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