All hell may be about to break loose in European telecoms. At its worst, this means that the days are numbered for any integrated fixed-mobile telco... 

A new round of acquisitions and takeovers in European telecoms could have a destabilising effect on traditional telco structures and an inflationary impact on their valuations. That’s a classic bad news/good news scenario. If you can handle both ends with equanimity, whether you are an investor or an actual telco, it’s a rosy prospect. If not, the sense is that today’s telco structures are entirely unsuited to the strategic and commercial challenges that lie ahead.

In the first of two articles, we set the scene.

Money matters
Ever since the telecom industry as a whole swapped conventional engineering for its financial equivalent, it has been subject to a new set of external variables. It’s a danger, not least because one is not always sure that the companies involved actually understand it.
 
It brings its own form of ‘convergence’. Forget whether IP or ATM is the technology of choice; forget managing the migration from 2G to 3G. Forget the ‘over-’ culture and it subsects such as voice-over-IP, Ethernet-over-copper and for all we know somewhere-over-the rainbow. We are talking here of the convergence between raw market economics and the cartelist behaviour one would expect from an industry populated in the main by a bunch of former state utilities.

The accountants are crawling over major telcos like maggots finding nourishment in the underbellies and limbs of their corpses – except they don’t care whether they are dead or not. Chasing behind are the venture and vulture capitalists. These two classes of financial investor are closely linked. Venture capitalists and private equity consortia may rank as ‘respectable’ progenitors of investment and innovation. Vulture capitalists feed on the carrion of such deals, not least the debt created in order to complete them.

Both classes of investor have now raised their benchmarks to ‘seven-zero’ targets; that is to say, investments worth more than US$10bn. This comes after five years or so spent nibbling at the industry’s edges, in large part feeding off the detritus of the dot.com era.

Seen in one way, the telecom sector may be about to pay the price for its resilience in the aftermath of the dot.com implosion. The dot.coms were supposed to kill the PTO dinosaurs. Boom to bust was supposed to unhinge debt-laden telcos. Pain there was, everywhere, but the doomsayers were wrong. So wrong that traditional telcos are now the biggest players in telecom-town.

And yet they are at risk. The telco survivors may preen and snarl but they are still wounded animals in a commercial territory where the law of the jungle most surely prevails. News this week that Deutsche Telekom is stalking UK mobile operator O2 (click here) or that TDC of Denmark is on the radar of private equity investors (click here) sets the stage for a massive, lengthy, convoluted and interconnected transfer of power in European telco equity. These two prospective deals encapsulate certain key aspects of what may be about to happen and about where it might all end.

Party game pentathlon
The last time such an upheaval occurred, in the 1990s,  it was the industry giants, and their smaller counterparts, indulging in the ultimate party game pentathlon – a bizarre combination of ‘musical chairs’, ‘ninepins’, ‘spin the bottle’, ‘pass the parcel’ and ‘pin the tail on the donkey’. Last time around, most of these industry players had the safety net of state involvement and the plastic shield of ‘golden shares’ to protect them.

Not this time. Most states, even the French for goodness sake, have relinquished formal proprietorial control of their flag carriers. In many cases, particularly the French for goodness sake, this does not mean an end to state protection of national champions; but the extent of such protection is considerably weakened compared to five years ago and the legal authority to challenge the use of those protective measures that remain has increased. This is the key that opens the door, quite legitimately, to the private equity profiteers.

Same old song?
Reading the runes in terms of the forces that would result from events such as a private equity takeover of TDC and/or the purchase of O2 by DT creates a strong sense of déjà vu. Here are three examples of ‘we’ve been here before’: one drawn from the TDC case, one from DT/O2, and one from the two deals taken together.

If TDC gets gobbled up, one can imagine small cap carriers huddling together for protection, forming alliances as they did years ago as a defensive gesture. This might be necessary since a sale of TDC would create momentum for copycat deals with other carriers more or less in ‘free float’. It’s open season. European flag carriers such as Belgacom, Telecom Austria, OTE in Greece, Telenor Cable and Wireless – even KPN in the Netherlands and Swisscom – all have market capitalisations under US$20bn and thus at the lower end of the ‘seven-zero’ bracket. Additionally, and of vital importance to private equity investors, they have portfolios of international investments that might be worth more, in the near-term, if they are broken up.

If Deutsche Telekom buys O2, it will trigger aftershocks across Europe and beyond. Do you remember what happened the last time that a German company bought a UK mobile operator? It was in 1999, when Mannesmann attempted to pay €30bn for the UK’s Orange, at that time owned by Hutchison. This stung Vodafone, Mannesmann’s erstwhile partner in German cellular, into launching its €180bn takeover of Mannesmann (oh for the days of the ‘eight-zero’ deal!). The repercussions of this action – to name but a few: the fracturing of the France Telecom/Deutsche Telekom alliance and the acquisition of Orange UK by FT, followed by the reverse takeover of FT’s mobile brand by Orange – reshaped the telecom landscape across Europe. The purchase of O2 might not prove quite so seismic, but don’t bet against it: O2’s German subsidiary would be ‘in play’ in the wake of any takeover. How its fate is decided might be pivotal in a new realignment of European cellular, not least if FT fancied not only O2 but also its KPN-owned rival, E-Plus.

Both these scenarios point to a third inescapable truth: value inflation. Peer pressure has a wonderful habit of driving up the values of potential target companies. After any deal, investors seek out similar companies that might be next on the list and predators (trade or private equity) seek out similar companies whose acquisition could be seen as a response, a we’re-not-getting-left-behind moment. What’s more, except in the most bearish of market conditions, post-merger asset disposals due to regulatory concerns over concentrations of market power can fetch inflated prices notably when, as is the case with O2 Germany, they carry ‘entry ticket’ status.

You can make out a case for these developments being some sort of Redux trend. You can also see it getting out of control and turning into dot.com dystopia, Mk 2. On the one hand, a rise in telco values is a form of Redux, as gauged by indicators such as our own Redux Global ICT 100 Index. On the other hand, an inflationary spiral brought about by lots of stupid chief executives pumped up by their own testosterone and chasing every bit of telecom ‘skirt’ on offer augurs ill for the longer term.

Old song, new singers?
Although much of this feels familiar, there are new things to consider as well that make the current situation different from last time; many of these can be put down to the presence of the private equity investors. Apart from the changed circumstances under which former monopolies now operate that were referred to earlier, the telcos need reminding of just how far their stock, in both senses of the word, has fallen since 2000. This is one area that private equity investors are keen to exploit.

The first result of this is the prospect of mano a mano combat between private institutions on the one hand and trade investors on the other whenever a telecom business is put ‘in play’. We have already seen this in the case of the takeover of Spanish cellular player Amena by France Telecom (click here); the deal was secured from under the noses of a number of rival VCs. The latter squawked that they were being manipulated to force trade buyers off the sidelines. Oh dear: it’s a nasty world, capitalism.

A second difference is that industrial investors – railways, highway companies, energy companies, etc – have largely departed the scene compared to five or ten years ago. This means trade buyers and their private equity counterparts must deal, for the most part, with large institutions, who in turn might be less concerned with strategy and synergy and more concerned with the return on their stakes. This would favour are private equity friends (importantly, they are usually friends with the institutions, too) in most cases. It also makes the whole process more messy and protracted. Hey, it’s a Friday, so we won’t mention that it makes it more prone to insider dealing and outright corruption, too.

A third point to note is that, this time around, US trade buyers are likely to be absent from any major deals in markets such as Europe. A decade ago, major US players such as WorldCom, Sprint and AT&T (where are they now?) along with the major RBOCs were never far from the fringes of any deal. Now they are in mufti in all but their home markets. That might prove counter-inflationary, but don’t bet on it.

A fourth consideration relates to the fact that trade buyers such as telcos were untouchable last time around. They were financially equipped to act as buyers in a sellers’ market. They paid top dollar for assets even when the industrial logic behind such deals was questionable or spurious. They then paid a heavy price when the extent of their follies was revealed. This is not something which the private equity players have done up until now, not least because they have been confining themselves to the sub-Richter end of the business. Most private equity deals will have done little to make AG Bell twitch, let alone spin in his grave. Now, however, aggressive telco behaviour must be tempered by the fact few are not themselves vulnerable. One bad deal, or one deal too far, and they are history: shareholders can bay for blood and the private equity corps can obligingly suck it out for them.

It might also be remembered, fifthly, that market consolidation in cellular (as opposed to market entry last time) looks set to become the guiding principle behind takeover deals. Regulators seem prepared to allow market consolidation at the smaller end of their wireless markets (think DT in Austria and now, possibly, DT in the UK). These moves offer regulators and operators one way out of the holes they dug for themselves in the auctions of 3G licences.

So a sixth and final conclusion to be drawn from the above is related to what might happen if private equity floods into a sector like European telecoms on the back of a new frenzy in M&A. It’s not a new question, but as events unfold it becomes a more and more pertinent and irresistible one: why on earth saddle wireless operators with the unedifying task of propping up  lumbering fixed-line operators?

Break it up?
In today’s telecom market, you have on the one hand the convergence between fixed and mobile services; on the other hand, you have the structural cohabitation between the operators of fixed and mobile networks. Convergence is a good thing; cohabitation is more difficult and at times downright nonsensical.

The second half of this article, published next week, will show how a new spree of acquisitions will see the  integrated fixed-mobile telcos, even the giants, suffering from a lack of financial firepower. This will be seized upon by the private equity camp, not just in terms of competing for assets but in making the case for the separation of fixed and mobile businesses in the largest incumbents.

Don’t forget, private equity bids are made on the basis of break-up values or cost reductions or both. Integrated telcos are prime candidates in this respect. Since the inception of mobile communications, telcos have had an awkward relationship with their mobile divisions. Witness the number of partial privatisations, spin-offs and buybacks and the never-ending search for an integrated structure.

Too often, this seems to result in mobile businesses that have few of the advantages of independence and all of the disadvantages of being shackled to a fixed-line bureaucracy. Now, in addition, it is the mobile businesses who are funding their fixed-line siblings and delivering the growth in almost any major telco you care to name.

And that is precisely what private equity investors look for when sizing up potential targets.
Jim Chalmers

A link to the second part of this report will appear here when it is published next week.