Join our community of smart investors

FTSE 350: Telecoms focused on consolidation

As competition becomes more fierce and services more broad, we think the sector could see a number of takeover bids this year
January 26, 2017

On an average morning commute, the majority of travellers will happily tap away at their phone or tablet for the duration of their journey. The power of connectivity means that even in parts of the London Underground we can now check our emails or the latest analysis from investorschronicle.co.uk. But the modern consumer wants even more: the ability to make free long-distance calls via the internet or catch up with the latest episode of The Great British Bake Off from anywhere in the country.

In a bid to meet these demands, Britain’s telcos are offering more services, and the lines between mobile provider, broadband supplier and broadcaster are becoming increasingly blurred. BT's (BT.A) purchase of EE in January gave the company access to the UK’s largest 4G network. This enticed Virgin Media to extend its contract with the network for another four years. In November, Sky (SKY) waded into the mobile market with its own offering.

You could see these two former broadband and fixed-line specialists as encroaching on Vodafone's (VOD) patch, but the latter has held its ground by investing in new products and expanding its offering in emerging markets. Vodafone did, however, face an embarrassing £4.6m fine after regulator Ofcom discovered that 10,500 pay-as-you-go phones had not been credited when customers had topped up. But TalkTalk (TALK) endured bigger sentiment struggles after a major cyber breach at the end of 2015 drove customers away. With little likelihood of a let-up in the industry’s fierce competition this year, the UK’s telcos can’t afford to lose the faith of their customers.

The regulation game

As well as the intense competition, regulatory issues are likely to continue to occupy BT in 2017. In November, Ofcom warned that it would be going to the European Commission to force BT to undergo a legal separation of its Openreach division after months of negotiations over a voluntary split. Openreach owns and operates the majority of the UK’s broadband cables, which are used by rivals to deliver internet services.

Critics have argued that BT has shied away from investment in Openreach in favour of plugging money into its television content, leaving many UK homes with unsatisfactory internet connectivity. BT has earmarked £6bn to upgrade its network to ultrafast speeds and recently made former Ofcom executive Mike McTighe the first independent Openreach chairman. But these changes are yet to satisfy the regulator: whether BT can do enough to retain Openreach’s cash flows for the wider business will be crucial.

Sky has also had to invest this year, upgrading its content. Like BT, it has felt the pressure of competition from Facebook (US:FB.), Google-owner Alphabet (US:GOOGL) and Netflix (US:NFLX) in news and entertainment consumption. This year is sure to be another interesting one for Sky after Twenty-First Century Fox made an £18.5bn bid for the group. The deal may yet be hampered by regulatory issues, particularly on media plurality grounds, although analysts think it may have a better chance than the previous failed bid in 2010-2011, due to shifts in the Murdoch media empire. Fox could offer to spin out broadcaster Sky News, which was offered as part of a similar deal last time around.

Consolidation is also rife in the pure broadcasting division of the market. ITV (ITV) may have failed to acquire Entertainment One (ETO) last summer, but it has been busy buying up production companies. Its studio sales have flourished as a result, earning 300 commissions for new or regular shows in the nine months to 30 September. This diversification has helped the broadcaster keep its head aloft in the face of falling advertising revenues. All forms of media advertising are expected to take another dive this year and this has hurt sentiment towards ITV’s shares. We recently speculated that the group’s diminished share price and the low value of the pound could entice a takeover from a foreign company such as Liberty Global, which already owns 10 per cent.

Entertainment One also remains attractively priced for a takeover. Its share price has not yet recovered from the disappointment of the failed ITV bid and its film division has, once again, failed to overly impress. But the group’s television business continues to perform well – driven by the success of the Peppa Pig franchise, which is beginning to make a splash in Asian markets.

Price (p) Market value (£m)PE (x)Yield (%)1-year change (%)Last IC view
BT Group38137,89811.73.8-17.2Hold, 306p, 25 Jan 2017
Entertainment One2331,00116.30.552.3Buy, 228p, 22 Nov 2016
Inmarsat6642,99915.24.3-36.2Buy, 734p, 05 Jan 2017
ITV2038,15511.73.2-21.3Buy, 170p, 08 Dec 2016
SKY99717,13915.83.4-3.4Hold, 997p, 14 Dec 2016
TalkTalk1631,55514.99.8-17.2Hold, 158p, 08 Dec 2016
Telecom Plus1,2441,000213.837.0Hold, 1208p, 22 Nov 2016
Vodafone20855,259456.1-2.7Buy, 204p, 15 Nov 2016

 

Favourites: Entertainment One, ITV and Inmarsat (ISAT) struggled in 2016, but we think investors overreacted to their various problems and have left them undervalued. Inmarsat suffered launch delays and patches of weak trading, which sent the shares spiralling to their lowest level in years. But recent contract wins, improving end markets and surging long-term demand for wireless connectivity suggest the sell-off has been overdone.

Outsiders: With competition hotting up in the mobile services space, there is no room for any errors, so investors could be best off avoiding TalkTalk. Aside from negative sentiment, we don’t see how the group can compete with behemoths such as BT, Sky and Vodafone. The same could be said of Telecom Plus (TEP), which also has to contend with price cuts across the energy market.