Full Article: Credit crunch – silver lining for telcos, part 2

Two weeks ago we presented a very gloomy picture of the developing stress in the financial markets, and its likely implications (positive and otherwise) for telcos. Two weeks is an awfully long time in today’s markets, and while it hardly gives us pleasure to acknowledge that much of what we previously envisaged is now playing out before our eyes, it probably makes sense to revisit the topic.

In short, things have gotten much, much worse since our original post only two weeks ago. Unless you’ve been hiding in a cave in Afghanistan, you have probably noticed the fitful attempts in the US to pass an economic stabilization package, to the tune of $700bn, with a lot of enhanced corporate governance provisions and regulation attached. The independent investment banks once known as the “Bulge Bracket��? no longer exist, and the stagnation of the credit markets is now resulting in a wave of nationalisations, quasi-nationalisations, and government-orchestrated private sector bailouts in Europe, as well as in the US. Business confidence in Europe is at its lowest ebb since the shock and awe of 9/11, and investor concern over the health of commercial banks, as reflected in a flight of capital into Treasuries, is at its greatest point since the Great Depression.

As the Western governments trudge through a multi-trillion dollar rescue exercise in the banking sector, from which they themselves will emerge as highly leveraged stakeholders in the financial markets, the alternative sources of liquidity on which companies have often relied in the past, namely hedge funds and private equity, are both under increasing pressure.

Beyond the direct effects of the banking crisis on private equity, the voices predicting an implosion of PE financing structures from the most aggressive vintages are growing in number and volume. The hedge fund industry, which is down by 10% overall year-to-date, is now grappling with a ban on short-selling of financial stocks, with talk in some circles of wider restrictions on short-selling if the market deteriorates further. This is hardly welcome news, as short-bias funds are one of the few bright points in the industry, up 9.4% year-to-date at the end of August. These additional constraints merely fan the flames of investor discontent, which manifests itself in rising redemptions.

The asset sales under duress which look likely to end up in the alternative investment space will place additional pressure on the currently healthier participants in the market, leading to intensified asset price deflation. The popular mood in the current climate means that few on Main Street will cry for Wall Street; however, as the current financial crisis shows, failures in complex systems often have far-reaching and unforeseen consequences, and ancillary industries (legal and transaction support, professional services, consulting, corporate advisory, IT, commercial property, corporate entertainment, catering, travel) are going to be directly affected, as are pension funds exposed to alternative asset classes.

So, in short, the picture is not pretty, and unravelling somewhat faster than we had expected. However, as we argued two weeks back, this grim background actually highlights the relative strength of telecom, a view seemingly shared by the stock market. Over the past week of turmoil, the telecom sector in Europe, as captured in the DowJones STOXX 600 definition, is at the bottom of the first quartile of industry groups in terms of performance – albeit not in positive territory.


At a time when investor concerns are tightly focused on ‘leverage’, telcos also look relatively conservative, certainly in comparison to the previous market downturn. Analyst consensus forecasts show leverage (defined as the ratio of net debt-to-EBITDA) at well below 2.0x for the vast majority of major telcos over the next two years, and in some cases (e.g., China Mobile), companies are sitting on significant net cash positions. Forecast leverage profiles are set to decline, or remain flat, even without the aggressive capex cuts and dividend haircuts which the companies could invoke should things turn really nasty. The contrast with private equity-backed cable companies, some of which carry 4.0x or more in leverage, could not be more striking.


Even taking for granted that current analyst estimates may be too optimistic, and that the cost of refinancing the not-inconsiderable debt maturities of the next three years (€76.8bn combined for AT&T, DT, FT, TI, Vodafone, Telefonica, Verizon, KPN and BT) might pose headwinds in de-leveraging, it is exceedingly difficult to picture any of these companies actually going bust – which makes them highly attractive in an era of rampant risk-aversion.


So, overall, things could certainly be worse for telcos. As we stated in our previous post, the sector possesses the financial flexibility to step up to emerging investment opportunities as we work our way through this crisis, be they distressed assets, stranded venture investments, or organic development programs. We think there are several important points to hold in mind to ensure that telcos emerge stronger once the storm is over:

1. Don’t be in a hurry. We are nowhere near the bottom of the current downturn – the systemic issues are profound and will take time to flow through the broader economy. Valuations will compress much further as levels of distress increase. However, potential opportunities should be firmly on telco radar screens and drawing boards.

2. Expect the unthinkable. We may be on the verge of widespread business failures, high unemployment, and a significant level of mortgage defaults. If telcos haven’t drafted a doomsday scenario, then it’s time to rally the troops and do so, and to be prepared to be frank with the capital markets about what might lie ahead. Certainly the financial sector itself serves as a salutary example of how nervous markets are inclined to punish companies which are less than forthcoming on the realities of their situations, or which don’t understand them.

3. Don’t unnecessarily give customers an excuse to leave. Economic forces will hit the customer base, it’s inevitable. However, when customers are already feeling vulnerable, there is no point in further frustrating them to the point of capitulation. Redouble efforts on improving customer care – voluntary churn due to dissatisfaction should be anathema like never before.

4. Pitch the proposition carefully. Abandon silly, frivolous and aspirational marketing campaigns, in favour of a more down-to-earth message: telco services offer good value for money (little white lies are permissible in an economic crisis), cheap entertainment, empowerment through access to information, and are as essential as electricity and water.

5. Most of all…Take the chance to change. Crisis has a unique power to focus minds. There is no downside in being open to some new approaches when in uncharted territory. In our previous post, we suggested that telcos could take the opportunity to diversify their DNA, create better structures (here is an interesting example) for interfacing with small, innovative companies, possibly even including equity participation – and we stand by that view. There is also now an opportunity to take a long, hard look at current areas of activity, and to reassess whether they actually make sense in this changed climate.

Where to start?…We believe of course that the Telco 2.0 Manifesto provides the direction. The tangible next step towards this is to pilot one or two two-sided business model concepts (see our Use Case project here). Here’s a tip for readers of this blog: our analysis suggests that supporting enterprise Customer Care processes offers the best new opportunity…

We’ll be demonstrating why at the Telco 2.0 event on 4-5 November (details here).

Full Article: Credit crunch – silver lining for telcos?

We’re delighted to welcome James Enck onto the Telco team. Reknowned financial analyst, hedge funder and blogger James will be helping us to make the Telco 2.0 vision more tangible for senior execs, specifically in the near term via a series of ‘use cases’ that show in more detail how Telco 2.0 thinking can work in practice. He’ll also help us engage more with the finance community.

We asked him to give his thoughts on what the credit crunch means for telcos:

Each passing day seems to bring some dire new revelation about the poor state of the financial markets. While life remains tough in Telcoland, in relative terms the financial strength of the industry generally remains enviable.

The current liquidity crisis in the financial markets may provide telcos with some unique opportunities for enhancement and transformation of business models, if they are open to deploying their capital in a manner consistent with Telco 2.0 thinking. Some of those are explored below, but there are no doubt others, and we’d be interested to hear of further examples from readers.

The U.S. government has clarified its stance on “moral hazard��? by allowing Lehman Bros, a major investment bank, to fail. The International Swaps and Derivatives Association is so focused on orchestrating an orderly unwind of Lehman’s positions that it held a special trading session on Sunday and has even canceled its own members conference, which should have taken place yesterday (perhaps they were afraid that the offer of a free lunch might trigger a riot).

AIG, which yesterday appeared to be on its knees, has been effectively nationalized. Apart from the human consequences for its 100,000 employees and consumers of its more conventional insurance and re-insurance products, its demise would have made the credit derivatives market significantly more complicated.

Sparing readers the tedious technical details, this is significant because: a) the market is huge – Moody’s estimated credit default swaps (CDS) at $62 trillion back in May (that’s the nominal, but replacement cost, which they think is more relevant, was a mere $2 trillion – in any event, as CDS has evolved to be a speculative trading, rather than commercial hedging, instrument, the contracts outstanding outstrip the underlying assets many times over, which may bring some problems of its own in time), and b) transactions are off-market, with limited visibility as to who’s doing what, and with whom.

So it’s only when the music stops that we learn which counterparties are exposed, and I assume an AIG implosion would have cascaded through similarly positioned insurers, hedge funds, and the remaining prop desks in a very ugly fashion. That nationalization was the final outcome is a symptom of just how dire things are, and does not fundamentally change the dynamic in the market, in my view. We dodged a bullet this time, but there will be more similar situations which do end badly, and my central thesis still holds.

We’re now more than $500bn down the road in the inappropriately named “credit crunch.��? I say inappropriately named because, to me, “crunch��? implies a sharp, ephemeral episode of pain or distress, but this is more akin to a pandemic wasting disease, and I think it represents a fundamental realignment of the way capital will be sourced and allocated in future.

Why should the denizens of Telcoland care? Well, because, as with most crises, there will be huge challenges and opportunities ahead.

First, the challenges.

1) Confidence, be it within the corporates (as we can see in the spike in inter-bank lending rates) or among consumers, is firmly in the toilet, ready to be flushed. Prepare for an aversion to spending, and for some of your customers to disappear.

2) Liquidity, where it exists at all, is going to be more scarce and costly. Given where LIBOR is at the moment, this could get very ugly indeed – in desperate cases, say where the margin over LIBOR is 1000 basis points or more, companies will be staring down the barrel of 17% annual interest rates. For the more creditworthy, things won’t be so dire, but it still will be a noticeable uptick.

Trawling through some Bloomberg data on debt maturities for six telcos (Vodafone, DT, FT, Telefonica, BT, and Telecom Italia), it is interesting to note that the average fixed coupon for this group’s current debt is just over 6%, i.e., below the level where banks are currently willing to lend to one another, let alone anyone else. However, these six companies combined have EUR37.5bn in debt maturing in 2009 – 2010. It will get refinanced, but every 100 basis point increment above where coupons are now adds EUR375m in interest payments. Not crippling, but not trivial either. Do you grow dividends at the expense of capex?

3) Speaking of capex, an industry contact yesterday described it as “the elephant in the room��?. If we assume that the industry globally needs a $1 trillion access overhaul, as some are already under competitive pressure to provide, then something’s got to give. Do you play “squeeze the vendor��? as your only card, defer certain projects, or find creative alternative structures to keep it off your balance sheet in the near term? Do you suddenly find that the municipal broadband “hippies��? are worth talking to afterall? Some of them might have access to cheaper finance…

4) Back to liquidity more generally. It seems clear that those investment banks which do survive are likely to be constrained by commercial and financial realities, and possibly by regulation, to a narrower mandate in future. So those with a business falling outside the “suitable for widows and orphans��? category probably won’t be able to reach out to the principal investing units of Wall Street nearly as easily as they could before.

Hedge funds with dry powder can always fill that gap, but it won’t be cheap money. And the hedge funds themselves aren’t exactly setting the world on fire as a group (keep in mind that this table may look different depending on when you read it, but at this writing, the Credit Suisse/Tremont AllHedge Index is down 6.07% year-to-date as of the week ending 8th September, i.e., before the most recent round of carnage).

There’s always private equity, but as per this analysis yesterday, we might actually find a bias towards disposal of assets here in some cases, and in any event, with the markets in the state they’re in currently, it is inconceivable that PE firms will achieve the kind of exit IRRs they might have envisaged two or three years back (I’m thinking here of some of the European cable deals which got done at eye-watering multiples – in some cases they’re very decent companies, but I can’t see an easy exit for any of them.).

And it’s probably really bad if you’re an early-stage company. There is not that much happening in early stage among the VC community, particularly in Europe, and those who are active can be extremely selective. We can expect a good number of the later-stage venture-backed companies may also struggle to attract fresh capital, especially if their funding is premised upon the promise of a traditional exit.

It ain’t gonna happen, at least not at 10x revenues, unless you’ve got something really special. The outlook is particularly poor for companies created to speculatively build large communities of users, in the hope of finding a revenue model down the road. These sites certainly create value and user benefit, but in a time of severe capital constraints, it’s going to be a hard story to sell. That pretty much leaves sovereign wealth funds ($3 trillion is a lot of money) and family offices, but they will know that they are in the driver’s seat and can be highly selective.

So, that’s a sufficient dose of pain on the challenges side. What about the opportunities?

Times may also seem hard in Telcoland, but let’s face it, telco margins are still at a level other industries would kill for, and it is not uncommon for even relatively small companies to produce EUR2 – 3bn in free cash flow annually. In the land of the broke, the man with one euro is king, so how might telcos deploy some of their relative wealth in a way that might really make a difference?

1) People – The collective stupidity of Wall Street should not obscure the real talent and intellect that rests with some of its individuals. As these firms implode, they will release some very bright people, some of whom have an intimate knowledge of their own industry and industries they have covered/invested in/done business with. Take this chance to diversify your telco DNA, particularly if you really have aspirations of competing with the likes of IBM.

2) Assets – Clearly, there is going to be a lot of distressed selling of assets. Fancy a Bulgarian incumbent or a Dutch cable company? There are deals available right now. But it won’t just be big iron assets. A lot of venture-backed companies are going to end up in distress, and some of them may possess technology platforms and/or communities that you as a telco actually can monetize.

However, you may need an outside perspective to do this (going back to the previous point), or you may need to radically change the way you think about where to take your business and how to get there. There will be huge opportunities, but it will require something other than conventional telco thinking, because the best answers will not be the obvious ones.

3) Engagement – Rather than simply waiting for companies to end up here before acting, why not partially fill the void left by the capital markets? This is not to suggest that telcos should play the pure VC role, but there is a great case for aligning strategic development goals with equity investment in companies that have something you can’t (or don’t want to) create yourself.

There is some of this going on in the industry, but not nearly enough today. Some of the companies which can help telcos reposition themselves are too small and young to be considered as suppliers – they typically can’t get in the door of corporate HQ. What might you be overlooking?

Encourage your workforce and your customers to find and evangelize interesting companies, and create a framework for vetting them, finding operational sponsorship for the suitable ones, and create a side-pocket for equity investments to let them develop.

All the evidence suggests that we’re all in for a fairly brutal couple of years, with the possible exception of talented distressed investors. Next spring may be short on roses, but they will come in time. Now go and start planting your garden.