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Vodafone - UK arm merging with Three UK

Vodafone has agreed terms with Three UK owner, CK Hutchinson, to merge their UK telecoms businesses. The combination of Vodafone UK and Three UK...

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Vodafone has agreed terms with Three UK owner, CK Hutchinson, to merge their UK telecoms businesses. The combination of Vodafone UK and Three UK will create a new entity, with Vodafone retaining a majority 51% share.

This is a non-cash deal, expected to generate more than £700m of annual cost savings by the fifth full-year post-completion. In the first five years, integration costs are expected in the region of £500m.

Terms within the deal allow Vodafone to acquire up to 100% of the new entity after a three-year lockup period, subject to certain valuation-based conditions.

The Transaction is expected to close before the end of 2024, subject to regulatory and shareholder approvals.

The shares were up 2.6% shortly after the announcement.

View the latest Vodafone share price and how to deal

Our view

The merger of Vodafone's UK arm (14% of Group service revenue) with Three UK is a deal that'll see the third and fourth biggest players create a new dominant force in the market. Negotiations haven't been easy, and the process has felt like a fairy tale at times, but the new joint entity will provide both parties with a renewed sense of vigour in a market that's tricky to excel in - assuming the regulators give a green light, which is by no means a given.

The wider story is one of lacklustre performance. Higher energy costs and continued weakness in Germany meant underlying cash profit came in below the recently downgraded company guidance in May's full-year results.

Sales in the telecom sector should be relatively robust, as broadband and mobile services are hardly optional. Yet, over the last ten years, telecom giants have had to pump huge sums of cash into building out fibre networks and snapping up parts of the 5G spectrum. The main challenge has been the low sales growth relative to spending when you look at telecoms compared to other sectors.

Vodafone's not only had the structural headwinds to battle, but it's also been underperforming versus peers on a relative level. Service revenue growth and customer satisfaction in key areas like Germany, Italy and Spain have struggled to keep pace with peers.

In response, Vodafone has outlined an evolved strategy. Initiatives include cutting around 11,000 jobs over the next three years, streamlining operations and focusing on growing the Vodafone Business division which has been a shining light.

We welcome the change, but there's a lot to do.

Service revenue growth is slowing in many of the most important markets across Europe. The key market of Germany is a perfect example of the challenges at hand. After more than €20bn of investment, growth trends continue to decline. IT systems have been slow to adapt to new regulation, and network performance continues to lag competitors. A new management team in Germany is in place, which we support, it now needs to deliver.

Outside Europe, the Vodacom subsidiary has some exciting growth opportunities in Africa, including M-Pesa which offers mobile financial services. Vodacom's targeting mid-high single digit cash profit growth over the next few years. Africa could become increasingly important as the region develops, and Vodafone's leading position in several markets means it's well positioned to benefit.

There was a positive move in net debt, which was €33.4bn last we heard - sitting in a range the new CEO says she's comfortable with. For us, it's still a little lofty and, while operating cash flow is stable, cash demands are high. We aren't immediately concerned about the dividend. Free cash flow for the new year is expected to cover the dividend payments, but when forward yields are around 9.7%, caution is advised. Remember, no dividends are guaranteed.

All-in-all then, while we think the portfolio changes and new strategy make sense, the fundamental challenges that go with being a telecom remain. And with growth hard to come by, we'll need to see sustained positive progress before getting too excited.

Vodafone key facts

All ratios are sourced from Refinitiv. Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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Written by
Matt Britzman
Equity Analyst

Matt is an Equity Analyst on the share research team, providing up-to-date research and analysis on individual companies and wider sectors.

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Article history
Published: 14th June 2023