Comments on the financial results

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

Consolidated financial results

Revenues, Operating Costs and OIBDA

The total consolidated revenues reached CZK 52.4 billion in 2011, down 5.7% year on year. In the second half of the year, revenues performance improved due to a stabilisation of spend in the mobile residential segment and the solid revenues from ICT and business solutions. At the same time, revenues in 2011 continued to be impacted by the prevailing competitive pressures largely in the corporate and SMB mobile segments and by the regulatory measures (mobile termination rates, MTR, cuts and lower roaming prices). Other income reached CZK 487 million in 2011 compared to CZK 242 million in 2010. The higher gains from the disposal of fixed assets were the key driver of this growth. The total consolidated operating costs declined 5.1% year on year, reaching CZK 31.1 billion in 2011, as a result of a strict financial discipline in this area.

Operating income before depreciation and amortization (OIBDA) amounted to CZK 21.8 million, down 20.4% year on year. The year-on-year OIBDA comparison in 2011 has been significantly impacted by impairment reversal (CZK 4,344 million) booked in the third quarter of 2010. Excluding this item, OIBDA declined 5.4% year on year in 2011. On a fully comparable basis 1, OIBDA declined 5.1% year on year, reaching CZK 22.9 billion in 2011, while the comparable OIBDA margin 2 improved 0.3 percentage point year on year to reach 43.7% in 2011 on the back of a focus on cost efficiency and the positive and growing OIBDA in Slovakia. OIBDA adjusted for guidance 3 declined 5.0% year on year, within the guidance range of -1% to -5%, to reach CZK 22.9 billion.

Operating Income, Income before Tax and Net Income

The consolidated operating income and consolidated income before tax went down 34.7% year on year and reached CZK 10.1 billion and CZK 10.0 billion, respectively, in 2011, largely due to the above-mentioned impairment reversal. The consolidated net income amounted to CZK 8.7 billion in 2011, down 29.3% year on year, due to a combination of the above-mentioned impairment reversal booked in 2010 and the deferred tax in Slovakia booked in 2011 (CZK 709 million). Excluding the impact of impairment reversal on the OIBDA, depreciation and amortisation, and the corporate income tax both in 2010 and 2011, and the impact of the deferred tax income in Slovakia booked in 2011, the net income declined 5.7% year on year to CZK 8.5 billion, largely due to the decline in OIBDA, which was not fully compensated by lower depreciation and amortization, financial expenses and income tax expense.

Cash and Debt levels

On 31 December 2011, the Group’s consolidated financial debts (long-term and short-term) amounted to CZK 3.1 billion, broadly in line with the 2010 year-end situation. The amount of cash and cash equivalents reached CZK 7.0 billion as at the end of 2011, compared to CZK 4.8 billion the year before. The combination of cash and debt balances resulted in a net leverage 4 of -5.6% and a gross leverage 5 of 4.4% as at the end of 2011, compared to -2.4% and 4.1%, respectively, as at 31 December 2010.

Capital expenditure

The total consolidated capital expenditure (excluding additions from WiFi acquisition) amounted to CZK 5.6 billion in 2011, down 0.7% year on year, in line with the Group’s full year guidance (CAPEX around CZK 5.7 billion). The Group continued to direct investments into the capacity expansion and quality improvement of the 3G network. In addition, the CAPEX budget was spent on a further expansion of the 3G network coverage, including coverage of areas currently without service, on the basis of a network sharing contract with T-Mobile. At the end of December 2011, the Company covered already 1,699 towns and cities in the Czech Republic with its 3G network, representing around 73% coverage of the population. Additionally, the Group focused its investments into the upgrade of its fixed broadband service with the VDSL technology, aiming at strengthening its position on highly competitive fixed broadband market in the Czech Republic and improving customer experience. Also, the relevant part of the CAPEX budget was spent on improving the Company’s systems (CRM), to further enhance the customer relationship, simplify and streamline processes and to consequently increase the operating efficiency. In Slovakia, CAPEX went largely into additional network investments related to the launch and expansion of the 3G network. At 2011 year-end, the 3G coverage reached close to 35% of the Slovak population.

Cash Flow

The total consolidated free cash flows 6 declined 8.6% year on year and reached CZK 15.0 billion in 2011; a combination of a 5.6% decline in cash from operating activities, which was broadly in line with the OIBDA decline, and an 3.8% increase in cash used in investing activities, which was driven by higher cash payments on investment in property, plant and equipment and intangible assets, and partially offset by higher proceeds from the disposal of non-core assets.

Over view of consolidated revenues

The total consolidated revenues in 2011 reached CZK 52.4 billion, down 5.7% year on year, mainly due to further cuts in the mobile termination rates, lower roaming prices and the continued strong competitive pressures largely in the corporate and small and medium business segments.

Revenues from voice services (voice – outgoing, interconnection and other wholesale services) reached CZK 18.2 billion in 2011, down 12.6% year on year. Voice revenues declined 12.0% to reach CZK 10.5 billion due to a lower volume of voice traffic generated in the fixed network, more minutes bundled in the monthly charges and the competitive pressure on per-minute charges. Revenues from interconnection and other wholesale services amounted to CZK 7.7 billion in 2011, down 13.3% year on year, on the back of the mobile termination rates cuts, lower incoming mobile voice traffic and the lower transit revenues.

The total volume of mobile traffic 7 generated by customers in the Czech Republic reached 8,956 million minutes in 2011, up 1.9% year on year; it was supported by the higher number of contract customers and the Christmas campaign to promote contract services that offered to double the free airtime included in the monthly subscription charge. Voice traffic generated in the fixed network declined 13.4% year on year in 2011 to 1,507 million minutes due to the continued trend of voice access losses and the effect of fixed-to-mobile substitution.

Revenues from monthly charges declined 4.9% year on year to CZK 12.9 billion in 2011, largely due to the lower number of fixed voice lines. This has not been fully compensated by a growth in the contract customer base in the Czech Republic and Slovakia.

The total mobile customer base in the Czech Republic reached 4,942 thousand at the end of December 2011, a 2.1% increase year on year. In 2011, the company recorded 103.1 thousand net additions in its mobile customer base, compared to only 5.0 thousand in 2010 (excluding the disconnection of inactive contract customers in the second quarter of 2010). The number of contract customers went up 6.5% year on year, reaching 3,049 thousand at the end of 2011, with 185.7 thousand net additions in the year (+15.9% year on year, excluding the disconnection of 111 thousand inactive contract customers in 2Q 2010). This performance continued to be supported by customers migrating from the prepaid to the contract segment, the positive effect of the growth in the number of mobile broadband customers, a higher smartphone penetration and a lower churn. At the end of December 2011, contract customers represented already 61.7% of the base, a 2.5 percentage point growth year on year, which was the highest figure ever. The number of prepaid customers reached 1,892 thousand at the end of 2011, down 4.2% year on year, with 82.6 thousand net losses in 2011 – compared to 155.2 thousand in 2010. Moreover, their number increased by 5.5 thousand in the fourth quarter of 2011, which was the first positive quarterly performance since 3Q 2009; it was credited to the successful Christmas campaign and the lower rate of churn.

The mobile blended monthly average churn rate in the Czech Republic reached 1.85% in 2011, posting a year-on-year decrease of 0.5 percentage point. This is a result of the continuous improvements in the churn rate of contract customers, which was contained to 1.09% in 2011 and was only 0.99% in the fourth quarter alone. It is historically the lowest figure, which represents a year-on-year decrease of 0.3 percentage point. The churn rate in the prepaid segment also improved to 3.03% in 2011, down 0.4 percentage point year on year; it was largely helped by our increased focus on the acquisition of higher-worth customers and the success of the Company’s loyalty scheme innovation which offered rewards for regular top-ups.

In 2011, the mobile blended ARPU 8 reached CZK 423.7, down 9.6% year on year, as a result of the continued effect of the MTR cuts and increased competition. Excluding the impact of MTR cuts, total ARPU in 2011 declined 5.7% year on year. The voice ARPU dilution driven by persistent competition was the key contributor to the decline. The contract ARPU reached CZK 577.9 in 2011, down 12.4% year on year (-8.9% year on year, not accounting for the effect of the MTR cuts). The prepaid ARPU decreased 9.6% year on year in 2011 down to CZK 186.2. The data ARPU declined 2.4% year on year in 2011 down to CZK 117.2. The Decrease in data roaming prices and continuous SMS/MMS bundling were the key drivers behind data ARPU dilution. Nevertheless, excluding these two items (SMS/MMS and roaming), data ARPU would improve 2.4% year on year in 2011 with mobile internet customer base uptake remaining the key driver of the improvement.

The total number of fixed accesses declined 5.2% year on year to 1,582 thousand at the end of 2011, while net losses were 87.3 thousand in 2011, well below 101.4 thousand in 2010 (-13.9% year on year). This is largely a result of the lower losses in the traditional fixed voice access (-22.4% year on year) and the continuous solid growth of naked access (+45% year on year).

In 2011, the total number of customers in Slovakia went up to 283.7 thousand as a result of the solid contract uptake. Consequently, the total subscriber base reached 1,164 thousand at the end of December 2011, posting a 32.2% year-on-year growth. The number of contract customers grew 48.9% year on year, reaching 498 thousand at the end of 2011, while the number of prepaid customers increased 22.0% year on year and closing at 666 thousand. Thus, the customer mix in Slovakia further improved and contract customers represented already a significant 42.8% of the total customer base, up 4.8 percentage point year on year.

Total data revenues were flat year on year and reached CZK 11.5 billion in 2011. Of that, revenues from leased lines and fixed data services recorded a 9.5% year-on-year decline to CZK 2.8 billion, mainly due to lower revenues from leased lines, which were not fully compensated by a growth in IP based data services. Internet revenues improved 2.8% year on year to CZK 5.5 billion, positively impacted by a growth in the number of xDSL customers and the migration of higher-value customers to VDSL. Revenues from mobile data grew 9.7% to CZK 2.6 billion. This is a result of our successful marketing campaign focused on the promotion of smartphone sales, which accelerated the smartphone penetration to a level close to 20% at the end of 2011. In addition, the growth in mobile broadband customer base and our higher revenues in Slovakia related to the launch of 3G services contributed positively to the increase of mobile data revenues.

The number of xDSL accesses reached 872 thousand at the end of December 2011, up 8.1% year on year. In 2011, the number increased 65.6 thousand. As for the VDSL service which was launched in May, already 103.2 thousand customers subscribed to this service at the end of 2011; the VDSL segment now represents 12% of the total xDSL base and some ¼ of the total addressable existing base. The total number of O2 TV customers reached 136 thousand at the end of 2011, up 5.0% year on year, with 5.0 thousand net additions in the fourth quarter alone – a result of our successful Christmas bundling proposition with broadband Internet.

Other consolidated revenues increased 1.1% in total year on year and reached CZK 9.8 billion in 2011. Of that, revenues from SMS, MMS, PRMS and contents grew 0.9% to CZK 4.8 billion, mainly due to the revenue growth in Slovakia, while in the Czech Republic, the revenues went down as a result of more integrated SMS/MMS bundling. Revenues from equipment and activation charges reached CZK 1.7 billion in 2011, which translates into a 13.2% year-on-year growth thanks to the higher revenues from handsets and broadband equipment sales. Revenues from ICT and business solutions reached CZK 2.4 billion – a respectable amount, considering the austerity measures in the public sector, which has been the principal client in this area.

Overview of consolidated operating expenses

Despite the higher expenses related to our intensified commercial activities, the total consolidated operating expenses of Telefónica CR Group declined 5.1% year on year to CZK 31.1 billion in 2011. Our continued campaign of strict financial discipline, which is aimed at offsetting the declining revenues to the maximum achievable degree, was the key driver for the savings of operating expenses.

Consolidated interconnection and roaming expenses went down 9.6% year on year to CZK 9.2 billion in 2011, in line with the lower interconnection revenues; this trend was largely due to the cuts in the mobile termination rates and the roaming prices. The cost of goods sold reached CZK 2.2 billion in 2011, representing a 13.0% year-on-year growth, which was expected with regard to the higher revenues from the sale of devices. Other direct costs of sales grew 7.9% year on year in total to CZK 3.4 billion. Of that, the cost of telecommunications services, content and other cost of sales went down 33.3% year on year to CZK 665 million, while sub-deliveries increased 20.5% to CZK 1 billion due to a higher volume of sub-deliveries in connection with ICT projects. Commissions went up 30.7% to CZK 1.7 billion due to more intensive commercial activity.

Staff costs including redundancy payments reached CZK 6.2 billion in 2011, down 12.6% compared to 2010. Excluding redundancy payments (CZK 174 million in 2011 and CZK 458 million in 2010) staff costs declined 9.2% year on year, as a result of a restructuring program executed in 2010 and 2011. The total Group headcount declined 8.4% in 2011 and as at 31 December 2011 it stood at 6,890 employees. In the fourth quarter of 2011 alone, the headcount reduction has been facilitated by the outsourcing of IT support services to Telefónica Global Technology, which is to provide IT support for Telefónica’s businesses in the Czech Republic, Slovakia and Germany.

Other operating expenses including capitalized own expenses on fixed assets reached CZK 10.1 billion in 2011, down 3.1% year on year. Lower expenses associated with marketing and call centre operation (-9.0% year on year, down to CZK 1.6 billion as a result of improved operating efficiency) were the key contributors to the decline. Significant savings have been recorded also in billing and collection and in the provisions for bad and doubtful debts, which decreased 13.3% year on year in total, down to CZK 831 million. In other categories, it is worth noting the decline in the cost of leases, buildings and vehicles (-4.4% down to CZK 2.1 billion) brought on by our campaign for more efficient utilization of buildings and the car pool optimization. Savings have been reported also in consultancy and professional fees and other external services, which declined 12.2% year on year to CZK 735 million. On the other hand, network & IT repairs and maintenance went up 6.0% year on year to CZK 2.7 billion due to the outsourcing of network-related activities. The growth, however, has been more than compensated by the savings in the related personnel costs. In addition, the Group recorded a higher cost of the utilities, which amounted to CZK 1.1 billion in 2011, up 5.0% year on year, which was mainly caused by the higher energy prices.

The outlook for 2012

In 2012, the Group will continue focusing on improving customer experience through a proposition of the new services that have value for the customer and on products that meet the customer’s needs. Additional investments in process optimization will aim to further improve the relationship with our customers and reduce the number of complaints – ultimately giving a greater customer experience. In line with the strategy to strengthen our market leadership, the Group will focus on customer value management in all segments. The Group believes that these activities will help it to better manage ARPU and churn, thus lowering the pressure in the highly competitive market environment.

Additionally, the Group will continue to enhance its fixed broadband proposition through additional expansion of the VDSL network coverage and to upgrade the speeds for the current accessible base. The Group will also pursue a gradual FTTx deployment with a view to strengthen its market share. In the mobile broadband area, the Group intends to further expand its 3G network coverage while enhancing the capacity and quality of the network, including a backhaul to exploit the opportunity of smartphone and data uptake. Moreover, it will closely monitor and analyze the conditions of the upcoming auction of new frequencies, in which the Group intends to tender for an LTE licence, which would allow it to build a 4G network and remain competitive in the mobile broadband market. In the segment of ICT, the Group will market a standard portfolio of services and solutions, so that the dependency on one-off projects is reduced. This should lead to an improvement in the revenue sustainability in this area.

Telefónica Slovakia will continue in its value- and simplicity-based commercial proposition, targeting higher value customers to maintain a solid subscriber growth while keeping a focus on further improvement of its financial performance through a lean approach to its operations.

The Group expects that, compared to 2011, the fixed and mobile broadband revenues, together with increasing revenues in Slovakia, will be the key drivers for the improvement of the top line performance in 2012. At the same time, the anticipated additional MTR cuts and pressure on ARPU from fierce competition will continue to affect mobile revenues in 2012. The Group will keep its focus on OPEX efficiency improvement, especially in operational areas (implementation of a leaner and more efficient organizational structure and processes, consolidation and optimization of call centre operations), through which it aims to maintain our best-in-class profitability. The investments will continue to go primarily in the direction of upgrades to the fixed and mobile broadband network and improvements of the mobile broadband capability, which are seen as vehicles of growth in the future.

With regard to the above, the Group gives the following guidance for 2012:

	2011 base	2012 guidance
Business revenues	-5.7% year-on-year	improving trends vs. 2011
OIBDA margin 9	43.7%	limited margin erosion y-o-y
CAPEX 10	CZK 5.6 billion	up to CZK 6.2 billion (flexibility to manage CAPEX/Revenue evolution)

© Telefónica Czech Republic, a.s., 2012 Contacts & Credits