For capital markets specialists, telecoms was the most exciting sector of the corporate world in 2013, with ratings downgrades, hybrid capital issuance, boardroom battles, a rise in mergers and acquisitions — and the biggest corporate bond of all time, Verizon’s $49bn issue to finance its $130bn takeover of Vodafone’s stake in their US mobile phone joint venture.
It’s not normally counted as a telco, but you could also chuck in Apple’s $17bn bond issue, its first for nine years, since the fortunes of device makers like Apple are now tied to how people consume voice, internet, music and video: the stuff of telecommunications.
What makes telecoms financiers particularly eager to see what 2014 will bring is a universal acceptance that the industry is in flux. A new stage of transformation has begun, but no one knows yet what the outcome will be — or how long it will take.
The last three years have been brutal for European telcos, as a depressed economy, regulatory sanctions, vicious competition and heavy investment needs have bitten them all at once. The result has been falling revenues, dwindling profits, rising leverage and ratings erosion.
“You could see 2013 as a watershed year,” says Mike Dunning, head of EMEA technology, media and telecoms ratings at Fitch. “The more intense the disruption gets, as a result of the fragmented, over-competitive nature of the European market, the more people are accepting that they’ve got to do something about it. That brings people round the table [for deals] in a way that hasn’t occurred in the past.”
Whatever solutions are found, they will involve the debt and equity capital markets — and probably M&A.
“There is a cycle in many countries where every few years the third or fourth mobile operator cuts its prices to grow market share,” says Louis Kenna, head of media and telecoms finance at BNP Paribas in London. “The other operators often match the price cuts within days. Market shares remain largely unchanged, but the operators collectively are earning less money. This pricing focus along with very high spectrum licence fees in the past has arguably come at the expense of investment in mobile infrastructure.”
It is perfectly common in the centre of London to have an intermittent mobile signal inside buildings. Analysts say Europe, which used to lead the US in mobile technology, is now lagging.
The main culprit, they argue, is a lack of investment. Mobile operators’ balance sheets are threadbare, stripped by excruciating spectrum auctions and price competition — and that was before the recession.
Many mobile customers are perfectly happy to go for the cheapest deal, irrespective of service quality — especially when tempted by a new handset. But telecoms investors long for a thinned-out market with fewer players, where price-cutting could be less intense and investment more affordable.
The fixed line and cable industries are in somewhat better shape. “Many cable operators got a lot of their infrastructure ‘for free’ because of the debt write-offs 12 years ago,” says Kenna.
“They have a real infrastructure advantage, which means they can compete on quality of service, principally download speeds, rather than pricing.”
Nevertheless, the cable industry has been consolidating — led by Liberty Global, the acquisitive vehicle of John Malone, the US telecoms entrepreneur. Liberty bought the UK’s Virgin Media in 2013 for £15bn.
Fixed line incumbents, too, most of which also have mobile, are licking their wounds and working out how to push fibre optic networks closer to the home while competing in a fast-changing market.
US gets moving
Industry observers shake their heads over the fact that Europe has, on some counts, 80 or 100 telecoms carriers, while the US has four.
Yet it is in the US where the biggest mergers have begun to happen. In late November, Comcast, the leading US cable company — fresh from swallowing NBCUniversal — agreed to consider a bid for Time Warner Cable, at the latter’s request.
Time Warner Cable is being hunted by Charter Communications — backed since March by Liberty Media. No deal has been agreed, but the energy driving structural change in telecoms markets is palpable.
Verizon Communications taking full ownership of its main asset, Verizon Wireless, was not real M&A from the point of view of US consumers. But the financing in September removed any doubt that debt markets were eager to finance the largest deals.
Not only did Bank of America Merrill Lynch, Barclays, JP Morgan and Morgan Stanley stump up $61bn of loans between them, but for 100bp of new issue premium, bond investors threw caution to the winds and put in $100bn of orders.
“People always say the Verizon deal changed the game, but in today’s market you can do more than Verizon has done,” says Wilhelm Schulz, head of TMT investment banking and head of European M&A at Citigroup.
As soon as Verizon was done, the spotlight shifted to Vodafone, as a potential target for AT&T. Vodafone’s enterprise value in a takeover would be about $125bn-$160bn.
At the smaller end of the spectrum, leveraged finance lenders are just as hungry for telecoms deals. “The debt markets have strong appetite for the telecom sector — both cable and mobile,” says Kenna, “but the dealflow is not materialising as quickly as many of us hope.”
Forced to transact
Completed telecoms M&A in EMEA rose to $77bn by late November, below 2013’s $100bn figure for the Americas, according to Dealogic.
But announced M&A — including $220bn for the rumoured AT&T/Vodafone — is $500bn, far more than in any year since 2006. That suggests European takeovers in 2014 could top last year’s level.
“Of course deals will happen,” says Schulz. The number one driver, he says, is “challenged business models which require self-help measures that are non-organic.”
European telcos, in the aggregate, are in a battered state. “Across the industry, one area that has not changed much is pretty dreadful operational performance,” says Simon Weeden, head of European telecoms research at Citigroup.
There are exceptions, such as BT — in a northern European market with fixed line only and a successful broadband strategy. “But,” Weeden says, “if you’re in southern Europe and in mobile, with mid-teens revenue declines year after year, it’s been very painful.”
When the economy crumbles, customers scour the market for the cheapest deal, or even give up their mobile phone altogether.
Telecom Italia has been hit hard. Having started 2013 rated Baa2/BBB/BBB, it is now Ba1/BB+/BBB-, despite trying to shore up its ratings by issuing hybrid capital.
CEO Franco Bernabè resigned in October, reportedly because key shareholders, led by Telefónica, blocked his wish for a rights issue to stabilise the balance sheet.
New chief Marco Patuano’s plan is to raise €4bn of capital with a €1.3bn mandatorily convertible bond — sold in November — and asset sales.
Telefónica has fared slightly better, helped by its big operations in the UK and Germany. Though it has had to cut its mobile pricing in Spain, it has managed to reduce net debt by €13bn since June 2012.
“Telefónica have done a very good job in getting a hybrid programme of about €2.5bn done, in euros and then sterling,” says Anthony Bryson, head of European corporate debt capital markets at BNP Paribas. “They clearly have access to the debt market and are expected to play a role in European telecoms consolidation.”
Hopes begin to rise
Despite the red ink across results, there is widespread hope that European telcos’ woes are easing. Their shares rose 19% in 2013. “Outperforming a rallying market is not something we often associate with telcos, but there is a sense that the worst is past, and there is outside interest in the assets,” says Weeden. “There have been plenty of small deals, price wars like in Austria and Italy seem to be moderating and the regulatory picture is easing.”
EU-enforced cuts in mobile roaming fees and termination rates are largely done.
What concerns the industry most now is competition policy. “After excoriating the industry for years, the European Commission has become more supportive, and has made a bit of progress in trying to understand the issues, and why investment has been curtailed in the sector,” says Weeden.
The European Commission is eager to see cross-border mergers, believing this will make the industry more efficient, but still competitive.
Investors disagree, as synergies would be minimal. “Where markets are still sceptical is cross-border mergers,” says Schulz. “If one national champion merged with another, you’re just putting two incumbents together. Investors wouldn’t see a real path to value generation.”
That is why Weeden rejects the idea that Europe having more carriers than the US is a problem. “If you go to Germany there are four national operators, same as the US,” he says. “The spectrum is the same everywhere, the handsets work, you can go anywhere in Europe and use your phone.”
What the industry wants, analysts agree, is in-country mergers. Most urgent, many believe, is consolidation of mobile, from four players to three in most markets.
“I see four to three happening in Italy and Spain,” says Schulz. “I think the European regulator has understood that in-country consolidation needs to happen.”
It has happened in Ireland and Austria, where Telefónica and Orange (formerly France Télécom) sold their businesses to Hutchison Whampoa.
Hutch also hopes to expand in Italy. Talks to merge its mobile network with TI failed in 2013, but it could buy the third player, Wind, if its Russian owner VimpelCom is willing to sell.
The deal that most cheered analysts in 2013 was Telefónica managing to merge its O2 Telefónica Deutschland subsidiary — partially floated in 2012 — with E-Plus, the German arm of KPN.
“We’ll see at the beginning of April, when O2/E-Plus will be approved, whether the regulator has learnt from its mistakes in Austria, where the remedies they imposed on Hutch were pretty draconian,” says Schulz.
Yet either the EU Commission or the German government could still decide to leave room for a new fourth player to enter the German market, so that customers can enjoy the price-cutting impact of an aggressive challenger like France’s Iliad.
Both France and the UK, which have some of the cheapest mobile rates, are thought unlikely to allow much mobile consolidation, though Orange and Deutsche Telekom have fused their UK networks into Everything Everywhere.
Quad play conundrum
The other driver of in-country consolidation is the convergence of mobile and fixed line, as companies strive to offer the new buzzword — quad play. A bundled package of landline, mobile, broadband and TV sounds like the ideal selling point for a telco — convenient and holding out the promise of more customer loyalty.
Vodafone’s exit from the US is a prelude to heavy investment in its “unified communications strategy”, as well as its Project Spring upgrade of mobile networks.
Vodafone’s first deal, the €7.7bn purchase of 77% of Kabel Deutschland, is waiting for final clearance. But it has plenty more cash to spend on buying other fixed line assets, such as Spain’s Ono or Jazztel, Italy’s Fastweb — or even, in some wild imaginings, Liberty Global itself.
But analysts warn against seeing quad play as a panacea. In countries like France, Spain and Portugal, where it has progressed furthest, consumers may have benefited, but the industry hasn’t. “You basically cut the price for everything,” says Dunning at Fitch. “Players think they can offer a bundled version that no one else can, but the technology allows anyone to do it in a virtual way. So everyone moves in step and you get a price war. No one has yet offered quad play at a price that was more than the sum of the parts.”
Weeden points out that cable operator Virgin Media has only managed to get 16% of its customers to use Virgin Mobile after seven years. “Virgin Media is a walking case study of why quad play is not disruptive, unless you put a whopping discount on it like Telefónica or Iliad, and then you are basically cutting your mobile revenues,” he says.
Hot to trot
While European telcos cautiously ponder M&A, with a bias to divestments, the continent’s assets are being eyed lasciviously by a more red-blooded group of foreign players.
Mark Chapman, telecoms analyst at CreditSights, divides the potential acquirers into two camps. For most — AT&T, Hutchison Whampoa, Softbank and Docomo of Japan and Etisalat and Ooredoo from the Gulf — “it’s about maximising earnings growth potential by buying cheap assets”.
They have a low cost of capital and strong domestic cashflow, giving them plenty of firepower. But, says Chapman, “it only makes sense for them to buy at the bottom. The difficulty is, the targets don’t want to sell themselves this low.”
The result is an uneasy truce, which could last a while longer. “In many situations, there is a strong incentive not to be the first mover,” Chapman argues. “Operationally, Europe is not attractive yet, and it doesn’t look like valuations are going to rise much, so acquirers can afford to wait.”
Big, transformational deals like AT&T-Vodafone are not in Chapman’s base case for 2014. But he puts América Móvil in a separate category.
The Mexican telco has had an easy ride from regulators in its home market, and in Colombia and Ecuador, giving it a very high market share. “At some point in the future, the regulators are going to take that away,” Chapman says. “They are not going to generate the same cashflow with a 40% or 50% market share as with 60% or 70%. So they have a strategic need to buy a new cashflow base, and have a reason to pay well.”
América Móvil was rebuffed in trying to take over KPN last year when a foundation executed a poison pill defence. But it has 30% of KPN and 23% of Telekom Austria in its pocket and can afford to wait for further opportunities.
Around the corner
Most observers expect gradual consolidation in European telecoms, with plenty of action in 2014. They believe there is some chance of regulators supporting less fiercely competitive markets in the future. This should be good for equity investors, and — if regulators stay on their mettle — ultimately for consumers.
Bond investors are likely to feel a few jolts, but most issuers’ credit quality should strengthen in the end.
But there is a sting in the tail. “TV content delivery has just received a third access technology leg, which is wifi,” says Schulz. “It’s probably a superior technology to satellite and, in terms of ease, to cable. TV is going to move into more tablet-like technology, and become a content hub for the home. So the only way you can compete is content.”
Valuations of content are rising — as in newcomer BT’s knockout £900m bid to show Champions’ League football. Yet away from sport, most premium content, because not unique, is widely available — and getting cheaper.
When Netflix will stream you unlimited movies for £6 a month, or a £100 AppleTV box lets you buy films and TV programmes on iTunes, are cable and satellite business models safe? And how are mobile operators going to respond to social messaging services like WhatsApp, which now carries 20bn free text messages a day — and no advertising?
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