Raising finance for telecoms
18 November 2011 | Kavit Majithia
Widespread consolidation, investment in new services and an expansion of network capacity does not happen without raising capital. Telecoms is proving big business and it is continually adding value as a major sub-sector of the world economy. Kavit Majithia asks how telecoms operators manage financing requirements.
Business economics is quite simple when you take out the buzzwords and the equations – positive and smart financing is the single biggest driver towards establishing a successful business.
When the first bell rings on the LSE and the last bell rings on the NYSE, the question most shareholders will ask is how many deals have been secured and how much money has been made or lost for their companies? How has stock value decreased or increased, and are we again talking about a global double dip recession?
The economy is made up of numerous sectors, and there is money to be made in all of them. Whether it’s in commodity, whether it’s financing through hedging, whether it’s in the corporate or government bond market, traders and investment bankers, CFOs, CEOs and strategists are persistently looking to make the right choices to cement a company’s growth.
This is no different to telecoms – there is a steady revenue stream and always an opportunity for M&A activity, regulation permitting – but what does differ is the scale and the forces driving such investment.
Telecoms is a recurring revenue business: this will never change because of a subscription model and peering agreements across the industry that tie in long-term partnerships, both established decades ago.
But it appears there is now the need for telcos to find growth opportunities that cash in on the evolution occurring in the value-added services shaping the industry, which is made even harder amidst an increasing maturity, and widespread consolidation in the major economies.
Financing in a down market
Of course, as in any industry, these global operators do not tend to finance themselves. There is huge amount of debt on most balance sheets, and it is almost always the case that financial institutions serve as advisors or underwriters for any major investments made in the telecoms industry.
The latest edition of Telecoms M&A Insights, published by telecoms advisory firm and global services company PwC, notes 354 deals in the telecoms industry in 2010: only 48% of these M&As announced transaction values, but these totalled at $250 million. Despite the high volume of deals, Arno Wilfert, strategist in telecoms at PwC, believes that telecoms operators are finding it increasingly difficult to attain fresh financing to fund M&A activity.
“This is not even a phenomenon of the telecoms market, but a more a general observation of the fact that banks are just reluctant to fund larger deals,” he says. “It is becoming difficult to secure fresh debt as variations also come down due to the stock market, which then means a price decrease. The multiples in the market also look poor which is driven by constraints in debt financing that are a knock-on effect from the sell side of the industry. Ultimately, however, telcos are not in the situation where they need to be sold because are constantly cash generating, but there is pressure on them because consolidation will not stop.”
There is clearly a case that telcos, and other global companies, are finding it difficult to secure the confidence for financing, but Wilfert also draws on the fact that there is significant opportunity for these companies to make smaller cash-generating investments if they look to increase and tap into new services.
PwC describes a market consolidation strategy with tier-two alternative fibre network operators as a telecoms deal ‘hot spot’, and notes that such asset mergers by the larger operators could result in a converged offering that is much more powerful for consumers. “As the pressure from increasing data usage in mobile, then the pressure to invest in fibre increases. The fact is over-the-top internet companies are taking telco service revenue and this puts pressure on these operators to further consolidate. I have no doubt deal value and deal volume will increase as a result of this risk.”
It is important to note that market watchers and economists believe the recession was a lot kinder to telecoms in comparison to other industries. In a down market, low confidence from borrowers is inevitable as the risk increases, but for telecoms, it could be a case that a reduction in M&A activity in particular is simply a back shoot of the fact its traditional financers do not have the capital to make the required investments, and not because the industry is suffering from a low-yield return.
“To a certain extent there is resilience in telecoms cash flows because it has nearly become a utility and customers do feel it is becoming a product that is vital to for them. It is a basic necessity,” says Karim Nasr, who has recently left his position as corporate finance officer at Orascom. “In the previous recession, one of the things we noticed was a surge in video on demand because people were cutting down on the amount they went out for entertainment.”
The risk of a low-yield return, however, can be a factor in securing financing not because of a decline in demand, but because of an increase in market pricing. Nasr says: “Ultimately telecoms is an industry with strong cash flows and financing is not an issue as long as market pricing stays low. If market pricing continues to increase, as we have seen, the industry becomes more difficult to finance because it is one that is renowned for its high dividend yield and it becomes difficult for operators to maintain CAPEX investments, keeping a relevant high dividend pay off and financing for both of them.”
Such economics may seem like the driver towards a stable business plan as long as sufficient financing is provided by the investors that fund the operators, but Nasr also draws on his own experiences at Orascom and the steps the company took internally to deal with a down market. “We had to cut down on investments when things got really bad in 2008. I cannot name the country, but we took the decision to bring down our CAPEX budget there from $1 billion to $100 million – we simply turned the tap off,” he says. “As is the nature of the industry, you cannot do it on the long haul but you can do it for periods of time when you are squeezing cash flows.”
Major investors showing concerns
One of the biggest investors and advisory firms in the telecoms market is investment broker UBS. Its portfolio of telecoms partners is unrivalled in the EMEA region, and the company has served as an underwriter for some of the largest deals in the telecoms sector over the past few years, including advising Vimpelcom over its acquisition of WIND, advising the sale of Zain’s African assets to Bharti, and also pledging over $750 million in LightSquared’s LTE project.
The role of a bank or a brokerage firm should not be underestimated in this process or in this sector, according to Christian Lesueur, managing director, EMEA media and telecoms at UBS, because of the complicated negotiations involved in M&A activity in the sector. “We not only advise the company on its approach, we help them source the buyer, negotiate the terms of the transaction which involves the value and also on the legal issues. There is also the element of due diligence – when an acquirer seeks to complete a deal they will go in and kick the tyres. If you are on the sell side like we were with the Bharti and Zain transaction you help prepare by opening the books to a lawyer.”
The telecoms, technology and media industries have served as one of the most important sectors for UBS’s wider portfolio investment, and one in which Lesueur claims the company has been the leading M&A advisor in EMEA for the last five years. Despite this, in February 2011 UBS analysts took the decision to cut its investment rating in the sector from neutral to overweight, citing long-term structural issues and a low-earning momentum, among other factors.
In keeping with analysts’ opinion at his company, Lesueur is notably less optimistic than Wilfert and Nasr in his assessment of further consolidation in the near future. “M&A rates will be significantly lower this year in the market because of an increasing macro environment,” he says.”Market volatility is not conducive for M&A considering the fact that financing and valuations are moving everyday and it is making it very difficult to find a willing buyer and a willing seller. If you also take into account the involvement of the regulators on the mobile side, which in most markets are insisting on cutting mobile termination rates, this is also putting pressure on revenues.”
Natural industry consolidator
Predicting the state of the market can serve a purpose, but perhaps it is more beneficial to draw on apparent examples in M&A activity this year to judge deal potential in the market. As Wilfert points out, “a mega deal or a spin off of network elements can change deal value significantly”: a statement which could be fully attributable to AT&T’s proposed $39 billion takeover of T-Mobile. However, this is not the only example of such consolidation in the market this year despite the level of caution expressed by much of the industry, and indeed the wider economy.
One of the major deals of 2011 was confirmed in late September this year, again involving a major US player. Level 3’s acquisition of Global Crossing, first announced in March 2011 for a reported $3 billion in enterprise value, allows the US carrier access to a global reach through Global Crossing’s network, and gives it the platform to now trade its common stock on the NYSE.
With access to over 165,000 fibre miles over intercity, metro and subsea links, Level 3 now has a network reach spanning 45 countries in three continents, and through Global Crossing, it adds to a vast portfolio of acquisitions made in the market. Since launching its operations officially in 1998, Level 3 went on to raise over $14 billion in finance and began its aggressive acquisition strategy, including the purchase of backbone provider Genuity in 2003; WilTel in 2005; Progress Telecom in 2006; and the acquisition of Savvis’s CDN business Broadwing in 2007.
Much of this strategy earned Level 3 the tag of “a natural industry consolidator” and is largely led by former Wall Street banker Sunit Patel, now CFO and vice president at the company, who believes Level’s 3 founding premise revolved around the boom and bust cycle. “Consolidation has been the theme in the US for the past 10 years, and we are finding it a good thing for the industry,” he says. “In regards to AT&T and T-Mobile, whether it goes through or not will not impact Level 3 because the demand for wireless data is constantly going up and our relationship with these providers has continued to grow with demands for data.”
Potential in data and Latin America
This trend towards data, he believes is where the biggest growth opportunities now lie in the market, and as the demand for bandwidth continues to increase, so does “the amount of people that prioritise communicating through their eyes instead of their ears”.
The other big growth area he notes is through untapped geographies, and Global Crossing’s significant presence in Latin America was also a central factor of an acquisition “that was a risk to take on in the current climate”. He continued: “Market trends are one thing, but you must also take into account the fact that a lot of telcos were started in a boom environment, meaning they already have the foundation of capital invested. Looking at the combined operation, taking into account the acquisitions made, the entity is worth over $40 billion and provides an infrastructure asset that has long-term utilisation potential.”
Indeed, Patel is not the only financial strategist working in a global telecoms operation to recognise the significant growth potential in Latin America. European telecoms operators, namely Telefónica, Portugal Telecom and Telecom Italia in particular, have embarked on a long-term strategy to invest in this market as growth in services and significant investment in infrastructure continues. Telefónica recently announced a four-year investment plan in Brazil worth $14.6 billion to contribute to the growth of its Sao Paulo-based operator Telesp and its recently acquired operator Vivo from Portugal Telecom.
David Nicholas, director of global communications at Telefónica believes such investment in the region is a natural progression considering the synergies between Europe and Latin America. “By addressing Latin America as well as Europe, we are able to help two major geographic regions take advantage of their distinguishing traits – a relationship with more than 300 million customers, capillarity and distribution channels,” he says. “Emerging markets, for Telefónica and all other global operators, will play a critical role as engines for further growth.”
Growing risk in the Eurozone
Emeka Obiodu, senior analyst at Ovum, takes a different view to the idea that this strategy is being approached on the basis on natural synergies between continents, and rather focusses on an inherent lack of market confidence in the region. As the state of the Euro currency is constantly under scrutiny in relation to foreign exchange rates, and widespread coverage from the world’s media that Greece, Portugal, Spain and even Italy could default on their debts, Obidu believes that “there seems to be a severe lack of support from European operators in backing M&A activity in Europe”.
He said: “Vodafone is very unlikely to buy anyone in Europe. Telefónica realigned themselves because of poor performance in Spain. And when it comes down to it, because of France Telecom’s Conquests 2015 strategy and its resulting investments in the Middle East and Africa, it has by and large forgone any plans to buy another European player.”
This could also be a knock-on effect of a suspected unsuccessful consolidation in the UK market for the France-based operator if market reports ring true. The company completed one of the most notable mergers in the European market in the last decade when it partnered Orange with T-Mobile in the UK to form Everything Everywhere, but market watchers have yet to see this large scale merger come to the kinds of fruition expected.
The joint entity declined to comment on the state of its operations at present, citing that “communications on the issue is challenged by the need to include our shareholders, Deutsche Telekom and France Telecom in any discussion on financial disclosure”. Unsurprisingly, both AT&T and T-Mobile also declined to comment on the state of their finances at present.
By and large, the industry still expects consolidation and there is a major scope for operators to make investments in a new evolution of value-added services. Commenting on the wider industry, Andreas Hipp, CEO at Epsilon, states most operators “have the cash reserves to act quickly because opportunities to invest are always emerging,” he says. “In times like this, cash is important and too much leverage on your business can be fatal”.
This is a strategy approach for the well established, capital intensive companies, according to Wilfert, and despite an apparent lack of confidence in the market, sourcing finance from private equity firms and investment banks still has the potential to drive market growth and consolidation. “Telecoms is a stable revenue stream,” he adds.
“If these investors work with the business model that is catered around a traditional telco mentality that they want to own their own networks and infrastructure, private equity can make a significant contribution for this. To raise finance, private equity firms can work to make telcos think in a more radical way and enable a rethink in the amount of infrastructure they actually need to own, and then create a real add on value.”