O2 and Virgin Media merger: what you need to know

Telefonica and Liberty Global hope to create a new telecoms giant that can shake up the UK market and rival leader BT Group. We explain everything you need to know about the O2-Virgin Media merger and what the impact could be.

Telefonica and Liberty Global agree to merge O2 and Virgin Media UK

Telefonica and Liberty Global have agreed to merge their respective UK businesses, mobile carrier O2 and broadband provider Virgin Media UK, to create a new telecoms giant that will shake up the UK market.

How will the merger be structured?

The deal will be structured as a 50:50 joint venture rather than a formal merger. It has valued O2 at £12.7 billion, or 7.8x adjusted operating income, and Virgin Media at £18.7 billion, or 9.3x. The combined entity will have an enterprise value of £38 billion.

Liberty Global will make an ‘equalisation payment’ to Telefonica worth £2.5 billion as the deal is being structured as a 50:50 joint venture rather than a formal merger but Virgin Media is worth more than O2. Plus, while O2 is bringing a clean slate to the table, Virgin Media is bringing £11.3 billion worth of debt to the venture. The new venture would start off life with about £18 billion of long-term debt, representing a net leverage ratio of 5.0x.

However, both companies will generate net proceeds from establishing the venture as they both need to carry out a series of recapitalisations, which should generate £5.7 billion for Telefonica and £1.4 billion for Liberty Global. This will include spinning out Virgin Media’s Irish business, which is not included in the deal.

What would the new company look like?

The combined company says it will become the largest telecoms provider in the UK in terms of customers based on 2019 numbers. Together, they will have 46.5 million customers comprised of 32.6 million on mobile, 5.3 million on broadband, 4.9 million on phone and 3.7 million on TV. That would be, according to Telefonica, ahead of BT Group’s 46.3 million customers, Sky’s 22.7 million, Vodafone’s 20.2 million, Three’s 11.6 million and the 9 million at TalkTalk.

The venture will be the second biggest in terms of revenue, operating profit and cash flow, sitting narrowly behind BT. Together, they reported £11.3 billion of revenue last year, £3.6 billion of operating income before depreciation and amortisation, and £1.5 billion in adjusted operating cash flow. Notably, the pair expect the new venture’s financials to improve once synergies are realised.

Virgin Media 2019 O2 2019

Revenue
£4.76 billion Revenue £6.23 billion
Operating income £2.00 billion Earnings before interest, taxes, depreciation, and amortisation (EBITDA) £1.62 billion
Operating free cash flow £751 million Operating free cash flow £819 million

Telefonica and Liberty Global are aiming to deliver £6.2 billion in synergies, which is equivalent to £540 million each year by the fifth year after closing. The majority of that annual run rate, at £430 million, will come from the savings from lower costs and capital expenditure. By combining and cross-selling mobile, broadband, phone and TV services under one roof, the pair hope to boost annual revenue with £110 million of synergies. However, it will have to spend £700 million to achieve those synergy targets.

Who will manage the new venture?

The two companies are yet to formalise the management of the new venture but they have revealed that the chief executive of Liberty Global, Mike Fries, and Telefonica, Jose Maria Alvarez-Pallete Lopez, will be on the board. There will be eight members in total, with four coming from each business.

The chairman of the venture will alternate every two years between a representative of Liberty Global and Telefonica, but it is not yet known who will take up the role first.

When could the O2-Virgin Media deal close and will it secure regulatory approval?

Telefonica and Liberty Global are hoping the transaction will close ‘around the middle of 2021’, after they have completed the necessary recapitalisations and cleared the regulatory hurdles.

Being blocked by regulators remains a threat. Telefonica tried to sell O2 to Three UK in 2015 but that deal collapsed after failing to satisfy regulators, with the Competition and Markets Authority (CMA) claiming it would cause long-term damage. The European Commission formally blocked the deal in 2016.

But there are reasons to be confident that this tie-up will get the go ahead. Firstly, while a merger between mobile carriers has been regarded as off the table, a deal between a mobile carrier and broadband provider will be considered differently. Market leader BT Group’s purchase of EE was given the green light in 2016 – and that could prove crucial to the argument that O2 and Virgin Media should be allowed to join forces.

BT Group has long had an unrivalled position in the market. Its ownership of the Openreach broadband network that spans the country meant it already had a major advantage over its competitors, many of which are forced to rely on BT to provide services. The fact it then managed to buy the largest mobile carrier in the country only strengthened its position and gave it a head start as the telecoms industry consolidates in an aim to ‘converge’ – whereby you bundle together multiple telecoms services like TV, broadband and mobile to squeeze more out of customers and increase loyalty.

BT’s unique position in the market has long made it a target of politicians and has led to a growing argument that it desperately needs competition. It was under the spotlight in last year’s general election, when there were calls for it to be nationalised.

The Conservative win means BT is safe in the hands of investors, for now, but even the pro-business party is aware that a substantial rival could be just what the market needs. For so long, the argument has been how to weaken BT to shore up the playing field – whether that be calls for it to sell off Openreach or go one step further and be nationalised – but the best way would be to strengthen other players in the market.

'Combining O2’s number one mobile business with Virgin Media’s superfast broadband network and entertainment services will be a game changer in the UK, at a time when demand for connectivity has never been greater or more critical.

We are creating a strong competitor with significant scale and financial strength to invest in UK digital infrastructure and give millions of consumer, business and public sector customers more choice and value,' said Telefonica’s chief executive officer (CEO). Although it doesn’t name BT outright, it is clear that providing better competition is a key argument for the O2-Virgin Media deal to be approved.

Any concerns over foreign companies owning vital infrastructure should be null and void considering the existing owners of both businesses are already in foreign hands, with Telefonica being from Spain and Liberty Global the US.

They will also bolster their case by arguing the deal will significantly raise investment in UK infrastructure at a time when the country’s 5G and superfast broadband infrastructure is at stake. The government has been forced to rely on BT to roll out faster broadband networks nationwide and for much of its 5G plans. The new venture intends to plough £10 billion into the UK over the first five years.

What does the deal mean for Telefonica and Liberty Global?

The combination of O2 and Virgin Media makes sense for several reasons beyond creating a stronger and more diversified player in the market.

Telefonica has been key to do something with O2 for years. After failing to offload the business to Three UK, it prepared to float the business in London but that was scuppered as the uncertainty over Brexit weighed on investor appetite. It has been keen to monetise parts of its business because it has a huge debt pile of €37.7 billion, or £32.6 billion. This deal should allow Telefonica to make a serious dent to its debt of between £5.5 billion to £5.8 billion.

O2 is also expected to be able to significant reduce its tax bill and free up cash for investment by taking advantage of Virgin Media’s tax losses that stretch back to when it owned struggling cable businesses.

Liberty Global also expects to benefit. It has been looking for a big new opportunity after cashing in on the sale of its European operations to Vodafone. It will also be able to save cash by having access to its own mobile carrier through O2 as it currently spends around £200 million per year to piggyback off other carriers.

What could it mean for BT Group, Vodafone and other telecom stocks?

The combination of O2 and Virgin Media will give the UK telecoms market a much-needed shake-up. The strategy being employed by most of the large telecoms companies around the world is based around convergence and selling bundled services to consumers, and this deal is just the latest combination of a mobile carrier and a broadband provider. BT has EE and has had a head start over its rivals, while Vodafone splashed out on Liberty Global’s cable assets in Germany and other European countries.

But BT is the only one that has managed to create a whole-package telecoms provider in the UK. Although Virgin Media is arguably BT’s biggest competitor when it comes to rolling-out faster broadband, BT’s dominance looked set to slowly erode Virgin Media’s position in the market over the long-term. The deal should free up cash so Virgin Media can become a viable alternative to BT when discussions about building faster broadband infrastructure are being held.

If the deal goes through then BT is the biggest loser. It not only threatens its monopoly and unrivalled position in the market, but it will lose it other business too. For example, if O2 can piggyback off Virgin Media’s networks then it would no longer have to pay considerable sums to BT to use its national network. Interestingly, Virgin Media is already making gains over BT in this area. If O2 joined the list, then Virgin Media would be providing backhaul services to three out of the four largest telecoms companies in the country – the exception being BT’s EE.

It will also place pressure on others to respond as it dilutes the position of smaller players like Three UK and TalkTalk.

Could rival bidders emerge to disrupt the deal?

The significance of the deal means we could see rival offers put on the table.

Vodafone has long been seen as a potential partner for Virgin Media and the pair already work together in some areas. It has already struck a deal to use Virgin Media’s backhaul services for 5G starting in 2021 and could benefit from the same type of cost-savings and cross-selling opportunities that O2 is hoping to achieve. The prospects dimmed after Vodafone splashed out on Liberty Global’s assets but it doesn’t rule out the possibility of Vodafone making an approach and arguing it could represent an even better partner than O2.

The fact Three UK, owned by CK Hutchinson, tried to purchase O2 not so long ago demonstrates there is some level of interest there – but as we have established, regulators might not warm to a merger between two mobile carriers. However, it could look at striking a deal with Virgin Media now that it knows it is open to a deal. Having moved its backhaul services for future 5G services to Virgin Media from BT and others, Three has tightened relations between the two firms over recent years.

TalkTalk, the sixth largest telecoms firm, could feel the need to make a big move to protect itself. TalkTalk shares briefly traded higher when the initial news about O2 and Virgin Media broke on theories that it could become a takeover target in the future if the market’s consolidation continues.

Read more: Can telecoms stocks provide a haven during the coronavirus crash?

How can you invest in O2 and Virgin Media, and will it ever go public?

The structure of the joint venture means O2 and Virgin Media will remain owned by Telefonica and Liberty Global, respectively, with costs and income being shared on an equal basis. This means the primary way to gain exposure to the new company is to invest in these two stocks.

There is a good chance that the O2-Virgin Media business could become a public company in its own right, but not for a while. Either company can trigger an agreement to take the business public after three years. Neither of them can sell their shares in the joint venture for the first five years, but are free to do so after that so long as the other partner gets first refusal.

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