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Convergence to Quad Play Reshapes Telecom

Europe leads the way in combining fixed-line and wireless telephony, broadband, and pay TV.

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The European telecommunications market has been focused on triple-play services of fixed-line telephony, broadband, and pay television for some time. Now the convergence of those services with wireless into a quad play is increasing. We think this will strengthen operators' moats and be a big driver of margin improvement for the next couple of years. Given the small quad-play subscriber base in most countries, convergence represents a robust opportunity for the firms best positioned to capitalize on this trend.

Our favorite European telecom stocks are  Millicom International Cellular (MIICF),  Telefonica (TEF)/(TEF), and  Orange (ORAN)/(ORA). Telefonica has been a leader in converged services in Spain and Brazil and is also benefiting from traditional in-country consolidation in Germany and the United Kingdom. Orange is leading the buildout of fibre in France, which is helping its convergence strategy. Millicom is benefiting from convergence in Latin America and has the fastest organic growth rate yet the lowest ratio of enterprise value to 2015 estimated EBITDA in our European telecom coverage.

In-Country Consolidation, Convergence Strengthen Moats
In the past two years, several telecom mergers have been announced. While some have accomplished the more traditional in-country consolidation, we are seeing more deals targeting convergence. In both cases, we think the driver is to create or strengthen the company's economic moat. The rationale for in-country consolidation is clear: Scale is critical to moat creation in the telecom world, given the high costs of building and maintaining networks, and with fewer operators in each country, the competitive environment and incumbents' returns tend to improve. However, mergers for convergence are a fairly new phenomenon.

While the reason isn't as obvious, we think mergers for convergence also strengthen an operator's moat. First, convergence leads to a reduction in churn. Generally, the more services a customer subscribes to, the lower the churn rate. For example, KPN (KKPNY)/(KPN) estimates that the churn for its mobile brands is approximately 50% lower for subscribers who are part of a quad-play subscription compared with a mobile-only subscriber. Proximus' (Belgacom changed its name to Proximus a couple of weeks ago) annualized churn for quad-play customers stands at 2.5%, relative to 8% churn for triple-play, 13% for double-play, and a whopping 22% for single-play customers.

One of a company's largest variable costs is subscriber acquisition costs. As churn rates fall, a company can reduce its SAC, which in turn lowers its cost structure and improves returns on capital. Secondarily, convergence often leads to improving the quality of a company's network. This occurs through the acquisition of wireless, fixed-line broadband, or television assets that the firm either didn't own or was poorly positioned in. The quality of the network is an important driver of our moat framework in telecoms, as it allows an operator to charge premium prices. The best examples of this are the wireless networks of Swisscom (SCMN) in Switzerland and Verizon (VZ) in the United States, both of which are viewed as having the best-quality networks; they have successfully managed to charge premium prices and also have the largest number of subscribers in their respective countries. On the wireless side, quality tends to be driven by the density of towers and the amount and type of spectrum in an area. On the fixed-line and broadband side, quality tends to relate to broadband speeds where fibre is the fastest medium of transporting data. Convergence is also increasingly related to acquiring fibre to improve the quality of the operator's network and compete better against cable TV. Additionally, most of the incumbent telecom operators have increased their capital expenditures to enhance the quality of their networks in order to distinguish them from alternative carriers.

Overall, we think the mergers that have occurred or been proposed make strategic sense and help move the industry toward converged services, which is leading to increased competition between cable television operators and telephone companies. In the short term, we think the current merger wave from convergence is nearing an end in Europe, except in the U.K., but is just getting started in Latin America. We also believe that convergence as a rationale for mergers will grow over time as in-country opportunities dwindle.

Millicom, Telefonica, and Orange Should Benefit From Convergence
All of Millicom's assets are located in emerging markets, and the convergence process is gaining steam in this region. Historically, Millicom was a wireless-only operator, but it has been increasing its exposure to cable television in order to offer a full quad-play suite, highlighted by the 2014 acquisition of UNE, one of the largest cable TV operators in Colombia. The company has the fastest organic revenue growth rate of our European telecom coverage (above a 6% five-year compound annual growth rate), yet trades at the lowest enterprise value/2015 estimated EBITDA (4.8 times) and has an average yield (3.6%).

Telefonica is the main beneficiary of consolidation in Germany; it is leading the quad-play movement in Spain and Brazil, which will be enhanced by its pending acquisition of GVT, and it is selling its wireless-only service in the U.K. Orange is the primary builder of fibre to the home in France in order to increase its broadband speeds as well as the leader in 4G, where it once again is able to distinguish its superior wireless network as Iliad's roaming agreement only applies to 3G. It is also acquiring Jazztel, an alternative telephone company in Spain, which will enhance its quad-play offerings in that country.

Convergence Is Driving Mergers
Before 2013, about the only communications company that had more than 10% of its customers with quad-play services was Virgin Media in the U.K. About 16% of its customers were taking all four services when the firm was acquired by Liberty Global (LBTYA) in the summer of 2013. We think Virgin Media's experience in marketing all four services was a factor in its acquisition. Before that purchase, Liberty Global's only wireless offering, which it previously referred to as a test, was in Chile. Since then it has begun to offer wireless services in several markets on a mobile virtual network operator basis, the same way Virgin Media has for well over a decade. Recently, the firm announced it would buy BASE, KPN's wireless business in Belgium. This will be its first foray into owning a wireless network. While this could be a signal of more wireless operator acquisitions by Liberty Global, we don't think this is the case. It was a unique situation in which there was a willing seller at a reasonable price, and the firm already has a decent-size MVNO business that it could add to the acquired business and generate cost savings.

Meanwhile, Telefonica and Portugal Telecom, the incumbent telecom operators in Spain and Portugal, respectively, began to aggressively market quad-play services to counter the subscriber hits they've taken due to their countries' weak economies.

Vodafone (VOD)/(VOD), which was traditionally a wireless-only company, is talking about convergence and has been acquiring assets to allow it to increasingly sell other services. The firm has had some capabilities in offering fixed-line and broadband services since its acquisition of Mannesmann in Germany in 2000, which provided it with Arcor, the second-largest fixed-line network in the country. This was supplemented by some small acquisitions, such as the purchase of Tele2's fixed-line assets in Italy and Spain in 2007. Activity picked up significantly with Vodafone's purchase of Cable & Wireless Worldwide in the U.K. and TelstraClear in New Zealand in 2012 and then its purchase of Kabel Deutschland, the largest cable television provider in Germany, in 2013. Most recently it acquired Ono, the largest cable television operator in Spain, and South African subsidiary Vodacom has agreed to buy Neotel, an alternative operator that has been laying fibre. Liberty Global has also been busy on the acquisition front. Besides acquiring Virgin Media in the U.K., it acquired Ziggo in the Netherlands. We anticipate additional M&A as operators around the world position themselves for the increasing importance of offering converged services.

Cable's Advantage Is Decreasing, and Valuation Gap Should Narrow
Historically, cable television operators have had an advantage over telecom companies in providing broadband and pay television services. The firms generally have a more extensive fibre footprint, with fibre running in front of most homes and then coaxial cable running into the home. This more extensive fibre network allows faster broadband speeds providing faster video streaming and other services. These networks are generally also easier to upgrade, providing the companies with a stronger moat. As such, we think cable operators deserve to trade at a premium multiple to telephone companies. That said, we think the multiples some European cable companies trade for have gotten ahead of themselves.

Additionally, in most European countries the cable networks only cover a portion of homes. Most of these networks were built during the telecom bubble of the late 1990s when financing was virtually free. Given the high cost of building a network, it is unlikely that cable firms will expand into many new areas other than greenfield sites or filling holes in their networks, as recently announced by Virgin Media. Thus, we don't expect the rates of homes passed to increase much, except for U.K. Virgin Media's recently announced infill buildout, which could take coverage to about 70%. In areas where there is no cable TV provider, people rely on the phone company or satellite television provider for pay television services or just subscribe to basic terrestrial television. In these areas, customers are generally dependent on the incumbent telephone company for at least the "last mile" connection into the home for any kind of fixed-line based telecom service, including broadband.

European telephone companies are also increasingly laying fibre, either to the curb or all the way to the home, particularly in areas served by cable television providers in order to compete more effectively against them. With European populations living in much more densely populated areas with apartment blocks or row houses, it is much cheaper in most areas to lay fibre than in the U.S. As fibre deployment increases, phone companies potentially have the ability to offer broadband speeds in excess of the cable operators, similar to what already exists in Japan. As fibre is built further into the network and the advantages of cable diminish, we think the spread between the multiples at which cable operators' stocks and phone companies' stocks have historically traded should narrow, supporting our overvalued calls on many cable companies.

Cable companies' multiples in Europe have also been pushed up by acquisitions, but we think the largest of these deals in Western Europe's biggest countries have now been announced. Longer term, we think Germany could use more consolidation of its cable television operators, but for now the regulators won't allow it, and we don't see this changing for some time despite comments from Liberty Global to the contrary. Likewise, we think Europe would benefit from more cross-border mergers, but these are unlikely due to political constraints. We particularly think KPN, Proximus, and Tele2 are too small long term and would be better off as part of a larger company. We think only Tele2 could be acquired without political change, but a takeover premium is already built into its stock price.

Generally, we think Spain is by far the furthest along the transition path to convergence and provides a template that other countries are following. France and Germany are also on this path, but behind Spain. The U.K. and Italy are much further behind, but BT's (BT)/(BT.A) offer for EE is kick-starting the move to convergence.

Allan C. Nichols does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.