We outline our ‘proxy model’ for valuing Digital Services Businesses, based on current best practice, which has significant advantages over traditional approaches. This report, our second of two on valuation, gives a worked example of a telco’s digital business in Asia that is already worth $1bn, and includes an analysis of approaches being taken by some leading telcos today.
When Hewlett Packard’s then-CEO (Carly Fiorina) defended HP’s infamous acquisition of Compaq in 2002, she offered a number of arguments as to why the deal made sense. Firstly, the combined entity would now be able to meet the demands of customers for “solutions on a truly global basis.” Secondly, she claimed that the firm would be able to offer products “from top to bottom, from low-end to high-end.” Lastly, but perhaps most importantly, the merger would generate “synergies that are compelling.”
‘Synergy’ is a straightforward concept: the interaction of two or more entities to produce a combined effect greater than the sum of their parts. Synergistic phenomena are ubiquitous in the natural world, ranging from physics (e.g. the building blocks of atoms), to genetics (e.g. the cooperative interactions among genes in genomes) and the synergies produced by socially-organised groups (e.g. the division of labour).
In the business world, ‘synergy’ refers to the value that is generated by combining two organisations to create a new, more valuable entity. Synergies here can be ‘operational’, such as the combination of functional strengths, or ‘financial’, such as tax benefits or diversification. Traditionally, however, investors have been deeply sceptical of synergies, in terms of both their existence and the ability of M&A activity to deliver them. This was the case with the HP-Compaq merger: the day the merger was announced HP’s stock closed at $18.87, down sharply from $23.21 the previous day.
Recently, ‘synergy’ has also become an increasingly familiar term within the telecommunications industry, owing to activities in two distinct areas. These are now discussed in turn.
Fixed-Mobile Convergence: How tangible are the synergies?
Fixed-mobile convergence (FMC) is a hot topic, and numerous substantial M&A transactions have occurred in this space in recent years (especially in Europe). Figure 1 charts some of these transactions, including publicly available synergy estimates (reflecting cost savings, revenue benefits, or both), below:
Figure 1: Fixed-mobile convergence driven by synergy value
Source: Vodafone, Analysys Mason, STL Partners
* Synergy run-rate by 2016; ** Revenue synergies only
With synergies estimated to account for over 10% of each of these transactions’ valuations, and in the case of Vodafone/KDG nearly 30%, they are clearly perceived as an important driver of value. However, there are two key qualifications to be made here:
- Discounted Cash Flow, or ‘DCF’, is theoretically sound but less credible in practice: Each of the estimates of ‘synergy value’ in Figure 1 were constructed using DCF techniques, which attempt to forecast future cash flows and ‘discount’ these to their overall value today (e.g. because one can save cash and earn interest) . Although theoretically sound, there are several problems with DCF in practice.
- Certain FMC synergies are more tangible than others: Whilst cost-centric synergies, such as economies of scale (e.g. combined call centres) and access to mobile backhaul, are tangible and easier to quantify, revenue-centric synergies (e.g. quad-play and upselling) are less tangible and more challenging to quantify
These qualifications mirror those raised in the ‘Valuing Digital: A Contentious Yet Vital Business’ Executive Briefing, which discusses the challenges telecoms operators are facing when seeking to generate formal valuations of their digital businesses.
Recap: Digital businesses are especially challenging to value
As telecoms operators’ ambitions in digital services continue to grow, they are increasingly asking what the value of their specific digital initiatives are. Without understanding the value of their digital businesses, telcos cannot effectively govern their individual digital activities: prioritisation, budget allocation and knowing when to close initiatives (‘fast failure’) within digital is challenging without a clear idea of the return on investment different verticals and initiatives are generating. However, telcos face significant challenges across three areas when attempting to value their businesses:
- There are challenges in valuing any business (analogue or digital): Although DCF has its drawbacks (see above), any quantitative ‘model’ is necessarily a simplification of reality
- Traditional approaches to valuation (e.g. DCF) are inadequate for digital businesses: DCF is especially inappropriate when valuing early-stage digital businesses due to their unique characteristics
- The potential for digital services to generate ‘synergy value’ presents further challenges for valuation: Synergy value presents additional conceptual and practical challenges when digital businesses are held within telecoms operators. Figure 2 outlines these below:
Figure 2: Conceptual and practical challenges caused by synergy value
Source: STL Partners
Therefore, telcos (but also the broader technology ecosystem in general) need a new set of tools to answer questions in two key areas. For example:
- How should telcos model the market value of their digital businesses?
- Introducing ‘proxy models’
- What are the advantages and disadvantages of proxy models?
- How can a proxy be built to account for issues around limited data availability?
- Case studies: example valuations of high-profile but privately-held initiatives
- How should telcos think about the ‘synergy value’ generated by their digital businesses?
- What is a useful framework for thinking about synergy value?
- How are some telcos using clinical trials to assist in the ‘measurement’ of synergies?
- Executive Summary
- Fixed-Mobile Convergence: How tangible are the synergies?
- Recap: Digital businesses are especially challenging to value
- A Digital Valuation Framework
- ‘Net synergy’ has four components: benefits and costs, to and from the core
- Benchmark data theoretically leads to conservative valuations
- How to Build a Proxy Model
- What is a ‘Proxy Model’?
- Proxy models have several advantages over DCF, but they also have data availability challenges
- Case Study: SK Telecom’s MelOn could be worth $1bn+
- How to Measure Synergies
- The Theory: Clinical trials reduce the synergy problem
- Case Study: A leading European MNO works with its OpCos to run clinical trials
- Conclusions and Next Steps
- STL Partners and Telco 2.0: Change the Game
- Figure 1: Fixed-mobile convergence driven by synergy value
- Figure 2: Conceptual and practical challenges caused by synergy value
- Figure 3: MTN Mobile Money Uganda, Gross Profit Contribution, 2009-12
- Figure 4: ‘Net synergy’ across four categories
- Figure 5: ‘Net synergy’ as a component of digital business value
- Figure 6: Facebook monthly active users vs. valuation, Q1 2010-Present
- Figure 7: Proxy model output – SME SaaS providers (financial driver)
- Figure 8: Total VC Investment by Geography, 2010-13
- Figure 9: Example operational and financial ‘Emerging Market Discounts’
- Figure 10: Proxy model output – Digital Music (operational driver; South Korea)
- Figure 11: Correlation vs. Causation