When Vodafone last week severed ties with Carphone Warehouse, the UK's leading retailer, most of the media attention fell on the emerging competition between the groups in converging markets. Vodafone is a mobile operator that is expanding into the broadband market while Carphone Warehouse is a retailer and a provider of mobile, telephone and broadband services.

Was Vodafone motivated by a desire to damage Carphone Warehouse which has now lost its position as the de facto 'comparative shopper' guide in the UK? This is undeniably the most attractive line of argument to pursue. But there is another agenda here and one which is emerging as the key success factor for fixed and mobile operators that want to pursue quadruple play strategies. This is the need to reduce costs. Much has been made of the potential for opex savings by building a single integrated core network (with multiple access networks) and operators are also looking to cut costs across their whole businesses including (in Vodafone's case) central marketing, content teams (T-Mobile) and network management. But the cost of signing up new customers is the most glaring example of where operators need to direct their belt-tightening efforts.

SACs, the curse of the mobile industry

Vodafone cited costs as the reason why it ended its relationship with Carphone Warehouse. Rather than selling through a number of different independent retailers - as well as its own shops - Vodafone decided to consolidate its business into just one independent dealership. Rival mobile operator Orange says it is also reviewing its third party distribution strategy citing a significant increase in costs over the last 12 months.

But Vodafone did not make reference to the bigger picture issue which resulted in its decision to consolidate its third party distribution - the arcane process of paying dealers massive bonuses to sign up new customers.

High subscriber acquisition costs (SACs), the official jargon for dealer bonuses, have plagued the European mobile industry ever since the inception of mobile telephony more than 20 years ago. There can be no denying that bonuses used to subsidise the upfront cost of a mobile phone were an extremely effective means of growing the mobile user population in the early years. But the effect of dealer bonuses on mobile operator profitability and its impact on churn is now causing such damage to mobile operators that Vodafone, for one, seems to have decided that it needs to do something about the situation. It's all very well buying 'new' mobile customers with high commission payments but in the UK there aren't many new customers left. Bonuses only exist today to lure people away from another network and, more importantly, to keep your own customers.

In the UK, one in three mobile customers defects from one operator to another every year. Over a period of three years a mobile operator needs to sign up as many new customers as it had at the start of the three year process just to stand still. And to attract those customers the operator needs to pay a bonus of Euro200 to subsidise a new phone.

The problem that operators such as Vodafone face is that ARPU levels are stagnating which means that it takes longer to 'claw back' their subscriber acquisition costs than it used to. Furthermore, handset subsidies rose sharply 18 months to two years ago as operators made a push into 3G. At the time the thinking was that 3G customers have a higher ARPU than 2G customers (both because of heavier data usage and the fact that 3G appealed to higher-spending customers).

The success of SIM-only MVNOs and wholesale mobile operator business models is also causing operators to question their approach towards subsidising handsets. German operator E-Plus which has pursued an aggressive wholesale business model for the last 18 months says the payback on a wholesale customer is three time faster than the payback for a retail customer because of the lower SACs. Its average SAC was Euro83 in the first quarter of 2006, down from Euro174 a year earlier. The success of MVNOs seems to indicate that there is a large untapped market for cheap voice and text services among people who are not that fussed about receiving a new subsidised device every two to three years.

Mobile operators could justify their high SACs if their customers were generating (operator) revenues from advanced features in most new phones such as cameras, music or music players. But more than 95% of mobile operators are still derived from simple voice and text services.

Buy one get one free

The rules of the telecoms, mobile, broadband and pay-TV markets are changing rapidly. People used to buy these services separately. When they did appear on a single bill (for example DSL/cable and residential telephony) it was clearly marked how much each service cost.

But in triple play markets such as France, broadband ISPs are bundling residential telephony, broadband access and pay TV in a single monthly bill. Meanwhile in the UK people who buy one service (Carphone Warehouse's Talk Talk residential telephone service, Orange's mobile phone service or Sky's digital TV package) are being offered another (broadband) free of charge. There is clearly a cost associated with providing the free services so the companies in question are cross-subsidising the new business with profits from their core businesses.

The name of the game here is to increase customer loyalty by making it more difficult for them to switch provider. Switching mobile operators is relatively easy now that mobile number portability is in place in most markets but changing broadband provider can be a real headache.

In the medium to long term operators hope that a fall in churn rates and higher ARPU from being able to sell a customer three or four different services rather than just one will reverse the downturn in their businesses. But in the short term the market is going to degenerate into a bloodbath.

In most European markets there are at least 10 (and in many cases more than 20) different companies providing one or more of the four quadruple play services. The 'virtual' operator model is now viable in most markets and for all four of these services. A shake-out will inevitably occur until such time as there are only a handful of dominant players and smaller niche ones. The larger operators will look to differentiate themselves through powerful branding, superior content and better customer service.  But an ability to compete on price is going to be crucial and facilities-based operators will need to cut costs to match smaller, nimbler players. Mobile operators employ thousands of staff. Some MVNO teams don't even reach double figures.

Many commentators are already questioning the wisdom of Vodafone's decision to stop supplying its service through the UK's dominant independent retail channel. Only time will tell whether they are right and if Vodafone's loss of market share outweighs the gains in terms of cost savings. But Vodafone is right to try and cut subscriber acquisitions in the UK. They are the highest in Europe and the country's five operators are all going to have a tough time operating profitable businesses unless they can substantially reduce their cost base.

Click here for more information on our mobile strategies research.