The incumbents must adapt their organizations and

acquire new skills to win the war of inches against their

attackers.

SHANKAR JAGANNATHAN, STANISLAV KURA, AND MICHAEL J. WILSHIRE

The McKinsey Quarterly, 2003 Number 1

Europes 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 percentmore cuts are to comeand pared
their capital spending to the bone (Exhibit 1).

But cost cutting alone wont 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 servicesa particular blow to incumbents, since a good deal of their
recent capital spending was devoted to building these networks (Exhibit 2) It therefore isnt surprising

will worsen and valuations will fall even further.

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 wont 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 cant rescue themselves with any single initiative,
undertaking several at once could do much to tide them over this difficult period: at Spains Telefnica,
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 dont require much extra spending, so the
resulting cash contributes directly to earnings, and even a modest program could raise a companys
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 dont 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 newcomerscable companies, wireline attackers, and mobile operatorshave 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.

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
The 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
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.

Such initiatives may target an entire market segmentall small and midsize businesses, sayor 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 werent 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 arent
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 incumbents brand is in trouble.
Residential customers wrongly perceive many European
incumbents to be much more expensive than their fixed-line competitorsa 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 percenta 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 productsof
course, taking into account a companys 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 telcos 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 Ethernetan extremely fast form of metropolitan data connection that can also cannibalize
existing data lines. Incumbents should install this technology only if revenues from a customers 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.
Such efforts can yield important gains. Flat-rate offersthe operator sells a defined number of minutes
in a single package for a fixed, discounted priceencourage 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 operators revenues in the short term but also provides
a uniform platform for future sales of other advanced servicesfor 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
markets particular conditions, such as regulatory constraints, and the operators capabilities.
Exhibit 5 shows each initiatives potential impact on a companys 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 requirementoffering directory servicesinto 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
telcos revenues by 3 percent in a year.

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 corporate
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 wont 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 customerssomething 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 capabilitiesfor 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 dont 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.

Notes:

Shankar Jagannathan is a consultant in McKinseys 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.
1
Third-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.
2
UBS Warburg and Salomon Smith Barney sum-of-part valuation for the fixed-line operations of Cesk
Telecom, Deutsche Telekom, France Tlcom, KPN, TDC, and Telecom Italia.
3
This 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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