Credit Crunch - Silver Lining for Telcos? (Part 2)
Two weeks ago we presented a very gloomy picture of the developing stress in the financial markets, and its likely implications (positive and otherwise) for telcos. Two weeks is an awfully long time in today's markets, and while it hardly gives us pleasure to acknowledge that much of what we previously envisaged is now playing out before our eyes, it probably makes sense to revisit the topic.
In short, things have gotten much, much worse since our original post only two weeks ago. Unless you've been hiding in a cave in Afghanistan, you have probably noticed the fitful attempts in the US to pass an economic stabilization package, to the tune of $700bn, with a lot of enhanced corporate governance provisions and regulation attached. The independent investment banks once known as the "Bulge Bracket" no longer exist, and the stagnation of the credit markets is now resulting in a wave of nationalisations, quasi-nationalisations, and government-orchestrated private sector bailouts in Europe, as well as in the US. Business confidence in Europe is at its lowest ebb since the shock and awe of 9/11, and investor concern over the health of commercial banks, as reflected in a flight of capital into Treasuries, is at its greatest point since the Great Depression.
As the Western governments trudge through a multi-trillion dollar rescue exercise in the banking sector, from which they themselves will emerge as highly leveraged stakeholders in the financial markets, the alternative sources of liquidity on which companies have often relied in the past, namely hedge funds and private equity, are both under increasing pressure.
Beyond the direct effects of the banking crisis on private
equity, the voices predicting an implosion of PE financing structures from the most aggressive vintages are growing in number and volume. The hedge fund industry, which is down by 10% overall year-to-date, is now grappling with a ban on short-selling of financial stocks, with talk in some circles of wider restrictions on short-selling if the market deteriorates further. This is hardly welcome news, as short-bias funds are one of the few bright points in the industry, up 9.4% year-to-date at the end of August. These additional constraints merely fan the flames of investor discontent, which manifests itself in rising redemptions.
The asset sales under duress which look likely to end up in the alternative investment space will place additional pressure on the currently healthier participants in the market, leading to intensified asset price deflation. The popular mood in the current climate means that few on Main Street will cry for Wall Street; however, as the current financial crisis shows, failures in complex systems often have far-reaching and unforeseen consequences, and ancillary industries (legal and transaction support, professional services, consulting, corporate advisory, IT, commercial property, corporate entertainment, catering, travel) are going to be directly affected, as are pension funds exposed to alternative asset classes.
So, in short, the picture is not pretty, and unravelling somewhat faster than we had expected. However, as we argued two weeks back, this grim background actually highlights the relative strength of telecom, a view seemingly shared by the stock market. Over the past week of turmoil, the telecom sector in Europe, as captured in the DowJones STOXX 600 definition, is at the bottom of the first quartile of industry groups in terms of performance - albeit not in positive territory.
At a time when investor concerns are tightly focused on 'leverage', telcos also look relatively conservative, certainly in comparison to the previous market downturn. Analyst consensus forecasts show leverage (defined as the ratio of net debt-to-EBITDA) at well below 2.0x for the vast majority of major telcos over the next two years, and in some cases (e.g., China Mobile), companies are sitting on significant net cash positions. Forecast leverage profiles are set to decline, or remain flat, even without the aggressive capex cuts and dividend haircuts which the companies could invoke should things turn really nasty. The contrast with private equity-backed cable companies, some of which carry 4.0x or more in leverage, could not be more striking.
Even taking for granted that current analyst estimates may be too optimistic, and that the cost of refinancing the not-inconsiderable debt maturities of the next three years (€76.8bn combined for AT&T, DT, FT, TI, Vodafone, Telefonica, Verizon, KPN and BT) might pose headwinds in de-leveraging, it is exceedingly difficult to picture any of these companies actually going bust - which makes them highly attractive in an era of rampant risk-aversion.
So, overall, things could certainly be worse for telcos. As we stated in our previous post, the sector possesses the financial flexibility to step up to emerging investment opportunities as we work our way through this crisis, be they distressed assets, stranded venture investments, or organic development programs. We think there are several important points to hold in mind to ensure that telcos emerge stronger once the storm is over:
1. Don't be in a hurry. We are nowhere near the bottom of the current downturn - the systemic issues are profound and will take time to flow through the broader economy. Valuations will compress much further as levels of distress increase. However, potential opportunities should be firmly on telco radar screens and drawing boards.
2. Expect the unthinkable. We may be on the verge of widespread business failures, high unemployment, and a significant level of mortgage defaults. If telcos haven't drafted a doomsday scenario, then it's time to rally the troops and do so, and to be prepared to be frank with the capital markets about what might lie ahead. Certainly the financial sector itself serves as a salutary example of how nervous markets are inclined to punish companies which are less than forthcoming on the realities of their situations, or which don't understand them.
3. Don't unnecessarily give customers an excuse to leave. Economic forces will hit the customer base, it's inevitable. However, when customers are already feeling vulnerable, there is no point in further frustrating them to the point of capitulation. Redouble efforts on improving customer care - voluntary churn due to dissatisfaction should be anathema like never before.
4. Pitch the proposition carefully. Abandon silly, frivolous and aspirational marketing campaigns, in favour of a more down-to-earth message: telco services offer good value for money (little white lies are permissible in an economic crisis), cheap entertainment, empowerment through access to information, and are as essential as electricity and water.
5. Most of all...Take the chance to change. Crisis has a unique power to focus minds. There is no downside in being open to some new approaches when in uncharted territory. In our previous post, we suggested that telcos could take the opportunity to diversify their DNA, create better structures (here is an interesting example) for interfacing with small, innovative companies, possibly even including equity participation - and we stand by that view. There is also now an opportunity to take a long, hard look at current areas of activity, and to reassess whether they actually make sense in this changed climate.
Where to start?...We believe of course that the Telco 2.0 Manifesto provides the direction. The tangible next step towards this is to pilot one or two two-sided business model concepts (see our Use Case project here). Here's a tip for readers of this blog: our analysis suggests that supporting enterprise Customer Care processes offers the best new opportunity...
We'll be demonstrating why at the Telco 2.0 event on 4-5 November (details here).