EC opens probe into Vodafone's proposed tie-up with Liberty Global's business in the Czech Republic, Germany, Hungary and Romania

The European telecommunications industry has been challenged by host of headwinds in 2018, including slowing economic growth and regulations, as companies eye innovation and M&A-driven strategies in the year ahead.

Telecoms have been generally suffering from slowing growth across the European continent, with economic sentiment squarely in negative territory.

Sentiment about the Eurozone’s economy rose by only 1.0 month-over-month in December to -21.0 – its worst level since August 2012, according to ZEW. Moreover, the current economic situation fell a further 6.1 over the same period to 12.1, while pessimism about inflation also grew.

European Central Bank president Mario Draghi said before the European Parliament’s Committee on Economic and Monetary Affairs in late November that while a slowdown in euro area growth mainly reflects weaker trade developments, it is also related to some country and sector-specific factors. Also, employment is expected to slow somewhat as labor supply shortages become more binding.

Meanwhile, although underlying inflation measures have inched up from earlier lows, they continue to be muted. HICP inflation increased to 2.2% in October 2018 from 2.1% in the prior month.

Draghi highlighted that significant monetary policy stimulus is “still needed to support the further build-up of domestic price pressures and headline inflation developments over the medium term.”

At its previous meeting in late October, the ECB left its key rates unchanged and said would make net purchases under its asset purchase program at a new monthly pace of €15bn until the end of December 2018, when the program itself is due to end.

Emerging 5G

Against this backdrop, several European telecommunications companies have been increasingly exploring novel approaches to growth, amid fierce competition.

Telcos have been generally ramping up their efforts to achieve an edge in rolling out nationwide 5G networks, which are widely expected to open up a vast array of services, including broadband, mobile and Internet of Things (IoT), while providing the necessary bandwidth and low latency for 3D and virtual reality (VR) applications.

Ericsson anticipates major 5G network deployments from 2020 and thinks 5G subscriptions for enhanced mobile broadband will amount to 1.5bn by the end of 2024 – reflecting almost 17% of total mobile subscriptions.

Sweden’s Telia (STO:TLSN), for example, recently spent SEK1.4bn (US$154m) at the Swedish Post and Telecom Authority’s license auction for 2x20MHz in the 700 MHz band, in part to position itself for nationwide 5G services.

Telia’s frequency purchase follows its recent partnership with Ericsson to launch Sweden’s first 5G network at KTH the Royal Institute of Technology in Stockholm, “a key step,” Telia said, towards commercially rolling-out the next-generation technology in the country in 2020.

The latest activity in 5G coincides with a recent slowdown in the firm’s domestic earnings.

Telia Company CEO Johan Dennelind said that in the third quarter of 2018, Sweden had, as expected, slower EBITDA compared to previous quarters, due in part to negative currency effects and inclement weather. He said that while “we have reduced costs year-to-date in Sweden under the cost program, we are still not happy with the pace of the turn-around.”

Shareholders, however, generally remain upbeat about the company’s plans.

Telia’s stock had grown almost 22% between February and May 2018, with shares at SEK42.50 intraday Tuesday – close to their 52-week high of SEK43.95.

(Click on image to enlarge)

Regulatory hurdles

In the meantime, regulatory risk remains critical for most European telecoms’ ability to compete in the 5G arena, as convergence-driven M&A transactions increase.

Fitch Ratings recently noted that regulatory developments will be key as the telecommunication industry in western Europe considers new approaches and structures to continue investment in fiber and the 5G network.

The European Commission’s unconditional approval of the merger of T-Mobile and Tele2 in the Netherlands in late November appears to have sparked some optimism about industry consolidation. Among other worries, the regulator’s decision laid to rest competition and pricing concerns spurred by the combination.

Analysts at J.P. Morgan noted that the EC’s ruling “offers a ray of hope for our long-held view that industry returns are unsustainability low (ROIC ~4%), and that with more pragmatic regulation, and associated market repair, we could see a meaningful inflection in sector-wide trends.”

Other pending M&A deals subject to regulatory approval may also help establish sentiment about the path of the sector’s potential growth.

Fitch Ratings recently noted that “Vodafone's planned acquisition of Unitymedia should also elucidate how anti-trust authorities approach convergence.”

The EC Tuesday opened an in-depth investigation to assess Vodafone's (LSE:VOD) proposed acquisition of Liberty Global's (Nasdaq: LBTYA) business in the Czech Republic, Germany, Hungary and Romania, amid concerns the takeover may reduce German and Czech competition.

The EC said that Vodafone and Unitymedia – Liberty Global's German unit – currently compete against each other in areas served by Unitymedia via cable on the retail fixed telecoms and TV markets.

The regulator noted it is concerned the transaction would eliminate competition between the merging companies, reduce the number of players and limit the merged entity's incentives to compete effectively with the remaining operators. The proposed deal could also harm competition in terms of investment in next generation networks and may “substantially increase” the bargaining power of the merged entity vis-à-vis TV broadcasters.

This, in turn, the EC said, could negatively impact these broadcasters' ability to stay competitive and to invest.

Also, in the Czech Republic, the EC said providers of standalone telecoms services could be shut out from the retail markets for mobile, internet access and TV, given the converged products that the merged entity could offer.

Elevated leverage

In the meantime, M&A activity could affect some issuers' credit profiles, due in large part to higher levels of incurred leverage. The market further anticipates continued high levels of capital spending into 2019, as firms continue to invest in 5G network-related research, development and deployments.

Certain companies are already pressured by elevated leverage, including UK-based Vodafone Group and Germany’s Deutsche Telekom (ETR:DTE). These firms’ financial and operational well-beings are further susceptible to the uncertainties over Brexit and domestic growth.

Competition is another factor that is likely to lead to a negative impact on some firms’ creditworthiness.

(Click on image to enlarge)

Moody's Investors Service, for example, recently cut its ratings on Altice Luxembourg, Altice France and Altice International one notch further into junk status to ‘B2’ from ‘B1’, with a negative outlook, based on the group’s strategy to combat its rivals.

Moody’s analyst Laura Perez said the downgrade reflects her expectations that revenue and EBITDA will decline over the next 12 months, mainly driven by “intensified competitive pressure in France's telecom sector."

Perez continued that Altice is reducing debt by selling infrastructure assets, which include critical towers and fiber – “positive for the group's liquidity at a time when its cash flow generation is weak. She added that “selling these infrastructure assets increases the group's complexity and reduces its operational flexibility when compared with a full ownership model."

While Moody's expects Altice Luxembourg's gross adjusted leverage to decline from 5.8x in 2018 to 5.1x by 2020 driven by these disposals, the group's underlying leverage will remain at an estimated 5.5x-5.6x, after taking into account greater economic operational liabilities from towers and the pro-rata consolidation of off-balance sheet vehicles.

Market participants’ perceptions of Altice’s creditworthiness have recently waned, with spreads on the company’s five-year credit default swaps roughly 3.7bps wider on the day Tuesday to nearly 413bps. Over the past three months, Altice Finco’s, Altice France’s and Altice Luxembourg’s five-year CDS have gapped wider by around 117bps, 70bps and more than 185bps, respectively.

Altice Luxembourg’s 7.75% U.S. dollar-denominated notes due May 2022 have also lost almost 11.3% of their value since setting a 52-week high of 106.25 on June 18.