Although investors have all but deserted Europe’s Internet stocks, the number of Internet users in Europe continues to grow. Demand for broadband is rising, albeit more slowly than expected (Exhibit 1), and the new popularity of on-line subscription services actually offers, for the first time, the prospect of substantial revenues from Internet users. Such conditions should attract entrepreneurs—independent Internet service providers, portals, content originators, and software service developers. But one deterrent remains: the hold maintained over the Internet access market by ISPs belonging to Europe’s incumbent telephone companies.
Telco ISPs have certainly enjoyed powerful advantages in building their customer bases. Nevertheless, for these companies, too, subscription services are the route to badly needed revenues, and even the biggest don’t have sufficient resources to develop such services alone; they will need partners. Europe’s Internet industry is thus shifting from a winner-takes-all game to one in which the greatest rewards will go to companies that share their assets. Entrepreneurs—at least if they find the right partners—can look forward to important opportunities.
Europe remains different
The telcos’ hold over the Internet in Europe often puzzles those familiar with the Net in the United States, but the two markets developed in very different ways. Because the Internet was created in the United States, stand-alone US ISPs such as AOL, EarthLink, MindSpring, and MSN were established well before the World Wide Web turned Internet surfing into a mass phenomenon and telcos started to pay serious attention to it. Independent ISPs could set up low-cost services easily because local telephony in the United States is charged at a flat rate rather than metered. The main cost of dial-up Internet services—paying for each individual telephone call—was thus borne by telcos rather than ISPs or consumers. By the time US telcos had set up ISPs, the independents had enough customers and recognized brands to match them on costs. In 1995, when the Web first became truly popular, AOL already had 4.5 million subscribers.
In Europe, too, thousands of independent ISPs sprang up with the Internet—4,000 by 1999, 1,000 of them in Germany. But Internet use grew more slowly, and the telcos, learning from the US market, launched their ISPs early and vigorously enough to prevent others from gaining ground. Telco ISPs, despite their numerous competitors, went on to build dominant market shares, largely because they had so many built-in advantages.
Marketing clout was the first of these: it cost less for telco ISPs to acquire new business because the public already recognized their parents’ brands; Deutsche Telekom, for example, easily stretched its T brand from its T-Mobil telephone company and T-Vision television to T-Online, its ISP. Telcos could also market their ISPs cheaply to their millions of telephony customers. France Télécom included a flyer for its ISP, Wanadoo, in every telephone bill. Other telcos used similar tactics.
Second, European telco ISPs had more robust economics than their US counterparts. It was crucial that European consumers pay for each local telephone call, since the telcos could use their growing telephone revenues from Internet use to offset some start-up losses from their ISPs. Furthermore, unlike independent ISPs, which had to build facilities from scratch, the telcos could use their existing infrastructure and back-office resources, such as billing and customer service. Since telco ISPs attracted more customers more quickly, they could spread their costs across a wider base and achieve better margins. Moreover, they earned advertising revenues from parent telcos keen to exploit the new Internet channels. Finally, in contrast with the United States, in many European markets, Internet-ready cable networks reached too few homes to compete for mass Internet access (Exhibit 2).
All in all, the telcos have had a pretty clear run at the market. EU regulators and some national ones have tried to level the playing field for independent ISPs, largely by requiring telcos to offer flat-rate, unmetered Internet access to independent ISP resellers. Outside the United Kingdom, however, telcos have been slow to comply (see sidebar, "National variations"). By the time legislation takes effect in the more intractable markets, incumbent telco ISPs will have an almost unassailable lead.
Tackling them head-on is tough indeed. AOL has managed a heroic second place in the three European countries it has entered most seriously, gaining a dial-up share of approximately 20 percent in the United Kingdom and France and 15 percent in Germany. But these shares have been won only at the cost of €1 billion (about $1 billion) in 2002 losses and an additional €7 billion in investments. Because AOL is large and has higher average revenues per user than most independents, it could soon break even, but it may never earn enough profits to recoup its investment.
In one respect, the US and European markets are similar: Internet access has been a dog-eat-dog game on both sides of the Atlantic. In both markets, the initial goal of the ISPs was to capture all the value from each customer for themselves rather than share assets with one another and thereby create greater overall customer value. The difference is that in Europe, telco ISPs have emerged as undisputed top dogs. By 2001, the 4,000 European ISPs had shrunk to 2,400, with each country’s telco typically holding a 30 to 60 percent market share.
Will the spread of broadband Internet access challenge the telcos’ dominance? We think not. In many European markets, cable companies still aren’t likely to compete strongly against DSL, because upgrading cable networks for broadband service remains prohibitively expensive. Only Belgium, the Netherlands, Switzerland, and the United Kingdom have upgraded networks with enough reach to provide wide-ranging broadband service, and their build-out costs have bankrupted the owners. What is more, as with dial-up, independents on the DSL side can’t get affordable access to the telcos’ networks. Although many national regulators require telcos to let competitors install their own DSL equipment on the telcos’ premises—to "unbundle the local loop"—foot dragging and pricing policies have so far restricted such unbundling to 3 percent of all DSL lines.
The remaining option for independent ISPs is to act merely as resellers of the telcos’ wholesale DSL services. Yet resale margins are so small that few if any resellers will build viable businesses. Small German ISPs face a wholesale price that is actually higher than the going retail one. Even in the United Kingdom, billing and customer-care costs consume up to half of the average resale margin of £8.50 ($13.20), and the cost of acquiring a customer can easily exceed £150. At this rate, an ISP won’t break even on that customer for two or three years.
These poor margins are unlikely to improve even if DSL wholesale prices fall, because competition among ISPs is so intense and barriers to entry are so low. Telco ISPs and AOL will probably continue to use low prices and high marketing expenditures to increase their market share, partly because the customers they acquire can help them earn profits from their other businesses. Meanwhile, new resellers entering the market will always compete away any profits remaining to the independent ISPs. When BT recently announced that it would lower its DSL wholesale price by 42 percent, for example, DSL resellers immediately cut their retail prices, leaving the average resale margin almost unchanged.
Moving toward partnerships
In these circumstances, it would be understandable if Internet companies outside the magic circle of incumbency were to shun Europe’s Internet market. But they should think again. For the first time, the Internet in Europe looks set to yield substantial revenues from subscription services—revenues that even telco ISPs require in view of the financial difficulties many of their parents now face. France Télécom and Deutsche Telekom, for example, are both trying to reduce debts of more than €65 billion apiece. And to realize the full value of subscription services, most telcos will need help, particularly from content providers and software specialists but also from other ISPs with large customer bases.
Some evidence suggests that a sizable paying market for quality Internet offerings is finally emerging
The first Internet businesses were mostly built on the promise of early advertising revenues and possible future subscription revenues. The collapse of the on-line advertising market means that it will be some time before advertising alone can sustain Internet businesses. Moreover, subscription revenues have developed more slowly than expected, because customers either didn’t want the content and services on sale or could get them free elsewhere. Yet some evidence suggests that a substantial paying market for quality Internet offerings is finally emerging.
Over recent months, subscription services have appeared all over the Internet. Leading on-line newspapers around the world1 have recently announced or introduced charges for their content. Meanwhile, a new generation of sophisticated, Web-based consumer software applications has come on stream. Apple, for example, has just released a suite of .Mac Web services, which include on-line storage, enhanced e-mail, personal information managers, Web publishing, and virus protection, all for $100 a year.
Services of this kind are proving popular. RealNetworks’ RealOne, which offers premium content such as sports highlights for $10 a month, signed up 400,000 subscribers in the year following its launch, in late 2000, and now has more than 850,000 subscribers. EverQuest, an on-line multiplayer game, has 430,000 subscribers. In the United States, AOL has more than a million "bring-your-own-access" subscribers who pay $15 a month to use its proprietary content and services but access them through other ISPs. MSN has announced that its next-generation Internet service will have a similar worldwide subscription offering. These and other subscription services look set to generate large revenues in Europe. The Financial Times’ FT.com, for example, expects to derive half of its revenue from subscriptions and to break even in 2002 after posting more than £30 million in losses in 2001.
Like companies attempting to float any other consumer product, those wishing to develop subscription content and services must first design offerings that specific consumer segments find truly valuable and worth purchasing. They then need to find cost-effective ways of reaching and serving a customer base big enough to help them amortize the cost of developing such offerings. In particular, they require marketing techniques that would enable them to sign up new customers quickly, so that each network offering crosses the line separating mass-market "must haves" from gimmicks. How useful were the mobile telephones now so common among teenagers until their friends had one, too?
Few Internet operators have the resources to undertake all of these tasks successfully. The solution is for ISPs, content providers, and software service developers to share resources and so maximize their individual gain from subscription services. In this way, such companies can cut the costs of development by sharing them with other players, reduce customer acquisition costs by getting the right product in front of a ready-made audience, and accelerate the kind of network effects that made every teenager want a mobile telephone.
Undoubtedly, telco ISPs control many vital resources themselves: for instance, their parent companies own the broadband infrastructure and give them cheap ways of acquiring customers. Nonetheless, they have neither the content—current movies, music, quality news, and the best local-language on-line magazines—that would attract targeted consumers nor the leading-edge software needed for real-time interactive games, sophisticated communications, and personal information services. Neither do these ISPs have the strong understanding of consumers needed to develop winning content and services or to market them to the customers who would value them most. There are important implications here for all participants.
Telco ISPs
Each country in Europe has one telco ISP, with the exception of Italy, which has two. Only the biggest—T-Online and possibly Wanadoo—have enough customers to spread the cost of developing subscription offerings, and even these ISPs aren’t likely to have the skills to develop leading-edge services alone.
The willingness of telco ISPs to negotiate with potential partners will vary from country to country (Exhibit 3). In Germany, they might struggle to strike a worthwhile deal with T-Online. But in less populous countries, such as Belgium and Portugal, telco ISPs have fewer customers and are thus eager to share access to them in exchange for content or services. Here, certain non-ISP companies have an opportunity to do creative deals with telcos. The first major European deal of this type was announced in November 2002: BT will be packaging its broadband offering with MSN’s new suite of on-line services, and the two will share the resulting revenues.
Independent ISPs
Independent ISPs will struggle to break into the big league. If they are happy to remain low-return, niche players, their narrowband and broadband offers can survive, but they will still need partners to provide content and services. If such ISPs purchase these necessities by allying with other ISPs, their collective customer base will be big enough to make them attractive to leading-edge providers—and give them more clout in negotiations.
Larger ISPs, particularly Tiscali, a pan-European operator with eight million subscribers, have customer bases more than big enough to attract potential partners. But independent ISPs, large and small, must prove to their potential partners that they can keep their customers loyal—and that will not be easy. Many ISPs, for example, have "pay-as-you-go" users who get Internet access for free and pay only for telephone time. The ISP has no billing relationship with them and usually doesn’t even know their names or addresses, so it has little ability to market subscription content or services to these people. Such loose customer relationships result in an average annual churn rate of more than 30 percent, which will make it difficult for ISPs to migrate their current narrowband customers if they develop broadband offerings. Instead, customers moving from narrowband to broadband Internet access will probably choose the lowest-cost provider unless they use enough of their original ISPs’ content and services to make switching too much of a hassle.
As a rule, the content and services that independent ISPs offer tend not to be "sticky" enough to persuade their narrowband consumers to migrate en masse to their broadband offerings. These ISPs urgently need to develop closer relationships with their customers—best achieved by offering Internet access, narrowband and broadband, on a subscription rather than a pay-as-you-go basis. Gaining marketing strength in this way would put such ISPs in a stronger position to ally with leading content and service providers, but making the initial move to this virtuous circle could be quite tough.
Portals
Portals such as MSN or Yahoo! don’t normally offer Internet access in Europe but act as a gateway to the content and services they aggregate. Subscribers like portals because they provide a simple route into an increasingly complicated Internet and a one-stop shop for the generally high-quality content and services they offer. But portals still need to develop or procure more broadband content and leading-edge services and to find cheap ways of reaching more customers and thereby spread the cost of development more widely. This problem makes portals potential partners for any ISP, whether independent or owned by a telco, that has a substantial number of customers and the ability to acquire more of them quickly. To keep the offering up to the mark, portals must also ally with leading content providers. One such alliance was MSN’s deal, early in 2002, with UK-based Sky Sports to create a co-branded site.
Integrated ISPs/portals
Like independent ISPs, AOL and other companies that offer both Internet access and substantial proprietary content and services must secure their customer bases. If such companies already have sticky relationships with a critical number of their customers—through direct billing, for instance—they are well positioned to market the content and services they obtain from partners or (as in the case of AOL Time Warner) originate themselves. But the cost of acquiring new customers makes the breakeven point ever more distant and must therefore be reduced. Partnerships with companies that can provide new customers cheaply are one possibility. These companies need not be other ISPs: traditional media businesses or service developers that succeed with subscription offerings will also be candidates.
Content and service originators
Content and service originators, such as the sports rights company Sky or the software service developer RealNetworks, could in theory target on-line consumers independently. But a majority of Internet users still choose the on-line services that come with their access providers or portals, so the best bet would be to form partnerships with ISPs and portals that have large and growing customer bases. Both types of companies must reach consumers quickly and cheaply to recover their investment. Software providers, however, must act even more quickly to create the network effects that will establish their services as standard.
About the Authors
Robert Niewijk is a consultant in McKinsey’s Chicago office; Charles Songhurst is an alumnus of the London office, where Paul Todd is an associate principal.
Notes