NEW ANALYSIS: The continual downward march of ARPU combined with rising investment demands is placing European markets on an increasingly unsustainable trajectory. While many of the larger European operators are coping with the reduction in cash flow that this engenders, for example by selling non-strategic assets and reducing dividend payments to shareholders, in the longer term such trends will inevitably fuel more market consolidation.

European telecoms policy has historically focused on infrastructure competition, and analysis by authorities is often dominated by the nirvana of ever lower retail prices. However, the merits of consolidation should be considered on a broader basis, taking into account the ability of operators to invest in next-generation networks. In the US, the FCC notably recognised that consolidation would facilitate investment in a third nationwide LTE network – through the T-Mobile and MetroPCS tie-up.

The growing need for consolidation highlights the complex nature of European regulation, with 28 separate national regulators across the region. On that basis, it is important to recognise that the synergies linked to consolidation can only be realised at a national, rather than a regional level.

2014 is already witnessing large European M&A deals – including Vodafone’s purchase of ONO, Altice’s agreement to purchase French mobile operator SFR from Vivendi, and America Movil’s offer for control of Telekom Austria. However, all eyes remain on the European Commission as it runs the rule over two earlier acquisitions (3 and O2 in Ireland; Telefónica and E-Plus in Germany).

The Commission’s decision on these deals will provide the industry with a litmus test as to what degree competition concerns will stand in the way of much-needed industry consolidation. However, there are signs that it will look to adopt a different tack in the near future, with Jean-Claude Juncker, a leading candidate to become the next European Commission president, commenting recently during his campaign trail that the “first thing we should do is rethink the application of our competition rules in digital markets.” He went on to note that “if we ask companies to offer their networks and services no longer only nationally, but on a continental scale, we should in my view also apply EU competition law with a continental spirit.”

Financial pressures depict an unsustainable European marketplace
As outlined in our earlier report Mobile revenue trends in a changing global economy, a number of factors have been negatively impacting revenue growth within the European markets that form the ‘Connected Players’ segment. Firstly, competition levels continue to increase, while unique subscriber penetration in most markets has reached a demographic ceiling, above which growth tends to stall. Furthermore, strong regulation on termination rates and roaming, coupled with weak or negative economic growth have exacerbated difficult market conditions and contributed to deeper declines in revenue and ARPU.

Over the four years ended Q4 2013, European ARPU fell by 5.9 per cent on average per year, with Southern Europe particularly hard hit, with a CAGR of -9.5 per cent. Over the same period, European mobile revenue fell by an average of 2.1 per cent each year. In smaller, more fragmented markets, the continual downward trend in ARPU is placing increasing pressure on European operator margins, and alongside an increasing need to invest in network infrastructure, is hampering their ability to pay returns to shareholders.

According to an HSBC study, evidence suggests that network investment is intrinsically linked to margin, up until an optimal threshold where network investment is sufficient in order to meet demand, after which incremental capex diminishes. Our analysis shows that European capex per unique mobile subscriber rose between 2009 and 2011, from €37 to €51 (on an annual basis), and remained at this peak value in both 2012 and 2013. This rising capex burden has been fuelled by the need to support data traffic growth and the rollout of 4G networks.

However, when we examine the trend in European capex and how it relates to unique mobile subscriber ARPU, we see an increasing proportion of ARPU allocated to capex in both 2012 and 2013. This shows that in order to maintain capital spending at 2011 levels, European operators have had to allocate a growing amount of the revenue they receive from each subscriber, up from 16.1 per cent in 2011, to 18.8 per cent in 2013. If ARPU in the region continues its relentless decline, the capex burden operators face in order to continue to expand both the coverage and capacity of LTE networks will become increasingly unsustainable. Larger European operators are often better placed to absorb these costs than their smaller counterparts, and as a result we may begin to see divergence in investment strategies between players.

Some operator groups such as Orange continue to ramp up investment in the face of falling margins. During the nine months ended September 2013, the group saw revenue decline 4.3 per cent year-on-year, despite measures that reduced its cost base by €617 million, EBITDA fall 7.4 per cent over the same period. Deputy CEO and CFO Gervais Pellissier noted that Orange was maintaining “the investments required to preserve our network edge in most of the countries.”

Therefore, despite the group’s worsening financial position, capex rose 2.6 per cent year-on-year “with a sharp increase in very high broadband investment in France and Europe, more or less two times what we did last year, nearly €400 million investment in 4G and fibre compared to €200 million done last year.” As a result of its declining top-line and increased investment, Orange’s cash flow fell 12.6 per cent year-on-year.

In parallel, other large European operator groups with international footprints have taken the opportunity to ramp up network investment through the sale of minority-owned assets. Vodafone is one example; following the sale of its stake in Verizon Wireless, the group earmarked an additional £3 billion in mobile network investment across Europe, as part of its ‘Project Spring’ investment programme. Within Europe, ‘Project Spring’ will see Vodafone add an additional 36,000 4G sites and 18,000 small cells, and modernise a further 15,000 sites.

Such financial pressures and difficult market conditions have been hampering the ability of operators to monetise data and to extend the reach of mobile into new services and adjacent industries. To compound matters further, despite rising network investment in the region, a growing number of European operators are choosing not to charge a premium for 4G services, thereby placing downward pressure on 4G ARPU in their respective markets and often forcing their competitors to follow suit.

The investment and long-term profitability challenges facing the European mobile sector are reflected in the performance of operators’ shares. In just over two years, from April 2011 to June 2013, the EURO STOXX Telecommunications Index (which contains 14 of the largest European operators) almost halved in value, falling from over 400 points to 219. This has served to fuel speculation that there will be a wave of consolidation in the European telecoms market, something that many operators in the region have been advocating for some time.

Providing incentives for investment through efficient consolidation
A number of operators have explicitly highlighted the need for consolidation if the industry is to invest in new technologies such as 4G. The CEO of KPN, Eelco Blok, recently claimed that “consolidation really needs to happen to do the necessary investments in both fixed and mobile. The first wave will be in-country mobile consolidation and then later wider-scale consolidation – in a few years’ time there could be [just] three, or four or five big groups in Europe.”

This would have implications for the complex nature of the European telecoms market, which is structured around 28 separate national regulators, preventing European operators from exploiting economies of scale. Given the current regulatory environment and the need for operators to guarantee profitability and sustainability in a marketplace where capex and opex are growing at a higher rate than revenues, consolidation is the only available alternative.

European policy should allow the mobile industry to realise the economies of scale offered by a single telecoms market, in order to reduce operating costs and so help operators fund investment in networks and new services.

The benefits of consolidation appear in general to be recognised by regulators in the US, as demonstrated in the recent merger between US operators T-Mobile and MetroPCS. The FCC justified its decision to approve the merger in part on its finding that the merger “would enable the deployment of a substantial LTE network nationally that would enhance competition and provide important benefits for consumers. By merging the two companies, and their network assets and spectrum, we find that the resulting Newco would provide for a broader, deeper, and faster LTE deployment than either company could accomplish on its own.”

Towards the end of 2013, the more significant M&A rumours centered on bids from non-European operators such as America Movil and AT&T, which are seeking international expansion and see opportunities in the European market. Whilst these deals did not materialise, there remains firm international interest in the region, with Hannes Ametsreiter, the CEO of Telekom Austria (in which America Movil holds a 23.7 per cent stake) recently remarking that “I believe we will see more consolidation in Europe, I believe international players from outside Europe will make acquisitions and I believe this means that the headquarters of some European operators might move outside of the region.”

However, of late we have seen an increasing prevalence of intra-European M&A activity, as European operator groups seek to strengthen their convergent offerings in key markets. In addition to Vodafone’s agreement to purchase Spanish cable operator ONO, Altice (Numericable) recently won a bidding contest for French operator SFR, despite strong interest and Government support for a rival bid from Bouygues. While both these deals would provide the resultant entities with strong fixed and mobile presences – as well as the economies of scale needed to better compete in their respective markets – the EC’s antitrust concerns remain a key hurdle to overcome. Two deals from mid-2013 remain on the table in this respect – Hutchison’s €850 billion purchase of Telefónica’s Irish subsidiary (O2 Ireland), and Telefónica’s acquisition of German mobile operator E-Plus. The decision of the European Commission on these deals – expected in June – should provide the market with a litmus test of its desire to promote much-needed market consolidation.

European capex per unique mobile subscriber, 2009–13
Source: GSMA Intelligence (click to enlarge)