Telecoms' tangled web

Global telecom tie-ups have come thick and fast this year, as companies have sought to enter high-growth territories, develop 'quad-play' portfolios of TV, broadband, mobile and fixed-line telephony, and scale up to meet surging demand for data and superfast '4G' broadband. The latest example is BT (BT.A) entering into exclusive negotiations to acquire mobile-phone operator EE, a joint venture between Orange (Fr: ORA) and Deutsche Telekom (Ge: DTE), after initially weighing a takeover of O2, owned by Telefónica (Sp: TEF). The move surprised investors, as the privatised UK telecoms titan had planned to launch its own offering in the domestic mobile market - which it exited in 2005 with the sale of Cellnet, an earlier iteration of O2 - early next year.

BT wants to buy EE in order to strengthen its portfolio of quad-play services, gain over 25m mobile subscribers - to whom it can cross-sell its other products - and avoid the risks that come with starting up its own service. EE also offers extensive 4G coverage, which would allow BT to bundle high-speed mobile internet with its fibre broadband. BT intends to pay about £12.5bn in cash and shares for EE, which would worsen BT's already chunky £8bn net debt position. The bet is that the benefits will outweigh the costs: in time, broker Jefferies expects the cross-selling of services to push up total sales by 2 per cent, and forecasts a 3 per cent reduction in the combined operating costs of BT's consumer division and EE.

Investors in BT face the prospect of either an extra present or a lump of coal, depending on the type of deal struck. But the Grinch could take the form of Sky (SKY) or Three-owner Hutchison Whampoa (HK:13), both of whom are reportedly looking to buy O2. And Vodafone (VOD) is unlikely to take BT's encroachment on its market lightly.

BT, which we recently tipped (Buy, 419p, 11 Dec 2014), is the best example of a lumbering telecom group displaying audacity and acumen - and taking risks. The group's upcoming mobile venture won't be the first time it has ruffled feathers. In the past two years it has outbid Sky for the broadcasting rights to top-flight domestic and European football, and launched a competing sports channel.

This battle may continue in next year's Premier League rights auction. The main concern is that BT will overpay. Jefferies thinks it will have to spend £344m just to retain its current Premier League rights - 40 per cent more than in the last auction. The exact price is meaningful - a 20 per cent rise in the cost of rights could dilute BT's adjusted cash profit by 0.7 per cent and EPS by 1.3 per cent.

However, even if BT ends up spending £640m for a larger share of Premier League games, the increased cost should to some extent be offset by more customers under a new charging model. BT would have little choice but to shift to a pay-TV model, which Jefferies estimates would yield £250m a year, assuming an average fee of £5 a month for its 5m subscribers. A larger tranche of games could attract 1m Sky subscribers, too, netting BT another £140m.

The main challenges facing BT are declining demand for its legacy products and regulatory headwinds. The group could get "bogged down in a cycle of overhangs", says broker Jefferies, referring to next year's auction - which could act as a "powerful deterrent" to new investors - and Ofcom's Fixed Access Market Review in 2017. But both threats are being countered by strong gains in the consumer division, as BT Sport and high-speed fibre broadband continue to attract new customers. Moreover, the decline of the other divisions is far from irresolvable. In the latest quarter to the end of September, a full two-thirds of the fall in underlying sales at its wholesale division stemmed from the loss of a key Post Office contract and a market review by telecoms watchdog Ofcom.

Two of BT's rivals, Sky and TalkTalk (TALK), have responded to its sudden entrepreneurialism by launching aggressive promotions. These took a toll on BT's first-half broadband growth, but may not be sustainable. For example, Sky risks cannibalisation as its cut-price offers could drive existing customers to seek better contract terms. And the discounts haven't stemmed a slowdown in Sky's triple-play growth: it gained some 500,000-700,000 new customers in the year to September 2012, but only 100,000-350,000 over the same period this year (the company doesn't disclose precise numbers). Meanwhile, TalkTalk expects to attract a third fewer TV customers this quarter in spite of a larger marketing budget. Jefferies thinks it may struggle to hit its full-year cash profit target of £287m; the first-half profit of £110m leaves little scope for further discounting.

Financial targets aside, TalkTalk's operational progress has been very promising. Its strategy of offering low prices and a broad range of high-quality content helped it add 300,000 TV customers in the six months to 30 September, taking its total to 1.2m. It plans to accelerate its customer acquisition rate by shelling out an extra £20m-£25m this year. TalkTalk has also addressed market concerns over its thin margins: it's on track to nearly double its cash-profit margin to 25 per cent by 2017. The company appears to have a knack for signing up customers cheaply. It currently spends about £125 to sign up a TV customer - a quarter less than a year ago - by encouraging self-installation and pushing online sales. We expect TalkTalk's growing content portfolio, which will include video-streaming service Netflix next year, to continue to attract customers.

IC VIEW:

Changing consumer habits are forcing telecom companies to adapt and innovate. We expect acquisitions, partnerships, network investments and expansion into new markets and territories to remain popular responses. Both BT and Sky have shown their willingness to embrace new technologies and take the risks necessary to transform their businesses. They may be fierce rivals, but we think there's room for both to perform. TalkTalk and Vodafone look on the back foot by comparison.

Favourites:

Sky remains the business to beat in Europe. The pay-TV, broadband and telephony provider has more than doubled its paid-for subscription product base in the past five years and grown its sales by 43 per cent. About 37 per cent of its customers are triple-play subscribers. And it has transformed its prospects by acquiring Sky Italia and Sky Deutschland this year. The latter deal expanded its customer base from 11.5m to 20m and is expected to generate over £200m in annual synergies by 2017. Shares in Sky are up 7 per cent since our recent buy tip (875p, 18 Sep 2014), but we expect further gains.

Outsiders:

Vodafone continues to suffer from a toxic cocktail of competition, regulation and economic weakness in Europe. Its Spanish and Italian operations remain depressed, with first-half service revenues down 9 and 10 per cent respectively. The carrier's strategy has centred on international expansion and broadening its product range: it bought fixed-line Spanish cable group Ono and Germany's Kabel Deutschland this year, and a large-scale network investment programme and 4G roll-out are well under way. But the group's short-term prospects remain weak, and it's likely to lock horns with Sky, BT and TalkTalk when it enters the UK residential broadband market next year.

How the telecoms companies compare