EU Regulatory Changes Make Telecom M&A More Difficult

Ofcom, the U.K. telecom regulator, has for years made its opposition clear to mergers that reduce wireless competition to three operators from four

Allan C. Nichols, CFA 29 March, 2016 | 2:24PM
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While the EU regulator's non-approval of telecoms companies Telenor's and TeliaSonera's proposed merger of their Danish operations increases the risk that wireless consolidation to three operators from four will be frowned upon, we don't think all future deals are dead. Looking at the previously approved deals in Austria, Ireland, and Germany with an overlay of the Herfindahl index provides insight into the potential approval of the currently proposed deals in the United Kingdom, Italy, and France. We believe there is about a 50/50 chance of the U.K. deal being approved, a one in four chance in Italy, and virtually no chance in France if it goes to the European Union.

However, if it stays in France, it has about a two in three chance. If the deals are approved, they should benefit all of the firms' stocks. Regardless of the decisions, we think Telefonica's stock is the best of the group to own.

Why We Disagree With Ofcom's Objections

Ofcom, the U.K. telecom regulator, has for years made its opposition clear to mergers that reduce wireless competition to three operators from four. For this very reason, Telefonica and CK Hutchison requested their proposed merger be reviewed by the EU. Ofcom subsequently requested jurisdiction over the proposal from the EU, but was denied. With this rejection, Ofcom president Sharon White sent documentation to the EU on why the merger should be rejected and also wrote to the Financial Times.

Among the justifications for the rejection was a study Ofcom commissioned from WIK Consult published July 3, 2015, "Competition & investment: An analysis of the drivers of investment and consumer welfare in mobile telecommunications." Unsurprisingly, its key takeaway agreed with Ofcom that the merger between O2 and 3 UK shouldn't be allowed. However, after reading the report, we think WIK's findings are more nuanced than they first appear. The paper admits there are issues with measuring and the length of time involved for concrete results that mergers raise prices.

Telecoms mergers table march 2016

The main study it uses to say that prices increased is a study by RTR Telecom Monitor in 2015 that split customers into four tiers based on the Austrian regulator that uses usage profiles of minutes, SMS, and data to assign a customer as a low, medium, high, or power user. Based on this methodology, prices initially declined for all but the low-usage segment and then later increased for all segments. We have two problems with this methodology.

First, it makes no adjustments for the amount of data being consumed, yet data usage has exploded. Thus, adjusting prices for consumption allowed removes the price increases. Second, it is based on what a new consumer would pay, but often existing subscribers are provided with incentives to stay. Also, operators have steadily been investing in their networks with the intent of attracting a larger number of higher-value customers. This tends to leave the low user with MVNOs (mobile virtual network operators) that compete more on price.

Given the importance of MVNOs, we think it is important for operators to be required to provide capacity to MVNOs as part of a package of remedies when approving mergers in order to assure a low-price option, but we don't think this is a reason to prevent consolidation.

Strong MVNOs Improve the Odds for Approval of 3 UK's Acquisition of O2

There are strong mobile operators already in the U.K; Virgin Media, owned by Liberty Global, is one of the oldest and most successful with three million customers, of which more than half are more valuable contract subscribers. In February 2016, Liberty Global through its subsidiary Telenet acquired Base, the third-largest wireless operator in Belgium, from KPN, moving from an MVNO to an MNO. Later that month it agreed to merge its cable business in the Netherlands with Vodafone's wireless business into a joint venture, which will again convert from an MVNO to an MNO. It could yet choose to convert in the U.K.

Additionally, Sky has announced it will enter the market as an MVNO. The advantage these operators have is ownership of existing infrastructure and customers. Sky is the largest pay television provider in the U.K. and second-largest provider of fixed-line broadband. As the U.K. moves to converged services, Sky is positioned well to add wireless service to its existing triple-play customers. Likewise, Virgin Media controls the cable TV market in the U.K. and is the second-largest provider of pay television and third-largest provider of fixed-line broadband. It also has the advantage of owning its own fixed-line network, which is much faster than incumbent telecom operator BT's and which Sky uses on a wholesale base. This makes these two viable competitors even if they don't own their own networks.

Remember, Sky doesn't own its fixed-line network either. Beyond these two other strong competitors are Tesco, which operates an MVNO with several million subscribers, and Talk Talk, which uses BT's network to be the fourth-largest broadband provider and has recently begun offering a quad-play bundle as an MVNO.

A complicating factor in the U.K. is network-sharing agreements. 3 has a network-sharing agreement with EE and Vodafone has one with O2. Hutchison has said it will maintain both agreements and treat them fairly. However, Vodafone has expressed concern that being part of both network-sharing agreements provides an advantage and 3 could use its power to the detriment of Vodafone or EE. We believe that Vodafone has some reasonable concerns and that allowing the enlarged 3 to have deals with the other two operators is asking for trouble.

We think some requirement to address network sharing will be part of any merger deal. We believe 3 will reach some kind of agreement on its network sharing if that is all that is holding up approval, but only if it is sure of a successful deal.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Allan C. Nichols, CFA  is a senior stock analyst and international investing specialist with Morningstar.