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EU competition commissioner consolidation plans misjudge investment principles

Margrethe Vestager, the EU competition commissioner, has indicated her intention to curtail consolidation in Europe’s telecoms industry by dismissing suggestions that a wave of big mergers is needed to boost investment. Her stance seems to fail to take account of the basic principles of how firms make investment decisions. In order for a mobile operator to invest in increased coverage or faster technologies such as LTE, for example, they need to expect to earn a return on their investment that is above their cost of capital. For many operators, their current return on capital employed is well below their cost of capital – the United Kingdom is a case in point, with average industry returns in low single digits, whilst their cost of capital is in the range of 7 to 9 percent.

To increase investment, operators need to improve their returns. This can be achieved by either increasing profits (by selling more or reducing costs), or reducing their capital employed (reducing fixed assets or reduce working capital). Competition, especially from Over the Top players such as Skype, What’s App and Facebook, have prevented mobile operators from increasing revenues. The industry has therefore been in a process of constant restructuring and cost reduction for the last ten years, and so an improvement in returns is not likely to be achieved through increasing profits.

Operators’ only option is therefore to reduce their capital employed. Working capital is insufficiently large to have a material impact on returns, and so this only leaves a reduction in fixed assets. Mergers, along with network sharing, are one of the few options that operators can take that would make a material difference to their returns, raise them above their cost of capital and hence promote investment.

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