Digital Services: What is Your Digital Business Worth?

Introduction

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:

  1. 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.
  2. 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:

  1. 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
  2. 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
  3. 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:

  1. 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
  2. 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
  • Introduction
  • 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

 

Valuing Digital: A Contentious Yet Vital Business

Introduction

Tech VC in 2014: New heights, billion-dollar valuations

Venture capital investment across the mobile, digital and broader technology sectors is soaring. Although it stumbled during the 2008/9 financial crisis, the ecosystem has since recovered with 2013 and 2014 proving to be record-breaking years. Looking at Silicon Valley, for example, 2013 saw deals and funding more than double compared to 2009, and 2014 had already surpassed 2013 by the half-year mark:

Figure 1: Silicon Valley Tech Financing History, 2009-14

Source: CB Insights Venture Capital Database

As Figure 1 shows, growth in funding has outstripped growth in the number of deals: consequently, the average deal size has more than doubled since 2009. In part, this has been driven by a small number of large deals attracting very high valuations, with some of the highest valuations seen by Uber ($41bn), SpaceX ($12bn), Dropbox ($10bn), Snapchat ($10-20bn) and Airbnb ($13bn). Similarly high valuations have been seen in Silicon Valley tech exits, with Facebook’s $19bn acquisition of WhatsApp and Google’s $3.2bn acquisition of Nest two high-profile examples. These billion-dollar valuations are leading many to claim that a dotcom-esque bubble is forming: what can possibly justify such valuations?

In some cases, these concerns are driven by a lack of publicly available information on financial performance: for example, Uber’s leaked dashboard showed its financials to be considerably stronger than analysts’ expectations at the time. In other cases, they appear to be driven by a lack of understanding of the true rationale behind the deal. See, for example, the Connected Home: Telcos vs Google (Nest, Apple, Samsung, +…) and Facebook + WhatsApp + Voice: So What? Executive Briefings.

The Telco Dilemma: What is it all worth?

Against this uncertain backdrop, telecoms operators are expanding into such new mobile and digital services as a means to fill the ‘hunger gap’ left by falling revenues from core services. They are doing so through a mixture of organic and inorganic investment, in different verticals and with varying levels of ambition and success:

Figure 2: % of Revenue from ‘New’ Telco 2.0 Services*, 2013

Source: Telco 2.0 Transformation Index
* Disclaimer: Scope of what is included/excluded varies slightly by operator and depends upon the ability to source reliable data
Note: Vodafone data from 2012/13 financial year 

However, this is a comparatively new area for telcos and many are now asking what is the real ‘value’ of their individual digital initiatives. For example, to what extent are Telefonica’s digital activities leading to a material uplift in enterprise value?

This question is further complicated by the potential for a new service to generate ‘synergy value’ for the acquirer or parent company: just as Google’s $3.2bn+ valuation of Nest was in part driven by the synergy Nest’s sensor data provides to Google’s core advertising business, digital services have also been shown to provide synergy benefits to telcos’ core communications businesses. For example, MTN Mobile Money in Uganda is estimated to have seen up to 48% of its gross profit contribution generated by synergies, such as core churn reduction and airtime distribution savings, as opposed to standard transaction commissions.

Ultimately, without understanding the value of their digital businesses and how this changes over time (capital gain), telcos cannot effectively govern their 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. Understanding valuation was therefore identified as the joint most important success factor for delivering digital services in STL Partners’ recent survey of telco executives:

Figure 3: Importance of factors in successfully delivering digital services (out of 4)

Source: Digital Transformation and Ambition Survey Results, 2014, n=55

Crucially, however, survey respondents also identified developing this understanding as more than two years away from being resolved. In order to accelerate this process, there are three key questions which need to be addressed:

  1. What are the pitfalls to avoid when valuing digital businesses within telecoms operators?
  2. How should telcos model the spin-off value of their digital businesses?
  3. How should telcos think about the ‘synergy value’ generated by their digital businesses?

This Executive Briefing (Part 1) focuses on question 1; questions 2 and 3 will be addressed by future research (Part 2).

 

  • Executive Summary
  • Introduction
  • Tech VC in 2014: New heights, billion-dollar valuations
  • The Telco Dilemma: What is it all worth?
  • Challenges in Valuing Any Business (Analog or Digital)
  • DCF: Theoretically sound, but less reliable in practice
  • All models are wrong, but some are more useful than others
  • DCF’s shortcomings are magnified with digital businesses
  • Practical Issues: Lessons from Uber, Google, Skype and Spotify
  • A Conceptual Issue: Lessons from Facebook
  • Proxy Models: An improvement on DCF?
  • The Synergy Problem: A challenge for any valuation technique
  • Synergies are Real: Case studies from mobile money, cloud services and the connected home
  • Synergies are Problematic: Challenges for valuation in four areas
  • Conclusions
  • STL Partners and Telco 2.0: Change the Game

 

  • Figure 1: Silicon Valley Tech Financing History, 2009-14
  • Figure 2: % of Revenue from ‘New’ Telco 2.0 Services, 2013
  • Figure 3: Importance of factors in successfully delivering digital services (out of 4)
  • Figure 4: Sensitivity of DCF valuation to assumptions on free cash flow growth
  • Figure 5: Different buyer/seller valuations support a range of potential sales prices
  • Figure 6: Impact of addressable market and market share on Uber’s DCF valuation
  • Figure 7: Facebook vs. yield businesses, EV/revenue multiple, 2014
  • Figure 8: Facebook monthly active users vs. valuation, Q1 2010-Present
  • Figure 9: Three potential investor approaches to modelling Facebook’s value
  • Figure 10: MTN Mobile Money Uganda, Gross Profit Contribution, 2009-12
  • Figure 11: Monthly churn rates for MTN Mobile Money Uganda users (three months)
  • Figure 12: Conceptual and practical challenges caused by synergy value

 

Reality Check: Are operators’ lofty digital ambitions unrealistic given slow progress to date?

Growing telco ambitions in new (digital) business models

Telco execs are bullish about long-term prospects for new digital business models

Respondents believe new business model revenues should reach nearly 25% of total telecom revenue by 2020

Despite recent evidence in Europe of material revenue decline from telecoms operators, the executives that STL Partners canvassed in its recent global survey  were relatively optimistic about the opportunities for revenue growth from new business models.  On average, executives felt that revenue from new digital business models  should reach 9% of total revenue in 2015 and this should rise to 24% by 2020 (see Figure 1).

In the case of 2015, 9% is way beyond what will be achieved by most players and probably represents respondents’ theoretical target that their organisation should have achieved by the end of this year if management had invested more effort in building new revenue sources earlier: it is where their organisation should be in an ideal world.   One of the few operators in the world that is at this level of digital revenues is NTT DoCoMo.  We explore its digital activities later in this report.

24% of telecoms revenue coming from new business models in 2020 is also ambitious but STL Partners considers this a realistic target and one which would probably result in the overall telecoms market being no bigger than it was in 2013 – see the forecast on page 15.

Two drivers of digital business model importance to operators: digital revenue growth and core business revenue decline

A key question for the industry is whether the 2020 target can be achieved by growing material new business model revenues in tandem with limited voice, messaging and connectivity decline or whether it could result from an implosion of these Telco 1.0 revenues.  In other words, modest new business model revenue could be 24% of a very much smaller overall telecoms market if voice, messaging and connectivity revenues suffer a precipitous decline.

Figure 2 charts the quarterly revenue for six European markets and illustrates a range of trajectories for telecoms revenues.  At one extreme is Denmark where telecoms revenue in Q3 2014 was nearly 40% lower than Q1 2008.  At the other extreme are the UK and French markets where the figure is 3% and 7% lower respectively.  Clearly, if most telecoms markets follow the Danish route then the opportunity for modest digital revenues to become important to operators grows substantially.  Interestingly, in most of the six markets, 2013 and 2014 has seen revenues stabilising (at least among operators that publish accounts which split out those markets over the time period) and in some cases, such as the UK and Netherlands, growth has been achieved from the lows of 2012.

STL Partners’ global forecast lies somewhere between the two extremes outlined in Figure 2: we believe that core telecoms revenues will decline by around 25% between 2013 and 2020.  If this is indeed the case then for digital revenues to represent 24% of telecoms revenue, they will need to be very material – around $250 billion for mobile telecoms alone!

Figure 1: Digital business model revenue ambition, 2015 and 2020

Source: STL Partners/Telco 2.0 Operator Survey, November 2014, n=55

Figure 2: Telecoms quarterly revenue in 6 European markets

Source: Telecoms company accounts, STL Partners analysis
Note: Revenue is for operators reporting quarterly figures for each market. As a result, not all market revenue is captured.

Belief in the importance of future telecoms business models varies greatly by business function and by geography

Respondents from Network functions were most bullish; IT respondents most pessimistic

Where there were 10 or more respondents in a functional or geographic group, we examined the responses for that group.  As Figure 3 shows, there were wide differences in ambition for digital services by functional area with respondents from Network being far more bullish than those in IT:  the former suggesting 30% of 2020 revenue should come from digital services compared with only 14% from IT.

North American respondents seem to anticipate unrealistic digital business growth

There was a consistency among functional groups in their ambitions for digital services: those that were more bullish for 2015 remained more so for 2020.  This contrasted with the regional split in which North American respondents believed the ‘correct’ proportion of revenue from digital services in 2015 is 7% (compared with 10% for Europe and Asia) rising to a formidable 26% in 2020.  This suggests that North American executives remain confident that their organisations can compete effectively in consumer and enterprise digital markets despite the US, in particular, being the home market of many formidable digital players: Google, Facebook, Amazon, Microsoft, Salesforce, Twitter, and so forth.

To put the North American perspective in perspective: if STL Partners’ global forecast for core telecoms services holds true in the US then a $120bn revenue telecoms company, such as Verizon, will lose around $30 billion in core service revenues by 2020.  In this scenario, for Verizon to end up the same size as it is now in 2020, it will have to replace this $30 billion with new digital business revenues (which would equate roughly to the 26% proposed by North American respondents).  In our deep-dive analysis of Verizon for the Telco 2.0 Transformation Index, STL Partners estimated that Verizon generated around $2.9 billion in Telco 2.0 digital business model revenues (around 2.4% of total revenue) in 2013.  For that $2.9 billion to grow to $30 billion by 2020 requires compound annual growth of a whopping 40% per year: a tall order indeed and one that is almost certainly unrealistic.

Middle Eastern respondents least ambitious: signs of complacency?

Unsurprisingly, the Middle Eastern respondents whose companies are enjoying continued growth in core telecoms services and, in many countries advantageous regulatory environments, were least bullish about digital services in the near and longer term.  The danger for this region is complacency: operators are in a similar position to those in Europe in 2007.  European operators failed to prepare early enough for core service decline – most digital activities were not kicked off until 2012 by which time aggregate revenue from voice, messaging and connectivity was either flat or in decline in most markets.

Figure 3: Average digital business model revenue ambition, 2015 and 2020 by function and geography

Source: STL Partners/Telco 2.0 Operator Survey, November 2014, n=55

 

  • Executive Summary
  • Growing telco ambitions in new (digital) business models
  • Telco execs are bullish about long-term prospects for new digital business models
  • Belief in the importance of future telecoms business models varies greatly by business function and by geography
  • Telco execs’ views on digital business Opex and Capex investment are closely correlated with their views on revenue growth
  • Calculating a telecoms digital business P&L:  Moving from investment in 2015 to (unrealistically?) strong returns in 2020
  • STL Partners’ forecast suggests that new digital business should be 25+% of revenue by 2020 to avoid long-term industry decline
  • The outlook for Telco 1.0 business models is not positive and Telco 2.0 business models are required to fill the gap
  • Investment in new business models is increasing but results from the Telco 2.0 Transformation Index suggest it is still inadequate to engender success
  • Scale of NTT DoCoMo’s ‘new digital business’ suggests bold vision is realistic for some players
  • Long-term downward trend in Telco 1.0 core services in Japan with digital services a ‘gap-filler’
  • Smart Life: A cloud-based (OTT) consumer-centric approach to digital services
  • A digital business has fundamentally different characteristics to a telecoms business
  • 9 challenges to overcome and all are important
  • Overall, operator progress on all 9 challenges remains slow
  • Too little progress on core challenges from most operators
  • What next?  Forthcoming STL Partners’ Telco 2.0 research supporting telecoms transformation
  • Appendix 1: Survey details
  • Appendix 2: Telco 2.0 Transformation Index overview

 

  • Figure 1: Digital business model revenue ambition, 2015 and 2020
  • Figure 2: Telecoms quarterly revenue in 6 European markets
  • Figure 3: Average digital business model revenue ambition, 2015 and 2020 by function and geography
  • Figure 4: Average required Digital Business Opex and Capex, 2015 & 2020
  • Figure 5: Digital Business P&L for a $100 billion revenue telecoms operator, 2015 vs 2020, $ Billions
  • Figure 6: STL Partners’ global mobile telecoms forecast by opportunity area
  • Figure 7: STL Partners Telco 2.0 Transformation Index summary results, December 2014
  • Figure 8: NTT DoCoMo quarterly voice, data and ‘other’ revenue, Mar 2007-Sep 2014
  • Figure 9: Smart Life – NTT DoCoMo’s customer-centric approach to transformation
  • Figure 10: Different companies…different business models – the change that telecoms operators are trying to make
  • Figure 11: 9 challenges scored by ‘importance for operator digital transformation and future success’
  • Figure 12: The degree to which operators have addressed the 9 challenges
  • Figure 13: Strategists are much more bullish than other functions about their organisation’s transformation progress
  • Figure 14: Lots to change…and its taking too long
  • Figure 15: Operators appear to be at very different stages of resolving the ‘Big 6’ challenges
  • Figure 16: Defining Digital Services