Industry Trend Analysis - O2 Sale An Upscaling Opportunity For Some - APR 2018

BMI View: There would be no shortage of prospective buyers for O2, should Telefonica decide to sell. The business is, however, a long way from being a major player in the converged services market and would be better positioned as a mobile-focused proposition, leaving its wireline assets to be picked up by a stronger multi-play provider.

Reportedly, Telefonica is considering the sale of its German unit, Telefonica Deutschland (O2), in order to refocus on its more profitable UK and Spanish businesses. Growth of the unit's wireline business has not been as rapid as Telefonica would have liked, despite forays into converged services and advanced offerings such as smart home solutions. Rivals Telekom Deutschland and Vodafone are better positioned in that regard and cannot be displaced. We believe there is better value still to be unlocked in O2's mobile business if it can focus on the segments of the market that demand premium non-voice services but without a convergence element. The wireline business could be sold off separately as regional players and stronger convergence providers would value it highly.

Wireline Is O2's Weakness
O2 Deutschland Key Financial Indicators, 2015-2017
Source: Telefonica Deutschland

At the end of 2017, O2 served 2.282mn wireline voice and 2.072mn Internet and data subscribers, numbers that only modestly improved year-on-year. Although the company reports success in upgrading customers to very high speed fixed broadband connections using VDSL and vectoring technology, uptake is mostly coming from its existing user base and market expansion has been limited. With Telekom owning the largest xDSL network in the country and Vodafone augmenting its extensive cable networks with DOCSIS 3.0 technology, O2 was always going to struggle to be relevant as a wireline player.

O2's telecoms revenues have been declining steadily in recent years, with wireline recording the fastest rate of decline. One bright spot has been growth of non-messaging mobile data services and we believe that, shorn of its wireline operations, O2 could appeal to the middle tier of consumers wanting affordable mobile broadband connectivity but not wanting a comprehensive service package. The business has been focusing more on those customers it directly serves, leaving low-cost customers to budget and 'no-frills' providers such as MVNOs. The decline of its mobile ARPU has halted as it focuses more on postpaid but that cannot be guaranteed if it perseveres with its multi-play strategy as convergence is often ARPU-dilutive in nature.

If Telefonica is keen to reduce costs, the sale of the wireline business seems most likely. Telekom would likely be unable to buy it due to its dominance in wireline and the copper infrastructure would not fit with Vodafone's wireline business. We believe minor wireline broadband players such as 1&1 Drillisch and Freenet would welcome the opportunity to buy assets from O2, expanding their reach faster than would be possible through building their own networks. Drillisch is moving upmarket after acquiring 1&1 in 2017, and it is an aspiring premium mobile services player. However, we do not believe it would be able to easily absorb Germany's third-largest mobile player and the profile of its target audience does not match that of O2. Similarly, Freenet is more interested in low-cost wireline broadband than in mobile and would only be interested in the wireline assets of O2.

However, if Telefonica is keen to exit Germany altogether, a potential buyer of the whole business would be UPC Deutschland. The Liberty Global-owned UPC group is on an acquisition tear at present and current merger discussions with Vodafone have identified Germany as a potential stumbling block owing to the expectations that a merged Vodafone-UPC would dominate the German converged services market. If Vodafone Germany is omitted from any deal - as seems likely - UPC could still upscale in Germany through buying O2. UPC is already present in the mobile space as a reseller and its wireline activities are relatively small and would not dominate the market after any deal is concluded.

O2 Would Bolster UPC
UPC Germany Key Performance Indicators
Source: Liberty Global Inc

Alternatively, there are numerous regional broadband players that might see value in O2's VDSL-enhanced wireline assets, complementing their own xDSL and fibre investments and providing an opportunity to expand beyond their regional footprints. However, most of these candidates - which include players such as Inexio - are looking to the future with fibre; O2's copper-based networks would merely be a short-term means of expansion rather than a long-term investment and so would be less likely to offer the kind of bids Telefonica would be looking for.

One of our key views for 2018 is that developed markets will continue to coalesce around two or three major players per market and the pace of consolidation will pick up. The prospects that O2 might be sold indicate that even the most mature markets such as Germany are not exempt from this trend.