Description

Iliad, operating under the brand “Free”, is a low-cost leader in French telecom.  As we know from business history, low-cost leadership can be a very powerful business model, with generally more sustainability than pricing-based models.  Iliad operates with very low costs and passes the savings on to its customers through very low prices.  As time passes, Iliad not only does not raise prices, but in fact delivers more value by enriching its existing offers with more minutes, more data, more free international destinations (Free’s slogan: “Always giving you more for the same price.”).  The result is a very sustainable business with very loyal customers. 

Iliad was founded by the very unusual Xavier Niel in 1991 (see a 2013 NYT profile here: https://www.nytimes.com/2013/05/06/business/global/xavier-niel-billionaire-who-breaks-the-mold.html).  From the beginning, Xavier was focused on delivering value to customers through high quality and low prices.  He named his internet service “Free”.  When he launched his ADSL broadband product in 2002, he priced it at €29.99 per month, about a third less than the market rate from other operators at the time.

Today, after 15 years of inflation and product improvement, Iliad has only raised the price by a cumulative €5/month!  Its low-end triple-play broadband offer (which now includes 1 Gbps fiber for no additional cost if your building is wired for it) is €34.99.  (Something like this would cost you >$120 per month in the US.)  

Iliad is a converged fixed-mobile operator, offering both services to customers.  Iliad currently has 24% market share in fixed and 18% market share in mobile.  Iliad’s goals are 25% market share in fixed and 25% market share in mobile. 

While Iliad’s optical market share in mobile is 18%, its actual market share of €20 subs is closer to 9% because a little less than half the mobile sub base is still €2/month.  Management’s goal is eventually to have 25% market share in mobile with 100% of the base paying €20. 

Iliad’s mobile network continues to increase in quality while the price stays the same.  Over time, a mobile market share in the 20-25% range should be achievable.  But even if Iliad for some reason gains no incremental mobile subs from today – there will still be significant value creation from converting its €2/month customers into €20/month customers – driven by the relentlessly increasing demand for data.  

Thesis:

·         Strong organic EBITDA growth:

o   Mobile

§  2 euro/month mobile subs become 20 euro/month mobile subs, driven by the demand for data (2 euros gets you very little data).  The shift from 2 to 20 comes at very high incremental margins, as the cost of network is fixed.  This is currently accelerating.

§  Save on mobile roaming as more and more traffic goes on Iliad’s own network instead of roaming on Orange’s.  Exact numbers for mobile roaming are closely guarded but we’ve seen estimates of €400 mm paid by Iliad in 2018 (8% of Iliad total revenue including broadband revenue) which should fade to zero over time, only partly offset by rising organic network costs as Iliad operates more stations.

o   Fixed

§  DSLàFiber. DSL pays a big copper line rental fee to Orange, ~30% of broadband ARPU.

·         Reduced fee to Orange.  There’s no fee for fiber except for outside the dense areas where the operators don’t duplicate infrastructure.

·         ARPU higher over time due to mix shift to fiber – if Iliad chooses to do so.

o   Right now, Iliad is upgrading its DSL customers to Fiber for no additional monthly fee.  In every other country there is a premium between DSL and fiber.

o   As a result of the above, I assume a 42% EBITDA margin by 2022 vs. 36% in 2017.

§  Iliad management guides to consolidated EBITDA margin of “over 40%” by 2020.

·         Capex will come down, driving significant FCF growth.

o   Mobile investment is currently peaking but will fall as Iliad finishes rolling out mobile sites by 2019.  Mobile capex is elevated at the moment because Iliad is rolling out both 3G and 4G at the same time.

o   Fiber peaking then falling over time as upfront fiber builds in dense areas finish by ~2018-2019 and fiber moves instead to variable-based co-investment in less dense areas.

o   Right now, we are in the perfect storm of capex where Iliad is heavily investing in mobile and fiber simultaneously.

Management is extremely smart & aligned. 

·         Management owns 56% of Iliad; Xavier Niel owns ~51% (€3 bn) and the rest of management ~5% (~€300 mm).

·         Long management tenures with few departures:

o   Thomas Reynauld, CEO – been CFO since 2008 but knew Iliad and Xavier since 2004, when he ran the IPO of Iliad while he was at Societe Generale.  Was promoted to CEO and replaced Maxime Lombardini in 2018 due to recent troubles at the company (will be discussed later in this memo).

o   Rani Assaf, CTO – been CTO since 1999, owns 1.3% of Iliad

o   Antoine Levavasseur, Information Systems Director – at Iliad since 1999

o   Angelique Gerard, Client Support Director – at Iliad since 2000

o   Patrick Fouqueriere, Director of Supplier Relations – at Iliad since 2001

How is Iliad low cost?

·         No suppliers – everything is done internally

o   “Our IT is 100% in house. <€10 mm/year cost.” (Niel)

§  “Network management, IT billing etc. account for 5%-8% of revenues for a typical carrier vs less than 1% for Iliad” (Iliad 1H16 presentation)

§  CRM (customer relationship management software) example – zero spending for CRM at Iliad vs. 50 mm at Bouygues.

·         Having simple offers helped.  In fact through much of the 2000s Iliad had just one offer -- €30 euro/month for DSL triple-play.

§  Mobile billing system example– Rani Assaf (CTO) hacked it together in 4 days.

o    “85% of our hardware is made in-house” (Niel).  This includes the set-top box.

o   Call centers – 100% is in-house, including the North Africa operations – everyone is an Iliad employee. 

o   Technical ops/field staff are all in-house.

·         Startup mentality – a very limited number of people at corporate HQ

o   Decisions are made quickly without a lot of bureaucracy.

o   And Iliad underpays top management – for example the recently departed CEO Maxime only made €384k/year; he is working for the benefit of his ownership in Iliad.  The top managers are all paid very little. 

·         Low employee count in general

o   9,800 employees inclusive of customer service employees (>70% of total) vs. 70,000 Orange France employees and 10,000 SFR employees (but SFR customer service is largely outsourced).

o   Iliad’s payroll cost as % of revenue, which is inclusive of customer care that other companies like SFR outsource, is a very low 6%.

·         Organizational focus on low cost, because they are very aware that low costs is what allows them to offer low prices

·         No marketing; benefit primarily from word of mouth due to its superior value

o   “Marketing we have 2 people. Competitors have 1000 people.” (Niel)

·         Few retail shops; almost entirely online distribution – this is a whole layer of cost that’s eliminated

o   Slowly opened 50 physical shops over time. (Orange and SFR each have upper hundreds.)

What has happened recently?

A price war has erupted in French telco.  For a while Bouygues had been offering low prices for fixed, trying to gain market share from a small starting base, and SFR was offering low prices on mobile and fixed through its RED sub-brand, but the scope of these was relatively contained.  When SFR entered distress and changed management in late 2017, new management really stepped on the gas pedal and went all-out with low-priced promotions on both fixed and mobile.  Bouygues matched & significantly dropped its own promotional prices.  Bouygues and SFR together did what Bouygues alone could not – these moves began to cause churn at Iliad and limit its gross additions.  Iliad’s €20/month mobile offer does not look as cheap when SFR RED and Bouygues B&YOU (their sub-brands) are offering high-data mobile bundles for €10-15/month. 

In 1Q18, Iliad’s broadband net additions turned negative for the first time, and in 2Q18 these declines continued and in addition mobile net adds went negative for the first time in Iliad’s history (though Iliad says that all of the decline came from 2 euro subs whereas 20 euro subs still grew). 

When it reported 1Q18 earnings, Iliad hosted an unusual conference call (it usually only does so for half-year results) and Xavier Niel came on to speak and answer questions.  He was pretty frank about his disappointment in recent results and announced a number of changes.  One of them was a major management change: CEO Maxime Lombardini was replaced (moved up to the Chairman role) and CFO Thomas Reynauld became CEO – an unusual move for a company that’s had the same management team for well over a decade.  Thomas seems like a very smart, high-energy and aggressive guy – this seems like a positive.

Iliad also announced some promotional changes, such as offering promotions on its website for the first time (previously the website only offered full-price offers even for new customers), using retention policies to retain customers (e.g. offering in-between deals to customers who are coming off promotion), and being proactive in trying to switch 2 euro mobile customers to 20 (with an in-between promotion, say at 10 euros).  These changes seem positive as well; previously, Iliad had operated at a marketing disadvantage by not being aggressive on promotions (except during limited windows intra-quarter when they offered very low-price promotions on the vente-privee flash sales website) during a time when its competitors were being extremely aggressive.

One risk is that the continuation of very low prices for broadband may indicate that Iliad’s ARPU of its existing fixed base may be too high for the current market environment of extreme competition.  Iliad fixed has an ARPU of €32.8 vs. SFR fixed ARPU of €32.1 (down from €36 at peak last year) and Orange ARPU of ~€34, so no gap there, but it compares with Bouygues fixed ARPU of €25.6, a gap that Bouygues can continue to exploit by being aggressive without worrying too much about its back book.  Bouygues has seen its fixed ARPU decline 23% from €33.3 in 4Q13, but it seems to be willing to make that tradeoff as fixed subs continue to increase.  That said, there is a high portion of Iliad subscribers that will remain loyal to the company, its ARPU is not above established fixed peers SFR & Orange, and fixed ARPU stabilized in this most recent quarter.  While I don’t expect the fixed business to grow, I also don’t expect it to decline significantly from these levels. 

Iliad’s valuation has crashed to extremely low levels, from 8x to 5x EBITDA.  Unfortunately, given no current FCF generation, there’s no way for the company to take advantage of this via buybacks.  Nonetheless, this is a historic low valuation for a company that should continue to grow and move toward a solid EBITDA-Capex margin due to the drivers above.  I think by 2022 Iliad has €5.6 bn revenue, 42% EBITDA margin, 20% capex margin (management historically has guided to 15% long-term), and thus €13.31 of FCF per share, which means at the current price we can buy Iliad at 7x 2022 FCF. 

Disclaimer: This memorandum is for discussion purposes only and is not intended to be, nor should it be construed or used as, financial, legal, tax or investment advice or a general solicitation.  This memorandum is as of the date posted, is not complete and is subject to change. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates. Certain information has been provided by sources believed to be reliable, but has not been independently verified and its accuracy or completeness cannot be guaranteed and should not be relied upon as such.

Catalyst

Promotional changes take effect and subscriber adds resume

Mobile roaming fees to Orange continue to come down which boosts EBITDA margin

Iliad launches new fixed boxes by end of year which should drive higher net adds and ARPU