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$13/100 Meg Profitably Sweeping Hong Kong
Written by Dave Burstein   
Wednesday, 26 May 2010 17:28
City Telecom/HKBN doubled their dividend as profits rose 54%. They added 73K broadband subscribers over six months while everyone else was flat to down. Chairman Wong Wai Kay has set a "10-year Big, Hairy, Audacious Goal (BHAG) of becoming the largest IP provider in Hong Kong by 2016. We are not only aiming at providing better service than the incumbent, but also services that they cannot match with the legacy network." They've now doubled up, offering a gigabit (really) for $27 (U.S.), an incredible story. Xavier Niel in France proved a low price strategy (30 euro triple play) can make money and HKBN is actually profitable enough to pay corporate income taxes. 
     ARPU for broadband fell from $23 to $17 (U.S.) but that was more than compensated by customer growth and sale of phone and other services. City is doing well enough to apply for an over the air free TV license and continue expanding the network. 100 meg is available to 1.68M  apartments and 1,300 corporate buildings, with 1 gig only in those with fiber all the way to the apartment. By the end of 2011, they expect to reach 2.1M homes, about 90% of Hong Kong. Their cost per apartment passed is about $100 (U.S), crucial to the business model. 
The prices for voice and video are competitive, but there are a few limits to the service. In particular, the speed out of country is capped at "only" 20 megabits. That's less of an issue than it would seem, because most services are available from in-country Google, Akamai, and other servers. Most p2p is fulfilled locally. 
      CFO NiQ Lai explains the low-cost model only works after the network is in place. "HKBN started the investment ten years ago, and we did not get a glorious result until two years ago. Most CEOs or management team in other companies would probably have been sacked in the middle of such a project before reaching the harvest stage. If you had HK$3 billion, instead of building our Fibre Network, you could have turned around a number of mid-sized profitable real estate projects in the past ten years. Why invested in the broadband business when there were so many other attractive businesses to make money in Hong Kong? In our case, our decade of focus and persistence is only just being rewarded today. However, now that we have an established “edge”, we believe will be here for the next generation,”HKBN_ARPU
     There's no reason that another carrier in a dense urban area  (Chicago, London) couldn't do similar.   (Special thanks to Glen Campbell of Merrill Lynch who first introduced me to the company.)
       Here's a note from the Chairman explaining the strategy.

Dear Fellow Shareholders,

2009 marks the 10th anniversary of the incorporation of Hong Kong Broadband Network Limited (HKBN), our wholly owned subsidiary for the Fixed Telecommunications Network Service business.

Proud of HKBN
We knew from day one it was going to be a difficult road ahead, but did not expect it was going to be this difficult. This may explain why, despite the deregulation of fixed telecom markets around the world over the past decade, only a few alternative operators have successfully put pressure on the incumbents. Just as I shared with the audience at the Geneva ITU conference in October 2009, we are so proud of HKBN that while customers switch from the incumbent over to us, they actually need to pay up to 100% more for our better value service. It is no longer about low prices, but about relative value in terms of BETTER bandwidth and BETTER customer service.

Our Big, Hairy, Audacious Goal (BHAG)
In the past 10 years of competition in the fixed telecom market in Hong Kong, some operators have given up and left, some have slowed down or even stopped their investments, but we remain persistent to our principle from day one, i.e. to build our network entirely end-to-end and with the latest technology without any reliance on the incumbent's network capacity. This is the only way to achieve our 10-year Big, Hairy, Audacious Goal (BHAG) of becoming the largest IP provider in Hong Kong by 2016. We are not aiming at providing better service than the incumbent, but also services that they cannot match with the legacy network.

BETTER Bandwidth
With 1.62 million homes pass today and target to reach 2.0 million homes pass by end 2011, I believe we are the only operator who can provide up to 1000Mbps broadband service on a mass scale on our current passive fibre infrastructure. Although some other operators also claim that they have extensive fibre coverage, their fibre is predominately laid only to the equipment room, typically on the ground floor of a multi dwelling building. For the majority of cases, to provide 100Mbps or 1000Mbps fibre service, there are still case-by-case obstacles to overcome before they reach the home in a multi dwelling building. Substantial engineering work is still required to provide 100Mbps and 1000Mbps fibre service on a mass scale basis.

I am very confident that our 100Mbps and 1000Mbps broadband services will continue to lead the market in the next few years. From our market intelligence, we know that our competitors are mainly using the second generation of xDSL technology, e.g. ADSL2+ or VDSL2 to boost the speed of their legacy telephone lines to the upper limit. However, whereas our competitors are on a linear improvement path, we can upgrade our fibre based services logarithmically from 100Mbps to 1000Mbps on our existing passive fibre infrastructure which existing technology cannot accomplish using legacy telephone lines.

BETTER Customer Service
Nowadays, customers are not just paying for our broadband Internet access but also for our superior customer services. We are pioneering the mass implementation of "Priority Banking" account management for our telecommunications business. Our teams are structured on a vertical basis, from on-site technicians, salesman to customer service officer, etc, in order to provide a "one-responsibility" contact point for our customers. Each team's compensation pool is directly proportional to the revenue generated from their group of customers over their service lifetime. This strategy ensures our frontline talents are directly responsive and responsible to customers' inquiries and complaints, giving their best efforts in keeping our customers happy. So far, the strategy has been very successful, with customers willing to spend more and maintaining the monthly churn rate of our broadband customers at well below 1.0% per month.

There is an old Chinese saying, "When life is good, prepare for the worst" (居安思危). So, what are the nightmares for us?

A. LTE (4G) wireless data technology as a substitute for fibre:

Personally, I am using three different High Speed Downlink Packet Access (HSDPA, 3.5G) mobile data services. While I enjoy the convenience of mobility that allows Internet access anywhere, at the same time I have to be very patient. I think they are very effective training tools on developing patience, especially for those like me, whom have little of it.

Our discussions with wireless vendors and test results indicate that LTE (4G) enabled service might be commercially available as early as 2011 but unless there is a direct line of sight, close proximity and limited concurrent users, it would still be very difficult for this technology to achieve performance that is competitive to fibre based 100Mbps. Furthermore, wireless' inherit high level of latency is a major disadvantage in its ability to serve the vast market of Internet gamers, where millisecond lags can be the difference between virtual life and death.

B. The incumbent building a brand new fibre network replicating ours:
  I noticed that the incumbent is upgrading its network by using second generation xDSL such as ADSL2+ and VDSL2. For them, I think this is the "right" thing to do now, but not a long term solution to their fundamental legacy network problem. I am glad to see they are putting in resources on the xDSL upgrade path instead of a real Fibre-To-The-Home (FTTH) network. The only fear I have is when they make a sudden revolutionary change and upgrade their infrastructure to FTTH, but even so, this process would take at least 3 years to catch up with our 10-year ahead start network infrastructure.
C. Price war:
  The most possible and realistic threat would be "Price War" at mass scale. However, since there are significant competitive edges in technology, we have already proven in the past 2 years that we could take more than 140,000 new subscribers from our competitors even in a hostile price environment with mature growth rates. This will eventually leave our competitors with no choice but to rage a price war at mass scale, as their customer loss continues to a critical level.

Industry Outlook
Rather than waiting for our competitors to initiate, we have gone on the attack to lead the market into a price war, with our Member-Get-Member (MGM) series of marketing programs, including our "AWESOME SPEED. FOR EVERYONE" campaign launched on 1 November 2009. Our MGM is planned with far-seeing intelligence and with the sole aim to increase our subscriber numbers significantly by leveraging our exceptional word of mouth, i.e. our happy customers are our best sales channel. With these MGM programs, we expect our total revenue will grow only slightly, albeit at incrementally lower Average Revenue Per User. It is our objective to collapse the market price to an affordable level which makes price irrelevant, such that customers can focus on our unmatched superior service experience. When price becomes irrelevant, even if our competitors further reduce their prices, their legacy offerings will not be considered by customers.

We are prepared to continue this kind of aggressive marketing programs until we hit our 10-year BHAG, preferably accelerating achievement before 2016. We do not see how our competitors could "copy" our marketing offers, as we believe we are the only operator to provide genuine 100Mbps broadband service on a mass scale as supported by our exceptional "word of mouth" standing amongst our existing customers.

Dominating the Market
With the unique advantage of our unmatched 100Mbps broadband service, we can either harvest from our investment by making more profits today with moderate increment in subscriber numbers and thereby giving time for the incumbent to react, or we can slam shut the window by assertively dominating the market. I picked the latter as our strategy for the next 3 years, as this is the best path towards accelerating our BHAG achievement.

Our Passion and Mission
The aim of HKBN is not merely to defeat the incumbent, but to develop a genuine FTTH network for the people of Hong Kong, maintaining Hong Kong's value of freedom to access global information in the region for the coming decade.

The establishment of HKBN is not purely for commercial reasons. We have the mission and duty to elevate and maintain Hong Kong as the preeminent "Free Information Hub" in the region. Since I do not see our competitors doing this effectively, and even though I do not want to (because I think we can make more money in the short term by selling our current assets), we have to continue this mission until we reached our BHAG.

Change of Dividend Payout Ratio
I am struggling to balance between the interests of my common shareholders and that of the public. However, in the long run, I am confident that the benefits and rewards to shareholders will be substantial when HKBN achieves our BHAG.

I ask my fellow shareholders to be patient with us for a few years. Starting from this year, our management team has much more confidence because of:

A. Growing gap of our leading technology over other competitors;
B. Large existing subscription base of 943,000 service accounts with far majority being on 24 months service contracts leading to stable cash flow; and
C. Increasing take-up of low latency and high bandwidth demanding applications which drives growing acceptance of 100Mbps service among the general public.

Based on the improving cash flow stability from above and our net cash balance sheet, we proposed to increase our dividend payout ratio, from ~30% of "adjusted free cash flow", defined as (EBITDA-Capex-Net Interest) to 50%-75%. By reference to the closing stock price of HK$2.57/share as of 4 November 2009, the total dividend for FY2009 is HK19 cents per ordinary share (FY2008: HK6 cents per ordinary share), and the dividend yield is 7.4%.

For FY2010 Guidance
For FY2010 guidance, we are aiming to deliver on 4 key metrics:

  • accelerate our broadband subscription growth from 391,000 as of 31 August 2009 to exceed 500,000 ubscriptions by 31 August 2010;
  • mild revenue growth;
  • flat core EBITDA; and
  • capital expenditure of HK$300-350 million.

Wong Wai Kay, Ricky

Hong Kong, 5 November 2009