Summary: Orange and T-Mobile UK are merging, thereby consolidating two of the UK’s five mobile operators. What are the likely benefits and consequences, and the implications from an investor’s viewpoint?
This is a Guest Briefing from Arete Research, a Telco 2.0™ partner specialising in investment analysis.
The views in this article are not intended to constitute investment advice from Telco 2.0™ or STL Partners. We are reprinting Arete’s Analysis to give our customers some additional insight into how some Investors see the Telecoms Market.
UK Wireless: Saucisse de Strasbourg
FT and DT cooked up their very own knackwurst with the planned merger of two (not very) hot dogs –Orange UK and T-Mobile UK. A deal — in fact, any deal — to consolidate the UK wireless market has to be applauded, given UK market EBITDA margins of only ~22% in ’08, now heading south again as a result of MTR cuts. DT should have exited the UK long ago (see DT: Turning a SuperTanker, Dec. ’06), but stubbornly hung on, believing in the potential for data growth.
If DT’s data thesis was flawed, at least it struck a favourable deal with FT, taking 50% of the new joint venture (less a balancing payment of £1.25bn). This values its future equity participation at ~ £5bn, far more than it could have achieved in a cash disposal (recently reported offers from Vodafone/TEF are in the £3.5bn to £4bn). For FT, the deal looks a little less sweet, but still accretive. Synergy estimates (gross cost savings of £550m p.a. by ’14) seem low-balled (unsurprising given both parents’ M&A synergy track record), leaving potential for a positive surprise. A Phase II EU merger control investigation is probable, leading to deal closure around mid-’10, once remedies (e.g., separate wholesale division, return of spectrum) are agreed.
The other large UK players — Vodafone and O2 (Telefonica) — should also benefit from market rationalisation longer term, although they seem likely to target the JV’s customer base in the near term to improve their own scale positions. The move should benefit the whole sector, just as consolidation in Holland caused a mini-rally. Speculation seems likely to flit towards the next in-market consolidation: Germany (e.g., TEF buying KPN) or a second UK deal (e.g., Vodafone-3). Our favoured plays on the consolidation trend are Vodafone or KPN, although we anticipate there may be a bit more life in the old hot dogs FT and DT.
Market Share Onions
Orange’s UK service revenue share was 22.4% at 2Q09, T-Mobile’s was 15.6%, leaving the combined entity with ~37% share after elimination of intercompany trading. In contrast, Telefonica has a 29.0% share, Vodafone 25.9%, and 3 just over 7%. Mobile is a scale game, and after cost reduction, the combined entity should easily be capable of exceeding O2’s market-leading 26% margins.
Although five operators make for a difficult environment, it is the UK’s reliance on third-party distribution that causes serious margin drag. Both Carphone Warehouse (the Best Buy Europe 50:50 JV) and Phones4U have significant market share in distribution and have traditionally managed to play operators off against each other, resulting in a high-churn, high-subsidy environment and consequently expensive SAC/SRCs (Vodafone customer costs were 36% of sales in FY08/09). Despite JV management claims of deep relationships with third-party distributors, the independent channel seems likely to be squeezed over time, which would be negative for Best Buy Europe’s UK returns (i.e., negative for CPW).
DT and FT estimate gross opex synergies of £445m by ’14 (7% of combined opex in ’08) and £100m in capex (15% of combined ’08 capex). Other in-market consolidations have achieved greater cost reduction, nearer 15% of combined opex. In part, the seeming shortfall is due to the cost reduction efforts already undertaken by both sides in a difficult market, but more likely represents the parent companies’ desire not to over-promise given their synergy and deal track records (Orange-Amena, T-Mobile Austria, FT-TeliaSonera promises, etc., etc.). Capex synergies of only £100m would leave the combined entity spending £550m+ p.a.), probably reflecting the need for catch-up of T-Mobile’s historic lowly 3G spend. The JV seems positioned to attempt to maintain market leadership rather than to maximise cost reduction.
JV/Capital Structure Chips
JVs are always difficult, especially in telcoland, but the proposed management structure and safeguards seem logical. What is less easy to comprehend is the financial leverage of the new venture: on a pro forma basis, the £1.25bn of debt from the balancing payment implies ’08 JV leverage of 0.7x (probably 0.9x in ’10E). This is substantially below the leverage ratios of the two parent companies (~2x), so it seems strange that the proposed dividend policy of 90% of FCF implies further deleverage. We wonder whether some headroom has been left to allow for future deals, spectrum purchases, or even expansion of the JV into Europe. We also disagree with DT’s assertion that the deal will be net debt-neutral: DT will likely wind up lending £625m to an unconsolidated equity participation, implying consolidated net debt rises by this amount.
FCF Fizzy Pop
Even taking into account a 90% dividend payout, the £550m of gross synergies and substantial tax assets are likely to imply cash flow accretion in the low-mid single digits for each parent. In addition, fears of further significant declines in UK profitability are likely to wane, probably implying an even greater long-term uplift to longer-term FCF estimates. Our own forecasts, which take a rosier view of synergies than DT/FT (especially in terms of Distribution savings), are shown in Table 1.
Competition Clearance Bunfight
The proposed deal is likely to be subject to EU merger control. Once the parties file a Form CO (likely before end Oct. ’09), the clock starts ticking on a Phase I investigation (25-35 working days). If, as we expect, this results in DG COMP deciding that the concentration raises “serious doubts as to its compatibility with the Common Market,” then there would be a Phase II investigation lasting 90-105 working days (with a “stop the clock” provision of 20 days). Given Christmas holidays, in all probability a final ruling would be made around mid-’10. We imagine the EU will require remedies to absolve the competition concerns, and see that a return of some of the spectrum and the formation of an arms-length wholesale division are among the most likely remedies. It is difficult to judge whether the companies will find these too onerous, though given the fragile state of the UK wireless market, we imagine there will be considerable pressure to continue with the deal unless proposed remedies are unimaginably severe.
Our first stab at the valuation of the new venture suggests an end ’10E EV of £12.3bn, equivalent to 8.6x ’11E EBITDA (after integration costs), falling to 6x EBITDA by ’14E. On an eFCF yield basis, this is equivalent to 8% in ’11E, but 13% by ’14E as integration costs drop away. These FCF yield estimates are on the basis of the venture being unlikely to pay tax before around ’20. We then value DT’s share of the equity in the venture at ~£5.5bn, substantially higher than our no deal value (£2bn) — i.e., adding an underlying ~90c/share to our DT DCF valuation. For FT to judge the deal against the previous valuation, we must also take account the £1.25bn balancing payment, implying a fair value of £6.8bn vs. our prior £5.1bn EV (i.e., adding ~75c to our underlying DCF valuation). Taking account of these changes and further (rather overdue) adjustments to forecasts, our new ’10E price targets (note that they are rolled forward a year, so are not compatible with previous targets) for FT (FTE FP-€18.4) and DT (DTE GR-€9.6) are €21.9 and €11.0, respectively. FT and DT now trade in the teens in terms of FCF yields.
Hot Dogs All Round
In-market consolidation tends to boost the telecoms sector (e.g., KPN-Telfort sparked a rally). In the case of UK market repair, this transaction should lift the margins of the least profitable market in Europe, making it harder for those arguing for perpetual structural declines in the industry to point to the UK example. T0068is seems likely to spur a further rally in EU telecoms stocks (EuroStoxx telecoms are up 19% in three months), before speculation shifts as to the most likely next consolidation candidate. Although the competition issues are far tougher, in our view, we see calls for consolidation of the German mobile market and investor speculation as to whether 3UK will also sell out. The stocks most exposed to this likely thinking are Vodafone (VOD LN-137p; Best Idea Long; ’09E target price 190p) as the general play on European wireless and KPN (KPN NA-€10.7; Best Idea Long; ’09E target price €12) as owner of E-Plus in Germany, and therefore seen as possible consolidation targets by Telefonica (TEF SM-€17.9; Best Idea Short; ’09E target price €13.3). Conversely, we see increased worries about the value of Best Buy Europe within Carphone Warehouse (CPW LN-187p; N; ’09E target price under revision).
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