Vodafone: sceptical CMA will check if adding Three equals 5G

Vodafone’s listing in London’s premier FTSE 100 index belies its real commercial strongholds. Germany and Africa each contribute more to the troubled mobile phone company’s sum-of-the-parts valuation.

New boss Margherita Della Valle aims to change that by merging Vodafone’s UK business with smaller rival Three, owned by Hong Kong-based CK Hutchison.

Vodafone UK has been locked in a self-inflicted spiral of misfortune in which low returns worsen under-investment and vice versa. The joint venture would boast leading UK market share, taking it ahead of current leader EE.

Della Valle hopes scale benefits will increase profitability. The UK mobile market is unbalanced, as regulator Ofcom has itself has noted. Two big operators, EE and Virgin Media O2, each generate pre-tax returns on capital employed significantly above a cost of about 9 per cent. Vodafone UK and Three manage less than half this.

Vodafone will control the JV via a stake of 51 per cent. The business will carry £6bn of debt, mostly offloaded by Vodafone. This compensates for Vodafone’s contribution of business assets producing roughly twice the earnings of Three.

Lex reckons the JV has an enterprise value of about £13bn. That would reflect a typical sector multiple of seven times applied to pro forma forward ebitda. The figure would chime with the minimum £16.5bn price at which Vodafone can buy out its partner three years after closing, if performance hurdles are surpassed.

The justification to competition regulators is that the deal will permit higher spending on the 5G rollout, benefiting consumers. Ofcom and the government want to increase 5G penetration this decade from 73-82 per cent nationwide.

That will be expensive. Vodafone UK has generated free cash flow for the last two years, but Three has outflows. Target annual cost cuts are £700mn or £7bn taxed and capitalised. This looks optimistic by at least a quarter.

Higher tariffs may make more difference than lower costs. And that brings us back to how the Competition and Markets Authority views the consumer impact. It will pick over this deal in painful detail. Expect a full CMA review over the next 18 months.

Della Valle deserves credit for pushing for consolidation in the moribund mobile market. But given its defensive nature, this transaction will hardly set hearts fluttering among shareholders.