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BT Group plc And Vodafone Group plc Will Be Squeezed By This Mobile Merger

Hutchison Whampoa has sealed its planned £10bn deal to acquire O2 and merge it with its own mobile operator, Three.

If the competition authorities approve the deal, then O2/Three will leapfrog rivals Vodafone (LSE: VOD) (NASDAQ: VOD.US) and EE, which is being acquired by BT (LSE: BT-A) (NYSE: BT.US), to garner a combined 42% market share of subscribers. EE and Vodafone have 32% and 26% respectively. The EU apparatchiks who will sign off on the deal have approved similar reductions from four to three competitors in other countries, so are likely to give the green light.

The emergence of a bigger beast in the playground is hardly good news for BT or Vodafone. However, the reduction in the number of competitors is likely to be overall positive for operators’ margins, if not subscribers, much to the concern of consumer groups. What’s more there will be a differentiation in customer offering, with BT and Vodafone moving to bundle mobile with landline, broadband and Pay TV whilst O2/Three remains a pure-play mobile provider.

The sting in the tail

But there’s a sting in the tail that could seriously hurt one or the other of BT and Vodafone. O2 has a mast-sharing agreement with Vodafone, whilst Three has a similar arrangement with EE. It would be logical for a merged O2/Three to terminate one of these agreements and throw in its lot with either BT or Vodafone. The jilted partner will effectively see those network costs double, and will have to support on its own a cost base that its two rivals will share.

This is no small beer. When Vodafone and O2 sealed a deal to pool masts, towers and radio equipment into a joint-venture in 2012, telecoms consultancy Ovum reckoned it would reduce each firms network costs by 25%, saving £1bn overall by 2015. Espirito Santo said it would “significantly improve network quality, speed to market with 4G, lead to much better cash generation, and enhance returns on capital in the UK market for both companies”. EE and Three ramped up their alliance just last year, agreeing to jointly invest £1bn to build a shared core 4G network.

Painful break-up

The loser would take a hit on all those aspects cited by Espirito Santo — network quality, speed to market, cash generation and return on capital. My hunch is that Vodafone, with its rickety earnings and negligible free cash flow, would feel the pain of a break-up more than the robust BT.

Since its highly-profitable disposal of US associate Verizon Wireless, Vodafone has become something of a story stock. In Europe its prospects depend on whether management’s investment of the Verizon proceeds in acquisitions and Project Spring comes good. Its emerging markets business, where subscriber numbers dwarf Europe, is a long-term play on those margins growing as countries become more developed.

BT’s £12bn acquisition of EE and investment into Pay TV (copying Rupert Murdoch’s proven strategy of using sports as a spearhead) is similarly transforming that company, but from a more solid base. The 15% rise in its share price this year is testimony to investors’ faith.

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Tony Reading has no position in any shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.