UK telecoms market: further consolidation likely

Tuesday 7 June 2016 | 14:59 CET | Background
The UK telecoms market is dominated by seven large operators. The new BT, including EE, leads the market in revenue terms. Its free cash flow generation compares to that of other large incumbents (DT, Orange). Virgin Media and Vodafone, candidates for a tie-up if Liberty Global and the Vodafone Group can work out their differences, score the highest and lowest profitability in terms of free cash flow. A merged 3 UK/O2 UK would have created a strong competitor, but still operating a mobile network only. Sky and TalkTalk are investing in fixed-line infrastructure and could be market consolidators. 3 UK will likely continue as a mobile-only operator. O2 UK could challenge Vodafone for merging with Virgin.

We have investigated the UK telecoms market using basic financial metrics, including revenues, opex and capex, similar to what we did before for the Dutch, the Belgian, the French and the German markets. The UK's diversity is comparable to what we have seen in Germany, with competition from the former PTT, a cable operator, a satellite group, 3 MNOs and one virtual operator. Smaller competitors, such as local incumbents (KC, JT, Sure), fibre operators (CityFibre, Gigaclear, Hyperoptic, B4RN), independent MVNOs and international business services providers (AT&T, Verizon etc.) have been left out of the comparison.

Consolidation continues: who will Virgin select?

Now that BT is absorbing EE, chances are that Virgin Media is in the comfortable position of selecting a mobile operator to merge with. After all, there is only one fixed-only operator left and three mobile-only operators. After the 3 UK/O2 UK merger was called off, based on EC objections, three MNOs may vie for Virgin's favors: Vodafone (with whom Liberty Global already has an understanding, see their planned merger in the Netherlands), O2 UK and 3 UK - although the latter will likely remain a mobile-only provider. That will potentially leave two MNOs without a fixed-line network or partner. Perhaps they will seek a tie-up with Sky and TalkTalk, who already cooperate with CityFibre for building a national FTTH network.

Overall comparison: BT largest, Virgin most cash generative

When it comes to size, the new BT (incl. BT Global and BT Ireland Business) is obviously the largest operator, with quarterly revenues of roughly GBP 6 billion. Virgin Media (UK & Ireland), Sky (UK & Ireland), Vodafone UK and O2 UK each have revenues between GBP 1 and 2 billion. 3 UK and TalkTalk rake in around half a billion in sales each quarter. We take a closer look at all seven operators.

  • BT (incl. EE, BT Global Services and BT Ireland Business; DT holds 12%). The financials results are quite stable, with EBITDA margins in the mid 30s and capex between 10 and 15 percent of revenues. This leaves free cash flow of 20-25 percent of revenues. BT's main focus point is the integration of EE, apart from expanding the broadband network and staving off the threat of structural separation. At the recent capital markets day, new targets for growth and cost reductions were announced, but a move to all-IP (by 2025) and a new operating model as well. The leading brands are BT, EE and plusnet.
  • Sky UK (incl. Ireland; 21st Century Fox owns 39%). The full Q1 2016 results are not in yet. The EBITDA-margin has been slowly improving to 23.5 percent recently. Capex is low (4% of reveneus, based on our assumptions), leaving free cash flow at almost 20 percent of revenues. Margins could be under pressure when the build-out of FTTP (with TalkTalk and CityFibre) is expanded. Sky is among the leading undbundlers of BT's copper network. Sky is the only operator not to offer mobile services (yet).
  • Virgin Media (incl. Ireland; part of Liberty Global). The EBITDA-margin is almost 45 percent and capex is limited (12% of revenues). As a result, free cash flow is a comfortable 30+ percent of revenues - despite Project Lightning under which the network is expanded to cover 17 million households by 2020 (from 12.6m in 2015). As stated above, Virgin will likely merge with one of the MNOs in the short to medium term.
  • Vodafone UK. The EBITDA-margin has been limited, at just over 20 percent, while capex is a relatively high 16.6 percent of revenues currently. Free cash flow is therefore just a few percent of revenues. The company has been a late entrant when it comes to fixed-line services. To this end, it acquired Cable & Wireless (a BT unbundler), but its fixed-line customers are a very limited 109.000 at the moment. It has yet to add TV services (planned for 2016).
  • O2 UK (Telefonica). The EBITDA-margin is at the mid 20s and capex is just over 10 percent. Free cash flow comes in at 10-15 percent of revenues. After the failed merger plans with 3 UK, O2 for now will continue on its own. It currently has just 21.500 broadband subscribers.
  • 3 UK (part of CK Hutchison's 3 Group). The EBITDA-margin has risen to over 30 percent, but capex is also up (almost 20% of revenues). Free cash flow is in the 10-15 percent range. 3 is the only truly mobile-only operator in the UK. After the failed merger attempt with O2 UK, 3 looks likely to continue on its mobile-only path.
  • TalkTalk. The EBITDA-margin has been volatile and is now 18 percent. Capex is slightly up to just under 10 percent of revenues and free cash flow is in the same range. TalkTalk is a virtual operator in both fixed and mobile. In 2015 it suffered a data breach, leaving a dent in the company's brand image and finances, but the company is recovering. The 'Make TalkTalk Simpler' program aims at reducing costs.

International comparison: Vodafone UK relatively weak

Based on our previous research into the Dutch, Belgian, French and German markets, we can also make a number of cross-border comparisons. How are the incumbents doing? How do the Liberty Global and the Vodafone subsidiaries compare? And how are virtual operators performing?

  • Incumbents. The larger ones (BT, DT, Orange) have free cash flow to revenue ratios of over 20 percent, versus over 10 percent for the smaller ones (KPN, Proximus). Here we can clearly see the benfits of scale. Given the path to all-IP and the benefits that DT is aiming for, KPN and Proximus seem likely to participate in M&A activity. DT, owning a 12 percent stake of BT, may be the market consolidator in the medium to long term.
  • Liberty Global companies. Currently Unitymedia scores the highest FCF/revenue ratio. Virgin's ratio is lower due to operating a large (lower margin) MVNO business.
  • Vodafone subsidiaries. The UK branch has a remarkably low ratio, possible necessitating it to aim for a merger with Virgin.
  • TalkTalk can be compared to the German virtual operators (United Internet, freenet, Drillisch). Its profitability, in terms of free cash flow over revenue, is however substantially lower. It compares with Iliad's, which is actively building out both LTE and FTTP. This suggests that TalkTalk may need M&A if it desires to build out infrastructure of its own on a larger scale.

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