Opinion The agreement announced earlier this month for BT to enter exclusive negotiations with EE is part of what we have discussed now for the past two years: a re-pricing of the premium associated with cellular businesses, in favour of those based on fixed lines.
This trend will continue and it is the yardstick by which you can predict new rationalisation opportunities.
But for us, this entire negotiation, along with the almost certain outcome of BT combining with mobile market leader Everything Everywhere, is all about bluff and also an example of the old boys act between dominant incumbent telcos across Europe.
Entering into exclusive negotiations means that the only thing that can prevent this deal from being done is an issue of diligence, and that means if something is turned up which suggests to either party that the buyer or seller may want to revalue the asset, such as a so far unrevealed black hole in its pension account or a legal liability which has not played out yet. If nothing like that emerges, this is pretty much a done deal. But what IS the deal, and does it have hidden consequences?
The ostensible deal is that Deutsche Telekom and Orange are selling all of their UK mobile business EE to BT for £12.5bn, on a debt- and cash-free basis. That means the enterprise value is £12.5bn and issues of debt and cash in the bank of the acquired business will be sorted out amenably between the parties. It will need some cash in bank, but being cash-generative, it won’t need much, and debt will need to transfer from one to the other or new debt be put in place to repay it, but one old European telco is pretty much like another to the debt agencies, so these are non-issues really.
But why would anyone want to sell a cellular business, which to date has always had a premium associated with it, due to their once immensely profitable operations, and why would anyone want to sell it to a company that does not even have a cellular operation to boost its own valuation? The answer lies in something we call “capex mitigation,” (Capital Expenditure) and we think you will see this all over Europe, as it has been a driver for consolidation in Germany, France, Spain and the Netherlands, to name but a few.
Let’s consider for a second a telco such as Germany’s Deutsche Telekom, which owns T-Mobile assets all over Europe. To install LTE and then rapidly after this to upgrade it to LTE Advanced and to take its installed handset base to each of these standards, and perhaps to add carrier aggregation, is a vast Capex burden. If you also have to fight against Wi-Fi by installing a multitude of small cells, with their numerous backhaul points, it makes it an even bigger capex burden.
All over Europe at least three teams per country are writing business cases for upgrades to every existing MNO - and the resulting Capex burden is frightening.
The shift to small cells in its own right involves a savage amount of civil permissions and a complete change in roof rights, which mutate from large macro cell towers to 40 or 50 positions on roofs or street furniture. The administrative burden alone is scary to anyone considering it. The possibility of making large mistakes – with the result of high Capex, with a low resultant increase in revenues – is ever-present and the more countries you are in, the worse it is.
It is always far easier to cope with all of this if you are, for the most part, dealing with your own companies – a subsidiary that can provide you with a 100 Mbps vectored VDSL or a 1 Gbps G.Fast or fibre line, wherever you want it in your footprint. And if that comes with a spattering of existing Wi-Fi resource, all the better.
Now consider the local incumbents where someone like T-Mobile has no fixed line assets. It has to pay the going rate for 40 or 50 times more backhaul points. So it has the double burden of high capex and increased Operational Expenditure (Opex) – no wonder half of the cellular companies in Europe are considering or in the process of cutting staff.
There are two ways to mitigate this capex. You can either reduce your effective footprint by selling off operations to another operator – get rid of the problem - or you can buy a local source of fixed-line capability, mitigating the capex in two ways, by attracting more revenue from other MNO providers to set against it, who spend their Capex with your new fixed line entity, and using it yourself.
British Telecom realised that it was in the perfect bargaining situation when it made it clear that since it did not own any cellular activity, it could behave like Free did in France and disrupt the UK market for cellular and the quad play.
Now it makes little sense for the incumbent to be the major disruptor, for two reasons: 1) It usually has a lot to lose and 2) It’s not very good at rethinking business models and bringing them to bear.
But BT has already lost the major asset that it had to lose, its own cellular operation, which now forms Telefonica O2... and although we don’t think BT would have been anywhere near as good as say Free, at finding the right deals to stimulate the UK Quad play market, it said that’s what it was going to do. It was a great bluff, because the operations which had the least amount of fixed line assets were Vodafone, O2 and EE, not to mention 3 – in other words in the UK market none of the Cellular groupings had really moved to build out fixed lines, except Virgin and it isn’t really a cellular operator, because it relies on an MVNO from EE.
The other fixed line holders, perversely are Sky and TalkTalk – who own no cellular infrastructure. In a way there is plenty of fixed capability to go around – Vodafone could have partnered with Sky and it also has its Cable and Wireless assets; EE with Virgin and TalkTalk with 3 and BT with O2, you might have thought, but the rising awareness that after all these years of the stock market valuing portability and cellular over high broadband speeds, was finally coming home to roost – and partnership deals left all of them without any control over those fixed lines.
The genius in this case was to sell off the cellular footprint to the incumbent with the dominant fixed network - and so that’s what O2 tried to do, relieving Telefonica of its capex burden in the UK and filling its coffers for elsewhere. Of course EE would look at that situation, and realise that it was now in a worse position than O2 and so it cut O2 off from BT, by finding a way to beat the O2 deal.
In many other European countries there is an incumbent and a second placed fixed lines business which control the fixed lines, and yet there are no less than three players which control cellular. There will be pressure to merge the two smallest of them and then buy the 2nd placed fixed line player. Where that is not possible, the fixed line player may try to buy the cellco and at some point, if valuations continue to go the way they are going, this will become possible.
In places like Austria, there are no less than three cable operators who could support perhaps separate cellcos to go up against Austria Telekom, a dangerous foe once reinvigorated by America Movile’s cash. In Germany, the consolidation is pretty much over. In France, the options have been all over the press for some months, and perhaps there is one more deal to do, perhaps Free buying Bouygues. In Belgium, the incumbent has lots of broadband lines and there are, similarly to Austria, enough cable operators to go around.
In some of the larger Western European countries, Italy and Spain for instance, Telecom Italia is the main source of fixed line power, and Fastweb, owned by Swisscom, the only other source, which explains why so many times it has been mentioned as an acquisition for Vodafone. Which would leave the 3rd placed cellco there, 3 Italia, stranded, as 3 UK also appears to be. In Spain there are enough spare cable operators after the ONO purchase by Vodafone, to support a third cellular operator, but with Telefonica dominant and Vodafone and Orange co-investing in Fiber, but with ONO on Vodafone’s side, we can see that Orange may have to snap up the spare cable operators, before Vodafone does. That would still leave 4th cellular licensee TeliaSonera-owned Yoigo with no fixed line partner in sight and at a distinct market disadvantage.
You can do this analysis in every one of the 28 countries that makes up the EU and it comes out the same – you will find that with the exception of a few of the larger Eastern European countries, where either Deutsche Telekom or France Telecom Orange, like in Poland and Hungary, have already acquired the incumbent, in each case there is at least one unlucky cellular player that will fail if there is a quadplay price squeeze in the territory, and it will have insufficient funds to service its capex requirement reducing the number of viable cellcos to three or even less in many countries.
What the finance markets demand right now are converged operators with both fixed lines and cellular base stations in a single network. So it makes sense for every cellco that is in say six countries as a pure cellco with only converged operation in its home country, to sell off three cellcos where it is least likely to find the right fixed line acquisition and buy two more fixed line players. In other words - move from five pure cellcos plus one converged, to three converged players. It may well do the same revenue, and its profits may fall slightly, but it will, in the long run, survive and thrive as its capex falls in relation to that of its rivals.
So where does that leave us in the UK? The truth is that if BT buys EE, it has no interest in savaging the market and its plans will change. For a start it will be more indebted, and companies with higher levels of debt do not want market disruption. So it moves from disruptor mentality to incumbent mentality and means that instead of using those 5.4 million BT FON Wi-Fi homes as a disrupting element to offload LTE and savage pricing, it can use it more sedately, as a churn-reducing feature and a way of capturing marginal market share and to protect it from a real innovator.
The UK will instead have to look for one of the other fixed line players, or combinations to create quad play disruption and this sits best culturally with TalkTalk, either offering cellular as an MVNO (with Telefonica) or buying the UK arm of O2 or even 3, or partnering with a merged entity, who could otherwise both remain disadvantaged after this BT deal.
The other part of the deal is that Deutsche Telekom will have bought its first slice of British Telecom, and will hold 12 per cent of BT, while Orange holds a further 4 per cent, and both tranches will likely vote the same way in all strategy matters, and DT would actually have a board member.
We would expect the old boys network of the telco incumbents of the larger EU countries to continue to get closer together, a kind of agglomeration, rather than acquisition, conducted in stealth over a period of years. The usual dispersal of some spectrum or other assets, may be needed to get the EE deal through, but we don’t imagine it will be challenged or blocked by the competition authorities.
But where we think this deal is disruptive is in the pecking order within the UK, and it leaves Telefonica and to a lesser extent Vodafone exposed in the UK. That means there could easily be a counter-bid somewhere in the system, yet to come, in order to prevent the casual acquiescence by the regulator to this deal.
O2 buying 3 might be enough, reducing the market to 3 players in cellular, arguing that if it did not make such a move it could not be competitive with BT/EE. And of course if Vodafone bids for Liberty Global, it may also upset the apple cart. So this deal is not quite out of the woods yet.
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