Vodafone (LSE:VOD) and Three UK, the UK’s third- and fourth-largest mobile operators have announced a merger agreement. Could this be the start of a turnaround for the embattled income stock?
Vodafone’s problems
As a business, Vodafone has had a number of issues. Some of those are specific to the company, but I’d argue its biggest issues are to do with the environment in which it operates.
First, telecoms is a capital-intensive business. Operators are constantly faced with high fixed costs and a need to invest more cash in their assets.
Second, the industry is somewhat commoditised. In the UK, for example, Vodafone competes with EE, O2, and Three with little to differentiate it from a customer perspective.
This means the most important issue for customers is price. And a third problem is its competitors appear determined to win at all costs, reducing returns for everyone.
In a market like this, what Vodafone needs is a competitive advantage. Until now, this has been conspicuously lacking, but news of the merger might be about to change that.
A solution
According to reports, Vodafone has agreed a deal to combine its UK operations with Three UK, currently owned by CK Hutchison. Doing so would create the UK’s largest mobile network.
The deal hasn’t been approved by regulators yet and there’s a chance it might not be. But if it goes through, it could be a significant boost for the company.
From Vodafone’s perspective, there are two main benefits. First, it would remove a major competitor, reducing the intensity around price competition.
Second, it would give the combined company greater scale than either has individually. This might help it reduce its own costs, giving it the kind of advantage it has been lacking.
It’s therefore understandable that Vodafone’s shareholders might view this positively. But it raises some other issues for investors to consider.
Investment thesis
I think there are two potential downsides for shareholders to consider. The first is that joining with Three might reduce the chances of the company being acquired itself.
Some of Vodafone’s major shareholders are other telecoms companies. And this has had stock market participants speculating a takeover offer might be coming.
Joining with Three probably makes this less likely. So investors hoping to be bought out at a premium might have to rethink their thesis.
There’s also a question of what the proposed arrangement means for the dividend. The 10% yield has seemed unsustainable to me and more shareholders on board makes this even more likely.
A stock to buy?
I think the announcement is positive news for Vodafone as a company and increases the intrinsic value of its shares. But there’s too much uncertainty for me to invest right now.
Will the deal go through? Will it give the company enough of a competitive edge? Does the merger make an acquisition less likely? What does the future of the dividend look like?
To me, these are all key questions. So I’ll wish Vodafone shareholders the best of luck with their investment, but I’ll be cheering them on from the sidelines for the time being.
This post was originally published on Motley Fool
