O2 and Virgin Media form an odd couple to transform telecoms

The unlikely duo could shape the future course of the telecoms industry

Illustration of Virgin Media logo with O2's, surrounded by celebrities / footballers that work with the brands

There was something familiar about the solitary, smartly dressed Spaniard approaching Virgin Media’s London headquarters at Griffin House, an unlovely low-rise in the shadow of the Hammersmith flyover.

Some of those who spotted the unusual caller eventually placed him. But what was Jose Maria Alvarez-Pallete, chief executive of Telefonica, Spain’s former state telecoms monopoly and owner of the mobile operator O2, doing there? And why was the man known in the telecoms industry as JMAP without his usual retinue of assistants and advisers?

The plot behind that discrete visit in 2016 – later developed and code named “Project Pink” – was finally revealed last week when Telefonica and Liberty Global, the New York-listed owner of Virgin Media, announced a £31bn merger of their UK businesses in the midst of a pandemic.

Mike Fries, chief executive of Liberty Global, told analysts the deal and its timing have nothing to do with coronavirus. “The timing is coincidental,” he said as investors scrambled to unpick the complex financing behind a landmark deal that few had seen coming.

Fries and Alvarez-Pallete, and their companies, make for an odd pairing in what will be an equal joint venture.

Liberty Global, controlled by the 79-year-old billionaire “cable cowboy” John Malone from his base in Denver, Colorado, casts itself as an anti-establishment financial innovator. It never pays dividends and helped pioneer share buybacks as a means of rewarding investors but minimising its contribution to the public finances, in line with Malone’s anti-tax libertarian views. Fries, 57, the son of a powerful Hollywood producer, is an extravert, heli-skiing rock guitarist who is often found in the upper ranks of America’s best-paid executives (he recently received a $5m bonus simply for renewing his contract).

By contrast, Telefonica sits at the centre of Spain’s corporate establishment. Its Madrid headquarters benefits from its own station on the Metro system, and the company retains a stake in the owner of El Pais, one of the country’s most influential newspapers (although it has been seeking to offload the shareholding). In common with most big telecoms operators and unlike Liberty Global, Telefonica is a big dividend payer and its shares are valued for the steady income they have provided. Alvarez-Pallete, 56, presents as a serious and modest bordering on diffident.

Going into business with Fries was not his first choice for O2, but the deal will deliver Telefonica a much-needed £5.7bn cash boost. Liberty Global is expert in complex debt structures that minimise the use of its own money and tax liabilities. The combined Virgin Media-O2 will enter the world with £18bn of debt on its books and Liberty Global’s multibillion-dollar cash reserves. City sources expect some of that money to be deployed in Switzerland in an acquisition of the mobile operator Salt.

Telefonica, burdened with debt built up in flawed South American empire building, has been seeking to cash in its UK business for years. In 2015 it offered O2 to BT, which instead spent £12.5bn on rival EE to create Britain’s first fully “converged” broadband and mobile operator. Then Telefonica agreed to sell O2 to CK Hutchison, the Hong Kong owner of rival Three, for £10.3bn. That attempt to consolidate a market of four mobile operators down to three was blocked by competition watchdogs. Finally, O2 came close to attempting a float in 2017, but was forced to pull out after Brexit-related uncertainties killed the market appetite for what would have been billions of pounds in new shares.

Richard Branson and Dita Von-Teese launch Virgin Media at Convent Garden Market in 2007 Credit: Chris Jackson  

Potential investors in O2 were also concerned about its lack of a fixed-line broadband business. They feared  BT’s takeover of O2 signalled the  start of a move towards packages  that blend broadband and mobile services. The arrival of 5G wireless technology was expected to accelerate the trend. Mark Evans, O2’s chief executive, was commissioned to reject such allegations of strategic weakness as Telefonica grappled with its debts.

“The reason BT has bought EE is because they believe in mobility. They know the future is mobile,” he said at the time. “The future isn’t fixed.” Now, by entering a joint venture with Virgin Media, O2 and Evans are on the same path as BT. Bringing broadband and mobile services together is a long journey, however, says BT chief executive Philip Jansen

“It’s a sensible move for them,” he says. “They’re following down a path that we have been treading for four years because convergence will be the answer in future.” The UK has been slower than most in Europe to move towards “convergence”. Jansen says the simplicity “is now catching the imagination of our customers”. Half of BT’s small business sales now blend mobile and broadband. More than one in six domestic customers have converged packages despite higher pricing. “It takes a bit of time to offer it in a cohesive way,” Jansen warns.

Few expect the merger of O2 and Virgin Media to trigger significant competition concerns. Likewise most of the £540m cost savings built into the financing should be readily achievable. Some £200m will be saved by scrapping Virgin Media’s deal to use the Vodafone mobile network. O2 will be able to avoid more than £100m in annual corporation tax by funnelling its profits through the cable operator’s historic losses.

The practicalities of bringing the two businesses together are likely to pose a greater challenge. O2 has a strong record in customer service, whereas successive rounds of outsourcing and cost cuts under Liberty Global have left Virgin Media among the industry’s worst performers despite higher prices than rivals on the BT infrastructure.

Fries, chosen as the joint venture’s first chairman, argues the merger of Virgin Media and O2 will strengthen the infrastructure challenge to BT in the race to roll out full-fibre networks. Liberty Global has had long talks with Sky about wholesaling cable broadband for the first time, a potential threat to BT’s Openreach unit. The discussions partly reflect BT’s plans to upgrade its network to faster and more reliable than cable broadband, demolishing the technical advantage on which Virgin Media has relied. The cable operator’s pay-TV business is also in decline.

The deal with O2 “doesn’t take anything off the table legally, structurally, we don’t believe from a regulatory point of view”, says Fries.

Well-placed City sources do not expect Vodafone – once considered a more natural partner for Virgin Media – to gatecrash. Senior executives have privately  expressed doubts about the condition of the cable operator’s business and value of its network.

Telefonica and  Liberty Global have meanwhile signalled their plans for the marriage with a contract that  allows either side to trigger an exit to the stock market after three years.