A help line for European telcos

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A help line for European telcos: illustration

A help line for European telcos: title image

The incumbents must adapt their organizations and acquire new skills to win the war of inches against their attackers.

The McKinsey Quarterly, 2003 Number 1

Europe’s incumbent telecom operators are heavily in debt following their ambitious expansion efforts in the 1990s and an enormous bill for third-generation licenses. 1 So far, the response has been to slash spending. In 2001, these companies trimmed their operating costs by up to 6 percent, reduced the staffs of their core fixed-line divisions by as much as 12 percent – more cuts are to come – and pared their capital spending to the bone (Exhibit 1). Chart: Damage control

But cost cutting alone won’t revive their fortunes: in addition, they must do something about falling revenues, for at some of the incumbents revenues from the fixed-line voice business, which still accounts for 70 to 90 percent of the wireline total, have been shrinking by up to 12 percent a year. So far, revenues from data have also been lower than expected, because an oversupply of data networks has forced down the price of such services – a particular blow to incumbents, since a good deal of their recent capital spending was devoted to building these networks (Exhibit 2). It therefore isn’t surprising that the market valuations of the telcos’ fixed-line businesses fell by 25 percent, on average, from 2000 to 2001. 2 Clearly, revenues are only one factor behind this decline, but if they don’t improve, cash flows will worsen and valuations will fall even further. Chart: Data alone haven

Perhaps because no “silver bullet” comes to mind, few incumbents have as yet done much to improve their revenues. Given the competition for voice traffic, these companies’ fixed-line voice telephony business won’t grow briskly regardless of what they do, but they can still squeeze more cash from their fixed-line voice and data services. Although the telcos can’t rescue themselves with any single initiative, undertaking several at once could do much to tide them over this difficult period: at Spain’s Telefonica, for example, revenues fell by 0.6 percent from 1997 to 2000 but rose by 2.5 percent from 2000 to 2001, following the introduction of such a program.

A typical European telco could expect its revenues to improve by 2 to 5 percent within a year after embarking on the course discussed in this article. Small beer? Not if you consider the alternative: stagnant or falling revenues. Moreover, these initiatives don’t require much extra spending, so the resulting cash contributes directly to earnings, and even a modest program could raise a company’s value by 15 to 20 percent. 3

Turning the business around

The voice revenues of the incumbents are stagnating because of increased competition, and their predicament will certainly get worse if they don’t act soon. Although overall telecom spending is up, the share of fixed-line voice operators is shrinking as mobile and data service providers capture most of the growth. Such newcomers – cable companies, wireline attackers, and mobile operators – have not only made considerable gains in market share but also, with help from tariff reductions imposed by regulators, forced down prices.

Mobile competitors have proved particularly threatening, for mobile telephony has swelled the voice market but, at the same time, eaten into the fixed-line operators’ share of it. Some 15 percent of UK residential users now regard their mobile telephone as their main one (compared with 13 percent a year ago); 6 percent of households in the United Kingdom have only mobile phones, as do 31 percent of households in Finland, where two-thirds of all 14- to 25-year-olds use them exclusively.

A model we developed to forecast voice and data revenues predicts that even telcos where they increased moderately in 2001 will see revenues from fixed-line voice operations fall by as much as 4 percent over the next three years (Exhibit 3). To reverse this decline, these companies must embark on a range of small-scale initiatives in three broad categories: preventing customers from defecting (and winning back some of those who have already left), launching new services, and encouraging existing customers to spend more. Chart: The price of idleness

The order of priority will differ among national markets, depending above all on the extent to which each of them has been deregulated. As a general rule, telcos operating in a newly liberalized market, such as Central Europe, can expect the going to get much tougher, since they have yet to experience the full impact of competition: the simultaneous erosion of their prices and their market share. Moreover, the penetration of wireless relative to fixed-line phones is already quite high there, so many customers may well give up or never adopt fixed-line services. When a Czech operator raised its line-rental fee in early 2002, for example, 2 percent of its subscribers, believing that it was no longer worthwhile paying for both fixed and mobile service, canceled the former. In these markets, initiatives aimed at preventing customer defections to new competitors should thus have a higher priority than they would for telcos in long-deregulated markets, where much of the customer churn has already taken place. Indeed, incumbents in more developed markets have a chance to win back customers because overcapacity there has already killed off some attackers.

A telco hoping to revive its revenues should direct its efforts toward the three main customer segments: households, small and midsize businesses, and corporations. The residential segment provides the steady cash flow needed to offset the fixed costs of the access network. Small and midsize business customers are important profit generators, providing typical earnings before interest, taxes, depreciation, and amortization (EBITDA) of approximately 30 percent, as compared with 25 to 28 percent for corporate clients. Yet though the corporate segment may be less profitable, it is essential for rolling out new services, since it helps to provide the volumes needed for network economies of scale.

Spoiled for choice

Th e revenue-generating ideas outlined here give an idea of the dozens of approaches that telcos can choose from to prevent their customers from defecting and win back some of those who have already left, to launch new services that will earn quick returns with little capital outlay, and to encourage their current customers to spend more on existing services.

Combating defections

Most customers who defect from the incumbents believe that their competitors offer better value In the three years following liberalization, the average European incumbent lost 22 and 35 percent of its share of the national and international long-distance markets, respectively, as customers signed up with competitors. Prices too dropped rapidly (Exhibit 4). Most of the defectors believe that the incumbents’ competitors offer better value for money, so initiatives to win back these people should focus on improving their perceptions of the value the incumbents offer. Chart: Effects of liberalization on incumbent telecoms

Such initiatives may target an entire market segment – all small and midsize businesses, say – or a particular subsegment. Targeted campaigns work best if they pinpoint customers, especially high-value ones, in the group most likely to defect. One operator, for instance, wanted to concentrate on retaining only those small and midsize businesses it risked losing. To that end, it analyzed its customer database to see if earlier defectors in this category had much in common. It turned out that they tended to make more customer service calls, suggesting some dissatisfaction on their part, and paid by check or payment order rather than direct debit, suggesting that they weren’t convinced the relationship would last. The telco then trained its sales force to approach similar customers, offering them volume discounts on their contracts. The sales reps received a special commission on these deals. During a seven-month trial, the company estimates, the initiative cut the number of customers that would have been lost over this period by 27 percent.

Another incumbent, which was trying to win back business from corporate customers, first identified accounts whose traffic had fallen by half or more. The company then targeted the biggest of these customers whose business it thought it had a fair chance of winning back; the targets represented about 10 percent of its total customer base. Next, the telco calculated the present value of the lost business from each of the customers should it be regained and tailored an offer (from a range including attractive packages of products to discounts on individual products) for each of them. The offer was designed to cost less than the present value of the incremental profit of the traffic won back from these customers. The result? Some 25 percent of the companies approached signed new, profitable contracts.

Although targeted initiatives are usually more successful and cost-effective than segmentwide ones, they aren Although targeted initiatives are usually more successful and cost-effective than segmentwide ones, they aren’t always possible: poor customer data might limit a company to segmentwide campaigns, for example, as would restrictions on the right to offer different prices to different customers. Nor are targeted initiatives likely to be effective if an incumbent’s brand is in trouble. Residential customers wrongly perceive many European incumbents to be much more expensive than their fixed-line competitors – a result of the attackers – energetic marketing and of the incumbents’ lethargy. Indeed, few of these customers know the actual price differences between the two. A few incumbents have fought back by launching price-perception campaigns: BT, whose advertising once focused on connectivity and customer service, recently ran a campaign to show that some of its packages were cheaper than those of its competitors, and a similar effort by an Eastern European incumbent raised residential off-peak traffic by 8 percent and revenues by almost 2 percent – a worthwhile gain given the relatively small advertising outlay.

Offering new services

When share prices were booming and telcos could borrow easily, adding new services to generate growth stood high on their agendas. Now that capital is tight, telcos have frozen their capital spending. We, however, think that many of them are acting too conservatively: they should consider offering new services, especially in data, to customers such as corporations and certain small and midsize businesses, which are often among the earliest adopters of new, sophisticated, and integrated telecom systems. The key is for the telcos to identify services that require a moderate investment on their part, have short payback periods, and can improve the bottom line without cannibalizing other products – of course, taking into account a company’s special skills and the level of competition.

Take, for example, Internet Protocol virtual private networks (IP-VPNs), which provide networks of secure links over a shared IP infrastructure. Their benefits to customers resemble those of dedicated IP networks using leased lines, but they are much less expensive, since the infrastructure is shared with other customers. For a fairly small outlay on encryption equipment, servers, and software piggybacked onto a telco’s existing network infrastructure, the telco can earn revenues by managing the IP-VPN infrastructure of their customers, by transporting higher volumes of data, by using the new network as a platform for other services (such as videoconferencing), and by providing services to remote locations. And as IP-VPNs become more popular, the technology may generate network effects: customers and suppliers of large corporations will want to adopt their IP-VPNs in order to be integrated into the same systems and share the same benefits.  

Yet the economic attractiveness of an IP-VPN to the customer carries some risks for incumbent telcos because, initially, some of their leased-line services may be cannibalized. A more economical option may be to provide smaller offices with cheaper alternatives, such as Asymmetric Digital Subscriber Line (ADSL) connections, while making IP-VPNs available to customers only if the incremental benefits outweigh the risk of cannibalization. By contrast, it will always be hard to make an economic case for Gigabit Ethernet – an extremely fast form of metropolitan data connection that can also cannibalize existing data lines. Incumbents should install this technology only if revenues from a customer’s data lines will probably be lost to competitors.

Encouraging customers to spend more

Wireline incumbents often overlook several ways to increase revenues from existing customers. These techniques include the promotion of existing services such as voice mail and call forwarding as well as attempts to stimulate traffic through promotional trials of new services, flat-rate offers, and the bundling of new services with those that customers already purchase.

The wireless operators, exposed to more competition, are ahead of the wireline ones in using offers to ensure stable revenues per user Such efforts can yield important gains. Flat-rate offers – the operator sells a defined number of minutes in a single package for a fixed, discounted price – encourage customers to use their telephones more often. Revenue gains of 10 percent from subscribers are not unusual, and the deal gives the operator a more constant cash flow. Wireless operators, which are exposed to greater competition, are way ahead of the wireline telcos in using such offers to ensure stable average revenues per user.

Bundling is another effective means of encouraging people to spend more; customers, it seems, are willing to pay for service bundles if they offer at least one of two benefits: convenience (eliminating the need to deal with different suppliers, say) or, more important, cost savings. A potentially lucrative example of this approach would be to offer small and midsize companies a bundle consisting of the core telco products they already use, such as voice or broadband access, together with new IT services, such as the management and security of their local-area networks (LANs) – a service they would normally buy from IT specialists or provide in-house. The telco can manage these services remotely over its existing networks, so it can offer them as a natural extension of core services such as Internet access.

This kind of bundled offer not only increases an operator’s revenues in the short term but also provides a uniform platform for future sales of other advanced services – for instance, virtual private networks between different locations. Such offers can attract small and midsize businesses by giving them complex IT services relatively cheaply and by simplifying their dealings with suppliers. Our analysis of one such bundled offer revealed a potential 4 to 6 percent cost reduction for the customer, whose value to the operator still rose by around 10 percent.

The impact

To show the potential gains of a suite of revenue-generating initiatives, we modeled the consequences of seven of them for a hypothetical telco operating in a Western European market that was liberalized in 1998. We chose the initiatives likely to have the most impact on revenues, taking into account the market’s particular conditions, such as regulatory constraints, and the operator’s capabilities.

Exhibit 5 shows each initiative’s potential impact on a company’s revenues. In the residential segment, the telco had an opportunity not only to undertake a price-perception campaign and to make targeted offers that could reduce churn but also to turn a legal requirement – offering directory services – into a revenue-generating offer: for a small fee, customers would get additional information such as driving directions or restaurant locations. The initiatives in the small and midsize business segment included a bundled offering, a targeted program to reduce churn, and a move into network security services. (This market, though small, is a lucrative one because of growing concerns about security, an area in which a telco can use its core network capabilities and infrastructure.) Finally, in the corporate segment, the telco, given its knowledge of standardized monthly billing processes, appeared well positioned to offer billing services to other companies: since its own billing operation was very large, it could add additional volume at marginal cost. We estimate that rolling out these initiatives successfully could increase the telco’s revenues by 3 percent in a year. Chart: A suite effect

Some incumbents recognize the impact a program of this kind can have. One such company forecast a 6 to 10 percent year-on-year drop in wireline traffic if it took no action at all to stanch the defection of its business customers to wireline competitors and of its residential customers to mobile networks. Moreover, the spending power of its customers was below the European average, so it was hard for them to pay for higher-quality but more expensive services such as residential DSL lines or corpor ate wireless LANs, which might help compensate incumbents in wealthier markets for lost customers.

Under these unpromising circumstances, the operator designed and carried out 17 initiatives in less than a year. While not all of the results are available, the company is on course to raise its average annualized revenue per user by more than 4 percent, and many of the initiatives showed results almost immediately. Although they won’t entirely offset the forecast fall in traffic, the company has learned a great deal about the behavior of its customers along the way, and the will to improve its core voice business continually is becoming a part of its culture. The company will find these new assets invaluable, for though none of the initiatives we suggest requires much capital outlay, many do require an understanding of the behavior and needs of customers – something that not all telcos have, given the protected environment in which they used to operate.

To win this war of inches, telcos with vestiges of the protected mind-set will have to adapt their organizations and acquire new capabilities – for example, better marketing skills and a better understanding of how their customers use their services. But these companies will find their skills constantly improving once they set in motion the approach outlined here. They don’t have to do everything themselves: they could, for instance, outsource customer loyalty programs or use third-party call centers that specialize in telemarketing. But since marketing skills and an understanding of customers will be crucial to many future operations of such companies, they will need to invest in these areas in any case. Of course, senior managers will have to pay close attention to choosing and coordinating the many different initiatives that revenue-enhancement programs entail. But the results should make the effort worthwhile.



Shankar Jagannathan is a consultant in McKinsey’s Charlotte office; Stanislav Kura is an associate principal in the Prague office; Michael Wilshire is a principal in the London office.

The authors wish to acknowledge the contributions of Monika Hencsey, as well as those of Santiago Comella, Nathan Marston, and Mark Steen.

1Third-generation (3G) wireless technology provides for packet-based transmission of text, digitized voice, video, and multimedia at rates of up to 2 megabits a second. In some countries, operators paid license fees as high as $7.6 billion.

2UBS Warburg and Salomon Smith Barney sum-of-part valuation for the fixed-line operations of Ceský Telecom, Deutsche Telekom, France Télécom, KPN, TDC, and Telecom Italia.

3This estimate was arrived at through a cash flow analysis of the incremental revenues that would be generated by initiatives contributing an earnings margin of 70 to 100 percent to the bottom line.

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