Credit Crunch: Silver Lining for Telcos? (Part 4)

Over the last six weeks on this blog we've been examining why telcos, in the current climate of uncertainty, are perceived as 'defensive' by investors - namely low financial leverage and robust cash flow generation (see here). This trend appears to be continuing, but telcos shouldn't grow complacent about their popularity - this will wane as the market eventually normalizes.

At that point, investors will return to their relentless reassessment of the long-term potential for sustainable shareholder value creation, and the historical record is not encouraging. Our discussions with investors this week strongly suggest that they share many views with the Telco 2.0 initiative - a need to identify and sweat core assets, develop creative approaches for areas of weakness, define a clearer vision, embrace partners, and focus on the wholesale platform.

In the article below we provide evidence suggesting that the interests of telcos and investors may actually be closely aligned in embracing a two-sided business model approach to redefining the future of the telecom sector. (We'll be presenting a summary of this and the previous analysis at the Telco 2.0 event next week as stimulus for the debate on how to work with the investment community):

The almost unprecedented financial carnage of recent months is not, as many have argued, a shock, but rather the natural consequence of years of poor corporate governance and regulation, unbridled optimism underpinned by voodoo economics, and good old-fashioned arrogance and greed. Whatever the excesses and failings of the financial world, that chapter is fading, and, as we have discussed previously, the next chapter - economic downturn - is upon us.

Telcos, of course, have been on the receiving end of precisely this dynamic before, during the post Web 1.0 bubble market collapse of 2000 - 2002, when share prices in the European telco segment fell by more than 30% per annum for three consecutive years, the vastly overcapitalized altnet space all but disappeared, and five incumbents came very close to financial oblivion.

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With the memory of this period still fresh in the mind of many, it perhaps seems counterintuitive that, against the background of the current turmoil and anxiety, telcos should now be viewed as a defensive sector by investors. However, that is precisely the message coming from recent market performance, shown in the chart below.

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We discussed reasons why this might be so in our previous two posts on the subject, and if anything the market recently seems to be validating our views with greater conviction (note that telco finds itself in the company of hardcore defensive sectors like food, healthcare and personal goods), but to recap, the main points to stress are as follows.

Cash generation and levels of financial leverage

Having lost discipline on both fronts during the late '90s boom, telcos have recovered admirably, with many of the worst offenders from that era now moving towards leverage levels (defined as net debt/EBITDA) of around 2x, and in some cases dramatically less.

Meanwhile cash flow remains enviably strong. A good case in point is the recently released third quarter results from KPN, in which this relatively small company confirmed its 2010 target of free cash flow of at least €2.4bn, i.e., a level consistent with its performance in recent years. Historically, the company has used almost all free cash flow for shareholder returns, typically evenly split between dividends and share buybacks.

Therefore, barring a catastrophe or total loss of management focus, an investor looking at the scarred financial landscape would naturally gravitate to such a company, and unsurprisingly KPN is the third best performer in the European sector year-to-date (and number 51 out of the STOXX 600).

From a longer term perspective, KPN's cash flow is also attractive for the future option value it delivers: it can be opportunistically deployed by the company to attack, defend, transform, or acquire as needed - the number of companies with such a range of options declines by the day.

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Refinancing risk

As the chart below shows, the amounts in question are not trivial, and a loosening of the credit market notwithstanding, refinancing will almost certainly be more expensive. However, it is important to note that in each case, the amounts in question are within the free cash flow envelopes of the companies, so refinancing should rightly be viewed as, at worst, an incremental source of pressure, rather than as a terminal event.

In contrast, many of the private equity-backed companies in the cable and alternative operator space are carrying 4x - 7x leverage, and will face serious challenges in refinancing - a view reflected in the fact that the debt of some currently trades at less than half of its face value.

The message is further underlined by Virgin Media's recent request for senior debt holders' consent to defer maturities to 2012, and also by Spanish cable giant ONO's reported intentions to lay off 30% of its workforce.

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While telcos may be attractive to investors in the current climate of uncertainty, this is in a sense a deeply unflattering compliment, akin to "Please hold my hand, you're the least ugly girl at the dance." Apart from the aberration of the late 90's boom, when explosive growth in mobile subscribers and enthusiasm over 3G prospects lent telcos an almost "dotcom" level of glamour, telcos as a group have rarely ever delivered consistently impressive long-term returns to shareholders.

In fact, an examination of annualized total returns for a selection of telcos since IPO demonstrates that the long-term, "buy and hold" investor would in many cases have been better off buying "boring" government debt, or even simply putting cash in a savings account. (In the specific case of the European telcos, Bloomberg data shows that average annual returns over the past 20 years have been 5.47% - bond-like, albeit with an awful lot of volatility along the way.)

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It is performance such as this which inevitably brings about investor skepticism over the entire industry's ability to execute and deliver shareholder value, which from our experience seems widespread and deep-rooted. One institutional investor observes:
"Telcos, particularly in Europe and Japan, need to either gain competence as investors or learn to give 100% of free cash flow back to their share owners. Many telecoms executives see themselves primarily as operations staff (they know how to run networks/businesses) and are not financial investors, but many of these same executives think it is a horrible idea to return 100% of free cash to shareholders, and instead want to do M&A for growth. Logically speaking, these are mutually exclusive perspectives."
Another institutional investor, in response to the question, "What do telcos need to do better?" responds bluntly:
"A) Anticipate the future and then formulate a vision of how to get there. These guys miss everything, it seems. B) Learn how to make nice with partners and not try to squeeze every ounce of blood from them."
Still another investor states, this time in response to the question, "What haven't telcos tried so far which you would like to see them try?":
"1). Good-faith structural separation.  NOT to keep the regulators happy, but to clarify their own internal cost/return structures.  2). Good faith wholesale service on flexible access terms (especially in wireless).  A simple, clearly-defined/specified, no-human-permission-required means to access a wireless network to achieve whatever ends the end device seeks (rather than having to sit down and negotiate customer terms with the carrier).
3). Auction structures for selling network capacity or some similar way a way to sell currently un-sold network time at say 3 AM (again, especially in wireless).  By definition, this needs to be low cost and low friction. "

Perhaps most telling in our discussions with institutional investors was the prevalence (among 60% of respondents) of a view that what telcos do best is, in fact, lobbying and engineering regulatory barriers to entry.

Given the apparent investor skepticism around telco capabilities, it is important to maintain a sense of perspective and not become complacent with the current popularity of the sector (nor with the prospect of a number of competitors going to the wall), because as one financial analyst was recently overheard to say, "The secular issues facing this industry make the cyclical challenges look almost trivial."

It may be safely assumed that, once the market stabilizes, investors will return to a greater focus on long-term strategic issues affecting telcos' ability to generate sustainable shareholder value, and here the jury is very definitely still out.

Moreover, though we may speak in terms of relative financial strength as a telco virtue currently in vogue, it is sobering to consider the possible long-term implications of the financial positions of a group of companies which we identify, for various reasons, as "encroachers" in various aspects of telco activities. This is presented again in terms of financial leverage (net debt/EBITDA), where a negative number indicates a net POSITIVE cash balance relative to annual EBITDA.

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Viewed in this light, telco financial flexibility looks somewhat less enviable, especially as we can expect that many of these truly global (a claim no telco can legitimately make with regard to more than one part of its business portfolio) "encroachers" will continue to innovate and invest through the downturn, emerging stronger in the end.

The challenge, and opportunity, for telcos is to do the same. The real window of opportunity is probably only as long as the looming recession itself, estimates of which seem to grow deeper and grimmer by the day. However, there's no time like the present to begin the process of repositioning for the eventual turnaround. We believe this process should be guided by the pursuit of two-sided business model opportunities, and consequently, the chance to force a fundamental re-evaluation by investors of long-term telco prospects. Why do we come to that conclusion, and what do we mean in concrete terms?

Lets go back to our fund manager friends for some guidance - after all, their views of "telcos of the future" will have a lot to do with what telcos can do, what they are worth, and what sort of capital they can raise.

"Telcos need to either gain competence as investors or learn to give 100% of free cash flow back to their share owners."

In practice, the years ahead will probably call for walking a tightrope between the two extremes, but investor response will be determined by how the message is communicated and executed upon. If cash needs to be redeployed in investments for transformation, reinvention, or asset optimization, that's a saleable message, if it is presented credibly.

What matters most is that it be backed by a well thought out plan, and that will initially require an honest audit of the company - what it's really good at, what it should and realistically can improve, and most importantly, what it needs to find another solution for.

"Anticipate the future and then formulate a vision of how to get there. These guys miss everything, it seems."

Reading the tea leaves has never been easy, particularly in a period of unprecedented economic turmoil. However, a few things we seem to know from history. Cross-border incursions and M&A strategies based on footprint have delivered very mixed results - a handful of successes as well as many humiliating retreats. Homegrown innovation has long-ceased to be an area where telcos can really play.

Neither is consumer experience an area in which telcos have covered themselves in glory. Optimization (product tailoring/segmentation/personalization, customer care and churn reduction), on the other hand, is hardly ever a bad thing, particularly when market growth falters. Ditto for a more robust approach to wholesale - not only in terms of the existing range of services, but more importantly, those services which you haven't created yet.

"Learn how to make nice with partners and not try to squeeze every ounce of blood from them."

The term "partner," by definition, suggests someone aligned with one's own interests, and by implication is someone with complementary attributes - if we were all fully-formed and complete, there would be no need for partners. Leaving aside the accusation of "blood-squeezing", the salient points for us are:

  1. Having the agility and flexibility to be able to partner with small and innovative companies in an equitable manner, to enable the wholesale platform services which you haven't created or thought of yet;
  2. Remembering the Peter Principle - "everyone rises to his own level of incompetence." Partners may also need to include those to whom you outsource (or even sell) elements of your business, if an honest review of your business suggests that they could run it better than you.
  3. Making friends with scary people - The "encroachers" mentioned above have a lot of cash, ability to innovate, and truly global scale, it's true. They may even have relationships of some sort with many millions of your customers - but what they lack is the level of insight into your customer base that you have. How might you be able to parlay that advantage into a viable partnership or a wholesale service that multiple encroachers would pay to access?

"Good-faith structural separation.  NOT to keep the regulators happy, but to clarify their own internal cost/return structures...  Good faith wholesale service on flexible access terms..." These soundbites from "Investor #3" really bring all the above points to a head, and demonstrate an imminent need to grab the bull (or, perhaps more appropriately in the current financial environment, the bear) by the horns (or ears).

In an era of constrained finance, everyone, from national finance ministers to individual consumers, has to adopt a Darwinist approach to how capital and effort are expended, and to what end. Telecom, like many other industries, is vulnerable to challenges as to how it is organized, and as to whether the status quo actually represents the optimal financial efficiency for the future.

Investor #3's opinions seem to point to the fact that there may be a confluence of interests between telcos (clarification of divisional financial performance metrics and capital efficiency) and investors in pursuing the broader opportunity to develop new markets around wholesale platform opportunities.

We look forward to engaging with you on practical steps to bring about the changes required to capture the two-sided market opportunity at our upcoming event.