Mallinson: O2 UK/Three UK, BT/EE mergers show devil is in the details on consolidation benefits

Keith Mallinson

It is not surprising that there are differences of opinion between operators, regulators and competition authorities on how few competing networks would be best for investment, innovation and consumer welfare. However, it is good that arguments for and against consolidation, including the proposed mergers of BT and EE, of O2 and Three, and the possible structural separation of BT's network from its downstream operations in the UK are being based on extensive evidence and analysis. Nevertheless, that still does not make it easy to make sense of all the facts and figures being selectively presented for and against the proposed changes, and from which markedly differing conclusions are being drawn by protagonists and antagonists respectively.

Agreement on "motherhoods," but not on how best to achieve them
While everybody says they believe in competition, things are not so simple in the real world. While competitors generally observe the law by not colluding or abusing dominant positions, they also work legally to marginalise or eliminate competition. They do this by trying to beat competitors with superior products and services, expanding scale and by merging with rivals, lowering costs and prices. Meanwhile, consumers do not always appreciate what authorities demand or encourage. For example, my son regrets Sky TV no longer monopolising premier soccer programming because his father refuses to pay for an additional pay-TV subscription with BT Sport so that any game might be watched.

The duties of UK's communications industry regulator Ofcom also seem straightforward and uncontroversial, but are significantly subject to interpretation. Ofcom's responsibilities include furthering the interests of citizens and consumers by promoting competition, and encouraging investment and innovation in relevant markets for availability and use of high speed data transfer. There is no industry, regulatory or political consensus on how best to achieve these aims. The question of how much horizontal and vertical consolidation should be allowed among players is particularly contentious. Will increased network provider consolidation reduce competition with less innovation and higher prices, or will it enable the urgently needed investments in network infrastructure? Is structural separation of a monopoly network provider from a downstream service provider required in the interests of competitors, or will this be cumbersome, costly and harmful to consumers?

Economics dictates that specific industries and markets can only efficiently and profitably support a limited number of players in particular roles due to high fixed costs. For example: multibillion-dollar capital investment costs in semiconductor manufacturing restricts the number of foundry operators and R&D costs limit the number of suppliers in particular chipset product markets, even when these suppliers are fabless and subcontract manufacturing to the foundries. In network infrastructure businesses it can be economically inefficient, as well as environmentally unfriendly, for several operators all to be building directly-competing network infrastructure. This is why, for example, it might be optimal to have collocation of four competing mobile operators' base station antenna arrays on the same single mast, and have them serve a certain picturesque area and connect them all over fibre or microwave links from one or two backhaul providers. Subsidies or coverage obligations may be required before even one network is extended elsewhere to remote areas.

It is not easy to discern what is best for competition and investment in communications network markets. Everything is in such flux, with significant uncertainties about the future in products, services, business models and consumption patterns. With the fast pace of technological innovation, network architectures and their economics are changing.

The rise of over-the-top service providers has been very disruptive to traditional network operators and their business models with alternative voice and text services such as Skype and WhatsApp, as well as new broadband data services. Media consumption is rapidly changing with a decline in "linear" broadcast TV watching and the rise of on-demand consumption with new services such as Netflix as well as those from traditional broadcasters such as the BBC with its iPlayer. Whereas fixed telecoms, mobile telecoms and broadcasting were once fairly distinct, they are now significantly converged with significant amounts of substitution and cord-cutting of fixed, cable and broadcast services. What are they key factors to examine, how can they be measured objectively (particularly pricing) and upon exactly what basis should conclusions be drawn?

He said, she said
It is good to see abundant empirical evidence is being presented to support arguments for and against consolidation. However, with industries being so disrupted and with major differences among markets including very large ones such as in the U.S. and much smaller ones in Ireland, Denmark and Austria, and with different regulatory and competitive histories among these, there is also no consensus on what the historical evidence proves or what future effects might be through regulatory intervention or forbearance.

While AT&T's proposed horizontal merger with T-Mobile US was blocked by the FCC in 2012, AT&T recently completed the acquisition of satellite broadcasting company DirecTV. According to the Financial Times, this deal was for cost savings and chiefly to access DirecTV's copious cash flows (a common characteristic with mature businesses in decline) which are needed to fund capital expenditures in network infrastructure and spectrum purchases. This is despite the fact that AT&T already had relatively strong operating performance among mobile operators worldwide with a wireless operating income margin of 23.1 per cent and adjusted EBITDA service margin of 42.0 percent with 121 million connections in 2014. Wireless capital expenditures were $11.4 billion (€10 billion) out of $24.1 billion for the entire company last year and it spent $18.2 billion on spectrum in the AWS-3 auction this year. Verizon and AT&T have led the world in deployment of LTE. AT&T has spent $140 billion on its networks in the last five years and plans to spend $21 billion on it this year.

The prospective UK mergers are also being proposed on the basis that they will provide cost efficiencies which will make capital investments worthwhile. According to a new report by ETNO and the Boston Consulting Group "empirical evidence as well as economic theory indicates that a degree of market concentration can help improve network operators' financial performance and their ability to invest." It calculates that network operators need an EBITDA margin of at least 25 per cent to cover their cost of capital and that almost a third of operators fail to achieve these levels. At a recent conference, one of the report's authors, Wolfgang Bock, claimed capital investment is up 10 per cent in 2015 and unit prices for data have declined 40 per cent since the merging of Orange and Hutchison 3G in Austria reducing the number of networks from four to three in 2013. The report also cites HSBC, April 2015, finding correlation between improving margins and higher levels of investment -- up to EBITDA margins of 35 to 40 per cent.

According to GSMA Intelligence, the UK's four mobile operators, with a total of 81.8 million connections, spent $3.75 billion on capital expenditures in 2014. This source also reveals that UK EBITDA margins are generally weak.

*Includes contributions from fixed line operators

However, European regulators and competition authorities are becoming less accommodating to consolidation demands. Following the completed German merger of O2 and E-Plus, which reduced the number of operators there from four to three, the proposed merger of TeliaSonera and Telenor, which would have also reduced the number of network operators from four to three in Denmark, was abandoned under pressure from the European Commission's new Competition Commissioner Margrethe Vestager.

With regard to the UK Competition and Markets Authority review of the proposed acquisition of EE by BT, in a recent speech Ofcom's head Sharon White said "we have published our evidence, highlighting issues around possible weakened competition in mobile." With the DG Comp's currently reviewing the proposed merger of O2 and Three, she also weighed in by stating that Ofcom's "analysis of a dozen countries, inside the EU and beyond, shows no relationship between consolidation and investment." She then went on to say "even at a time when UK operators are investing billions to roll-out 4G, they are maintaining a healthy average cashflow margin of more than 12 per cent." She also cited figures from the Austrian regulator indicating mobile prices have risen 28 percent in Austria since the merger of Orange and Hutchison 3G.

The tide has turned
With the drive for ever-lower prices taking precedence over performance and quality improvements in this globally innovative and capital-intensive industry, and absent significant financial distress among operators, European authorities are reluctant to approve additional mergers which would reduce the number of mobile network operators from four to three nationally. They believe intense competition will attract major investments in network infrastructure and spectrum rather than deter it. 

Keith Mallinson is a leading industry expert, analyst and consultant. Solving business problems in wireless and mobile communications, he founded consulting firm WiseHarbor in 2007. Find WiseHarbor on Twitter @WiseHarbor.