O2 UK: How much more will Telefónica spend on a market it wants out of?

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Telefónica's O2 UK is in the process of renegotiating its mobile network-sharing deal with Vodafone. The project, known as Cornerstone, has been in place since 2012, building on prior sharing deals, and has allowed both players to grow their 3G and 4G coverage at a reduced cost. The formation of the Cornerstone JV was partly a reaction to the merger of Orange UK and T-Mobile UK in 2010 which created new market-leader EE.

Strong competition in the UK

Competition in the UK mobile market remains fierce, with EE, O2 and Vodafone all holding subscriber market shares of over 20% while CK Hutchison's 3 holds its own with around 12%. There is also a strong MVNO sector, led by the likes of Tesco Mobile and Virgin, the latter offering a quad-play option to Liberty Global-owned Virgin's strong cable fixed-line business . EE was snapped up by BT in 2015 and while the fixed giant plans to keep the EE brand for the time being, it has already started integrating its products with a free three-month subscription to its BT Sport app for all customers, leveraging its heavy spend on TV sports content.

Telefónica sold its minor UK fixed-line business to Sky in 2013, and, faced with a lack of multiplay capability it made plans to exit the UK market completely, aiming to sell the whole of O2 UK to CK Hutchison for £10.3 billion . However, the deal was blocked by the European Commission in 2016 citing competition concerns, and subsequent plans for a partial IPO of O2 UK have been shelved indefinitely due to economic uncertainties. Now Telefónica is stuck with an unwanted unit in a fiercely competitive market that it can neither float nor sell.

O2 UK struggles with Brexit blues

O2 UK's mobile subs growth is relatively sluggish, with the number of users rising by just 1.5% year-on-year (y/y) to 25.4 million at the end of September - a market share of just under 30% (including hosted MVNOs). Unfortunately, the financial side was less pretty:

  • Mobile ARPU in January to September fell by nearly 11% compared to the same nine-month period in 2015.
  • While some of this can be attributed to a fall in the pound following the Brexit vote, that is not the whole story; in fact, ARPU fell nearly 5% year-on-year in the first quarter of 2017 from January to March, before the Brexit vote .
  • The revenue picture is worse: Sales from January to September plunged 17% compared to the same nine-month period in 2015.
  • Revenues dropped by 5% year-on-year in the pre-Brexit period from January to March.
  • O2 UK saw data traffic grow 61% in the year to end-September, and it managed to cut operating expenses in the nine-month period by 4.3% year-on-year , while capex has stayed pretty much flat.
  • However, in the face of plunging revenues, O2 UK's capex as a percentage of revenues has jumped to 14.2% from 11.7% in the same nine months of 2015.

The rise in capex in proportion to revenues is making O2 UK even more of a drain on debt-laden Telefónica's bottom line. The question now is how much longer Telefónica's shareholders will be willing to maintain these investment levels particularly as the shadow of the UK's "Hard Brexit" and further macroeconomic turmoil looms large.

So what's the future for Cornerstone?

There are a few sunny spots in the dark skies, the most notable being a carrier deal with Sky's new MVNO, launched at the start of the year. However, O2's lack of any fixed multiplay capacity is restricting its growth opportunities in a competitive market approaching mobile saturation.

It's not yet clear whether Telefónica's recent woes have been the sole prompt of the potential renegotiation of Cornerstone deal, but Vodafone will be keen to ensure its partner meets its network investment pledges, and if Telefónica is not prepared to maintain its (currently increasing) level of capex this could signal the end of Cornerstone. This result would weaken both operators and offer a slew of new problems - and opportunities - for the tumultuous UK mobile market.

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