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CARPHONE WAREHOUSE (CPW)

Created:

1 February 2008

Written by:

Tim Bradshaw

BEAR POINTS

Struggling to generate cash

Lower growth in fixed-line telecoms

Pre-paid mobile market slowing

Latest results missed expectations

BULL POINTS

Possible bid target

TalkTalk is price competitive

The next two months will be crucial for Carphone Warehouse. TalkTalk, its UK telecoms division, has almost finished the expensive process of moving its broadband customers from BT's lines to Carphone’s own network. Carphone says it will soon reach its target of “unbundling” 70 per cent of the UK population. As a result, "by the end of March, we won't have any [TalkTalk] customers on whom we are losing money," says finance chief Roger Taylor.

Profits are one thing, but cash generation is another. Some City analysts are doubtful that Carphone will generate an acceptable return on the cost of unbundling, which led to a £109m cash outflow in the first half of 2007-08. Dan Gardiner, an analyst at stockbroker Landsbanki, says that the prospects for returns on £700m that Carphone has spent on its UK fixed-line operation are "modest, given intense price-based competition". He adds that Carphone’s lack of cash flow and heavy debt mean it “does not have the resources to keep up with its competitors”.

TalkTalk’s early customer-service and reliability problems may have eased, but the coming months will also see the first wave of customers coming out of contract, leaving them free to switch provider. Its low-priced offer may prove attractive if consumers start feeling the pinch, but, with TalkTalk already the third-largest player in the UK's maturing market for broadband, growth rates will be hard to sustain.

Some analysts also question how profitable broadband customers will be, when acquisition costs are taken into account. Giving away laptop computers, in much the way that telecoms providers give away mobile phones, expands the market, but at a high cost. And, as Carphone continues to unbundle more of the UK's population, it may find its return on investment even lower as the most densely populated areas, or those with the most potential TalkTalk customers, have already been done.

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Carphone's bosses remain bullish, suggesting that year-end broadband customers will be at the top end of their 200,000 to 250,000 estimates. But the group missed the City's estimates on almost every measure in the third-quarter trading of 2007-08. Retail revenues, mobile connections, residential broadband revenues and business revenues were all behind target. True, its exclusive agreement to sell Apple’s iPhone brought more customers into Carphone’s stores. But chief executive Charles Dunstone admitted that pay-as-you-go mobile sales were “probably a little bit lighter than some had thought”.

Pay-as-you-go sales are less profitable for Carphone than selling subscription packages, but there is little evidence so far that the drop-off will be made up by increased subscription sales. The mobile handset market is still growing at double-digit rates, but the pace is slowing. True, the rate at which consumers replace their handsets is “slightly accelerating”, say analysts at investment bank Citi, though this could change if economic conditions worsen.

Indeed, the economic outlook leaves Carphone’s nascent expansion into the US looking risky. It may be that Carphone's relationship with US electrical retailer Best Buy is more important. Best Buy owns 3 per cent of Carphone's equity and is rumoured to be a potential bidder. But Best Buy’s trading has been poor. Besides, Best Buy's decision to buy the stake may be compensation for diluting its relationship with Carphone from a joint venture to a less binding 'strategic alliance'.

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