Research Notes

Leaked documents from Hutchison / Telefonica deal in UK shows EU competition authorities don’t understand telecom markets. DG’s Comp’s inability to update analytical framework dooms mobile mergers.

Telecom investors have focused their attention on the forthcoming May 19 decision of the European competition authority, DG Comp, on the proposed Hutchison 3G UK and Telefonica UK (O2) merger. This comes on the heels of an averted deal between Telia and Telenor in Denmark last fall, which DG Comp claimed would increase prices in Denmark. Earlier this year the UK Competition and Markets Authority approved the merger of British Telecom (BT) and Everything Everywhere (EE) without remedies, a £12.5 billion deal combining the country’s largest fixed line and mobile businesses. Unlike the BT/EE deal, the 3/O2 deal needs EU approval. This research note, based in part on leaked documents from DG Comp, reveals that the agency is making decisions about an industry which it does not understand, and this bodes poorly for the merger.

Strand Consult has followed the consolidation of the European telecom market for many years and has frequently criticized the unpredictable black box of DG Comp. Predictable regulation is a prerequisite for investment in a capital intensive industry such as telecommunications industry which requires a long time horizon.

In spite of much discussion about the need for investment, the European Commission has not succeeded to create a conducive environment to build and run telecom networks. The problem stems from a conflict in leadership and policies from competing agencies within the Commission. Using empirical evidence and ongoing surveys of member states, DG Connect attempts to design a modern framework for telecommunications. Meanwhile DG Comp, using its rules of thumb, determines the future by deciding which mergers happen. Whether enterprises can succeed to merge is a crucial factor in whether they will invest.

DG Competition behind on how the modern telecommunications market functions
In this research note, we assess DG Comp’s market descriptions, whether it is true, and whether it can be used to base regulatory decisions. Then we will look at how professionals with knowledge of the telecommunications industry make market descriptions when developing and implementing their marketing strategies. One of the documents Strand Consult reviewed is called Hutchison – Telefonica UK oral hearing from March 2016 containing DG Comp’s outlook on the UK market. It is not an exaggeration to say that if an undergraduate student in a marketing or business program submitted such an assessment, she would flunk. No person working at a telecom operator, nor investor for that matter, would consider competition in such simplistic, monolithic terms. DG’s Comp’s analysis is not only misleading, it shows that the agency does not understand what drives competition in the market.

It is clear that DG Comp sees the Hutchison/O2 the deal in UK from the paradigm of the market vertical. That is that the telecommunications market consists of distinct networks (mobile, fixed line, broadband, TV, etc.) which have little to no influence on the other. In practice, however, the modern telecom operation is assembled horizontally, offering bundled products commonly known as triple and quatro play solutions. DG’s Comp’s obsolete view is likely rooted in the fact that its employees have limited understanding of how the telecommunications market works in practice and don’t understand how triple and quatro play provider benefit consumers, or they refuse to update their framework as it would create political challenges.

Documentation – A market description must be horizontal; a vertical view is too narrow
Let’s deal with the facts. Single play providers, both Hutchinson and O2 in this case, offer their customers service via the mobile network. This is very different from a triple or quatr play provider which offers not just mobile service, but broadband, TV, and wireline telephony. In practice, competition is it not just about being able to offer customers a one-stop shop but also about the opportunities to reduce costs in marketing, distribution and customer service; and the ability to cross-subsidize products. In the UK, BT paid millions of pounds for TV rights to the Premier League football. But the deal would not be so valuable for BT if it could not bundle the Premier League with its broadband product, thereby cross-subsidizing one business line to another. Needless to say, pure play mobile operators don’t have this capability.

To explain in further detail, consider that while cost of infrastructure is considerable for a telecom operator, some 10-20% or revenue, this amount pales in comparison to cost of customer acquisition and retention, about 25-30% of revenue. One must also look at how the churn (customer defection) from single play versus triple and quatro play providers. To get an insight to how triple and quatro players can leverage lower costs across the enterprise, check out the presentation at TDC’s Capital Market Day. Slide 19 shows that churn of customers who only have one product is 21%; those with two products is 16%; those with three products is 13%; and those who have four products is 11%. In practice, the marketing cost to retain triple and quatro play customer is significantly less than those who buy a single solution from a mobile operator. It terms of the UK deal, this means that its far cheaper for BT/EE to keep a customer on its rolls than for Hutchinson or O2 to acquire him. For DG Comp not to discuss the reality of the modern mobile operation, then they do not provide a true and accurate representation of the market. And hence their predictions of the future—essentially what DG Comp does when it approves or denies a merger—is made on incomplete information and is likely to be wrong.

It begs the question that if telecom operators and investors recognize the role of triple and quatro play into their analysis, why does DG Comp not? It is likely that should DG Comp incorporate any new information into its frameworks, then it will create a political problem by revealing the mistakes it made in the past, for example the mergers not approved because of an incomplete analysis. Because of its fear of being exposed, DG Comp continues down the same misguided path rather than admitting that it is not omnipotent. However, the competition authority should it admit its mistakes, could actually gain credibility. Indeed it would take out some of the sting from the length of time it takes to review mergers, which drag on one third longer for telecom than they do for other digital industries.

To be sure the blame does not fall solely on DG Comp. The same Consumer Market Authority in UK which approved the BT/EE deal without remedies (thus creating one of the strongest incumbents in Europe ) told DG Comp to block the merger of Hutchinson/O2. European merger policy has been criticized as protectionist by nations outside the EU, but it’s hard not to make the same case in the UK. Indeed the European Commission which has been advocating “cross border” consolidation as the key to its Digital Single Market would seem to have the ideal case with Hutchison and O2, two foreign firms in the UK. It’s not the first time that a nation’s incumbents have been rewarded at the expense of entrants, and indeed that competition and regulatory authorities continue to delay the modernisation of their regimes only serves the cosy relationship they keep with the largest companies they regulate, not to mention delaying the true free market competition that makes such authorities obsolete.

There is no doubt that network sharing which criss-crosses the UK is complex, but this is manageable compared to fundamental problem of erecting mobile masts and towers. Not only are building permissions difficult to obtain in the UK, the rental price for land has exploded, as private landlords with a monopoly on essential locations have made a practice of extorting mobile operators. Strand Consult’s report 10 Steps to reduce cost for mobile masts and improve mast regulation documents that it will not be possible to split the UK operators’ shared network and create three independent network entities within a 4-7 year time horizon, yet another harebrained idea from the authorities.

The conclusion is clear – Competition authorities will do greater damage to the mobile market than any in-market consolidation
It is not in-market consolidation that is a problem. Mergers are a logical outcome to a maturing market, technological change, and falling prices. The problem is the outmoded framework practiced by insulated competition authorities with little to no honesty or accountability. It would be quite a different world if competition authorities made their work transparent and were held accountable for their decisions. Instead they make their decisions in secret based on incomplete knowledge, while in public they pronounce their decisions with arrogance about what the future will bring.

As Strand Consult observed at the FT–ETNO event in Brussels, the European Commission lacks coordination. It may well be that Andrus Ansip and Günther Oettinger of DG Connect have a grand vision for European telecommunications, but it doesn’t mean a hill of beans because Margrethe Vestager calls the shots. The mergers that are approved today or not are what determines what investment comes in the future. The EU has a €100 billion gap in private investment, and it’s DG Comp which bears much of the responsibility for the shortfall.

Telecom investors from around the world who are confounded by the European Commission whose actions excerbate the problem of the EU becoming ever less competitive to other regions in the world. The next crisis impacting the EU will likely be digital as people will want services from networks, but the networks will not have been built for lack of investment.

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