Fixed and incumbent operators – dying slowly but profitably?

In November 2006, the Lex Column of the Financial Times commented that European telecoms companies (meaning fixed and incumbent) are in a tricky trap. The markets like their short-term cash flow yields, but in maintaining cash flow devotedly, management may not be doing enough to reinvent the company. The European telecoms sector has been in the doldrums due to slow revenue and margin growth (if not decline), and a lack of consolidation (despite rumours). Perhaps a change of strategy is required to survive in the brave new world?

Recently, news about private equity funds buying into telecoms has increased. Blackstone bought a stake in DT – highlighting that various PEs (increasingly involving new players such as funds from the Middle East) are circling operators including large European incumbents. In July 2006, the Australian-based investment fund Babcock and Brown bought a controlling interest in Irish incumbent Eircom. Last year, Apax Partners led the purchase of TDC in Denmark, although in Spain, France Telecom beat two rival offers from investment groups for Amena. Other PEs came close to buying NTL and various operators in Eastern Europe are at least partially owned by PEs. Why are they interested?

Firstly, there is a view within the financial community that telcos are underperforming in terms of what they give back to their shareholders, and in terms of their share prices. While telcos (particularly incumbents) can generate cash (and so pay short-term dividends), they are finding it much harder to grow revenues as the fixed business declines and as mobile growth becomes increasingly difficult in matured markets – hence low share prices. But there is a belief within the financial community that telcos could do far better, particularly as they are high-tech industries. The opportunity for investment houses is to buy now while share prices are low, get involved in the management of the company, develop the business and then sell in the future when bigger profits drive values higher.

Secondly, if we look at how the telcos are structured, it is not difficult to conclude that the whole is worth less than the sum of its parts. Traditional telcos used to be organised in vertical silos, such as fixed/mobile/ISP, or by product line within these broad headings. We refer to these structures as ‘monuments to the past’. While this approach has its advantages – in terms of P&L focus, clear management responsibility, etc – they are largely internal to the company. Externally, they create obstacles to doing business: customers have to talk to each line of business separately, and in general none of the silos are able to talk to each other freely. The opportunity for financial investors is to re-orientate the business to create a greater customer/market focus and in so doing simplify their operation and release value. This is rationalising the distribution side of the business.

The third reason why investment houses are interested relates to consolidation and transformation. So far we have seen consolidation through ownership – Cable & Wireless/Energis in the UK, Neuf Telecom/Cegetel in France and SBC/BellSouth/AT&T in the US are all examples. The first thing Cable & Wireless and Energis agreed to do was to consolidate their business onto one network and so take out a large swathe of costs. But consolidation of this type does not have to take place at an ownership level. There is no reason why telcos cannot consolidate the supply side of their business (including the network) onto a wholesaler or outsourcer. The transformation of the industry through next-generation networks (NGNs), convergence of telecoms and IT, and convergent services enhances this opportunity rather than diminishes it. So opportunities exist in telecoms to rationalise the supply side of the equation too.

Of course, such investment is not without risks and challenges. Aside from complications with regard to how to physically separate the access network (where is the line?), organisational and IT issues, pensions funds, employee and union concerns, there are major regulatory issues to consider. While most regulators are finding it difficult to regulate resource-heavy incumbents, they may also be concerned about the consequences of a national incumbent being split up.

Indeed, the European Commission has already demonstrated a certain wariness about structural separation. Recent studies, though not accepted by all, supported the view that incumbents themselves might be best placed to make the significant investment in core and access infrastructure.

In addition, regulators might be concerned about comments by investment funds that question whether these new investments are justified and provide good returns (not unreasonable questions to ask, of course, particularly given the historically technology-centric behaviour of the industry). Economic analysis has also demonstrated that, in theory at least, an integrated operator model is the most efficient approach to serving the public (that is, generating the greatest economic welfare). Moreover, structural separation might be seen as a risky step – if the experiment fails, it is difficult to revert. Furthermore, regulators may also take differing views of the appropriate rates of return that may be applicable following a structural separation, thereby affecting one of the key value driver assumptions on which the business case might rest.

The opportunity to create and unlock value is just too significant for investment funds to ignore at the moment, but they have to do their numbers carefully and think through the technical, organisational and regulatory challenges that they may face.

What view will the operators take?

Structural separation will meet some scepticism. Incumbents value the access network as it provides their primary connection with the customer. However, the option to unlock value through a securitisation effort might be compelling (assets are value depreciated though they are still useful – securitisation provides the venue for a revaluation of these assets). Furthermore, with securitisation the incumbent might also retain some control. Beyond securitisation, the response or position will depend on the market situation, particularly competition and regulation. It might be tempting to escape the scrutiny of the regulator and just get on with it.

However, telecoms is different to other infrastructure industries. Technology is at the core of it and it is getting more and more complex – convergence of fixed and mobile networks and convergence of telecoms with other industries are additional complicating factors. The introduction of NGNs blurs the dividing line between access and core, and will ultimately make it less relevant.

As the industry moves from the ‘spaghetti of traditional networks’ to the ‘layered lasagne of IP-based communications’, a horizontal separation at the application layer might make more sense. Apart from the technology and regulatory issues, management and boards will be more aware of the union, pension and other organisational issues than external investors that take a fresh look.

Whilst operators are reluctant when it comes to structural separation, investment in next-generation networks is still not mass-market, but a growing number of operators are investing in NGNs as well as new services such IPTV that require infrastructure investment.

The concern here is: do these new investments generate the same returns as old /previous investment? Those good times might be over; a critical view might be that expensive legacy products are being replaced by new services, which customers use more but for which they pay lower prices.

The ‘good old times’ may indeed be over, but fixed telcos may have indeed little choice – perhaps it is more about investing to stay in business to reduce costs, improve flexibility and time to market, and defend revenue streams rather than creating substantial new ones. Investors have to carefully assess whether the telcos are initiating heavy capex programmes to cover up for other shortcomings and avoid addressing more fundamental changes, or whether investment in things like NGN is indeed the only way to defend against nimble competition and stay competitive.

Key issues for investments funds:

• challenge the assumptions that management and the industry may still be consciously or subconsciously attached to, but recognise that telecoms is different to other utility industry infrastructure investment opportunities – it is far more complex
  
  
• do the business case, but also realise that the regulator, unions and other stakeholders may want to see a long-term business case – not just a three- to five-year one
  
  
• develop a regulatory negotiation strategy and a PR strategy, and define key messages to overcome objections
  
  
• understand the impact of NGNs on any separation; understand the business case for NGNs (core and access) and new services in the market and competitive context.
  
  

Key issues for operators:

• separation and restructuring can help to unlock value, be it to fill chests for acquisitions, fund investment to reinvent themselves and compete and grow, or simply to reduce debt. Are these potential upsides greater than perceived downsides?
  
  
• consider the relative merits of the different ways to leverage the strategic value of their infrastructure
  
  
• sell the need for investment in new technologies and services better to investors.
  
  

Key issues for regulators:

• aim to achieve the right mix of competition and overall sector effectiveness and efficiency. More competition at all costs does not always lead to better public welfare. Do not interfere with market forces too much, and listen to the cases being made to them.
  
  

Ovum Consulting (www.ovumconsulting.com) combines financial expertise and consulting methodologies with insight and research in technology, regulation and markets. Its Regulatory and Strategy & Commercial practices have the experience, people and insights to assist investors, operators and regulators on issues such as structural separation, NGN, valuation, commercial strategies, regulation and economic analysis.