutes per year by 2009. And the problem for the operators is that the existing second-generation networks are filling up rapidly, especially in urban areas, increasing the number of "service unavailable" messages that users receive.

So this is where 3G networks will come in, providing more voice capacity for operators at lower costs. "One of the key opportunities is to significantly increase voice revenues, and to take significant revenues from the fixed-line operators," says Mark Heath, of research consultancy Sound Partners. According to Dr Heath, the cost per minute of a 3G network is around one-fifth of the cost of a second-generation network, presenting the opportunity to reduce prices dramatically to a level that competes with the fixed-line players. "They key issue," he says, "is whether the operators are going to seize the opportunity."

But while the voice opportunity presented by 3G is enormous, the risks are also significant. Until now, the mobile sector has been characterised by pricing discipline among key players. Small tariff differences exist, but none of the major operators significantly undercuts the others. By reducing some prices dramatically - for example, by offering large 'bundles' of minutes for a fixed price - operators may lose out on revenues without achieving the required increase in volumes.

A new generation of costs

New entrant 3 has attempted to attract users with low rates for voice bundles, but with limited success. None of the operators has an interest in provoking a price war, and those operators owned by fixed-line companies (such as Orange and T-Mobile) have an added incentive to slow the rate of fixed-to-mobile migration. While virtual network operators (including Virgin and Tesco) may like to offer much lower call charges, they rely on the prices charged by their suppliers (network owners such as mmO2 and T-Mobile).

There are also extra costs attached to dramatically increasing the number of minutes carried over mobile networks. According to research from Morgan Stanley, the initial 3G roll-out programmes in western Europe have concentrated on breadth, rather than depth, of coverage, so that initial services can be rolled out quickly. The consequence is that the networks are not designed for handling the increased volumes of voice traffic that dramatically lower prices would attract. The cost of upgrading these networks to handle the extra traffic would, according to Morgan Stanley's estimates, prove detrimental to the operators' free cash flow.

Despite this, a UK price war is possible. Unlike most other countries, the four leading players have very similar market shares, so they have to work hard to maintain their positions. And two of those four, Vodafone and mmO2, have no ties to fixed-line operators, so they have little incentive to slow the rate of fixed-mobile migration. Also, the terms of the UK 3G licences mean that there is more capacity available to the UK operators, so more of a risk that they will have surplus capacity.

Given the uncertainty over 3G voice revenues, the operators will have to look elsewhere if they are to justify the GBP22.5bn that was spent in the UK alone on 3G licences. Both investors and customers will be waiting for the exciting, non-voice services that were promised. The camera phones, photo-messaging services, music downloads and games that are available on existing networks are all designed to get consumers into the habit of buying data services over their phones.

Consumers won't notice the switch to 3G immediately. Both Vodafone and mmO2 stress that the move to 3G services will be an evolution rather than a revolution. However, 3G networks will give the operators more capacity, allowing the gradual introduction of more advanced services. Photo-messaging will become video-messaging, football score updates will be accompanied by a video of the goal, and synthesised or polyphonic ringtones will be replaced by real music.

"In entertainment, the biggest area is personalisation, and music is the core area of that," says Eden Zoller, analyst at telecoms consultancy Ovum. "Ringtones are still popular, as are the new polyphonic ringtones. We are also looking at truetones, which is real music as a ringtone, rather than a synthesised tune.

"In information services, sport is the biggest content strand. It accounts for about 60 per cent of premium content revenues of information services."

According to Analysys, non-messaging services will account for over half of mobile revenues by 2009 (see chart, above). Of those services, entertainment and information are expected to be the most popular. In the industry, 3G is often said to stand for girls, gaming and gambling.

Profits - a tough call

But it's not clear who will profit from 3G services. The operators are the most obvious beneficiaries. In the first place, they'll be able to charge customers for the airtime taken in delivering the services. The greater the capacity taken up by the services, the more the operator can change, so a video download will cost more than a photo one.

But charging by capacity alone is unlikely to satisfy the operators, or to pay back the billions that were spent on the licences. A video download, for example, will attract both a charge for the capacity taken in delivery, and a charge for the content itself. It's the destination of the content charge that will be hotly contested.

The content owners themselves will be keen to get their slice of the pie. Music publishers, for example, will want a slice of the revenues that come from ringtone downloads, and football clubs will want money every time a fan downloads a video of one of their goals. They already take a portion of revenues from existing services, but they're getting more demanding. "Music publishers get 15 per cent on a ringtone at the moment, but they're looking for up to 50 per cent on a real tone," says Wayne Pitout, chief executive of content aggregator iTouch.

For their part, operators have been working hard to ensure that customers see them as the primary source of content. Portals such as Vodafone Live! are designed to provide everything that the discerning mobile user needs. Content bought through their own mobile internet sites will give the operators a bigger cut of the premium content charge.

Operators will face stiff competition, though. Handset manufacturers, such as Nokia, are keen to promote customer loyalty by offering content that is unique to their phones.

Content still king

More threatening than the handset manufacturers are the content aggregators. These companies sign up content from the owners, and deliver it to mobile users, either directly or through partnerships with operators. Either way, they represent a middle man that has the power to take revenue from both the operators and the content owners.

The direct model, in which the aggregators advertise directly to consumers and deliver their services through messages, is becoming more popular. "Direct will be our primary source," says iTouch's Wayne Pitout. "We are teaching the market how to buy direct, rather than through Vodafone Live and other menu structures." It's easy to see why he's so keen. Under this model, of the GBP1.50 that a customer pays for a ringtone via SMS, the operator will take 55p, the content owner will take 9.5p and iTouch will take 85.5p.

Unfortunately for Mr Pitout, competition will be intense. There are already three UK-listed content aggregators: iTouch, Monstermob and Stream. There is also competition from overseas aggregators, such as Buongiorno and Index. The first evidence of a price war emerged this week when Monstermob warned that margins will be hit by an advertising campaign designed to counter aggressive marketing by rivals, and by investment in new products. Its shares dropped 23 per cent.

According to Ms Zoller, the aggregators that will succeed are those that offer something extra. She says that those offering technology platforms, management services or even an international element will be best-placed. In that light, iTouch looks strong, with operations in the UK, Ireland, Australia and South Africa, and trials in two further countries. Mr Pitout hopes that scale will be a winning factor when it comes to dealing with the content owners.

But, even once they've signed up distribution deals with content owners, the aggregators will have to rely on the operators to dictate the speed of migration to 3G. And that may not be as rapid as some would like. The experience in Asia, and from 3 in the UK, is that the roll-out of 3G services is a tricky process. 3 pays about E600 to connect each subscriber, but revenues have so far been disappointing.

At its annual results last week, mmO2 painted a cautious picture of its roll-out plans. In Germany, for example, it has already covered 25 per cent of the population with its 3G network, in accordance with its licence conditions. "We won't build out any more in Germany until we're sure of the revenue stream," said chief executive Peter Erskine. The UK launch will only be in major cities.

So while Vodafone has been out to impress this week with its 3G handsets and datacards, dramatically higher revenues may be some way off. And even when those revenues do eventually arrive, there will be a feeding frenzy involving the operators, virtual operators, handset manufacturers, content owners and middle men. True, the network owners are better-placed than the rest - but the rivals won't be far behind.

The Asian example

While European consumers are getting excited about camera phones and photo-messaging, Japanese users are already getting to grips with videophone and TV downloads. 3G was first launched in Asia in 2002, with mass-market launches in 2003. Initial news on the usage front is encouraging for the operators. In Japan and Korea, video telephony, video-on-demand and music-on-demand have proved popular. TV downloads accounted for 32 per cent of 3G revenues for Korean operator SK Telecom in the final quarter of 2003.

But while consumers are enjoying the new toys, the operators are suffering. 3G services have, so far, been a financial disaster. "The two main Japanese operators have launched 'all-you-can-eat' data plans, capping the potential revenues," says Mark James, telecoms analyst at Nomura. "Cash costs and amortisation costs are also rising, pushing down margins." NTT DoCoMo, Japan's largest operator, warned that revenues will fall this year due to pricing plans, while competition for new 3G subscribers is pushing handset subsidies up. If European operators are to avoid the same fate, they'll have to maintain pricing discipline, and persuade consumers to spend more for 3G handsets.