Business Analysis: To break up BT or not ... that is the question

Whether or not to separate the telecom giant's wholesale network from its retail division has split competition experts

Shares in BT Group tumbled again yesterday after analysts downgraded expectations for two of the company's main drivers of growth - broadband connections and technology solutions for big global clients - which are said to be "losing their lustre".

While the market focuses on these short-term concerns, another potentially more important argument that impinges on shareholder value at BT is attracting little interest among analysts and investors, although the debate has been raging for the past week in the letters pages of the Financial Times.

The knotty problem of whether to split BT into its two main parts - BT Retail and BT Wholesale - refuses to go away. According to the proponents of a break-up, including Stephen Littlechild, the influential former electricity industry regulator, BT still enjoys unfair and damaging monopoly power.

Mr Littlechild and his allies argue that BT, by controlling both the national telecoms network through BT Wholesale, and by being the biggest supplier of telecoms services through BT Retail, smothers competition to the detriment of its consumers - households and business.

The answer, they argue, is to split the two asunder and de-merge BT Retail from BT Wholesale - or at least the final mile of copper wire, called the local loop, running from local exchanges to people's homes said to be the worst "regulatory bottleneck".

Drill down into the BT annual report and it is possible to quantify just how important BT Retail, run by Pierre Danon, is to BT Wholesale, run by Paul Reynolds, and what the companies would look like as independent entities. Our first table, which should be read from left to right, shows that BT Wholesale relies on Mr Danon for £6.9bn of its £10.9bn of sales. The other three tables show how the main legs of BT Group would stand alone, assuming they all kept their current internal sale, as independent companies.

Few in the industry realistically believe such a tectonic event as a demerger is going to happen soon. However, with Ofcom about to deliver the initial findings of its strategic industry review in three to four weeks, a compromise could be around the corner. Rivals of BT Retail say they need not only enjoy the same access to BT's wholesale network and local loop as BT Retail but also on the same terms, something they call "equivalence", a situation that does not prevail today.

BT, perhaps sniffing the prevailing regulatory wind, argues it has no problem with equivalence and that it is largely a technical matter to deliver it.

Equivalence seems to be the most likely regulatory outcome but its importance should not be overlooked, say analysts. It could still have huge implications for shareholder value and could yet prove a crucial staging post towards the inevitable break-up of BT in five to 10 years' time. The idea is that equivalence will benefit shareholders because BT Wholesale will be encouraged to maximise profits by innovating for the market as a whole while BT Retail escapes certain price caps as a quid pro quo.

With Ofcom about to opine, the debate is hotting up. Mr Danon said: "If we can achieve equivalence then the case for separation would be at best marginal." Others are not so sure. If equivalence and greater transparency really do work in future then this could ultimately lead to a realisation among shareholders that a split would deliver greater shareholder value.

One analyst, who did not wish to be named, said: "Any increased visibility has got to be welcomed. But the company is still difficult to model because of the huge overlaps within its operations. It depends how far equivalence goes but it could result in more speculation that BT will be split which would be positive for the shares."

Mr Littlechild's idea of a full demerger is, says Mr Danon, too costly, too complicated and too distracting for management. It would also stop BT's boffins from inventing the cool new telecoms technology that our communication-obsessed society requires. He also dismisses the idea that he and Mr Reynolds share information to the detriment of others. "The idea that Paul and I have joint intelligence of what we're doing in the market is just not true," Mr Danon said. "We do not share anything. In broadband there is equivalence already. In other areas the arguments are about detail. If we can do a deal and satisfy the competition that there is no advantage to BT then that should be sufficient.

"The wholesale business needs an anchor. Telecoms is fast moving. With a big investment decision to be made the fact that BT Retail has definitely said that it will take a particular service makes a big difference to Wholesale when it's making its decision. If I want to do something I can go to Wholesale and say 'why don't you change your network to do it?'"

This final remark reveals all that is worrying about BT, say the critics. First it reveals that BT believes it needs to retain its monopoly structure to innovate and second, it proves that within BT it is Mr Danon, at BT Retail, who is calling the shots when it comes to investment.

David McConnell, at the UK Competitive Telecommunications Association, a collective of BT's rivals, said: "Maybe greater transparency and equivalence is a form of organisation that is sustainable. For BT Wholesale it's a good opportunity for them to grow. But at the moment many requests from rivals for certain products don't seem to make any progress. Can Mr Danon tell us if BT Retail has a similar experience? We don't see BT Retail complaining to the regulator about its treatment by BT Wholesale."