Two years on, Israel’s cellphone companies still reeling from Kahlon revolution

For the Israeli consumer, Moshe Kahlon’s 2012 cellphone revolution was an unmitigated blessing. The old three-way cartel was broken and new entrants offered packages at a fraction of rates prevailing until then. The veterans were forced to match the super-low rates and at the same time had to step up investment to ensure better and newer services. Even so, they lost hundreds of thousands of subscribers.

More than two years later, the industry is still looking for the bottom. Whether they were mobile or landline companies, all were busy aggressively cutting back operating costs while increasing spending on infrastructure and rebuilding their balance sheets.

At the end of 2014, the cell companies can boast being more efficient, sport more advanced infrastructure and have much less debt, but that doesn’t mean the blood-letting is over.

As communications minister, Kahlon upturned the comfortable world that Cellcom Israel, Partner Communications and Pelephone – Israel’s three veteran cellphone companies – had been accustomed to for more than a decade. Suddenly they were faced with aggressive, lower-cost competition from the likes of Golan Telecom and Hot Mobile, and forced into a nasty price war. Cash no longer flowed like water; instead they had to become lean firms fighting for every drop of revenues and subscribers.

Since 2012, the three companies have cut their combined payroll from their 2011 peak to just 8,700. Some of them were fired outright, but most of the reduction came through a hiring freeze in their call and service centers, where relatively high natural rates of employee turnover made the job painless.

Meanwhile, operating expenses at the three companies have been cut since 2011 by 4.4 billion shekels ($1.1 billion) even as they continued to provide the same level of services. Cellcom made the biggest cuts, trimming operating costs by 370 million shekels a year, compared with cutbacks of 231 million and 110 million shekels, respectively, for Pelephone and Partner.

Average revenue per user, or ARPU continued to fall in 2014, but the rate of erosion slowed. The average fell by 7 shekels in 2014, compared with 11 shekels in 2013 and 15 shekels in 2012. Pelephone still generates the most profit per subscriber: Each one provides ARPU, of about 78 shekels a month, some 3 shekels more than at Partner and 6 shekels more than at Cellcom.

The companies can at least take some succor that the high rates of customer turnover that characterized the first years of competition are gradually falling. The average customer attrition rate for the three companies was 37% in 2014, about one percentage point higher than in 2013. But compared to the steep increase in 2012 and 2013, the 2014 increase is almost trivial.

The question is whether 2015 will see a rise in ARPU and a drop in the attrition rates? The one who can best answer that is Michael Golan, CEO of Golan Telecom. As the industry’s most aggressive upstart he is the one who moves the market. He has the cost structure to do things the others can’t.

“How can I compete with Golan Telecom?” asked rhetorically the CEO of a veteran cellular company a few weeks ago.

In spite of the drastic cutback since 2012, each of the three veteran cell operators employs up to 4,000 people. It has a smaller subscriber base and piggybacks on another networks, but even taking that into account Golan’s estimated payroll of 250 to 300 is lean and mean.

Pelephone employs 200 people just at its headquarters, Cellcom counts 2,900 people working in customer service and Partner employs 600 people in marketing.

Golan has proven he can provide the same services as they do with a lot fewer employees. It’s a lean model that scares the veteran telcos, even Bezeq, because it means that the painful layoffs and cost-cutting they have been making are not about to end any time soon. Their employees know it too, and in the era of competition have unionized.

It’s not just employees who have suffered from the Kahlon reforms, shareholders have as well, although for them the worst may be over. The three veteran cellular operators saw their combined revenues fall 870 million shekels in 2014, while earnings before interest, taxes, depreciation and amortization, or Ebitda, declined 260 million shekels. It’s bad, but nothing like the bleeding they experienced the year before when total revenues plunged by 2.7 billion shekels and Ebitda by 1.3 billion shekels. The companies have succeeded in adapting themselves to the new market conditions.

Competition has not only benefited the public with much lower rates, it has spurred the providers to offer more advanced and better service. That has meant stepping up spending on networks at a time when their profits are squeezed.

The three companies spent the equivalent of 13% of all their revenues from phone services on expanding their infrastructure and preparing for future demand. That was the highest percentage in six years.

The companies understand that they can only stay in the game by offering the most advanced services. All three launched fourth-generation cellular networks last year, while Cellcom inaugurated its own television product, which left Cellcom as the biggest spending of them all for capital projects, shelling out some 490 million shekels.

Not just capital spending, more recently the companies have begun to rebuild their balance sheets. Pelephone is wholly owned subsidiary of Bezeq and didn’t need to act, but Partner and Cellcom both suffered from controlling shareholders who emptied their coffers by distributing huge dividends. After control changed hands, Cellcom and Partner stopped paying dividends and begun adding capital and reducing debt.

Over the past three years, Partner and Cellcom have reduced their total debt to 10.6 billion shekels, from 15 billion shekels. At the same time, the ratio of equity capital to balance sheet has risen to 16.7% at the end of 2014, from a very low 3.9% in 2011.

Bezeq, Israel’s biggest landline operator, didn’t feel the same competitive heat the mobiles did, but it has also been suffering for years from falling revenues, which has forced it to reduce costs. Relatively quietly, and in cooperation with its very strong union, Bezeq has laid off 1,500 employees over the past two years – 515 alone in 2014. Unlike the cell companies, Bezeq has maintained a relatively stable Ebitda over the past three years of about 2.7 billion shekels annually.

In 2014, Bezeq suffered a sharp drop in ARPU from its landline customers, its most profitable business. ARPU fell by 11 shekels in 2014, to 63 shekels a month, the steepest drop for the company since it was privatized in the 1990s. At the same time, however, Bezeq lost only 9,000 landline customers, the smallest number in years. The company was even more successful when it came to Internet services, and signed up some 100,000 new subscribers.

Bezeq has managed to exploit quite successfully the strategic decision made by the cable company Hot to focus on its so-called “triple” customers, who buy a bundled package of phone, cable and Internet services. Bezeq has won over many customers who are not interested in Hot’s television offerings. At the same time, Bezeq has also found ways to evade archaic rules that prevents it from reducing the charge for telephone services by bundling phone service into packages with Internet services.

If not quite the Kahlon revolution, much stronger completion awaits Bezeq over the coming year as the so-called wholesale market for landline gets underway. Bezeq is now required to lease space on its land line network, enabling a host of new competitors, including the cell companies, to offer landline services. Bracing for that, Bezeq, for the first time in three years, increased capital spending.

Hot, too, isn’t being left behind. It invested 1.7 billion shekels in its fixed-line infrastructure last year, some 280 million shekels more than in 2013. Some 100 million shekels of that was in its fiber-optic unit Unlimited.

Will all three companies continue to invest such sums in 2015? The experience of the cellular sector shows that in the year after competition opened, the companies reduced their investments – but then they increased them in the second year. Bezeq and Hot may well do the same in the short term, but not for very long.