Your client is a large company in the Polish telecommunication sector, providing and maintaining the infrastructure for telephony and ADSL and offering services like phone & internet subscriptions and televison to consumers. As in most countries, the regulator has ruled that new entrants must be given access to the infrastructure to offer their own services. For competitive reasons, the company asked you to assess whether under the current environmental conditions a competitor (let's call the hypothetical competitor NewCorp) could run a profitable business offering consumer ADSL services.
Short Solution (Expand) (Collapse)
A good approach would be to first calculate the break-even point and then make sophisticated assumptions to define time horizon and feasibility of reaching that number of customers.
- Technical setup consists of three elements: MDF access (copper wire), ADSL equipment, internet uplink capacity
- MDF access is fixed at 15€ per line per month, set by the regulator
- Required investments for the ADSL equipment is 180,000€ per location, depreciation period of 5 years (linear, no interest cost). To cover all households of Poland, 1000 locations need to be equipped with the ADSL devices.
- Internet uplink can be bought at an average rate of 1€ per line per month
- We can assume that the modems are either bought by the customers themselves or already in their possession from a former contract
III. Calculation of break-even
We start off by calculating the break-even point for NewCorp:
0 = revenue - costs
0 = price * amount - variable cost * amount - fixed cost
Wait for the interviewee to ask the right questions:
- Assume that in a country of comparable conditions yearly overhead costs of 3.6m € were a reasonable amount.
- Current price of the incumbent provider is 27€/month.
Another cost that we want to consider is the depreciation of our investment in the ADSL equipment. The 180,000 reduces in value over 5 years, so 36,000 per equipment per year, which leaves us with monthly depreciation of 3000 per month per equipment.
0 = (Price – VC) * amount - overhead - depreciation of investment
0 = (27 – (15+1)) * amount - 300,000 € - 3,000 € * 1000
3,300,000/11 = 300,000 customers
You should ask the interviewee, whether this seems a realistic number. If requested, provide information that Poland has around 36m inhabitants.
A tricky detail is that not the number of inhabitants, but rather the number of households is the relevant metric for answering this question. For simplicity assume that the average household in Poland encompasses 3 persons.
This leaves us with 12m households in Poland, of which NewCorp needs to acquire 300,000 or 2.5%. This doesn’t seem to be too unrealistic.
To verify the feasibility of running a profitable competition, we need to consider the market. Questions could be:
- What are the players in the market and their respective market shares?
- How is ADSL perceived in the market (necessary vs. nice-to-have vs. luxury)?
- Is the market growing?
NewCorp should focus on the current non-clients rather than existing clients that NewCorp would have to convince to switch. If we assume the same growth rates, 15% more households will have upgraded to ADSL in 4 years (since 8 years is quite a time horizon to reach break-even, so we take half of it). So, 1.8m more households will have ADSL in 4 years’ time.
We are now making some assumptions:
Say the incumbent provider will convert 50% of the new adopters for it has the brand name. The remaining 50% will be split between two competitors, leaving each with 25% of the 1.8m, which equals to 450,000 households.
It looks like a new competitor could reach break-even merely relying on new customers.
IV. Different Scenario
As this directly affects the new entrant’s contribution margin (divides it by 2), NewCorp would need twice the number of household to break-even. It would need to persuade customers of the incumbent provider to switch.
Calculation: Contribution margin: Revenue - variable Costs
Before: CM = 27 € - 16 € = 11 €
After: CM = 21.5 € - 16 € = 5.5 € ( 50% of 11 €)
As the new entrant can hardly offer lower prices (the closer a new entrant gets to the variable cost, the more households it will need), it would need to offer better services.
These could be faster connection (premium offering) or complementary products (having paid the MDF fee already) like telephony or entertainment.
If the new entrant, instead of focussing on the whole country, focused on areas of high population density, it could probably reach 50% of the households with only 25% of the investment in the ADSL equipment.
Given the current price level, entry barriers are very low for new entrants to the market and break-even can be reached by new customers only. This is mainly due to the high price level currently present in the market.
The incumbent provider should leverage on its strong brand name and focus on acquiring the households that are thinking of upgrading to a broadband connection or ADSL. Upselling could then be an effective strategy for the former, once a client relationship is established.