The impact of the credit crunch on telcos’ WACC and interconnection rates

Vasileios Petinis, Consultant

In addition to the EC recommendation on interconnection rates, telcos are suffering from the effects of the financial crisis and the difficulty of sustaining an efficient WACC. What impact does the turmoil have on WACC and interconnection rates, and how can telcos respond?

The weighted average cost of capital (WACC) is a measure of how much, on average, it costs a firm to raise the capital required for investment across its entire business. The WACC is a key component in long-run incremental cost (LRIC) models, which are broadly used in setting interconnection charges. The value of WACC directly affects the call termination charges calculated in both the fixed and mobile LRIC regulatory models. A slight change in the WACC is likely to cause a significant change in costs due to the high levels of capital investment in the telecoms industry. If the WACC is set correctly, it encourages efficient investment and does not discriminate against either the service provider or others that are seeking access to its services.

Aiming to encourage competition and lower mobile charges, the European Commission started a public consultation on the future of voice call termination rates. According to the EU Telecoms Commissioner, over the next few years mobile phone call charges should be expected to decrease by 70% from their current level, which can be achieved by decreasing mobile termination rates.

On the other hand, the current economic climate has made it more difficult for telecommunications operators to raise capital – either from debt or through equity. This implies a high risk involved in the financing of high-capital consuming telecommunication projects such as next-generation networks (NGNs) and 4G network deployments. The negative sentiments created from the liquidity crunch as a result of the sub-prime crisis and the fall in the worldwide financial markets have also been reflected in the level of WACC values.

It should be noted that the EC recommendation was published in June 2008, just before the beginning of the financial crisis.

We look at the following issues:

• Has the WACC been affected by the financial crisis, and in what direction?
  
  
• Is the current level of WACC an extra burden that communications operators will suffer?
  
  
• Is the current level of WACC a barrier for the implementation of the EC recommendation?
  
  

We examined whether the WACC value of European integrated communications providers (such as KPN, Deutsche Telekom, France Telecom, TeliaSonera, Telecom Italia and Belgacom) has changed over the last six months following the collapse of big investment banks and the financial crisis. We estimated the cost of capital over two periods: January 2008 to July 2008, and August 2008 to January 2009. Our quantitative analysis showed that over the two periods under examination the risk-free rate, debt and equity premiums and beta values have changed due to the financial crisis, while the impact on gearing and tax is not material. More specifically:

Risk-free rate: The average yield of the selected countries’ government bonds in July 2008 was 4.40%, which is considerably higher than the yield in January 2009 of 3.65%. Over the period January 2008 to July 2008, the average risk-free rate was 4.34%; during the period August 2008 to January 2009, the risk-free rate decreased to 4.01%.

Figure 1 Yield on long-term government bonds

Source: Ovum 

Debt risk premium: Compared to the end of 2Q08, debt premium in January 2009 increased from 1.4% to 3.3%. Looking at the periods of January 2008 to July 2008 and August 2008 to January 2009, debt risk premium increased from 1.5% to 2.7%.

Figure 2 Bond yields and debt risk premium

Source: Ovum 

Equity risk premium (ERP): Based on Dimson et al and IRG, the historical equity premium of our selected sample of countries is 5.3%. A number of studies show that market ERP estimates have increased significantly over the last few months. Professor Damodaran has estimated the implied ERP over the period of 12/9/08 to 16/10/08 and found it to vary from 4.2% to 6.39%, which is higher than the geometric average of the historical ERP of the US over the period 1927–2007, at 4.79%. Evidence from brokers (e.g. Credit Suisse) highlights that the implied current market ERP for KPN has increased significantly over the last few months. For example, although Credit Suisse submits that the long-term historic average ERP for the Netherlands is 4.4%, current market-implied ERP is 8.17%. The case is similar in Austria, where the current implied ERP is 6.3% compared to a historical average of 4.5%, according to the same analysts. Although it is very uncertain what the value of ERP will be over the next few years, we can assume that, in light of the financial crisis, ERP has increased from 5.4% (over the period of January 2008 to July 2008) to at least 6.4% (over the period of August 2008 to January 2009), based on evidence from current market-implied ERP estimates.

Beta: Five-year average monthly historical estimates of beta values have not changed and are stable at 0.7. But, at the same time, weekly observed beta values over the period of January 2008 to July 2008 and August 2008 to January 2009 have increased from 0.59 to 0.71, implying that risk has increased.

Figure 3 illustrates how WACC has changed over the two periods under consideration.

Figure 3 WACC evolution over the last six months

Source: Ovum 

What can be observed is that the pre-tax nominal WACC in the period of January 2008 to July 2008 was approximately 9% and increased to 9.7% from the beginning of the financial crisis (August 2008) to January 2009. Furthermore, point WACC estimates increased from 8.6% in July 2008 to 9.7% in January 2009.

Conclusions

Our quantitative analysis has indicated that the current financial crisis has affected the WACC estimates of communications providers, due to the higher risks in order to raise debt but also to invest. Over the last six months, the cost of capital of our sample of European communications providers has increased from 8.6% to 9.7%. This clearly means that without taking into consideration any other factors, LRIC-based interconnection rates would be likely to increase if they were to be calculated today. This is definitely not in line with the EC’s recommendation, which supports a decrease of interconnection rates by 2010. The recommendation was submitted in June 2008, just before the financial crisis, and possibly did not take into consideration the higher WACC values that communications providers are currently facing and the likelihood they will increase in the long term. Although this is a preliminary study, the WACC might even be higher in following quarters. It is likely that our WACC estimate is too low, if we consider that our analysis includes incumbent operators that are likely to face less financial problems compared to smaller scale operators; that NGN and 4G assets are riskier than current ones; and that although the duration of credit crunch is difficult to be predicted, the situation is unlikely improve before 2010.

We recommend that NRAs need to take into consideration the impact of the credit crunch on their estimates of cost of capital when assessing future interconnection rates. Operators should carefully budget for future investments in NGN and 4G networks, and each regulatory decision, especially in the area of interconnection, should focus on how to create opportunities for such efficient investment and enhancement of competition, instead of creating additional barriers to operators’ plans.

Limitations of the study

Our quantitative analysis is limited to a sample of incumbent communications providers in Europe, and therefore our general outcomes need to be carefully adjusted before they are applied to different countries or communications providers.

Vasileios is a Consultant in Ovum’s Regulatory and Policy Practice.