It's 8am. 2degrees' US-born chief executive Eric Hertz has already been for his regular early-morning swim - 90 lengths in a 25-metre pool. He's red-eyed, but perky, dressed in a sharp high-street shirt that appears wrinkle-free. Mr Hertz didn't want to do this interview, but in the end, has fronted up.

The challenger company is facing a potential PR nightmare after news broke that it wants to dismiss founder Tex Edwards, who battled the regulators for years to get a third player in the market.

Mr Edwards has secured an interim injunction from the Employment Court which prevents his job as company "strategist" from being disestablished. A rumoured dispute about the dilution of Mr Edwards' shareholding in 2degrees lurks in the background. Not a good look for the company that built its brand on being the friendly underdog.

"I won't comment on that," Mr Hertz says, looking down. The substantive hearing on the employment dispute is due to be heard on August 22.

What he will talk about is the company's greatest challenge - how to be truly sustainable up against the deep-pocketed market incumbents, Telecom and Vodafone.

“Until there are three entities on a strong standing, large dominant incumbents have an economic incentive to see the small, third one, as at best a healthy dwarf," he says.

Industry commentators say most people, apart from 2degrees' rivals, agree the newcomer's success is important to Kiwi consumers. For years Kiwis paid extremely high prices for mobile calls and texts because of a lack of competition under the cosy market duopoly of Telecom and Vodafone.

The catalyst for change came in 2006 when the Labour government's telco reforms gave the Commerce Commission wider powers to investigate the mobile market without ministerial approval.

The commission identified that mobile prices were significantly above the average for other Organisation for Economic Development Co-operation and Development countries and did a series of things to remove entry barriers for a third player.

The sheer speed at which 2degrees has picked up customers since its launch in August 2009 is surely testimony to how many Kiwis were eager to take up a more affordable mobile option.

In the first seven months of operation, the company acquired 209,000 mobile customers. By March 2011, it had 580,000. It expects to hit the one million customer market next month - 20 per cent of market connections.

Telecommunications Users Association chief executive Paul Brislen reckons 2degrees was the fastest growing third-mobile-entrant in the world. It took Meteor in Ireland five years to get a 5 per cent revenue share of the market.

“2degrees busted through that within two years.”

The company's success, say financial analysts, is largely down to savvy marketing.

From the start, the irreverent comedian Rhys Darby fronted its TV advertisements. His quirky humour worked, according to University of Otago marketing lecturer Roel Wijland.

“MORE established competitors have regularly mismanaged the ironic popularisations of their corporate culture and talked down to consumers.”

2degrees was more conversational, he says. But its market penetration has also been about price and modern, efficient systems backed by locally based phone support, which has made for good customer service.

2degrees entered with a simple pre-pay product, 44c for voice and 9c for text, at a time when the standard charge was 89c for voice and 20c for text. Since the third player launched, Mr Hertz estimates prices have fallen across the board by 30 per cent.

Telecom began undercutting 2degrees in January through its Skinny discount mobile brand, which offers a casual pre-pay calling rate of 39c. That Forced 2degrees to quietly withdraw a claim on its website of having the "lowest pre-pay prices" in February, but does not appear to have stopped the third entrant's growth.

The Commerce Commission said the biggest price-falls had been for calls between different mobile networks, known as off-net calls, and mobile calls to a landline. This has brought the price of these calls closer to the average price for calls on the same network, known as on-net calls, which were already relatively cheap.

Mr Brislen says the question is how much it has cost 2degrees to obtain customers. The company might have nearly one million customers, but only an 8 per cent revenue share of the $2 billion mobile market, as many of these customers are low-spending pre-pay customers.

The fledgling company is yet to turn a profit. It incurred a net loss of $92.6m in 2011, despite a 72 per cent rise in revenue. Its shareholders, including majority owner Trilogy International, have invested $450m to date.

Deutsche Bank head of institutional equities Geoff Zame says the challenge for 2degrees is to tap into the profitable area of the high-value consumer and small to medium-sized businesses.

“Toget those customers requires handset subsidies, because we have become addicted to them, and that means further cash-burn. That is the bit where the brand is unproven.”

He calculates 2degrees needs to have a more “balanced” 20 per cent of the overall market to be sustainable long-term.

Mr Hertz, whose 30 years of work experience in the mobile sector includes the presidency of Bell South International in Equador and chief executive officer of Seattle-based mobile company Zumobi, concedes 2degrees needs to get more customers on to accounts.

Only 100,000 of its 950,000-plus customers are currently on accounts as opposed to pre-pay.

It faces some potentially big investments in the future, but despite this, is on track to have positive earnings, before interest and tax, this financial year, he says.

The company will have to go up against rivals Telecom and Vodafone and fork out for 4G radio spectrum this year or next, when the Government allocates new spectrum for even faster mobile data services and will later need to invest in a 4G network itself.

It won't say what it expects the likely cost of the radio spectrum will be, but it could conceivably need to pay as much as $100m, or more, if the spectrum sells at the going international rate.

The company is majority-owned by United States-based investment company Trilogy International. Just how deep the pockets of Trilogy's private US investors are remains a matter of conjecture.

Regulators need to continue to monitor the market, Mr Hertz says, until 2degrees can generate enough cash internally to fund growth and have revenue share to demonstrate the market is truly competitive.

Many of the barriers to entry had been lifted by the Commerce Commission - the major one being the cut in the wholesale rates mobile operators charge each other for receiving calls, known as mobile termination rates.

But on-net discounts and off-net penalties for customers on other networks to call 2degrees' customers is still an issue, Mr Hertz says.

However, the commission appears happy with progress. It released a report this week showing there continues to be a fall in the difference between the cost of calling and texting on the same network, compared to calling and texting other networks, though the average price premium for calling between networks is still a whopping 52 per cent.

Mr Brislen believes a lot of cost pressure is being brought to bear on 2degrees at a time when its major shareholder might be looking to sell.

Potentially the biggest spanner in the works though has been the takeover of TelstraClear by Vodafone, the country's largest mobile operator, he says.

Many saw Telstra as an obvious buyer for 2degrees should its private equity owners want to exit soon, but the deal has left the small player out in the cold.

Venture capital firm Trilogy is probably in it for the short-term, says Mr Brislen. “I wonder who it will be now TelstraClear can't buy it. I can't see anyone in New Zealand buying it."

Mr Hertz rejects the perception Trilogy is keen to sell, saying it has been in mobile communications for 30 years and knows it is a long-term game. “They know this could be a $1 billion business if we do the right things.”

The big hairy audacious goal for 2degrees was to surpass Telecom and be the No 2 player in the mobile market by customers, Mr Hertz says.

He'd be happy with a third of the mobile market, or $660m a year.

That would take growth beyond what it's doing now. Vodafone dominates the mobile market with 56 per of revenues and Telecom has 36 per cent, while 2degrees is a long way back on 8 per cent.

But Mr Brislen reckons Mr Hertz's goal is no pipe dream.

Financial analysts doubt 2degrees will ever attain the No 2 spot. But then again, they underestimated how quickly the company would attract and retain the customers it has. Consumers' best hope of getting more competitive prices may be to see Mr Hertz move at least a bit closer to his ultimate goal.

Who Owns 2Degrees
Trilogy International, United States: 59.8 per cent
Tesbrit, Holland: 28.6 per cent
Hautaki Trust, New Zealand: 10.6 per cent
NZ Communications, owned by 2degrees: 1 per cent

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