4.42 Some stakeholders have raised concerns that the profitability of the UK mobile sector is low in comparison with that of mobile sectors abroad. For example, it has been noted that operators’ EBITDA margins are lower than in some other international markets and that, as a result, multinational operators may be more likely to invest elsewhere. It has also been argued that operators’ returns on capital employed (ROCE)59 have fallen significantly over time and are below the industry’s cost of capital. We note some stakeholders’ arguments that our approach to regulation may have contributed to such outcomes.
4.43 Research by WIK-Consult suggests that UK mobile operators’ EBITDA margins are lower than those in a range of comparator countries60. However, independent analysis also suggests that, in general, European operators’ ROCE is not below the industry’s cost of capital. For example, New Street Research’s61 analysis suggests that, whilst overall EU mobile sector ROCE has halved from c20% in 2010 to c10% in 2015, it still exceeds the industry’s cost of capital. Our own analysis (set out below) suggests that the UK mobile sector is earning returns above its cost of capital within the current market structure and regulatory environment. In some cases, mobile operators are earning returns significantly higher than the cost of capital.
4.44 A key consideration in policymaking is the effect of regulation on operators’
anticipated returns on efficient investment, and the implications for potential future investment. The most important consideration for companies that are not capital- constrained is whether future investments will make what shareholders would consider to be an adequate return.
4.45 ROCE is a measure of the profitability of historic investments, which can be
compared to the cost of capital. With appropriate adjustments to make this measure
59
Returns on capital employed (ROCE) is a measure of the relative profitability of companies, taking into account the amount of capital they use.
60
WIK-Consult, Competition & investment: An analysis of the drivers of investment and consumer welfare in mobile telecommunications, July 2015, p.43:
http://stakeholders.ofcom.org.uk/binaries/consultations/dcr_discussion/annexes/Competition_and_inv estment_mobile.pdf
61
New Street Research, European Telecoms Review, October 2014. New Street Research’s more recent estimates, provided to Ofcom, suggest that EU mobile sector ROCE fell from c21% in 2010 to c11% in 2015.
forward-looking, ROCE is a useful indicator of an operator’s incentives to invest if the operator is not capital-constrained.62
4.46 With regard to some stakeholders’ concerns that mobile operators’ ROCE is below their cost of capital, we note that such calculations can be sensitive to the operator’s accounting treatment of assets with a current value substantially lower than their historic value (e.g. spectrum licences). They can also be sensitive to the treatment of intangible assets created at the time of a merger (e.g. goodwill) rather than through capital investment in the business. Without appropriate adjustments, these
calculations may not reflect true underlying returns on actual investment.
4.47 An example of the adjustments needed to use ROCE as a forward-looking measure of operators’ profitability is the treatment of 3G spectrum licences. These were
purchased in 2000 for over £4bn in each case. Accounting spectrum costs at too high a level would be likely to distort any forward-looking measure of profitability
significantly. Today, the value of the licences on operators’ balance sheets is still a significant proportion of their initial cost, although it is widely accepted that their current value is lower than that cost. Investors would expect that the future costs of this spectrum (either to replace the spectrum, or the costs of paying future annual licence fees) would be based upon a current, lower valuation. Adjusting both the asset valuation and depreciation to reflect the current value of spectrum provides a better indication of forward-looking profitability.
4.48 When calculating operators’ forward-looking profitability, replacing historic spectrum licence costs with estimates of future costs and excluding the value of certain intangible assets where appropriate, such as goodwill, has a positive effect on the calculation of forward-looking adjusted ROCE.
4.49 By way of example, we undertook analysis of EE’s adjusted ROCE based on publicly available information on its recent financial performance. We used EE’s results as EE has published a significant level of detail about the valuation of its assets. In doing so we calculated its capital employed on the basis of adjustments to figures in its
statutory accounts, as appropriate for calculating forward-looking profitability. For example, our adjustments excluded certain intangible assets (goodwill and customer relationships) that were not likely to have an accounting value corresponding to capital invested in the business.63 We also adjusted the value of 3G spectrum licence assets to match their estimated current value.64 On the basis of appropriate
62
In general it is appropriate to take into account the incentives of unconstrained investors, as a governance structure that constrains capital investment in otherwise profitable investments may not best deliver investor value, or good consumer outcomes.
63
EE’s annual report for the year ended 31 December 2014 includes intangible asset values for goodwill (net book value = £5,692m at 31 December 2013) and for customer relationships (£1,216m at 31 December 2013). Each was calculated at fair value at the time of Orange and T-Mobile’s merger. Customer relationships were subsequently amortised, and that amortisation charged to the P&L.
64
The value we used for EE’s 3G 2.1GHz spectrum was £11.07m per MHz, which for EE’s 2x20 MHz allocation gives a gross value of £443m. The figure of £11.07m per MHz is used in our model for the mobile call termination market review for the period 2015-18. See Mobile call termination market review 2015-18 statement, March 2015, Annex 11, p.131:
http://stakeholders.ofcom.org.uk/binaries/consultations/mobile-call-termination-
14/statement/Annexes_7-13_final.pdf. This total value (£443m) is considerably lower than the c£8bn paid by Orange and T-Mobile for the spectrum and the gross book value in EE’s statutory accounts for its 3G spectrum (£3,682m at 31 December 2012).
adjustments, we calculated that EE’s adjusted ROCE in the calendar years 2012 and 2013 was c27-28%, significantly above its cost of capital.65
4.50 The published results of the other operators do not provide sufficient detail to perform similar adjustments. However we are not aware of any observable factors that would mean that other operators’ adjusted ROCE would be so much lower than that of EE that their returns would not also be significantly above their cost of capital. Three’s smaller scale could make it more likely to have a lower adjusted ROCE than EE. However, our indicative analysis suggests that, in general, the sector is earning returns above its cost of capital, and in some cases mobile operators are earning returns significantly higher than the cost of capital.