Zeniths and nadirs

Zeniths and nadirs

Chris Godsmark reviews the telecoms highs and lows in the capital markets in the last 10 years, and asks where the future financial hot spots will be.

Age can play funny tricks on us. When asked recently to write my first column for Capacity since 2004, it seemed more like a generation ago that I was considering the arcane world of narrowband internet and the arrival of carrier pre-selection on the M&A market. But the most remarkable feature of the past few years has been the sheer pace of technological and business change. As ever, the underlying drivers of this market have been the cocktail of technology and regulation which have driven the transition from narrowband to broadband. This has resulted inevitably in winners and losers and will continue to do so.

I began writing for Capacity during the aftermath of the collapse in sector valuations following the crazy boom years of 1998 to 2000. By the end of 2002, the received wisdom was that the market value of physical telecoms assets would likely never reach their replacement cost, let alone their peak valuations in early 2000. So there was effectively no incentive by operators to invest in physical capacity. Assets languished in value to such an extent that in December 2002 National Grid Transco – the former British Gas and now part of National Grid plc – offloaded its 186K national fibre network to Hutchison Whampoa for just a single £1 and a £25 million cash dowry. The asset had cost almost £400 million to build.

This wasn’t to say that M&A was dead – far from it. I have always operated principally in the middle market, away from the headlights of mega deals; there was a healthy “bread and butter” market for acquisitions and disposals during 2003 to 2006, often in the reseller sector and often driven by entrepreneurs seeking to monetise their business creations.

Just as sentiment reached its nadir, the market took a different turn – a development which during 2003 and 2004 most of us in the UK failed to spot. In the United States, the technology sector, although badly mauled in the Nasdaq collapse, had continued to invest in internet-focussed business models. In the UK, the transition to IP took longer and was much more low key. I was amazed when writing this article at how recent the explosion in broadband in the UK has been. As late as October 2005, BSkyB had us scratching our heads over its takeover of Easynet Group, a move which enabled the broadcasting giant to get its hands on the former British Waterways fibre network as the platform for local loop unbundling. It wasn’t until April 2006 that Charles Dunstone stunned the market by launching “free” broadband.

The rapid catch-up of UK broadband penetration to western European average levels has had profound effects on the shape of the sector and on M&A deals. Firstly, there has been industry consolidation into a near oligopoly of consumer broadband operators, with the jigsaw completed in 2009 with Carphone Warehouse’s acquisition of Tiscali UK. Secondly, the playing field of operators has changed completely. Who remembers Freeserve, now part of Everything Everywhere (the merged Orange and T-Mobile)? Thirdly, the consumer segment has become a scale game where only a few very large operators can and will survive. Like the mobile sector, market maturity in the broadband space has made customer growth and margins harder to maintain.

The other result of the explosion of IP traffic has been on the B2B space. Millions of content-hungry broadband consumers needed feeding and the results on the shape of the industry have been profound. The most obvious development has been the growth in the web-hosting industry. The market valuations of co-location companies are generally higher than managed or shared hosting companies, despite the fact that many invest all their cash flow into new capacity. The average EBITDA multiple for recent US larger hosting deals has been 11.5 times, a clear endorsement by investors and trade buyers.

Less obviously, the other impact has been the consolidation of the altnet segment as the transition to IP necessitated a reduction in cost bases which was only achievable through the synergies achieved from industry consolidation.

So what are my predictions for the next five years? I think historians will look back on the last 10 years not as a period when long-run demand for capacity drove the industry in new directions. It is not just hosting assets which have risen in value. The pricing and demand for physical fibre, although unlikely to reach the dizzy levels seen in the hosting market, is clearly on the increase. New open access network models are arriving, pioneered by the likes of Geo, which built a new and non-vertically integrated business model on the Hutchison network acquired from National Grid. And sitting on top of these networks are, I am pleased to say, many entrepreneurial middle-market resellers which I sincerely hope will continue to provide us with clients for years to come...

Chris Godsmark is a partner at Oakley Capital Corporate Finance. Email: chris.godsmark@oakleycapital.com


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