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Article08 May 2018

First Activist Victory Linked to Telecom Break Up: Five Questions for Investors

Citi GPS Opinion
Are Markets Starting to Validate our DIGITECCS Vision?

Telecom valuations have been under pressure for some time, which is consistent with our strategy views on the telecom sector1. Earlier this year we pointed to the vulnerability of the global tech industry while suggesting solutions based on our DIGITECCS framework.2 Our DIGITECCS (DIGItal TEChnology, Connectivity and Service) vision calls for deep telecom infrastructure sharing on the one hand and investment in digital consumer platforms and smart industrial Internet networks by telecoms, tech, and other industries, on the other. This would lead to markets in connectivity-linked tech/software services that are more diverse than the ones we have today. We think that such a setup may better suit digitally-savvy nations and we think recent events, market moves and investor sentiment are moving positively towards such a vision.

    • The recent selloff of the world’s leading Internet/tech stocks, including Google and Facebook, may be a sign that investors are starting to expect potential (regulatory-invoked) changes to the big tech business models. A change in regulatory emphasis away from net neutrality towards regulating data security is already underway in the U.S. and beyond. If the origins of such a change lie in efforts to tackle market dominance and possibly excessive power of the world leaders in software, platforms, tech and big data, new opportunities in those areas may arise for other players including telecoms.


    • Recent weakness in European telecom stocks show that investors’ backing for the legacy telecom business model, centered on monetization of existing infrastructure assets through vertical integration with services, may be fading. As of the end of March 2018, each of Europe’s top four telecom incumbents (Deutsche Telekom, BT, Telefonica and Orange) lost value in local currency terms on a 3-month and 12-month basis. Moreover, the two less fiber-focused incumbents, Deutsche Telekom and BT, also underperformed the MSCI EU Telecom index, MSCI Europe index, and MSCI World Telecom Service index in both time periods.


    • $12 billion of new money has recently been committed by investors to structural separation-like (i.e. deep infrastructure sharing) transformation of telecoms in up to six European countries. On March 21st a Czech private equity group PPF agreed to buy Telenor’s telecom assets in Hungary, Bulgaria, Serbia, and Montenegro for $3.4 billion. PPF believes in structural separation, which it successfully pioneered at O2 Czech Republic in 2015. On February 12th, TDC of Denmark accepted a $6.7 billion offer from an infrastructure investor, Macquarie, and Danish pension funds. Inspired by the Czech case, the acquirers outlined their plan to structurally separate TDC.

Finally, after acquiring a stake in Telecom Italia, Elliott Advisers, an activist investor, announced on March 16th its intention to push for changes that include structural separation. Elliott Advisers currently owns a stake worth an estimated $1.9 billion in Telecom Italia. All this coincides with the EU plans to promote a wholesale-only (structurally separated) model. According to Reuters an agreement was reached in the European Parliament on March 21st to encourage such model by giving wholesale- only network companies (NetCos) regulatory benefit in a new code to be passed later this year.

    • All three main types of telecom M&A in the past two years are consistent with our DIGITECCS vision. The most typical telecom deals in the past two years were:
      (1) in-market consolidation (i.e. convergence to our deep infrastructure sharing vision, e.g. India); (2) investments into upwards vertical expansion in services (consistent with our digital platforms vison, e.g. US telecoms); and (3) divestments by multi- national operators (consistent with a view that legacy telecom models are also being challenged on the cross-border synergies side, e.g. the Nordic telecoms).


    • Based on our recent surveys, financial investors are beginning to support digital investments, deep infrastructure sharing, and FTTH/P investments by telecoms, despite short-term risks and profit concerns. Our global e-mail survey showed that 67% of investors think that telecoms would benefit from giving up control to share some infrastructure. 61% believe that telecoms should not oppose government FTTH/P bias, if confronted with it, and instead focus on achieving the best regulatory conditions and returns within such ‘fiber framework’. Electronic voting at our recent London telecom conference showed that 72% of investors want BT to keep or accelerate its FTTH/P plans, 68% want KPN to replace its copper by FTTH/P (if NPV positive) and 56% support Altice’s FTTH/P upgrades in the U.S., although all this would negatively impact short-term cash flows. Interestingly, financial investors also see fiber and 5G capital expenditure as the main risk and a reason not to invest in telecoms (56% for Deutsche Telekom and 49% for BT). This implies that investors in Europe are beginning to see FTTH/P as an inevitable short-term cash flow burden. Finally, our e-mail survey showed that a majority of investors (70%) support our thesis of material expansion by telecoms into digital services, but only 46% think that telecoms should aim at freer service regulation by offering concessions in infrastructure. Only 42% agree that telecoms should reform radically.

Strategic Optionality Discount May Explain Low Telecom Valuations

Why are private equity, infrastructure and activist investors suddenly interested in European telecoms? Why are telecoms in the U.S. and some other countries willing to commit material capital towards expansion into digital platforms, content, and even artificial intelligence? Finally, why are some of the established telecoms, which are meeting their financial plans, frustrated from a lack of appreciation by the stock markets? All these questions have in our view one common answer, which is Strategic Optionality Discount. To explain this, let's first look at how stock markets value tech companies:

Share Price = Financial Outlook Based Value + Strategic Optionality Premium


Financial Outlook-Based Value is based on a reasonably predictable outlook for profits and cash flows from the existing business. The Strategic Optionality Premium is based on the companies' envisaged ability to find new opportunities, and possibly also deal with threats. This relates to (1) envisaged business synergies; (2) entry barriers; (3) management's strategic and execution capabilities; (4) perceived ability to respond to change; (5) corporate culture and flexibility; and (6) influence on policies etc. Similarly, stock markets may see telecoms as follows:


Share Price = Financial Outlook-Based Value - Strategic Optionality Discount


Management incentives at telecom companies are usually based on the former, which is seemingly not fully aligned with shareholder interests. Similarly to tech, the latter includes expectations ranging from future synergies up to influence on policies.


It also includes expectations about management's ability to respond to external changes in technologies, consumer behavior, monetary policies, government infrastructure policies etc. Historical precedent has so far made stock markets much less optimistic about Strategic Optionality Value for telecoms vs. tech. The scale to which markets penalize telecoms may be right or wrong. However, the fact that telecom valuations have been under pressure for a longer period and some operators, including the U.S. ones, are responding with bold strategic moves while new investors are taking positions in some European telecoms to drive strategic changes, in our view makes Strategic Optionality Discount an important topic for both telecom companies and investors.


Why Do the Established Roles of Telecoms and Tech Need to Change?


Revolutionary changes often happen fast, but foundation for them can build over decades. Consumers associate the Internet with services such as Google, Facebook or e-shopping and possibly with phones such as Apple and Samsung. They tend to pay somewhat less attention to telecom products and brands, because telecoms are seen only as providers of connectivity, which is deemed a utility, and hence draws attention mainly when it goes wrong. While our surveys from 2014 and 2016 showed that 30-50% of investors saw telecoms as utility proxies, most operators would disagree with such position. Given their limited ability to create differentiated products most telecoms instead focus on aggregation, i.e., selling third party innovation ranging from phones and sport videos to software. Meanwhile, most of the capital in the telecom industry remains tied up in relatively old and simple assets such as decades-old copper networks, originally built as state monopolies, and some of the technologically simplest products of the building industry, i.e., towers and fiber networks, or spectrum.


Can companies who have so far focused largely on laying cables, building towers, and buying spectrum, be reasonably expected to become successful aggregators of innovative digital services? We think that this may be almost impossible without radical transformation. By strongly linking their infrastructure to services, telecoms would not only limit their service scale economies (to areas where they have infrastructure), but naturally also attract regulatory attention, because using their advantage in oligopoly- prone infrastructure as an entry barrier into services will always be seen as problematic.


This perhaps explains why stock markets are burdening telecoms with the Strategic Optionality Discount. Telecoms may need to make their strategies more credible rather than just talking about service bundling (aggregation). Meanwhile, the recent stock market moves show that big tech may have to deal with fresh regulatory and strategic challenges, which are emerging in response to major market share successes, and hence a growing influence of the leading players. Such pressures on both industries to change are further underlined by the envisaged arrival of industrial Internet, 5G, and digitalization across different segments of the economy, as well as new challenges around data protection and cybersecurity.


Four Key Stakeholders in Digital Connectivity Transformation


We see four key stakeholders driving the change in the telecom and Internet industries:
(1) established telecoms and cable providers, which currently control most of the infrastructure and a large part of the infrastructure investment; (2) the infrastructure community, which often favors fiber, shared infrastructure, universal coverage, investments in preparation for 5G etc. (it may entail various entities ranging from policymakers, the emerging infrastructure industry, vendors, some telecom and tech companies, non-TMT companies and other entities etc.); (3) non-TMT business interests; and (4) the tech industry.


The key dilemma in digital connectivity transformation in our view lays in the debate on where is it best to standardize and regulate, possibly with a heavy hand, and which markets should be left as free from regulation as possible. In theory, dividing lines between the former and the latter should be driven by (1) innovation (regulating of innovative businesses slows progress); (2) externalities (if duplication causes negative externalities and brings no economic value, there may be a case for regulation-enforced sharing); and (3) national interests (regulated, standardized, and secure infrastructure may in some cases fit with national interest). Irrespective on how the above dilemma is tackled, regulatory clarity and predictability is always helpful for investors. As the digitalization of national economies continues progressing, pressures from various stakeholders to build a robust, universal, secure, and efficiently utilized connectivity infrastructure, particularly in fiber, is likely to continue rising.

Utility Model in Telecom Infrastructure Including Fiber

Telecoms are a somewhat unusual industry. As we learned at a CIO event in Oxford last month, infrastructure industries such as airports and utilities often appreciate regulation, because it boosts entry barriers and protects them from potentially disruptive competition. A number of service industries such as banks and taxi services may benefit from regulation in a similar way. Even Apple’s CEO, Tim Cook, recently said that the tech industry would benefit from some regulation. Instead, telecoms are largely known for their opposition to practically any heavy regulation of their business. The very idea that some telecom infrastructure could be better run as a structurally separated regulated utility is quite controversial and polarizing within the telecom industry. It is perhaps slightly ironical that the Sunil Bharti Mittal, Chairman of the world’s leading telecom association, GSMA, outlined his vision of the (structurally separated) Network Company/ Services Company (NetCo/ServCo) model at the Mobile World Congress this year.

We are well aware of theoretical and practical complexities of the NetCo/ServCo model. The former includes the exact choice of assets to be separated and effectively outsourced (Mr. Mittal spoke about undersea cables, towers, and fiber), but also questions about the future of the ServCo. The latter involves major corporate restructuring of often complex businesses and consolidation of competitive infrastructure markets with possibly diverse technologies. We learned at Oxford that majority of large business transformation projects in the U.K. tend to fail, partially because stakeholders do not sufficiently believe in them. This could be a major problem in telecoms as well, and indeed a reason why still a large number of investors are vocally opposed to structural separation. Similarly to Mr. Mittal, we do however see utility-like infrastructure as a natural evolution in telecom infrastructure, at least in some areas. Moves towards such model can benefit the established telecoms in the following ways:

    • The regulated infrastructure utility model could reduce the risk of future technological and regulatory disruption (such as the one currently faced by copper networks). A national fiber network may be seen as strategic infrastructure, possibly even linked to other national utilities etc. Such a solution would for example reduce the need for some of the currently applied regulations such as opening of passive infrastructure.


    • If major fiber investment becomes a must as opposed to a choice, telecoms may need long-term investors such as infrastructure and pension funds, to fund network expansion. These investors appreciate the protection as well as the predictability of the utility-based model, in which pricing and returns could be determined for example by the RAB (Regulatory Asset Based) model.


    • Structural separation can force a major review and ‘cleaning-up’ of inefficiencies in the underlying incumbent businesses. This effect was crucial in success of the Czech case three years ago, when the ServCo share price appreciated more than five times in the few months post separation.


    • By supporting the concept of shared utility infrastructure, some telecoms could resolve major conceptual conflicts with their regulators and instead focus on shaping future regulations in their favor (this is currently driving Elliott Adviser’s efforts at Telecom Italia; if the mentioned EU agreement to promote the wholesale-only model becomes EU law, this issue may gain more relevance across Europe).


    • Finally, in the longer term, 5G is likely to bring new opportunities in shared fiber infrastructure for connecting a dense network of smaller cells. Fiber infrastructure duplication for 5G may not be economical. Utility-like fiber infrastructure companies would be in best position to benefit from such opportunities.

DIGITECCS – Turning Telecom Strategic Optionality Discount into a Premium

Can telecoms turn their Strategic Optionality Discount into a premium? Telecoms, which want to achieve this, in our view need to: (1) become open minded about the future of their infrastructure assets, particularly passive and capital-intensive ones. Although this does not mean instantly turning all such assets into separate utility-like companies, it does mean taking a longer-term view about shareholder interests and the future role of networks in a digitalized economy; (2) show greater strategic flexibility in pursuing opportunities in the most attractive growth areas such as software, platforms, content, big data, and over the longer-term also smart networks for industrial internet (IoT); and (3) present a convincing plan about execution of their transformational strategies. This involves creation of the right structure to support innovation. Equally, this may involve scaling down the legacy telecom businesses, which are no longer needed due to digital innovation.3

Most importantly, successful DIGITECCS transformation requires strong conviction and belief in the process and its objectives not only by the telecom companies, but ideally also by policymakers, investors, customers, and other stakeholders. Such an economically- and strategically-backed belief would in our view allow telecom companies to achieve more supportive stance from policymakers and other partners. This would in turn justify taking the necessary risks towards dismantling and voluntarily disrupting legacy businesses, structures, management incentives etc. and replacing them with ones more suitable for digital economy. We think a risk-taking, radical approach and long-term strategic perspective are necessary for conducting such a transformation in a shareholder value accretive way due to a need to beat the industry’s inherent inertia.

To further justify the DIGITECCS transformation we also draw attention to new opportunities for telecoms arising from: (1) regulation of big tech; (2) changes to big tech business models (including for example Microsoft’s recent push into Cloud and move to sell its products as services, which led to broadening of its partnerships also with telecoms); (3) data and cybersecurity (telecoms can aim to become trusted national software-driven digital service providers); (4) industrial Internet (IoT, 5G) driven future demand for bespoke connectivity with quality guarantees to be delivered via smart networks; (5) national data sovereignty regulations; and (6) environmentally and socially responsible investing (limiting unnecessary network duplications and focusing on building employment in progressive areas).

Many telecoms are already experimenting in the software and digital service layers, although most of them on a relatively small scale. Corporate venture capital investments,
i.e. tech investments via newly established separate vehicles, have been favored by some, for example by Orange and the Saudi Telecom Company. To materially boost their Strategic Option Value telcos in our view need to overcome fear from making their underlying business less dependent on basic network infrastructure and take enough risk in the service business to warrant a meaningful return. Taking such risks may be justified by synergies with infrastructure assets retained in the service company (e.g. active components, spectrum) along with opportunities discussed in the previous paragraph.

To make other stakeholders believe in DIGITECCS-inspired strategies, telecom executives in our view need to clearly distance themselves from the legacy business models. Similar to the tobacco industry, telecoms need to accept some short- term pain linked to speeding up the transition from a challenged legacy business to their new business model. Many telecom managers find it challenging to take such a clear position, also due to a wide range of conflicting interests.

One operator, whose transformation stood out last year, is Turkcell. Its management, which has relatively limited legacy telecom experience, fully and clearly outlined the company’s aspiration towards an asset-light and software platform-driven strategy, mirroring our DIGITECCS concept. Turckell was the world’s best performing telecom stock last year (out of MSCI included stocks), based on local currency return including dividends. Its re-rating was driven by both an improvement in near-term financial outlook, i.e. Financial Outlook Based Value, but also a valuation multiple re-rating reflective of boosted Strategic Optionality Value.

DIGITECCS – A Win-Win Outcome for Telecoms and Policymakers

Successful TMT companies are prone to building scale economies and also influence. Hence regulation will always matter. The route to success in our view entails the creation of win-win situations, where the companies’ and policymakers’ interests become aligned. Policymakers usually focus on economic growth, infrastructure investments, competitiveness in innovative industries, national security, employment, and the environment. The Silicon Valley success story is an example of such alignment, when an innovative industry drives growth, and indirectly also drives infrastructure investments, national innovative competitiveness and high skilled employment. Telecoms with DIGITECCS strategies may in our view face similar opportunities. Shared utility-based infrastructure can attract cheaper and longer-term funding. Meanwhile the ServCo businesses focused on software and technology differentiation would help boosting the innovative competitiveness of countries and play a central role in the future of industrial internet (IoT/5G), both from smart connectivity as well as a security point of view. Such an alignment may elegantly address the two main challenges that telecoms face today— regulation and growth.

1See our global reports such as Re-Birth Of Telecom Monopoly and Re-birth of Telecoms Into a New Digital Industry or our Europe-focused reports including Why are the incumbents being challenged about fibre? and The lack of EU policy boldness should concern telco investors

2See for example DIGITECCS: The world after net neutrality

3We call this DIGITECCS transformation of telecoms as described in our report Why Tech Expansion by Telcos May Appeal, Time for a leopard to change its spots and become “DIGITECCS” from October 2017.

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