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Dark Horse in 5G Auction Is Trouble for Telefonica

Dark Horse in 5G Auction Is Trouble for Telefonica

(Bloomberg Opinion) -- A high stakes game of 3-D chess is currently playing out in the sleepy German town of Mainz. The outcome will determine the landscape of the country’s telecoms industry for the next 20 years. Telefonica SA’s local unit is at particular risk of losing out.

The Spanish carrier is bidding alongside Deutsche Telekom AG, Vodafone Group Plc and 1&1 Drillisch AG in the auction for 5G spectrum: the radio bandwidths for next-generation telecommunications. So far, they’ve staked a combined 3.3 billion euros ($3.7 billion) in the process, which is run by a Mainz-based arm of the German Federal Network Agency. The unbalanced distribution of the spectrum from the auction so far suggests it has some way to go, according to Bloomberg Intelligence analyst Erhan Gurses.

Dark Horse in 5G Auction Is Trouble for Telefonica

It’s notable that there are four bidders, since just three companies operate mobile networks in the country right now. That’s allowed them to charge higher prices than in markets with four players, such as France. 

The fourth bidder, 1&1 Drillisch, is a mobile virtual network operator. It serves its customers by leasing capacity wholesale from Telefonica Deutschland AG, which operates the O2 brand in Germany, and Vodafone. That saves it the cost of building out its own network. Most of the 600 million euros Drillisch spent on leasing last year went to Telefonica which, for antitrust reasons, must provide 30 percent of its network to a virtual operator through 2030.

For CEO Ralph Dommermuth, owning the spectrum would be a significant bargaining chip. True, it also brings along the expense of having to build a new network. But it would also reduce his dependence on Telefonica. In order to retain as much of that lucrative wholesale business as it can, Telefonica might be tempted to offer Drillisch better pricing when the contract comes up for renewal in 2020 and 2025.

A Drillisch win also increases the likelihood of German politicians passing a “national roaming” law, which would require all carriers to make their network available to virtual operators. If a firm acquires spectrum, German regulations stipulate that it must sacrifice its mobile virtual network operator status. Since Drillisch is unlikely to get all the spectrum it needs to run a national network, a roaming law would allow it to plug coverage gaps with others’ networks. Politicians who have advocated creating a fourth player would need to push for the legislation, in order to ensure that operator is competitive.

Dark Horse in 5G Auction Is Trouble for Telefonica

The threat to Telefonica is two-fold: it faces an emboldened competitor at the low end of the market, and the prospect of less free cash flow from its existing lucrative network deal. Telefonica Deutschland had 711 million euros of free cash flow last year, and the Drillisch arrangement likely represents more than a third of that. If things go particularly badly, its Spanish parent might even be forced to rethink its exposure to the German market.

The best outcome for Telefonica would be for Drillisch to be priced out of the spectrum auction. HSBC analyst Christian Fangmann estimates the upstart will need to spend a minimum of 3.3 billion euros on the network and spectrum, which would outweigh any savings on its wholesale costs over the next five years. That may not be a concern for the firm, which is 73 percent-owned by United Internet AG.

Dark Horse in 5G Auction Is Trouble for Telefonica

But that also puts the onus on Telefonica to keep the auction pricing high enough to make it uneconomical for its rival. For Drillisch, the worst-case scenario is preserving the status quo, which would still be a satisfactory outcome. It would also be good news in the near term for investors: Dommermuth said last week he would cut the dividend should he win any tranches of the spectrum auction.

Telefonica Deutschland has a choice: pay more in the auction or face more price pressure. It may struggle to emerge unscathed.

To contact the editor responsible for this story: Jennifer Ryan at jryan13@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Alex Webb is a Bloomberg Opinion columnist covering Europe's technology, media and communications industries. He previously covered Apple and other technology companies for Bloomberg News in San Francisco.

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