Comments on the financial results

In this section we present and comment on the consolidated financial results of the Telefónica O2 Group prepared in accordance with International Financial Reporting Standards (IFRS).

Consolidated financial results

Revenues, Operating Costs and OIBDA

The consolidated revenues reached CZK 55.7 billion in 2010, down 7.0% year on year. Gains from the sale of non-current assets reached CZK 92 million in 2010, compared to CZK 422 million in 2009. As described in 2009 Annual Report, in 2009 the Company sold its former headquarters with a one-off gain of CZK 342 million. The total consolidated operating costs declined 1.8% year on year, reaching CZK 33.4 billion in 2010, as a result of strict financial discipline and the booking of several non-recurring items.

As a reaction to uncertain and potentially negative developments in the telecommunication market and the regulatory environment, in 2003 ČESKÝ TELECOM (predecessor of Telefónica O2 Czech Republic) booked an impairment loss of CZK 9,909 million from fixed line assets which constitute a cash generating unit (CGU). Since then the impairment tests were performed annually. The most recent impairment test performed as at 30 June 2010 took into account the Company’s fixed broadband and data focused strategy, enhanced fixed network performance as well as the continuous synergies from integration with the mobile segment, and resulted into an impairment loss reversal of CZK 4,344 million, which amount was positively reflected in OIBDA.

Consequently, with the help of the above item, the consolidated operating income before depreciation and amortization (OIBDA) increased by 1.1% reaching CZK 27.4 billion in 2010. Without the impact of the impairment reversal, OIBDA would have declined 14.9% year on year in 2010 to CZK 23.0 billion; the decline was driven by the lower revenues and non-recurring items booked in 2009 and 2010. Comparable OIBDA 1 decreased 6.7% year on year to CZK 24.5 billion in 2010, while comparable OIBDA margin 2 reached 44.1% in 2010, which was basically a flat year on year trend (2009: 44.2%). OIBDA adjusted for guidance 3 decreased 8.4% year on year and reached CZK 24.1 billion in 2010, which was within the guidance range of -5% to -9%.

Depreciation and Amortization

The consolidated depreciation and amortization amounted to CZK 11.9 billion in 2010, resulting in a 1.2% decline year on year. The impairment reversal led to an increase in the depreciation and amortization by CZK 316 million in 2010.

Operating Income, Income before Tax and Net Income

The consolidated operating income and consolidated income before tax went up 3.0% year on year and reached CZK 15.5 billion and CZK 15.3 billion, respectively, in 2010, largely due to the above-mentioned impairment reversal. Without the item factored in, operating income and income before tax would have declined 23.7 % and 24.1% year on year, respectively, driven by the declining OIBDA and slightly higher net finance expenses, which were not fully compensated by the lower depreciation and amortisation charge. The consolidated net income amounted to CZK 12.3 billion in 2010, up 5.3% year on year, due to the combination of the above-mentioned factors. Excluding the impairment reversal, the net income would have declined 22.7% to reach CZK 9.0 billion.

Cash and Debt levels

On 31 December 2010, the Group’s consolidated financial debts (long-term and short-term) amounted to CZK 3.0 billion, down 3.4% compared to the 2009 year-end. The amount of cash and cash equivalents reached CZK 4.8 billion as at the end of 2010, compared to CZK 1.3 billion the year before. The combination of cash and debt balances resulted in a net leverage 4 of -2.4% and a gross leverage 5 of 4.1% as at the end of 2010, compared to 2.5% and 4.2%, respectively, as at 31 December 2009.

Capital Expenditure

The total consolidated capital expenditure amounted to CZK 5.7 billion in 2010, down 12.7% year on year. As in the previous years, 2010 investments were selectively targeted at the growth areas of the business. The expansion of mobile broadband networks (EDGE and UMTS), enhancement of the fixed broadband network and upgrades to the information systems ranked among the key investment priorities in 2010.

Cash Flow

The total consolidated free cash flows 6 increased 21.2% year on year and reached CZK 16.4 billion in 2010, largely due to the lower amount of paid taxes (down 40.1% year on year) and the lower payments on investments in property, plant and equipment and intangible assets (down 34.9% year on year to CZK 5.5 billion).

Overview of consolidated revenues

The total consolidated revenues in 2010 reached CZK 55.7 billion, down 7.0% year on year, mainly due to further cuts in mobile termination rates, the slow economic recovery impacting on customers’ spend patterns and the lower-than-expected revenues from IT and business solutions due to the lower number of projects in the public sector segment.

The total consolidated voice revenues (voice-outgoing, interconnection and other wholesale services, monthly and one-off charges from voice services and connection charges) amounted to CZK 34.4 billion in 2010, down 11.1 % year on year.

In the highly penetrated mobile market in the Czech Republic, the total active mobile customer base decreased 2.1% year on year down to 4,839 thousand at the end of 2010. This performance has been impacted to a large extent by one-off disconnection of 111 thousand inactive contract customers in the second quarter of 2010. Excluding the effect of the one-off disconnection, the customer base would have increased 0.1% year on year. The number of contract customers went up 1.7% year on year, reaching 2,864 thousand at the end of 2010 (+5.7% year on year, discounting the impact of the disconnection of inactive accounts). Consequently, contract customer net additions reached 160 thousand in the year (excluding the disconnections). The solid performance was driven by the continuous growth of O2 NEON tariffs, customer migration from the prepaid to the contract segment and a solid uptake of mobile broadband customers. At the end of 2010, contract customers represented 59.2% of the base (+2.3 percentage points year on year). The number of prepaid active customers reached 1,975 thousand at the end of 2010, down 7.3% year on year.

The blended monthly average churn rate reached 2.4% in 2010, posting a 0.3 percentage point year on year increase mainly due to the disconnection of inactive accounts the contract customer base. In the fourth quarter of 2010, however, the churn rate declined 0.2 percentage points down to 2.2%, which was facilitated by the improved churn of prepaid customers.

In terms of usage, mobile traffic 7 carried in the Czech Republic grew 6.8% year on year to 8,790 million minutes in 2010.

In 2010, blended ARPU 8 reached CZK 468.5, down 8.1% year on year, impacted largely by MTR cuts. However, the year-on-year decline of ARPU decelerated during 2010: from 11.2% year on year in the first quarter to 6.0% year on year in the fourth quarter 2010, which is attributed to the ongoing stabilization in the customer spend. Not including the impact of the MTR cuts, ARPU would go down 6.6% in the first quarter, 3.7% in the second quarter, 3.5% in the third quarter and 1.9% in the fourth quarter. Contract ARPU reached CZK 659.7 in 2010, down 11.4% year on year, while the rate of decline in the fourth quarter slowed down to 8.5% year on year and closed at CZK 643.5. Customer migration from prepaid to the contract tariffs and MTR cuts continued to drive contract ARPU dilution. The prepaid ARPU decreased 7.8% year on year down to CZK 206.0 in 2010 with just a 5.4% drop to CZK 212.3 in the fourth quarter. The data ARPU was down 4.1% year on year to CZK 120.1 in 2010, and in the fourth quarter saw a year-on-year improvement of 2.7% to CZK 123.1.

The total number of fixed accesses operated in the Czech Republic declined 5.7% year on year to 1,669 thousand as at the end of December 2010. Compared to 2009, the number of net losses decelerated 17.4% to 101 thousand in 2010 (2009: 123 thousand), a trend propelled by a healthy demand for naked access and the increasing number of VoIP lines installed for corporate customers.

Voice traffic generated in the fixed network went down 13.1% year on year in 2010 to 1,741 million minutes as a result of continued fixed telephony lines losses and fixed to mobile substitution.

The total number of active mobile customers in Slovakia reached 880 thousand at the end of December 2010, up 59.2% year on year, with 99 thousand net additions in the fourth quarter (+10.6% year on year). Additionally, in absolute terms, Telefónica O2 Slovakia considerably grew its customer base by the figure of 328 thousand in 2010, posting a 44.0% year-on-year growth. The number of contract customers was up 71.0% year on year, reaching 334 thousand at the end of 2010, while the number of prepaid active customers increased 52.8% year on year, closing the year at 546 thousand. Consequently, contract customers represented 38.0% of the total customer base at the end of 2010, up 2.6 p.p. year on year. Contract ARPU reached EUR 19.0 in 2010, while prepaid ARPU stood at EUR 8.5.

Consolidated revenues from monthly and one-off charges from voice services went down 11.8% year on year to reach CZK 13.6 billion in 2010. The decline was driven mainly by the lower number of fixed telephony accesses and the impact of the new concept of services for the consumer segment, which is based on a broadband proposition, including naked ADSL. The revenues from the mobile segment declined only slightly; the decline reflected the preference of contract customers for lower-priced voice tariffs.

Revenues from outgoing voice reached CZK 11.9 billion in 2010, down 9.8% year on year due to the lower volume of voice traffic generated in the fixed network, the higher proportion of mobile customers on semi- and flat-rate based tariffs and lower roaming revenues.

Revenues from interconnection and other wholesale services declined 10.4% year on year to CZK 8.9 billion in 2010 as a result of namely the 28.1% reduction in MTR and lower revenues from roaming visitors, which have not been fully offset by the marginal growth in international transit services in the fixed line segment.

Revenues from SMS & MMS & value added services were down 2.7% year on year to CZK 4.8 billion as a result of a higher proportion of SMS revenues being included in the monthly charges for O2 NEON tariffs and the higher number of customers subscribing to these tariffs. In 2010, O2 customers in the Czech Republic sent 2,477 million SMS in total, which represents a 2.5% year on year increase.

Revenues from leased lines and fixed data services went down 10.7% year on year to CZK 3.1 billion, mainly due to lower revenues from leased lines, which were not fully compensated by a growth in IP based data services.

Revenues from internet (including monthly and one-off charges), mobile data and IPTV grew 12.6% year on year in total and reached CZK 8.3 billion in 2010, largely as a result of the positive reception of the new broadband-centric (naked ADSL) proposition by the market and the growth of the O2 Internet customer base. The total number of ADSL accesses reached 806 thousand at the end of 2010, up 11.1% year on year, with 81 thousand net additions recorded in 2010. In the fourth quarter, the company reported 29 thousand ADSL net additions, helped also by the upswing in wholesale accesses. The total number of O2 TV customers reached 129 thousand at the end of 2010. Additionally, from the second half of 2010, this revenue stream has been positively impacted by a growing contribution of mobile internet revenues driven by the growing demand for mobile broadband. This was a result of our successful marketing campaign promoting the advantage of mobile broadband networks for customers.

Consolidated revenues from IT and business solutions went down 7.4% year on year to CZK 2.6 billion, largely due to a year-on-year decline in the number of public sector projects in the second half of the year. Revenues from equipment and activation fees declined 4.7% to CZK 1.5 billion due to lower sales of handsets and other equipment. Other telecommunication revenues went down 6.7% year on year to CZK 915 million, to which the lower revenues from Universal Service (2009: CZK 367; 2010: CZK 47 million) contributed.

Overview of consolidated operating expenses

The consolidated operating expenses of the Telefónica O2 Group declined 1.8% year on year and reached CZK 33.4 billion in 2010 as a result of our strict financial discipline implemented by the Company to offset, to the maximum degree possible, the declining revenues and the impact of several non-recurring items. While in 2009 the consolidated operating expenses have been positively impacted by the settlement agreement with T-Mobile (CZK 1,027 million), in 2010 the redundancy payments related to the Company’s restructuring programme (CZK 458 million) became more prominent in the context of the operating expenses. Excluding these two items, the consolidated operating expenses would decline 6.0% to CZK 32.9 billion in 2010.

The interconnection and roaming expenses declined 10.3% year on year to CZK 10.2 billion in 2010, in line with the interconnection revenues; this was mainly due to the MTR cuts and lower roaming prices. The cost of goods sold fell 16.8% year on year to CZK 1.9 billion in 2010, as a result of the lower handset sales and the lower average cost of equipment. Other costs of sales, which comprise the costs of contents, sub-deliveries, the customer loyalty program, telecom services and other cost of sales, decreased 27.5% in total and reached CZK 1.8 billion in 2010. The costs associated with the Universal Service in 2010, together with the lower revenues and lower sub-deliveries for ICT projects, were the key drivers of this trend.

The total personnel costs including redundancy payments amounted to CZK 7.1 billion in 2010, which is 0.7% higher year on year compared to 2009. Not accounting for redundancy payments booked in relation to the restructuring programme (CZK 458 million), personnel costs would go down 7.1% year on year. The total number of Group employees reached 7,522 as at 31 December 2010, down 13.4% year on year. The headcount of Telefónica O2 was reduced 13.4% year on year, down to 6,936 as at the same date, of which some 50% related to the outsourcing in network area.

The marketing and sales expenses (marketing and commissions) declined 6.1% year on year in total, down to CZK 2.6 billion in 2010, as a result of the Company’s continuous effort at efficient marketing expenditure. The network & IT repairs and maintenance expenses increased 3.9% year on year to CZK 2.5 billion, largely as a result of the outsourcing of network-related activities. Rental, buildings and vehicle costs reached CZK 2.2 billion, up 1.7% year on year, while the costs of utilities were down slightly (1.4% year on year) and reached CZK 1.1 billion in 2010. Other external expenses (billing and collection, call centres, consultancy and professional fees and other external expenses, including royalty and management fees), and other operating expenses, reached CZK 2.8 billion in 2010, 1.3 times higher year on year, largely due to the settlement agreement with T-Mobile reached in 2009. Excluding this item, this expenditure category would increase 25.5% year on year, driven by the higher cost of call centre operation, as a result of the Company’s campaign to improve the quality of customer experience.

Taxes (other than income tax) and provisions for bad and doubtful debts and inventories increased 16.1% year on year in total and reached CZK 1.1 billion in 2010, and were impacted by a review and adjustment of the bad debts provision policy in 2009 based on the success rate of collection on accounts receivables.

The outlook for 2011

In 2011, Telefónica O2 Group will continue to focus closely on its customers - by further improving and strengthening its relationship with the customers through better quality of service and offering new products to meet the customers’ needs. The primary goal of these initiatives is to offer a best-in-class customer experience and level of satisfaction. In particular, the Company will continue with its innovations to the fixed broadband value proposition; by introducing VDSL-based services it plans to stabilize fixed access losses and maintain competitiveness. In line with its 3G coverage expansion strategy, and thanks to its recently signed 3G network sharing agreement with T-Mobile, the Company intends to introduce an innovated proposition of mobile broadband and data services to the market. In 2010, Telefónica O2 built up a competitive advantage of having the widest quality 3G network coverage. In 2011, the Company will aim to retain this advantage and increase the number of mobile broadband and data customers, hence improving the respective share of this segment in the total mobile revenues.

Telefónica O2 Slovakia will continue in the active marketing of its ‘transparency, value and simplicity’ customer proposition. By doing this, it plans to further improve its financial performance and profitability while maintaining a solid rate of growth of its customer base.

The group does not have a full visibility of its revenues performance in 2011. It expects that ICT revenues could continue to be under pressure of the lower-than-expected number of projects in the public sector. In addition, mobile revenues will be hit by additional MTR cuts (-35% in 2011). The Company will persevere with its effort to tap into efficiency reserves in the area of operating and investment expenditure, while investing prudently in areas where investment generates value for the customer and maximizes cash flow generation, which remains one of the primary goals for 2011.

In 2011 9, the Group expects OIBDA 10 to decline within the range of 1% and 5% and CAPEX to be around CZK 5.7 billion.

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© Telefónica Czech Republic, a.s., 2011 Contacts & Credits