For how much longer can integrated telcos continue to rely on their mobile divisions for growth before investors call for the spin-off of these wireless businesses? 

Whisper it, but the telecom sector is showing signs that the early stages of Redux are afoot. In markets such as Europe, telcos are performing strongly and they, in turn, are benefiting to a dramatic extent from the growth in revenues from wireless services. If you take a holistic view of telco fortunes, this is a welcome state of affairs and marks a change from five years which were notable for the considerable levels of pain experienced in the telco world. 

We are not alone…
Not everyone takes a holistic view, however. As was pointed out in the first part of this article (if you missed it, click here), there are a number of different conditions today which were not present the last time the industry was forced to react from the eye a maelstrom of opportunities and threats.

Chief among these is likely to be the contest, between the established telecom ‘trade’ and a new generation of private equity investors, for control of the industry. We have already seen one pitched battle of this type for control of Spanish cellular operator, Amena: in that case, the trade prevailed in the shape of France Telecom and the equity venturists were left licking their wounds and muttering about ‘foul play’ in the context of the US$11bn deal. The trade vs. private equity battle is likely to rejoined if, as seems likely, a revival in industry fortunes leads to a new round of acquisition and consolidation.

Telco war chests, depleted to near-ruinous degree in the 1990s, are filling again. Today’s telcos, especially those that were privatised in the course of the last boom, have a poor record when it comes to returning cash to shareholders. Now, with debts paid down to manageable levels, the money appears to be burning a whole in their collective pockets.

The same return to health that lines telco pockets also serves to attract the attention of private equity investors, of course. Their interest is likely to drive up the price of telecom assets. In the 1990s, an asset sale might attract the interest of two or three rival telcos; today, a private equity consortium or two is sure to be added to the bidding mix.

In the past, these investors have tended to focus on smaller companies or, over the last five years, ailing businesses in the telecom sector. Recent talk of a private equity takeover of TDC in Denmark raised the bar to the ‘seven-zero’ (US$10bn-plus) mark.

A bullish private equity sector might not stop there. If leveraged buy-outs take off in telecom, there is little to prevent bids for some of the largest telcos. Indeed, if private equity groups find their ambitions frustrated by cash-laden telcos on successive smaller deals, they could well turn their attention to these giants instead.

Asset strippers?
To understand how this works and why it is important, a brief (if simplistic) outline of private equity investor strategies is in order. Most specialise in identifying business whose value is not reflected in their share prices; by attempting to take the company private, they offer existing shareholders an ‘exit route’ – sometimes welcomed, sometimes not. From there, the challenge is to oversee an increase in corporate value, typically to be realised and monetised through cost-cutting, break-up strategies or a return to the stock market through an IPO.

At times this can look like little more than asset-stripping, like capitalism at its most venal. This is especially the case when the new owners saddle their acquisitions with the debt they have incurred in financing the takeover. At other times, the companies in question are rejuvenated and it seems wrong to begrudge the investors their profit on the turnaround.

Different strokes
In the context of the looming contest between trade and private investors in telecom, there are three key and connected points to consider.

The first is simply that whereas trade investors are motivated by consolidation (with the possibility of some limited disposal of peripheral assets or those that conflict in a regulatory sense), private equity rivals stalking ‘healthy’ companies are guided solely by the break-up value. The result of this is that when one from each camp is chasing the same target, their valuations (and hence, one would assume, the price they are willing to pay) will differ. Since break-up values will almost always be higher than consolidation values, telcos may find themselves being forced to overpay for assets, simultaneously being obliged to underprice those assets that they are  required to sell.

A second factor refers specifically to the valuation of cellular businesses. Here, agglomeration suits traditional telcos while disaggregation is the tactic of choice for the private equity gangs. It has already been noted at the start of this article that integrated telcos are relying heavily on their wireless arms for free cashflow and growth, given the ‘challenging’ conditions faced in fixed-network operations. If a proportion of mobile revenues are being used to prop up other parts of the business, the actual value of the cellular unit is necessarily diluted.

Thirdly and crucially,  a wireless operator obliged to finance other parts of the telco enterprise is therefore obliged to work harder for its M&A cash than a ‘pure-play’ mobile company or, arguably, a private equity consortium. Once acquisition targets get up to the ‘seven-zero’ range, the sums involved become massive with the basic financial advantage to non-telco investors commensurately so.

Under pressure
The implications for future investment trends in cellular, notably in Europe, are immense. PTO-linked mobile operators are forced to punch below their weight on the eve of what might turn out to be one of the biggest acquisition sprees ever witnessed in any industry. In turn, this brings up the spotlight on the business logic behind keeping fixed and mobile operations under the same roof.

Ironically, those leading the line of commentators pointing out this fact are likely to come from the private equity community itself. The simple fact that integrated mobile operators are being forced to work harder to accumulate funds for investment is precisely the sort of thing that has these parties chirping ‘undervalued’ to anyone who will listen.

All this is a headache for PTOs and it has to be said that they have a long history of being unsure how to handle their mobile arms in relation to what was formerly the core business. Believers in the cyclical nature of all things might believe that a new wave of spin-offs is now overdue.

In the earliest days of mobile, in the analogue era when most countries in Europe operated on a telco-owned monopoly basis, the argument about putting a degree of distance between fixed and mobile arms popped up mainly in the handful where there was a degree of competition, such as Sweden. There and then, the argument focused on gaining access to leased lines at cheaper rates than were on offer from the telco parent, even in the opaque regulatory environment of the time.

The advent of two-way or three-way competition in GSM saw high-profile part-privatisations of wireless units in key markets such as Spain and Italy. Often, although tellingly and embarrassingly, these units quickly came to surpass their erstwhile parents in market capitalisation.

Then as boom turned to bust came the firesales. BT was forced to divest O2 as a condition of its restructuring. France Telecom floated Orange in order to pay off the debts accrued in its wide ranging acquisition strategy, although it only managed to do so once the market had peaked. Deutsche Telekom would have followed suit had not worsening market conditions stayed its hand.

It may be that DT’s decision was also based on the growing realisation that selling off such a major source of revenue was unwise. Since then, France Telecom and the owners of Telecom Italia have brought mobile subsidiaries back into their embrace. O2 remains high, dry and independent but is being stalked by DT, and perhaps others.

The way we were
The situation today is reminiscent of the time when debates over the separation of posts and telecom in classical ‘PTTs’ were to the fore. ‘Why should telecom subsidise the post?’, it was asked. So who now is asking, ‘why should wireless subsidise fixed telecom?’.

The defensive answer of course, focuses on ‘convergence’ and the growing role of wireless as the access technology of choice for voice services, and for other services as well, de nos jours. From a holistic telco standpoint this a no-brainer.

Institutional investors, who tend to play a major role in most telcos today, egged on by private equity groupings, who would love to play such a role, might dissent from this view. Ironically, any renewed wave of consolidation initiated by the telcos would throw this into the sharpest possible relief.

It is like a levee, waiting to break…
Jim Chalmers