Vodafone and Three merger is blessed, but much could go wrong

After a regulatory review that has lasted a year and a half, and a recent shortening of the odds on the likelihood of a deal, the UK has finally lost its faith in the sanctity of a four-player mobile market and allowed its convergence to three. Approval this morning of the mega merger between Vodafone and Three, the country's third- and fourth-biggest operators, allows them to create a new market leader with a vast swathe of 5G spectrum, a presence in both the UK's network-sharing joint ventures (JVs) and – for now – about twice as many mobile sites as either BT or Virgin Media O2 (VMO2), its rivals.

Unsurprisingly, then, it is a controversial decision by the Competition and Markets Authority (CMA), one vehemently opposed by BT, the incumbent, which had unsuccessfully pushed for more stringent "structural" remedies of the kind normally attached to such deals.

The CMA did consider forcing Vodafone and Three to relinquish spectrum. It also took a long hard look at those JVs, after it first recognized that one company straddling both camps would be a problem. But an offer by Vodafone and Three to sell an undisclosed quantity of spectrum to VMO2 seemed to address the CMA's concerns about a possible frequency imbalance between telcos, if not BT's. Eventually, the CMA decided – to BT's disgust – that Vodafone-Three's role in MBNL, the JV between BT and Three, as well as Cornerstone, the arrangement between VMO2 and Vodafone, was not such a problem after all. More likely, it was simply flummoxed by the difficulty of untangling those JVs.

Vodafone and Three had positioned their deal as a lifesaver operation, seizing on data from Ofcom, the UK telecom regulator, that appeared to show neither was able to cover its costs. Licenses required each to maintain a nationwide network and yet neither had enough customers to earn a decent return on that investment. Despite at first insisting both telcos would remain commercially viable in the absence of a deal, the CMA ultimately seemed to buy the logic. A promise by Vodafone and Three to invest £11 billion (US$14 billion) in a state-of-the-art 5G network was persuasive.

Be on your best behavior

Under standard economic theory, however, companies have less incentive to make improvements when rivals disappear. For years, BT continued to sweat its copper assets, resisting an upgrade to the full-fiber networks more widely deployed in other European countries. That only changed when private equity-backed "altnets" piled into the UK broadband sector, threatening BT's business.

To counter the risk Vodafone-Three reneges on its £11 billion investment pledge, the CMA has opted for less orthodox "behavioral" remedies as a condition of the deal. Besides requiring the new operator to cap prices for lower-spending customers over the first three years, it will also have Ofcom supervise the rollout of 5G. At regular intervals, the operator must show it has put spectrum into use across a certain percentage of the network.

There are various problems with these remedies, which will smack of the Soviet-style command economy to critics. The first is the misleading nature of the £11 billion pledge. A footnote in Vodafone's original press release shows this really refers to combined capital expenditure, rather than the sum intended solely for a 5G upgrade. Moreover, an annual investment of £1.1 billion ($1.4 billion) would be £400 million ($509 million) less than Vodafone and Three spent together in 2022.

Their £1.5 billion ($1.9 billion) that year was, of course, spread across networks comprising about 36,000 mobile sites. After the merger, they plan on decommissioning about 10,000 of those sites. But this will inevitably gobble funds. Even if those can be minimized, the annual per-site capex figure is only marginally higher under the £11 billion, 26,000-site plan than it was across the Vodafone and Three footprints in 2022.

The expectation is that Vodafone and Three will concentrate their decommissioning efforts on the MBNL estate, making Vodafone's Cornerstone sites the main foundation of the new network. Yet Three cannot simply ignore its MBNL contractual obligations, according to BT. Under those, site rental and maintenance costs are shared. If Three has to keep paying them even when it has decommissioned equipment, its bill could soar.

A profusion of suppliers

The combined networks also bring a messy jumble of vendors and a philosophical clash. Technology executives within Three remain unpersuaded open radio access network (RAN) technology – which allows telcos to combine different vendors at the same site – is ready for mass-market deployment. Vodafone, however, is fanatical about open RAN and due to replace about 2,500 Huawei sites with open RAN technologies, provided mainly by Samsung.

Three, meanwhile, uses perhaps a bigger number of RAN vendors than any other country operator in Europe, including Nokia (3G), Samsung (old 4G), Huawei (new 4G and 5G) and Ericsson (also new 4G and 5G). Huawei is being phased out under government orders, and 3G is due for imminent switch-off, but this rationalization of suppliers also carries a cost. The likely outcome is that Vodafone-Three will be heavily reliant on Ericsson, currently Vodafone's main RAN vendor, except at those 2,500 open RAN sites. It is hardly the picture of RAN diversity.

Circumvention of the behavioral remedy remains a risk, the CMA acknowledged in a report published only a few weeks ago. The operators could, for instance, invest in lower-cost microcells to realize the targets monitored by Ofcom. The regulator cannot mandate the use of a specific category of macrocells because these would be inappropriate in some locations. An alternative would be to attach minimum power requirements to each 5MHz of spectrum put into service, the operators have suggested. But the deal has been given the green light before these and other concerns have been adequately resolved.

Telecom's days as a growth story are long over and there remains little consumer appetite for spending more on 5G, which has been a commercial disappointment for telcos since its launch in 2019. The worst-case scenario for Vodafone-Three is an economic downturn. By setting firm targets for site upgrades, the behavioral remedy will effectively prevent Vodafone-Three from reducing capital expenditure, as companies would typically do in response to a slump.

Earlier such mega deals have not been transformative for the companies involved. In the UK, they include BT's takeover of mobile operator EE in 2016 and Virgin Media's merger with O2 in 2021. BT's share price has fallen 68% since early 2016, while Liberty Global, one of VMO2's parents, is down 47% since mid-2021. The pre-Christmas champagne may be flowing at Vodafone and Three today, but the fizz could quickly fade.