Why did Carphone Warehouse buy AOL UK's "access" business!?

So finally AOL UK’s access business has been bought and the winner of the dutch auction is Carphone Warehouse (CPW) who acquired the business for £370m from AOL’s parent company Time Warner. This makes CPW the third largest ISP in the UK with 1.1 million broadband customers behind BT Retail (2m) and NTL (1.5m). (see the table below from issue 12 of UKBBMM)

But why are CPW chasing so hard to be a major player in the broadband access market given that broadband has already become a “free” commodity bartered by the likes of Orange, Sky and CPW themselves in exchange for something else? Personally I find this deal very odd because the numbers and the strategy just don’t stack up.

First the numbers. Based on the subscriber numbers below, CPW’s newly acquired “broadband” customer base cost £370 per customer to acquire. I guess what CPW are hoping to do is convince the vast majority of AOL’s 1m broadband customers and especially the 600,000 dial up customers (not listed in the figures below) to migrate over to their TalkTalk phone service worth £9.99 per month with the carrot of “free broadband”.

So doing the maths, it will take approximately three years of TalkTalk revenue per customer before CPW breakeven on this deal i.e [(£9.99 x 12months) x 3 = £359]. This assumes that at least 60% of the AOL access customer base sign up for TalkTalk which seems unlikely given the fact that less than 50% of the current CPW TalkTalk customers applied for the “free” broadband offer and less than 10% of them actually ended up migrating over to their free broadband offer.

“In April 2006, Carphone Warehouse launched a major new initiative, offering free broadband to its 2.7m voice customers, and it attracted 625,000 applications for this service over the last six months.” – CPW Press Release (note: only 62,000 are active CPW broadband customers)

UK Subscribers Table

To make matters financially worse, CPW recently announced that their “free” broadband offer was going to cost them a further £20m to subside, which takes their costs over £70m this year alone and all of this additional expenditure is being funded through increased debt.

Carphone said “that while it has unbundled 370 exchanges, with a further 476 exchanges handed over by BT Openreach, it only has 20,000 customers on unbundled lines.”

So in the medium term (3-5 years) CPW might expect to have around 4-5m TalkTalk phone customers in the UK using their own CPW network which is probably why CPW saw their shares rise 5% in morning trading in London.

This of course assumes that the phone call charges won’t change from £9.99, but as we all know this revenue stream is also coming under strong competitive price pressures i.e currently TalkTalk and BT Together charge £9.99 per month but the likes of NTL and Sky are already offering phone services for £5.00 per month plus free broadband.

So to convert and retain those expensively acquired AOL customers, CPW might have to consider reducing their own call charges further in order to ensure that they migrate at least 60% of their AOL customers over to TalkTalk and not lose them to Sky or NTL instead. And if they don’t reduce the price, it might mean less people convert over to TalkTalk and in turn it will make the breakeven point for this deal longer than 3 years which will certainly cost CPW more than the £70m already accrued.

So in a “free” broadband market with potentially falling phone revenues I seriously question why CPW bought the AOL access business. In fact speaking with a senior AOL UK executive yesterday about this deal, he told me that they were dancing in the hallways of AOL tower and popping the champagne corks. “Getting rid of the access albatross hanging around our necks is possibly the best thing that could have happened.” [note: AOL is aiming to cut $1bn in costs over the year and getting rid of access costs will certainly go a long way to achieving this goal.]

So now I have briefly explained why I think this deal is odd from a financial point of view given the backdrop of falling revenues, I will now try and explain why I think this is also an odd deal from a strategy point of view.The second part of the press announcement mentions that “AOL will provide a co-branded portal, content and other services and will also manage the online advertising sales for Carphone Warehouse’s combined broadband customer base through a revenue-sharing agreement.”

Basically in English that means all of CPW’s broadband customers will be pointed back towards an AOL UK portal as their homepage which will have some minor CPW branding and then AOL will charge CPW for providing this portal and for providing CPW customers with other AOL services such as email, IM content etc. AOL will also manage the online advertising for this co-branded site and again charge CPW for doing so whilst sharing the potential upside revenue from any advertising generated.

This deal actually reminds me of the awful BT Yahoo deal where BT were totally “suckered” into using a co-branded Yahoo portal which was nothing more than a thin veneer pretending to offer joint value to BT customers. Whereas in reality Yahoo get every new BT broadband customer to sign up to Yahoo services – email, IM etc. and to make matters worse BT actually pay Yahoo for this privilege!

“Even though you’ll receive a new BT Yahoo! Mail address, your existing Yahoo! account will stay unchanged. If you like, you can have email sent to your Yahoo! address automatically forwarded from your BT Yahoo! Mail inbox, so you won’t need to check two accounts.” – Taken from the BT Yahoo FAQ

The bottom-line is CPW have taken the cost headache away from AOL UK and paid AOL for doing so. Equally they now send those very same AOL UK customers back to AOL plus CPW’s own broadband customers and again CPW pay for the privilege of having them sign up to AOL services?

This is why I think this deal is odd because the long-term game for all of these providers – BT, NTL, Sky, Tiscali, Orange, CPW, Tesco etc. has to be to become a quadplayer offering their own – voice, video, content plus mobile services – in order to move beyond simply being a communications access pipe where in the medium to long-term there is no money into revenue services.

BT has finally woken up and is fast becoming a quadplayer. They are launching BT Vision, their own IPTV service to compete with NTL and Sky. BT Retail is also looking to provide web services that change the balance of its future revenues from access – broadband and voice services – to web services such as BT Contact, BT PodShow etc. I wonder how long the BT Yahoo deal will remain in place. Not long me thinks as the future value of any network is in owning the online customer and providing them a whole host of free and chargeable services.
CPW on the other hand have only two parts of the quadplay equation voice and mobile in place today. I guess some CPW executive sold the idea of an AOL partnership to fill in the gaps for now. Personally I think it would have been smarter had CPW bought HomeChoice but instead of Tiscali snapped it up. Right now CPW have taken on a significant cost with the AOL access business with no guarentee that the customers will migrate to TalkTalk and instead of filling in the gaps in their quadplay strategy they have made the same mistake as BT Retail did a few years ago.

So in answer to the question “Why did Carphone Warehouse buy AOL UK’s access business” I really don’t know. I would add that in the coming years we will see further consolidation in this marketspace and maybe CPW will become an attractive acquisition for NTL/Virgin given the joint venture between CPW and Virgin in France and also the possible desire of NTL to become the clear leader ahead of BT in terms of broadband access.