Merging companies typically extol the universal benefits of their marriage in statements designed to win over dubious watchdogs. Shareholders will prosper, services will improve, 5G will quickly spread across the land, bringing a banquet of high-speed goodies to end the technology famine. There was some of this in Vodafone's recent notice about merger talks with Three, a UK rival. But the potential deal was sold mainly as an operation to save two companies with long-term health issues. Both firms, said Vodafone, "lack the necessary scale to earn their cost of capital."

For months, Vodafone CEO Nick Read has been highlighting a metric known as return on capital employed (or ROCE, for short) to prove his point. That is unusual. ROCE rarely receives a mention in telcos' earnings updates or annual reports, and Light Reading was rebuffed when it asked for a country-level breakdown from Deutsche Telekom, Europe's biggest operator (which does publish an aggregate figure in its annual reports). But ROCE is commonly used by investors to figure out how much profit a company is generating for each dollar of capital it employs. Across Europe's uber-competitive telecom markets, and not just in the UK, it is often lousy.

Figure 1: Vodafone CEO Nick Read is no fan of the four-player set-up.
(Source: Vodafone)

To calculate ROCE, analysts usually divide operating profit (or earnings before interest and tax) by capital employed, determined by subtracting current liabilities from total assets. The resulting figure, typically expressed as a percentage, needs to be assessed against the cost of capital. Investors normally rely on a formula for the weighted average cost of capital (or WACC), which considers factors like the market value of equity and debt, the cost of equity and debt and the corporate tax rate. If ROCE is lower than the cost of capital, the long-term outlook is bleak.

This was noted in a paper published earlier this year by Ofcom, the UK telecom regulator. To Read's evident satisfaction, Ofcom's own calculations show that ROCE for both Vodafone and Three was below the cost of capital (as calculated by Ofcom for a UK mobile operator) in both 2019 and 2020. If that trend persisted for any operator, "this could dampen its incentive to invest," said Ofcom.

Figure 2: Economic ROCE by mobile operator, pre-tax nominal (Source: Ofcom)

As far as Read is concerned, the blame lies with the long-running European opposition to mergers. For years, authorities have blocked deals that would reduce the number of mobile operators in a country from four to three – or allowed mergers while inviting in new entrants. The more operators per country, the fewer customers there are per network. Smaller companies cannot cover their costs, as the ROCE data shows.

It is not just Read who has reached this conclusion. One source in the investor community broadly agrees with the Vodafone CEO's assessment. "I would say the ROCE is typically lower in four-player markets versus three-player markets," he said, asking not to be named. The logic is not hard to fathom, either. Licensed nationally, mobile operators must hit certain coverage thresholds for regulatory and competitive reasons. The smallest faces roughly the same investment challenge as the biggest but has less money to pay for it.

Between a ROCE and a hard place

The ROCE problem is now endemic in Europe. Data obtained by Light Reading shows the figure is in decline and below the cost of capital in numerous countries. At a group level, Deutsche Telekom's ROCE fell from 5.8% in 2017 to 4.1% last year. The German incumbent does not publish its WACC, and says it expects ROCE to be slightly above this undisclosed figure for 2022. But a Barclays report from June this year said operators in France, Italy, Spain and the UK were on average failing to cover their costs. Germany – currently the only three-player market in the mix – was the sole exception out of Europe's five biggest countries.

Barclays' calculations show ROCE for these five countries plummeted by five percentage points between 2016 and 2021, to just 4.5%, as operators pumped money into fiber rollout while sales and earnings were being squeezed. The situation is direst in the southern European markets of Italy and Spain, and especially the former. ROCE there had sunk to just 2% last year after falling by ten percentage points since 2016. Not a single Italian network earns its cost of capital, according to Barclays.

Figure 3: Deutsche Telekom's ROCE (Source: Deutsche Telekom)

Even in Germany, there is cause for concern. Through a mobile subsidiary called 1&1, United Internet has until now been functioning as a mobile virtual network operator, renting capacity from Telefónica Deutschland to offer services. But after securing its own spectrum licenses in the most recent airwaves auction, 1&1 is now building a fourth German network. Barclays remains optimistic about the German outlook but says 1&1's entry "could cap ROCE progression."

The data seems a compelling sign of a structural problem in European telecom, especially considering the juxtaposition of profitable three-player Germany and the other failing four-player markets. Regional and national authorities have continued to resist merger activity on the grounds that it would limit competition and hurt consumers. But if network investment dries up, as Ofcom this year recognized it could, nobody will be rejoicing.

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— Iain Morris, International Editor, Light Reading