Vodafone and Liberty combine Dutch assets, changing the quad play rules

We’re not sure how proud the European Commission will feel as it dawns on its senior technology executives that they may well have killed off their first incumbent telco in Europe – as the merger between Vodafone and Liberty Global begins to challenge KPN in the Netherlands in competition that looks terminal.The EC approved Liberty Global’s purchase of cableco Ziggo in October 2014, and now the merger between Vodafone Netherlands and Ziggo immediately puts KPN on the defensive. It will overnight increase both its capex and marketing spend and continue its revenue reduction at a rate which is likely to destabilize it and put it up for sale in the next couple of years.Right now KPN is riding high financially on the back of its sale of E-Plus in Germany to Telefonica for €8.6bn, but while it wiped some €4bn off its net debt with that transaction, it would take very little to send the troubled telco back to the debt markets. This year its revenues fell by around €500m, and if that happens for each of the next two years, chances are its ability to generate cash will be severely compromised.

When approving the merger of Liberty’s UPC arm with Ziggo, the EC chose to allow the creation of a single, countrywide cable player, and in the process opened the way for the first country in Europe to drop to just two operators in both broadband and mobile, something it has shown itself to be dead set against in other countries.

Since this new deal is between one company strong in cellular and another strong in fixed lines, there is no further concentration of market power in either of those markets individually, and the European Commission has no real grounds to oppose this merger. Still it may try to.

The third strong cellular operator in the Netherlands is T-Mobile, a company that Deutsche Telekom was prepared to sell to Liberty Global as it contemplated life in the Netherlands after a deal like this, given that it has no fixed line assets to rely upon.

All cellular operators everywhere have to look at how they would fare against a localized quad play – if they have no TV or broadband infrastructure, they are immediately in danger of price erosion and a drift into unprofitability. This is happening all over Europe to players like Vodafone, T-Mobile, Orange and Telefonica, where in some markets they have no fixed lines, or perhaps just a few million older DSL lines, and in other markets they are the incumbent. A slow retrenchment towards their stronger markets has been going on now for some years, and is set to continue.

When DT tries to sell off T-Mobile Netherlands to either KPN or Ziggo-Vodafone, it will find the regulators sit in its way, and it will be forced to cut to the bone in order to remain competitive, while the competition regulator is unlikely to be able to offer it a way out. This is pretty much what happened to it in the US when the AT&T-T-Mobile USA deal was vetoed by US regulators. There it has managed to pile in enough cash to solve the problem.

So the Netherlands, if it allows this deal, will have two quad play operations, one cellular business losing money and a few minor players like Tele2 with a few broadband lines and an MVNO, barely enough competition to keep prices competitive.

This deal seems to have come about because Vodafone thinks it would be better to be fighting on fewer fronts and sharing its capex around. If it can avoid small cell and fixed line fiber build-out in the Netherlands, then someone else will have to do it. If T-Mobile doesn’t do it, it will fail. The only possible way for T-Mobile to get on is if KPN buys it. And if the European Commission blocks that deal, as we suspect it would, then Deutsche Telekom must buy KPN. That’s a tougher deal to say no to because, apart from the 3.6m mobile customers it already has, which it might be forced to offload, there is little basis for rejection. Ironically it might have to sell them to private equity or to the newly merged Liberty Vodafone.

The outcome is also dramatic in the wider sense. This creates a two-operator quad play environment in Europe with the regulator’s blessing and so that should reset everyone’s ambition across Europe – a drop to two quad players is now okay, so let’s do it everywhere (though it was recently refused in Denmark).

To Vodafone and Liberty this means that if this deal works out well, it can consider similar deals in the UK and Germany, citing its regulatory permission in the Netherlands. It is an advert for doing deals in the right order – had Vodafone merged with Liberty Global in the Netherlands first, you have to believe that no merger with Ziggo would then have been allowed.

The deal is a 50/50 joint venture, with a $2bn imbalance in the respective enterprise valuations, leading to Vodafone having to put an extra €1bn in. It means that the WiFi and backhaul assets of Liberty Global can be freely given to Vodafone at internal prices, and the merged company has 5.3m mobile customers, 3.1m broadband lines, 2.6m fixed phone lines and 4.2m broadband customers, up against KPN, which has 7.75m mobile customers, 2.9m broadband lines and 2.25m TV customers (at a far lower ARPU). The combined company will overtake KPN in terms of revenues and profits within two years at current growth rates. Financially KPN has €7bn in annual revenues, but €748m of that is in Belgium, and the new merged entity is €4.3bn. Currently both are cash generative, but the smaller business generates more cash.

Cost, capex and revenue synergies will throw another €280m a year into the pot eventually, but a €350m spend on reorganization will have to work its way through the system first. It will be ready to chase the enterprise segment that KPN has always assumed is its own, and should make rapid inroads there.

The joint venture will borrow cash against its assets, to a specific ratio and then return all of that to its shareholders, so neither will include anything but the annual dividend in their accounts and will not consolidate its numbers.

Liberty Global will contribute an estimated €321m of Ziggo net operating losses to the JV at closing and retain ownership of the remaining €2.9bn of its other Dutch net operating losses for future tax purposes.

A Supervisory Board will be comprised of three representatives from each company and certain matters will require unanimous votes. The post of Chairman will be held for alternating 12-month periods by a Liberty Global or Vodafone appointed director. Key management positions will be announced prior to completion of the transaction.

Each shareholder has the right to initiate an IPO of the JV after the third anniversary of closing, with the opportunity for the other shareholder to sell shares in the IPO on a pro rata basis. The parties have agreed to restrictions on other transfers of interests in the JV until the fourth anniversary of closing. After the fourth anniversary, each shareholder will be able to initiate a sale of the entire JV to a third party, subject to a right of first offer in favor of the other shareholder.

That’s all as it should be. Liberty Global in that time frame may want its cash applied elsewhere, for instance in Latin America, and Vodafone may be ready to assume command for a decent payment, at that time. The deal will complete by the end of 2016.

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