Vodafone and Three can cope without merger, says UK regulator

Organizations conventionally talk about how good they are, but UK reporters and analysts meeting either Vodafone or Three these days are likelier to be told the opposite. The two operators are unashamedly exposing their flaws as they press the case for a merger. As singletons, we make for a stunted and ugly pair in the UK telecom landscape, is the message. Allow us to merge and we'll be dynamic and beautiful. Unfortunately, the judge thinks they look much better than the telcos say they do.

In March, the Competition and Markets Authority (CMA) pushed its investigation of the merger plans to "Phase 2," a more in-depth study, after raising pricing and other concerns well publicized by the mainstream media. This much seemed routine and met with a what-did-you-expect shrug from the operators. But the detailed paper on the CMA's Phase 1 findings, published this week, discloses some fundamental concerns and casts fresh doubt on the likelihood any merger will be approved.

The basic case made by Vodafone and Three is that four mobile network operators (MNO) are one too many in a country of the UK's size. Each is held to stringent coverage obligations, and yet the smallest players have insufficient customers and revenues to pay for it all. Unless the UK magics up a few million additional subscribers, this won't change in a market where just about everybody already owns a phone. But if one network were eliminated by takeover, the others would receive a boost and the economics would improve.

Accordingly, Vodafone and Three have seized on an Ofcom report from 2022 showing that each MNO's return on capital employed (ROCE) was lower than its weighted average cost of capital (WACC) in 2019 and 2020. "If ROCE was to fall, or was expected to fall, below the cost of capital for a sustained period of time for any MNO, this could dampen its incentive to invest," wrote Ofcom.

Each has also abandoned the standard practice of flaunting strengths and instead highlighted its weaknesses. This culminated with Three's recent publication of financial results for 2023 that showed its first operating loss since 2010. "This financial performance is clearly unsustainable despite scaling back our 5G investment," said Robert Finnegan, Three's CEO. Vodafone echoes all this. "There are only two players with the scale to invest to a level the UK deserves," Andrea Dona, its chief network officer, recently told Light Reading in reference to BT and Virgin Media O2 (VMO2), his big rivals.

Viable on their own

But the CMA serves up a damning assessment of certain pleas. Its investigation so far "suggests that both VUK [Vodafone] and 3UK [Three] are viable and competitive businesses and that they would continue to invest in their networks absent the merger," it states. It found no evidence, it says, that Three's financial predicament is perilous.

On the contrary, evidence it uncovered in Three's internal documents showed "a strong commitment to long-term growth, along with a positive outlook on its ability to deliver against its strategic objectives and compete sustainably," said the CMA. This was the opposite of what Vodafone and Three told it in their submissions, it points out.

Regarding Vodafone, the CMA says it has "consistently shown EBITDA profitability," referring to the popular telco metric that looks at profits before accounting for the four items of interest, tax, depreciation and amortization. On EBIT, Vodafone did record losses between the 2020 and 2022 fiscal years but "achieved a return to EBIT profitability" for 2023, notes the CMA.

It acknowledges the Ofcom analysis of ROCE and WACC but draws attention to caveats. Ofcom itself has argued that variation in financial returns is to be expected in a market such as the UK, where competitors are pursuing different strategies. It has also said, in the CMA's words, that "there is scope for smaller MNOs to improve their financial performance by continuing to compete (and invest)."

Authorities also seem to have a much rosier assessment of Three's efforts on 5G rollout than the operator does. During a January press conference held in Glasgow, Iain Milligan, Three's chief network officer, put 5G coverage at 62% of the UK population and said expansion had stopped in late 2022 because "the cost of deploying 5G is huge" and Three faced other investment demands. But Ofcom data put Three's outdoor 5G coverage at 78% in December 2023, ranking it ahead of every other telco on this measure. 5G skeptics would add that most buildings are well equipped with Wi-Fi and therefore have little need for the cellular technology.

In promoting their merger, Vodafone and Three have promised to invest £11 billion (US$13.8 billion) in capital expenditure if the tie-up is allowed, accelerating the rollout of a standalone 5G network across the UK. This standalone (or 5G SA) version of the latest cellular standard severs the link to the old 4G network provided by today's non-standalone (NSA) 5G, and it supposedly comes with all sorts of exciting new features. Without it, the UK could be left behind other countries prioritizing rollout, goes the implication.

But the CMA does not sound willing to overlook the drawbacks of a merger just because it might speed up standalone 5G deployment. It was apparently told by one mobile operator that "5G SA is a nascent technology that is yet to make a dramatic impact or be required for widespread specific use cases." Another operator (so that's two of the four?) said "it does not see any immediate benefits of 5G SA versus NSA 5G."

Taking network sharing to an extreme

Mainstream media publications have tended to focus on the risk that competition will suffer, prices will increase and consumers will be disadvantaged if Vodafone and Three merge. These, after all, are familiar consequences of mergers in any sector. But one specific to UK mobile is the possibility of damage on the network-sharing side.

Vodafone is currently involved in a network-sharing joint venture with VMO2 known as Cornerstone, while Three has a similar arrangement with BT called MBNL. The combined entity, therefore, would be active in both. Unsurprisingly, this worries the CMA, which dedicates a good chunk of its paper to this specific topic. Because it would appear to have more at stake in Cornerstone, the new entity could attempt to "limit or block the funding of MBNL," says the report.

Its involvement in both MBNL and Cornerstone could have other anticompetitive effects, too. The company might, for instance, know if BT had no plans to roll out standalone 5G in a particular area. The realization that it would not face a competitive challenge in that area could lead it not to invest. "Therefore, the CMA believes there is a realistic prospect that the merger entity could cancel or delay the parties' previous rollout plans on the basis of receiving information regarding competing MNOs' rollout plans," says the report.

An analysis of the entire analysis, which runs to 243 pages, is clearly beyond the scope of a single Light Reading story. And the job of Phase 1 is obviously to identify potential problems and not expound on the positives. The CMA's negativity does not mean the merger will be stopped. But it is hard to see it going ahead without major remedies. And the flags raised by the CMA are painted a more vivid shade of red than either Vodafone or Three would like. If their plans are ultimately thwarted, the operators now baring all their ugly spots will have to hope consumers didn't see.