With the recent entry of Saudi Telecom Company (STC) into Telefónica’s shareholding, the debate on the low valuation of telecommunications operators in the European Union and the competition policy of the European Commission (EC), already a hot topic because of the Orange-Mas Móvil operation, has resurfaced.
Some say that the policy of forcing a minimum number of competitors in each market is the cause of the low value of operators. Others say that operators would be more competitive if they were present across Europe rather than competing only in one or a few Member States.
Once again, we find governments and regulators confronted with the realities of the market and economic theory.
Pan-European operators are desirable from a political standpoint rather than an economic one. The actual functioning of telecommunications markets suggests that they would not attain the economic viability and strength they are presumed to possess, unless they face sustainable market structures in each geographic area. The reasons for this follow.
The physical reality behind telecommunications
For European citizens to enjoy telecommunications services, operators have to roll-out networks and deploy antennas, which carry the desired information from one point to another. All these means together constitute the telecommunications network. But deploying and maintaining the telecoms network is costly and can only be done if sufficient revenue is generated to cover these costs, including the return expected by investors.
Logically, the network deployed can only offer services to the buildings served by it or to individuals moving within the covered area, in the case of a mobile network. Consequently, the necessary revenues must necessarily be derived from individuals residing or moving within the area.
This is why an operator, to be viable, has to achieve a minimum number of customers in the area covered by its network, usually measured as a % of homes passed.
How to achieve profitability in the telecommunications network
This minimum percentage depends on two aspects: the cost of deployment in the particular area, and the price the inhabitants are willing to pay for the service, which is measured by ARPU (Average Revenue Per User). The higher the cost of deployment, the higher the minimum market share required; the higher the ARPU, the lower becomes the minimum market share required.
Operators cannot predict the future and may make errors in their assessments of the commercial success of their deployments. What is certain is that, once the investment has been made and the network deployed, the operator’s sole opportunity to recover its investment is to attract a sufficient number of customers to subscribe to its services. It has already been noted that if the price of the provided services decreases, the required market share to achieve profitability in that area will need to be higher. Moreover, if the operator fails to attain the necessary market share at that price level, it will likely reduce the price with the hope that the increased market share will offset the lower revenues, thus recovering the investment.
Competing with other operators
Of course, if there is only one network in each area, the network owner would be in a relatively comfortable position to be profitable. However, as would be the case in any other market, if that lone operator is very profitable, other operators will see the opportunity to deploy their network in the same area and capture some of the profits. New entrants will face a challenge analogous to that of the initial operator, i.e. to achieve a minimum market share in that same area that allows it to be profitable at the charged price.
However, it’s important to note that the total number of potential customers remains unchanged. In other words, the required market share must be obtained from the same buildings where the initial operator is already competing for customers. It is possible that multiple operators believe they can capture this market share and choose to enter the market by deploying their own networks. Nevertheless, the more common scenario in Europe is that operators perceive a regulatory environment conducive to their entry. This often involves the ability to enter the market without deploying their own network, instead renting another operator’s network at cost-oriented prices.
A vicious circle towards the loss of profitability
Regardless of the circumstances, the introduction of new operators into the market implies that an increasing number of participants need to secure a minimum market share for profitability. If they fail to attain this share, they are likely to adopt the pricing strategy previously outlined: reducing prices in the hope that the resulting growth in market share will offset the decline in ARPU.
If they are successful, other operators will be forced to do the same, but at a lower price corresponding to a higher minimum market share. Therefore, as prices go down, it becomes increasingly difficult for operators to achieve the market share that makes them viable. And so the vicious circle could continue until none of them is viable, networks are no longer maintained and upgraded, and customers lose quality of service or even, in the extreme, are left without it.
Market dynamics provide mechanisms to stop it going so far: the bankruptcy or exit of those marginal operators who realize that they are not viable.
This exit restores for the remaining operators the possibility of being viable if they achieve that minimum market share, now in competition with fewer players. In markets such as telecommunications, where, as we have seen, the agent had to invest in deploying a network, it cannot be expected that the operator will simply abandon it: what it normally does is sell the network to another of the existing operators or try to merge with it. This is what we are seeing in the case of MásMóvil and Orange.
And suddenly, competition policy
However, the European Commission has often hindered this restructuring mechanism due to its particular interpretation of competition. According to the EC, competition is deemed to exist only when a certain number of operators operate in the market. To achieve this, it compels the consolidating operators to provide favorable conditions to a new entrant, referred to as “remedies”. This, when it does not directly block the operation, as was the case of Hutchinson O2UK in the UK.
In this way, competition policy hinders the natural market consolidation process, which, it should be emphasized, occurs periodically in all markets. As a result, the vicious cycle described earlier is reinstated, albeit each time edging closer to an unsustainable situation. This cycle is perceived by potential shareholders and represents one of the factors contributing to the continuous erosion of value among telecommunications operators in Europe, something that currently appears of concern for EU governments and administrations.
The mirage of cross-border mergers
What alternative does competition policy propose? The one mentioned at the beginning of the article: mergers with operators in other geographic areas until a pan-European dimension is achieved.
However, as is evident from the preceding explanation, such consolidation does not resolve the operator’s fundamental challenge, which is to secure a minimum market share within the regions where it has established a network.
The size they need is not in absolute terms, being big for the sake of being big, but in relation to the geography they cover. An operator with 1,000 customers accounting for 40% of its coverage may be viable, while another with several million across the EU may not be profitable if its market share is insufficient in each of the areas in which it is present.
Moreover, the argument is not merely theoretical.
Operators’ experience has shown time and again that an increased pan-European presence does not improve the position of operators unless each local operation is economically attractive and profitable in its own. It is enough to look at the presence that operators such as Vodafone, Telefónica, and to a lesser extent Orange and DT, had in the EU and compare it with the presence they have today, all of them having abandoned part of their previous presence. Such an exit would not have occurred if the pan-European reach were profitable. By contrast, operators such as Swisscom, with a presence only in Switzerland, outperform other European operators spread across several Member States in terms of capitalisation.
This is the reality of the telecoms market, and as long as technologies or customer preferences do not change, there is little the European authorities can do to change it. Attempting to distract from reality with the lure of cross-border mergers will not change reality, nor the urgent needs of the telecoms sector.