The U.K. Fixed Broadband Market Will Start To Pick Up From 2021

After three years of declining revenue, things are looking up for the U.K. fixed broadband market. We expect a slow recovery over 2021 and 2022, as pandemic headwinds ease and telecoms companies (telcos) upsell gigabit-speed broadband following network upgrades to data over cable service interface specifications (DOCSIS) 3.1 and fiber to the premises (FTTP). Such sales could more than offset the adverse effects of market saturation.

However, we expect an uptick in customer churn and pressure on average revenue per user (ARPU) from the practice of end-of-contract notification, which increases the number of lower-priced offers a provider makes to retain its customers when they reach the end of their contracts. In addition, a no-deal Brexit could subdue the pick-up in corporate and consumer spending on fixed telecoms services.

The decline in the U.K. fixed broadband market started in 2018 and continued throughout 2019, despite significant growth in data consumption (see charts 1 and 2).

Chart 1

Chart 2

The decline was due to market maturity and an intensification of competition, especially from Vodafone Group PLC (Vodafone) and TalkTalk Telecom Group PLC (TalkTalk). Competition increased partly because U.K. regulator Ofcom adjusted the price of telcos' access to fiber broadband of up to 40 megabytes per second (mbps). Ofcom cut the fees that BT Group PLC's (BT's) wholesale network division Openreach can charge telcos by roughly one-third over 2018-2020. Subsequently, TalkTalk and Vodafone undercut BT's price for 36 mbps broadband. The price difference is effectively about 15%-20% for 67 mbps broadband (see table 1), for which TalkTalk and Vodafone have volume discount agreements with Openreach.

Table 1

Weakness in the fixed market this year is due to revenue erosion during the pandemic. BT took a hit to its televised sports, small-to-midsize enterprise, and wholesale revenue. An inability to increase prices has pressured ARPU for Virgin Media Inc. On the other hand, the impact from end-of-contract notification has been lower than we expected due to lower customer churn during the pandemic.

Network upgrades will bring long-term benefits

Upselling gigabit-speed broadband is an important factor in the market's recovery. Virgin Media has the greatest potential to upsell gigabit-speed broadband in the short-to-medium term, as it is on track to bring DOCSIS 3.1 gigabit speeds to its entire network of 15 million premises by the end of 2021. Of these, 14.3 million are hybrid fiber coaxial and 0.7 million are FTTP.

In addition, in May 2020, Openreach announced an accelerated FTTP target of passing 4.5 million premises by March 2021 and 20 million premises by the mid-to-late 2020s, subject to it obtaining the necessary critical enabling factors. As of Sept. 30, 2020, Openreach's FTTP footprint was 3.5 million premises. This FTTP investment will erode Virgin Media's speed advantage over time, supporting BT's customer retention, as well as Openreach's revenue through customer upgrades.

Although telcos' high capital expenditure (capex) on network upgrades will weigh on their free cash flow generation over the short-to-medium term, we anticipate that this investment will secure an attractive and predictable return in the long term. We view Ofcom's regulatory framework as supportive, since we expect it to permit a fair return on FTTP investments prior to any regulatory intervention. Moreover, Ofcom recently announced that it intends to forgo fiber price regulation for at least 10 years on higher-speed services (over 40 mbps for downloads and 10 mbps for uploads). BT expects a 10%-12% return on its FTTP investment at the wholesale level.

The investments by Virgin Media and BT, along with other companies rolling out FTTP--including City Fibre, Hyperoptic, and Gigaclear--will help the U.K. move toward the government's target of gigabit-capable broadband coverage of a minimum of 85% of the country by 2025. While the U.K.'s gigabit-capable FTTP and DOCSIS 3.1 coverage lagged well behind Germany, Italy, France, and Spain in 2019 (see chart 3), it has grown significantly in 2020 and will continue to do so over the coming years.

Chart 3

The U.K. Mobile Market Will Start Recovering In 2022

The U.K. mobile market is also entering calmer waters. We expect revenue to stop declining as quickly in 2021, before slowly increasing in 2022. We anticipate that pandemic headwinds (particularly for roaming revenue) will ease, and pressure on ARPU will abate, supported by rational pricing and customer moves to larger data allowances. We also consider that the merger between Virgin Media and O2 (owned by Telefonica S.A.) will likely put an end to Virgin Mobile's aggressive offers, which could help prices recover. At the same time, however, the merger could offer more attractive bundled prices than O2's stand-alone prices.

The brighter outlook for the U.K. mobile market follows three years of decline, despite growth in data consumption (see charts 4 and 5, showing the decline in 2018 and 2019).

Chart 4

Chart 5

The decline in 2018 and 2019 was characterized by a fall in ARPU, partly due to the increased take-up of SIM-only plans and more aggressive data offers (see table 2), especially from O2 and Three (owned by CK Hutchison Group Telecom Holdings Ltd.).

Table 2

The pandemic hit the mobile market hard in 2020. In particular, roaming revenue for all mobile network operators (MNOs) has fallen significantly. Handset revenue has also declined materially for Vodafone and EE Ltd. (part of BT), while surprisingly, it has continued to grow for O2. However, O2 saw a steep decline in its prepay customer base, reflecting retail store closures and reduced customer activity during the lockdown. Still, the overall decline in roaming and handset revenue has only reduced earnings modestly. This is thanks to an offsetting reduction in roaming costs and the low-margin nature of handset sales.

The recovery will be muted until new 5G uses are introduced

The recovery we expect in the U.K. mobile market is limited by a shift toward unlimited data offers and a lack of monetization of 5G (see table 3). The potential for generating 5G revenue is more promising over the long term from new uses, such as Internet of Things-connected devices and services, but this is beyond our forecast horizon. In addition, despite carriers' attempt to apply a "more for more" strategy to grow mobile service revenue, we think the competitive environment--along with customers' use of more fixed rather than mobile data due to the pandemic--will lead the market to offer "more for the same", meaning limited upside for retail service revenue.

Table 3

U.K. MNOs will continue to invest heavily in rolling out 5G over the next few years. The U.K. government's proposal to remove Huawei equipment from 5G networks by the end of 2027 will increase capex further for BT, Vodafone, and Three. BT estimates that compliance with the proposal will cost it £500 million, as it first announced in January 2020, but the nearly seven-year timeline will help it spread the cost.

In our view, the upcoming 5G auction in January 2021 is unlikely to be aggressive. We understand that Ofcom is targeting investments in 5G coverage rather than maximizing auction proceeds. We therefore anticipate relatively moderate spectrum investments by MNOs. In BT's case, we assume an investment of about £1.0 billion-£1.4 billion.

We do not view possible health concerns related to 5G as a meaningful risk to the rollout in the U.K. We understand that Ofcom takes Public Health England's (PHE's) recommendations into account in managing radio waves, and PHE has found no evidence that 5G poses any new health risks compared to previous mobile technologies.

The U.K.'s Low Uptake Of Converged Services Might Limit The Benefits Of The Virgin Media-O2 Merger

The merger of Virgin Media with O2, due to close in mid-2021, will establish a solid No. 2 converged player behind the incumbent BT. We anticipate stronger medium-term growth prospects from the combination of two premium telecoms brands, the cross-selling of services to customers, reduced customer turnover, and increased competitive strength in the U.K. telecoms market over the longer term. Nonetheless, the benefits stemming from the merger might be limited by the U.K.'s low uptake of converged fixed and mobile services compared with many other European markets (see chart 6). The lack of significant discounts for convergent fixed and mobile offers--which limits convergence mainly to premium customers--exacerbates the situation.

Chart 6

The Virgin Media-O2 merger will attempt to drive up the U.K.'s fixed-mobile convergence (FMC) penetration rate, as the VodafoneZiggo Group B.V. joint venture did in the Netherlands. VodafoneZiggo's share of FMC connections rose from about 15% pre-merger in 2016 to about 40% in 2019 post-merger, according to consultancy and research firm Analysys Mason.

Pay-TV Revenue Will Recover In The Short Term But Faces Structural Pressure

We forecast a short-term recovery in pay-TV revenue as sports revenue picks back up and prices increase. If periodic lockdowns occur in the first half of 2021, we expect football fixtures to still go ahead, as they did in November 2020, but the recovery in revenue from pubs and clubs could be subdued. Nevertheless, pay-TV revenue is under long-term structural pressure as the number of pay-TV households dwindles.

The decline in the number of pay-TV households in the U.K. started in 2018 and continued in 2019, with drops of 3% and 4% in those years respectively, and we estimate a similar rate of decline in 2020. On the other hand, the number of U.K. households accessing subscription video on demand (SVOD) services such as Netflix and Amazon Prime Video has risen rapidly, meaning there are now more SVOD households than pay-TV households in the U.K. (see chart 7).

Chart 7

The recent decline in pay-TV households in the U.K. has been the fastest in Europe, according to data, consulting, and research firm Strategy Analytics, and only slightly lower than in the U.S. This points to the maturity of the U.K. pay-TV market, as well as an increasing propensity for cord-cutting, that is, transferring from pay-TV services to SVOD, rather than just subscribing to SVOD as an add-on service, particularly among households that do not subscribe to sports content. An additional challenge for U.K. pay-TV providers relative to their European peers is the absence of differentiation between pay-TV and SVOD platforms in terms of local language content. In France, for example, the amount of French language content on pay-TV platforms exceeds that available on SVOD platforms. In addition, a pay-TV subscription is not necessary to watch content from public service broadcasters such as the BBC. Public service content has remained consistently popular; its share of broadcast TV viewing was 51%-52% in 2012-2018 and over 55% in the first half of 2020, according to Ofcom.

Despite the decline in the number of pay-TV households, U.K. pay-TV subscription revenue still managed to increase by 0.75% to £6.4 billion in 2018, as a result of price increases, according to Ofcom. Pay-TV revenue was flat in 2019, adjusted for a change in reporting methodology by Sky Ltd.

However, 2020 saw pay-TV revenue decline, driven by a fall in sports revenue during the pandemic. Sky and BT suspended billing for pubs and clubs during the lockdown in March to August and offered them discounts for the remainder of the year. In addition, the cancellation of sports events in March to May led some consumers to cancel their subscriptions, pause their subscriptions (Sky and Virgin Media), or apply for bill credit (BT). BT and Sky also offered steeply discounted sports packages ahead of the resumption of football fixtures in the summer.

Revenue from pubs and clubs should continue to recover over the medium term, but we expect structural pressure from subscribers continuing to switch from pay TV to SVOD. It is uncertain how long U.K. pay-TV providers can continue to offset subscriber churn by raising prices, as they did in 2018-2019, particularly since newer SVOD players like Disney+ and Apple TV+ offer significantly cheaper services.

U.K. telcos and cablecos can mitigate the impact of cord-cutting on their overall revenue by charging a premium for stand-alone broadband, and then inducing a portion of cord-cutters to buy faster broadband. Hybrid linear and over-the-top solutions, like the Sky Q and Virgin TV 360 set-top boxes, can also support pay-TV customer retention over time by intelligently aggregating content from SVOD services alongside pay-TV content.

In terms of costs, we anticipate that BT and Sky could pay slightly less to secure Premier League rights in the next auction, which could take place next year, given the limited growth in monetization opportunities. There is also a possibility that Amazon.com Inc. could increase its share of fixtures.

The Pandemic Has Hit BT The Hardest, And We Forecast Only A Modest Recovery In 2021-2022

Overall, we expect the U.K. telecoms market to stabilize in 2021, before slightly growing in 2022 (see chart 8).

Chart 8

BT has the highest average rate of decline in revenue over 2020-2022, of 1.8%. This is due to about a 6% decline in 2020, largely due to the pandemic denting fixed and mobile revenue (including handsets), followed by only a modest recovery in 2021-2022. TalkTalk has the lowest average rate of revenue decline in 2020-2022, of 0.3%, thanks to solid growth potential from fiber upgrades and its lack of exposure to a slight mobile revenue decline in 2021. The combined Virgin Media and O2 on a pro forma basis also has a relatively low average rate of revenue decline of 0.4% over the same period. This is thanks to Virgin Media's resilience in 2020 and O2's revenue growth in 2022 from mobile (including handsets) and smart metering services. Cross-selling could also support the combined entity's growth.

The gradual recovery we expect in the U.K. telecoms market over 2021-2022 supports our stable outlooks on BT and the combined Virgin Media-O2 entity, VMED O2 UK Ltd., and our positive outlook on TalkTalk.

Table 4

Fixed: Vodafone comes out on top

Vodafone, growing from a low base, is the standout fixed market performer in 2020-2022, based on our forecasts (see chart 9). Vodafone is adding new broadband customers at a fast pace, about half of which are converged customers, and is also increasing B2B revenue.

For BT and TalkTalk, we anticipate a bounce-back to revenue growth of above 1% in 2021 from a decline of about 4% in 2020, as adverse pandemic effects subside. We assume that BT will benefit from a recovery in televised sports revenue and that both players will benefit from upgrades to faster fiber broadband.

We don't forecast a similar rebound in 2021 for Virgin Media. This follows resilience in 2020 thanks to a comparatively modest decline in cable revenue and strong business-to-business (B2B) growth on account of large dark fiber contracts. We expect B2B growth to offset a continued modest decline in cable revenue, with limited upside since prices are already quite high and most of its customer base has already upgraded to its fastest broadband tiers. Nonetheless, we see Virgin Media as having the potential to upsell gigabit-speed broadband, especially in 2022, as its network upgrade to DOCSIS 3.1 should be complete by the end of 2021. This should help Virgin Media's growth converge toward BT's in 2022.

Chart 9

Mobile: The players are on a level pegging

In the mobile market, we forecast similar trajectories for BT and O2, with revenue declines of about 1% in 2021, followed by growth of close to 1% in 2022. For Vodafone, we forecast a slightly steeper revenue decline of closer to 2% in 2021, followed by slightly stronger growth of about 1.5% in 2022. The revenue trajectories for all players reflect the slow easing of pandemic headwinds, particularly on roaming revenue, and an only a gradual letup of the pressure on ARPU. There is no clear standout mobile market performer in our forecasts (see chart 10).

Chart 10