Vodafone’s Doubt: CMA to Scrutinize the Impact of Three’s Addition on 5G

Vodafone’s impressive listing on London’s esteemed FTSE 100 index doesn’t accurately reflect its true sources of commercial success. In reality, Germany and Africa are the primary contributors to the mobile phone company’s valuation. However, the new CEO, Margherita Della Valle, plans to change this dynamic by merging Vodafone’s UK business with the smaller rival, Three, which is owned by CK Hutchison, a Hong Kong-based company.

Vodafone UK has been caught in a self-inflicted downward spiral, where low returns lead to underinvestment, and vice versa. The proposed joint venture would establish a dominant market share in the UK, placing Vodafone ahead of the current leader, EE.

Della Valle believes that the benefits of scale will lead to increased profitability. The UK mobile market is imbalanced, as acknowledged by regulator Ofcom. Notably, two major operators, EE and Virgin Media O2, generate significantly higher pre-tax returns on capital compared to a rate of approximately 9%. In contrast, Vodafone UK and Three manage less than half of this.

Vodafone will maintain a controlling stake of 51% in the joint venture, which will carry a debt of £6bn, predominantly transferred from Vodafone. This offsets Vodafone’s contribution of business assets that generate roughly double the earnings of Three.

Lex estimates that the joint venture has an enterprise value of approximately £13bn, based on a typical sector multiple of seven times the pro forma forward ebitda. This would align with the minimum price of £16.5bn at which Vodafone can buy out its partner three years after the deal’s closure, provided certain performance criteria are met.

The justification for the merger, as presented to competition regulators, is that it will enable increased spending on the 5G rollout, ultimately benefiting consumers. Both Ofcom and the government aim to achieve 73-82% nationwide 5G penetration by the end of this decade, a costly endeavor.

Vodafone UK has generated positive free cash flow over the past two years, whereas Three has experienced outflows. The target annual cost cuts for the joint venture amount to £700 million or £7 billion after accounting for taxes and capitalization. However, this figure seems overly optimistic, likely to be reduced by at least a quarter.

Instead of cost reduction, it is possible that higher tariffs may have a more significant impact. Consequently, the Competition and Markets Authority will conduct a thorough review of the deal, scrutinizing its potential consequences for consumers. This review process is expected to last 18 months.

Della Valle deserves recognition for pursuing consolidation in the stagnant mobile market. However, due to the deal’s defensive nature, it is unlikely to generate great excitement among shareholders.