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BT’s G.Fast Cost and a £500m Risk to Openreach from Ofcom and the EE Deal

Tuesday, Dec 15th, 2015 (1:05 am) - Score 2,213

Financial analyst firm Redburn has published a new piece of research that offers some extra cost predictions for BT’s forthcoming roll-out of 500Mbps G.fast broadband tech and also warns that the merger with EE could help create a £500m+ risk to Openreach’s cash flow.

Redburn’s research, which has been seen by ISPreview.co.uk, is based off an attempt to answer the question of how much upside will exist after the completion of BT’s £12.5bn merger deal with EE, particularly given the potential impact from Ofcom’s “re-regulation of Openreach” (i.e. the on-going Strategic Review). Openreach is responsible for BT’s national UK telecoms network.

The study suggests that more than £500m of Openreach EBITDA (Revenue – Expenses [excluding tax, interest, depreciation and amortization]) is at risk, regardless of whether or not Ofcom refers BT to the competition regulator.

Nick Delfas, Redburn, said:

Our bear case is >£700m EBITDA at risk by March 2018, of which only a part is likely to be offset by cost reductions, leading to our >£500m headline risk above. Our base case is for a £400m gross effect, with a £150m net reduction in Openreach EBITDA over FY17 and FY18 thanks to cost cuts and some growth in GEA.

Consensus forecasts for flat Openreach EBITDA in FY18 look too bullish. Further cost efficiencies to offset bear case outcomes will be hard for Openreach to achieve given pressure on quality metrics (connection times, fault rates) from Ofcom. Our bear case is not the absolute worst case for BT but a reasonable downside scenario.”

Naturally there are some positives from the BT and EE merger too, such as the ability to reduce the very high marketing / distribution costs and churn, which are inherent in the mobile business model, and to push them “towards levels more normal in fixed line businesses“.

On this aspect there’s a possible upside of around £400m, but the negatives will weigh against that.

Nick Delfas added:

However initial FY17 figures will need to take account a range of negative factors. EE capitalises some costs which BT will expense (~£40m); there will be some ongoing TMobile and Orange brand rights for a short time (£40m but falling); Openreach capex will be impacted by Broadband Delivery UK (BDUK) clawbacks; Wholesale will be hit by the business review; Global Services will continue to decline; BT may raise EE capex above 8% of sales and then add the initial capex for the Emergency Services contract on top; and cash tax will rise by 50% for one year in FY18. On revenues some brokers seem to have forgotten to include inter-company revenues which reduce the combined revenue base by perhaps £500m.”

Despite all this Redburn has given the operator a ‘neutral’ rather than ‘sell’ status, not least because there should still be plenty of flexibility left so as to “create significant room for manoeuvre and offsets some of the Openreach risk“.

The regulatory problem in a nutshell (Redburn Statement)

The regulatory issues involved can seem very dry. So to understand why EBITDA and overall returns at Openreach are liable to fall we try to limit our views to four bullets:

• Openreach makes a huge amount of cash for BT: >£1.4bn in opFCF per annum.

• On a regulated asset base of £12.3bn it is making around a 10% unlevered pre-tax return in a world of very low rates for the last 8 years;

• Capex has been more or less flat for nine years at around £1.1bn, so if depreciated cost rather than a regulatory basis partly using current cost, the asset base would be even lower and the returns even higher.

• The high returns are not there by accident. The high RAB is there purposely to encourage overbuild by new operators. However for the most part this has not happened – Project Lightning [Virgin Media’s expansion] is only in its infancy, and most of the competing broadband lines were built in the 1990s as CATV was rolled out.

In summary UK consumers are paying high prices for legacy copper products by design, in the hope that someone will over-build copper with new networks. But new network build has been very thin in the UK: the UK is not even on the scorecard for Fibre To The Home in Europe or worldwide.

Interestingly the report then starts to focus more on broadband and notes that Ofcom could incentivise investment in new infrastructure via lower prices, but this is risky and will only work if used in the right way. For example, lower wholesale costs can help but they may not necessarily be passed on to consumers (Ofcom could view this as a regulatory failing), but if they are passed on then equally it could have a “chilling effect on already thin levels of network investment by other parties“.

At this point Redburn suggests three “intelligent” solutions for Ofcom to balance the challenge. 1) Take money from Openreach in another way (not lowering prices) that could ease access bottlenecks to infrastructure, 2) Announce a cut to copper returns at some future date beyond 2020 to incentivise network replacement by Openreach, or 3) Raise copper prices in areas with ultrafast FTTH to incentivise both new investment and consumer transition to the new networks.

The idea of pushing up copper broadband (ADSL) prices in order to foster adoption of newer fibre optic (FTTx) based services isn’t new and probably won’t go down well with some ISPs or consumers, particularly those on lower incomes.

On the other hand we’ve already seen broadband and phone bundle prices rising sharply at some ISPs this year, as well as in previous years. Similarly the uptake of “fibre” services is already growing through organic upgrading, with consumers active seeking faster connections in order to enjoy new content (4K etc.) or perform existing tasks more quickly.

At this point the report switches its focus to BT’s G.fast technology, which is expected to begin a commercial deployment in 2016/17 and could deliver broadband speeds of up to 300-500Mbps to 10 million premises by 2020 (roughly 40% of the UK), with “most of the UK” following by 2025.

BT has previously indicated that they currently spend around £300-400m per annum on “fibre” and broadly expect that to continue for the next 5 years until 2020, with the majority going towards their G.fast / ultrafast broadband roll-out. This can all be done within BT’s original £2.5bn commercial commitment, partly due to having dramatically scaled back their plans for a wider native FTTP deployment.

By comparison the Redburn report doesn’t tell us much that we didn’t already know, but it does put it all into a useful regulatory context.

Redburn on BT’s G.fast Deployment – Cost and Regulation

The implementation of G.Fast could mean very different things however:

• Fibre-heavy. It could mean a very large fibre programme, taking fibre to within 30 metres of properties at 4 million ‘Distribution Points’. BT says in its response to the DCR (p27) that this would cost £8bn.

• Fibre-light. It could also mean simply adding G.Fast electronics to existing street cabinets, and running the technology over the existing copper of 300m. Covering around 30-35k cabinets at between c£10 and £30k per cabinet could cost only £500m.

The second solution is what BT is proposing. Luckily UK loop lengths averaging 350m mean many customers could gain a benefit, whereas in Germany (where loop lengths are 420m) it is more challenging. However as with most things in life, cheap solutions can work well, but they often have drawbacks. In the case of G.Fast these are quite clear:

• Customers beyond 400m from a street cabinet won’t get any benefit at all. The reason 10m homes are targeted is that these are the ones with average loop lengths giving a significant uplift in speed, but out of the 10m homes some homes will see no benefit at all.

• Customers at 200-300m will reach speeds of perhaps 100-300Mbps (the technology has not been widely deployed yet anywhere in the world over long loop lengths so the precise figure is uncertain) but G.Fast is unlikely to give symmetrical speed;

• The cost of maintaining large parts of the copper network, with attendant problems e.g. with water ingress would continue. Fibre networks have significantly higher operating margins as maintenance costs are far lower.

The question for regulators is quite simple. If the cost of G.Fast implementation is only £500m, why should Openreach be allowed to have a further period of unregulated returns on this investment, when the risk taken is relatively small?

One option would be to regulate both GEA and further evolutions of GEA – which is what G.Fast would be – in the same way, based on an asset base and regulated return.

If returns were disappointing on the G.Fast investment, Openreach could be allowed to recoup the losses from elsewhere in the business, but currently it is able to utilise its dominance in access to create new unregulated products at costs far higher than any risk taken really merits.

It’s worth pointing out that if Ofcom did impose strict regulation then BT has hinted that they may scale back their future investment plans (a moot point perhaps if the regulator goes for full separation of Openreach), although doing so would leave them increasingly vulnerable to rivals like Virgin Media and even altnets that continue to expand (e.g. Hyperoptic, Cityfibre + partners and Gigaclear).

Redburn believes that, over the longer-term, the UK will not be a global leader in broadband connectivity because other countries, such as those that are now starting to focus on a more pure fibre optic approach (e.g. France), will eventually surpass us. Mind you it’s not clear how many of those will deliver 100% FTTH coverage and if the measure of progress should only focus on speed.

On top of that they say that the “arguments in favour of full separation still seem incredibly strong to us” and that the “arguments against separation look very weak“. At this point the report appears to adopt a more presumptuous position, which makes a lot of overly simplistic comparisons and doesn’t answer the key question of what benefits consumers can reasonably expect or how those would be funded / delivered.

Ultimately it all comes down to Ofcom’s decision and design for the future. We did ask Openreach for a comment, although like most operators they don’t tend to comment on market speculation.

Mark-Jackson
By Mark Jackson
Mark is a professional technology writer, IT consultant and computer engineer from Dorset (England), he also founded ISPreview in 1999 and enjoys analysing the latest telecoms and broadband developments. Find me on X (Twitter), Mastodon, Facebook and .
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