Will telecoms be a rising star? An analyst’s view of the European sector

1. Will telecoms be a rising star?An analyst’s view of the European sector December 2013 Stephen Howard* Head of Global Telecoms, Media & Technology Research +44 20 7991 6820 stephen.howard@hsbcib.com Disclaimer & Disclosures : This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations Issuer of report: HSBC Bank plc View HSBC Global Research at: http://www.research.hsbc.com

2. The European telecoms sector is under immense pressure • European telecoms is much more fragmented than its international peers US Japan Europe Source: HSBC, Datastream (1 October 2013)

3. Leverage high • Not only is telecoms leverage* higher in Europe vs Rest of World… Source: Company reports, HSBC estimates • * Ratio of net debt (total debt less cash) to EBITDA (earnings before interest, tax, depreciation & amortisation)Europe: DT, Orange, Telefonica, TI, BT, KPN, Telenor, TeliaSonera

4. Profitability trends deteriorating • …but profitability (EBITDA*) trends are much worse… • Ratings agencies look at debt levels in conjunction with profitability trends • As profitability declines, operators ability to support debt progressively undermined Source: Company reports, HSBC estimates • * 5-year compound growth rate in EBITDA (earnings before interest, tax, depreciation & amortisation)

5. Revenue trends dreadful • …as are trends in revenues*… • Negative revenue trends give investors & ratings agencies grave cause for concern Source: Company reports, HSBC estimates • * 5-year compound growth rate in group revenues

6. Dividends cut • …and dividends have already been slashed in response Source: Company reports, HSBC estimates

7. Capex trends weaker • Capex* weaker than international peers • Note that capex/sales ratios quoted in isolation can be misleading • Europe’s sales are contracting, whereas international peers’ sales are growing • Hence, even if capex/sales ratios uniform, implies European capex declining vs peers Source: Company reports, HSBC estimates • * Capex indexed 2006 = 100, international = US + Japan

8. Fibre deployment slower • Europe lags international peers in the roll out of fibre… Source: Company reports (Q2 2013), HSBC estimates

9. LTE adoption slower • …and in the uptake of LTE Source: GSMA (2012)

10. Telecoms share price performance since January 1999 (Eurostoxx 600) rebased to 100 Total market: +5% Telecoms: -57% Source: Thomson Reuters Datastream, DJ Stoxx Telecoms investors have suffered poor returns for over a decade…

11. …and now there’s the risk the economy will suffer from a lack of fibre Progress vs Digital Agenda targets Source: European Commission

12. The fixed-line recommendation: a fresh agenda in European telecoms • Frees incumbents to set own NGA prices until 2020(+) • Enables operators to create innovative packages to better mine the consumer surplus • Copper a partial substitute and priced low enough to stop any over-charging of NGA • Regulatory focus not on price cuts but on wholesale-based competition/equivalence • Positive pricing signals to help convince investors • Halts the automatic decline in ULL (and thus also downstream retail broadband) prices • Improved top-line trajectory will give investors more confidence to back the industry • Better copper pricing supports better NGA pricing and hence NGA investment case • Fully embraces principle of technology agnosticism/neutrality • FTTP the most capable technology, but very expensive and deployment time lengthy • FTTN (ie FTTC) to receive equally supportive regulation as FTTP • FTTN much more cost-efficient and adequate to meet foreseeable bandwidth demands

13. Four steps for fibre Simple 4-point plan to secure investment in NGA Free operators to set their own prices for wholesale NGA Provide positive pricing signals to convince sceptical investors Continue adherence to the principle of technology agnosticism Liberate national regulators to consider needs of network investment

14. Investor feedback • Investors see recent regulatory proposals as move in the right direction… • Our thanks to all the investors/CEOs/politicians/regulators with whom we’ve met • Investors have been keen to talk with regulators to understand developments • Regulators have been interested to hear about financial markets’ concerns • …but most still see telecoms as unattractive for the time being • Don’t underestimate the challenge: a material minority see telecoms bankruptcy risk • All cite as issues declining revenues, excessive competition, obstacles to consolidation • Anxious that more positive regulation will not be implemented ‘on the ground’ • Investors loathe to back investment unless see rising ARPUs & revenues • While revenues shrink (NB mobile as well as fixed), expect further capital withdrawal • Proposed ‘carrots’ are long term: risk there’s not enough to win earlier investor support • Many (most) would prefer to wait 2-3yrs to see some growth & rebuild trust in telecoms

15. Key items of unresolved investor uncertainty • Questions over implementation • Is there disagreement both between bodies within the EC and beyond it with BEREC? • Will all NRAs go along with the new proposals, or will there be local deviations? • What are the risks of ‘opportunism’ once investors’ capital has been committed? • Questions especially over mobile and also over content • How can operators spare the capital to invest when mobile doing so badly? • Can mobile market structure be addressed (given already such rivalry from WiFi, OTT)? • When will content market rigidities be tackled to facilitate IPTV-driven NGA uptake? • Questions about the new telecoms single market measures • Can spectrum reform proposals gain support & address one prominent risk factor? • Will net neutrality regulation give operators sufficient scope to charge for prioritisation? • Could the relevant market review process see certain market segments deregulated?

16. Achieving a win win win win win win (win6) scenario via Moore’s Law • Prices will fall whatever happens – the only question is how • Value-for-money gains bigger from new technology than pricing existing services lower • Cf candle vs light bulb: no candle price cut can match a light bulb’s value for money! • Customer best served by growth environment promoting investment in latest platforms • Needs of incumbents, altnets & cable operators can all be addressed… • Incumbents: will invest more in fibre & mobile upgrades once can demonstrate benefits • Altnets: opportunity to up-sell NGA-based services to their customer base at a premium • Cable operators: supportive investment context will (in time) stimulate additional build • …while benefits are clear for consumers, regulators & politicians • Consumers: economic growth plus better value-for-money of services that can do more • Regulators: Europe could finally start to close 10-year technology deficit vs US & Asia • Politicians: macro stimulus via investment in key infrastructure not needing tax funding

17. Scale and consolidation – cross-border and in-country • Either Europe builds scale to invest or others will do it for us • Even largest European players have been investing slower than global peer group… • …and are also divesting European assets, increasing the market’s fragmentation… • …creating entry point for global players e.g. Mexico’s AMX or possibly US RBOCs • European market is fragmented, contracting and under-investing • Given the ongoing process of convergence, European telecoms is very fragmented • Need to take fuller account of platform-based competition (e.g. WiFi) & role of OTT • Single market proposals/dynamic efficiency arguments help legitimise in-country deals • To address this fragmentation will involve some in-country consolidation • Investors usually hostile to telecoms cross-border acquisitions, e.g. FT/TeliaSonera • Bitter experience that cross-border deals are challenging, with high execution risks • Without an in-country dimension to M&A, creation of cross-border scale will not happen

18. Summary: how telecoms can become attractive again • Investors still loathe telecoms: Q. Why does this matter? A. Investment • When will investors push for network spending? When see rising ARPUs & revenues • Hard for operators to justify spending: (i) fixed line & mobile consistently contracting • (ii) fragmented market structure, especially given platform competition (eg WiFi) & OTT • Single market can deliver a more supportive investment environment • Focus on dynamic not static efficiency gains & reflect breadth of competition (incl. OTT) • Need consolidation, with in-country/x-border in parallel given overlaps/investor hostility • Would address capex/scale gap of Europeans vs global players (otherwise are targets) • Prices will fall whatever happens – the only question is how • New technology gives bigger value-for-money gain than lowering existing services price • Cf candle vs light bulb: no cut in candle prices can match a light bulb’s value for money! • Customer best served by growth environment promoting investment in latest network