Credit Crunch (Part 5): Escaping the Ghost of Telco Past
This post is the fifth in our series on telcos and the credit crunch.
The audience at our November event seemed comforted by the appeal which the capital markets currently find in telecom as a defensive sector. However, we also stressed that this is likely to be a fleeting phase, as underlying concerns about the industry's ability to generate sustainable value will return. The key challenge is to invest now in the sort of transformation which will allow the industry to emerge from the current crisis with a different story, the "Ghost of Telco Future" rather than the "Ghost of Telco Past". We look below at three examples of companies which made bold investments in new business models during periods of pessimism and disruption, and emerged transformed.
At our November event, we examined in detail why the capital markets would naturally look to telecom as an island of relative defensive stability. In support, we showed ranked returns for the EuroSTOXX 600 which placed telecoms in the top quartile of performance, and sought to explain why (those who weren't present can watch the presentation here). Our reasoning will by now be familiar to regular readers of this blog (balance sheet strength, cash flow generation, and a growing recognition of telecom as an essential service), and the audience seemed to take comfort from the message.
However, one point we were keen to stress is that the current market love affair with telecom is a temporary infatuation driven by the relative pain generated by other sectors, and that as the market eventually stabilizes, investors are certain to return to the secular challenges facing the industry and go in search of sustainable value elsewhere. The key, as we stated, is for telcos to seize the opportunity to invest in emerging on the other side of the current crisis with a new story for the capital markets.
Indeed, in the past month, the investor's eye seems to have begun to wander as the market has staged a rally of sorts. The updated chart of ranked performance of European industry groups over one month to 15 December, shows a number of beleaguered sectors rotating back into the top quartile, at the expense of defensive names, including telecom, which is now firmly second quartile.
DJ STOXX Europe industry ranked returns, 1 month to December 15
Source: STL Partners, from Bloomberg data
Even if the market is sending somewhat more ambivalent messages regarding confidence in telecom, it is still capable of voting with its very large feet when it has conviction. Verizon's recent success in gaining commitments from eight institutions to provide $17bn in acquisition financing for the Altel transaction was nothing short of stunning in the current glacial credit market. Equally stunning, and coming in the same week, was the collapse of the $43bn leveraged buyout of BCE by a private equity consortium. If there is a message to take away from these two developments, it is probably that the market is currently minded to back strong incumbent management teams over private equity interlopers - a reversal of the consensus views of two years ago.
So, it appears in broad terms as though the capital markets have generally given telecom and telco management a vote of confidence, but is this a new lease of life or merely borrowed time? Do investors back companies with expectations of more of the same (The Ghost of Telco Past), as the Verizon news would seem to suggest, or of something different (The Ghost of Telco Future)? Most importantly, do investors really know what they want on a long-term view? In general terms, probably so, but companies have a crucial role to play in shaping expectations and opinions by defining publicly where they're investing and to what end.
We stressed in our message to the audience at our November event that there is a risk of complacency developing in the current crisis, as heretofore aggressive competitors become financially constrained and more risk averse, giving incumbents a license to ease off the accelerator. As the Amazon Web Services example so clearly illustrates, sometimes a company has to actively invest, with conviction, against conventional wisdom, and be misunderstood for a time before its vision is vindicated. We live in difficult times, true enough, but history offers some encouraging examples of companies which invested through periods of intense uncertainty and disruption, only to emerge either entirely transformed, or with very different prospects:
- 1991: Collapse of the Soviet Union - This event caused severe disruption to the Finnish economy, forcing many companies to revamp their business models. For an obscure industrial conglomerate manufacturing rubber boots, tyres, paper, and electronics on an OEM basis, this appears to have been a key catalyst in forcing greater focus on its early work in analogue mobile telephony. True enough, Nokia had already established the building blocks of its future business, but the decision to exit businesses it had been in for 100 years in order to redefine itself in an emerging market (remember that as recently as the mid-90s, forecasts of peak mobile penetration were in the range of 20 - 25%) was perhaps not as obvious (or popular) at the time as it might appear retrospectively. Nokia's market value today is 6,900% higher than in July 1991.
- 1997 - 98: Asian Crisis and Russian default - NTT DoCoMo was very much a victim of its own success as market leader in Japan's explosive wireless market. The company had suffered a number of very high profile network failures in Central Tokyo during peak usage times (e.g., New Year's Eve), and there was much scepticism about the company's ability to scale with its growing customer base. This was an unwelcome background against which to conduct its long-awaited IPO, a situation made more challenging by two major financial crises in as many years, and there was very real concern that the October IPO (then the largest in history) would be delayed. Unbeknown to anyone on the outside of the company, a small working group was already at work on a solution to drive traffic towards data and away from voice. In a move uncharacteristic of NTT and Japanese companies generally, two of the principal figures in this development were company outsiders, and one was a newcomer to the industry. The launch of imode in February, 1999, was the first step in DoCoMo's ongoing journey towards redefining its service as a platform to enable transactions.
- 2000 - 2004: Post dotcom tech bear market - From the peak in the NASDAQ on 10th March 2000 to the close of trading for the year, Apple Computer underperformed its benchmark by 52%, quite an achievement even in those days of fear and loathing towards technology stocks. Little did the world know that the first iPod was under development, to be unveiled in October the following year, as the basis for an ecosystem of products which has entirely reinvigorated the company and the brand, generating a halo effect in the process. Apple has outperformed the NASDAQ by 1,085% since January, 2004.
Admittedly, these are extreme examples of success derived from outside-the-box thinking and countercyclical investment programs, but they demonstrate how the process can work, and coincidently two (iTunes and imode) are examples of two-sided business models. The circumstances may be different this time around, but our view remains that telco's destiny is still very much within its own power to shape and define. The process requires some DNA diversification, huge conviction, and a lot of good communication with employees and investors, but it's far from impossible. The question is whether the "Bah, humbug" mentality of complacency leads to the industry again being haunted by the Ghost of Telco Past.