Finance and funding: the return of the money men

Could 2011 be the year that Vodafone and Verizon light up the telecoms sector with a mega marriage proposal? It’s the $200 billion question that every investment banker the world over would like Vodafone CEO Vittorio Calao to pop. And it would certainly put a rocket under a sector that many stock market analysts believe could benefit from a post-recession rerating.

The coming months will undoubtedly see relations between the two phone giants continue to thaw as money starts to trickle out of Verizon Wireless, their immensely profitable but hugely controversial joint venture, and City optimists are ever-hopeful that Calao will coax Verizon down the aisle. It is perhaps testament to the outlook for the telecoms market in general, and the wholesale sector in particular, that a wide range of financial backers, including private equity houses and institutional pension funds, are lending their support to a new wave of mergers and acquisitions (M&A). Such confidence can best be seen in the US metro market, where a raft of relatively small, but strategically important deals in the $100 million to $200 million range is prompting a near-frenzied revaluation of assets.

But this confidence is equally important among the full service operators. A rerating of telecoms businesses, prompted by an uptick in big-ticket mergers, will by its very nature inject liquidity into the wholesale sector, freeing up cash, reopening credit lines and reinvigorating private equity interest in both acquisitions and exits. So the dealmakers will take considerable cheer from the fact that three of the 20 largest mergers in the world in 2010 came from the telecoms sector: Centurylink’s $22.15 billion purchase of Qwest Communications; America Movil’s $19.36 billion purchase of Carso Global Telecom; and Bharti Airtel’s $10.7 billion purchase of Zain Afirca. A little optimism, it would seem, can go a long way.

It certainly needs to: gone are the days when carriers basked in reputations as high-flying tech stocks. Indeed, the telecoms sector is only now catching up with the so-called “dash for trash” rally of 2009 when shares in commodity producers surged as recessionary fears began to fade.

Good news, then, that in a recent survey of dealmakers, Mergermarket, a data provider on mergers and acquisitions, found that 78% of respondents expect activity to pick up over the next year. And more pertinent still, over half of those expect the major hotspot to be in the telecoms, media and technology arena.

The survey’s findings are echoed by Nik Stanojevic, an analyst at UK broker Brewin Dolphin, who takes a cautiously optimistic stance on telcos. Cautious, because while many companies boast strong cash flows, they face some big capital outlays: “There’s concern as to how much fixed-line providers will have to pay to invest in fibre networks and the extent to which networks might need to be upgraded to cope with the explosion in data traffic prompted by the advent of the iPhone and iPad,” he says.

Moreover, threats by European regulations to impose another round of cuts on termination rates could cost some European players with significant mobile assets as much as 3% in revenue growth over the next three to four years. But there’s reason to be optimistic, Stanojevic adds, because that very explosion in smartphone technology has opened the door for operators to revamp their tariff models. Additionally, he says, many companies are heavily geared towards the emerging markets, where economists are busily upgrading growth forecasts. “All in all, the outlook for M&A is pretty favourable. Balance sheets are very healthy and there’s a strong need to guarantee revenue growth by acquiring rivals with good cash flows.” 

Chris Godsmark, a London-based partner at the investment banking boutique Oakley Capital is similarly positive. “Let’s make no mistake – we are by no means looking at the boom times of 2006–07 but there are a number of factors that are cheering,” he says. For one thing, private equity houses are once again dipping a wary toe in the market. “Throughout 2009, the private equity contingent was largely noticeable by its absence, with the exception of all but one or two names,” he says.

“That’s changing. There are a number of closed-end funds out there that are still under-invested and are facing considerable pressure to top up their portfolios under the terms of their mandates.” In some cases, this could involve anything up to 20% of the entire fund and for mid-market specialists in the wholesale sector that could mean a meaningful war chest.

While some funds undeniably took a big hit on their telecoms exposure in the credit crunch, their new-found interest stems not from their readiness to put the past behind them, but from the opportunities to create value in what remains a largely unloved sector. “Be in no doubt – there are some very canny private equity specialists out there and it would be entirely wrong to assume all of them have had universally bad experiences in the crash,” Godsmark says.

But constraining the ability of private equity houses to bid up for wholesale assets is the lack of appetite for their debt. At the height of the boom, it was not uncommon for private equity buyers to finance a purchase with as much as 70% debt and just 30% equity. Now that ratio has flipped the other way. Nevertheless, advisers expect keen bidding interest from secondary funds in wholesale assets.

Nowhere is this more apparent than in the US, where the wholesale market is populated by a relatively large number of niche players serving local markets. Some are cash-rich; some have considerable market penetration; and many are putting themselves in to play.

In the last few months, a raft of companies have changed hands and some industry insiders believe that anything up to half of the total number of players could be taken out by larger rivals, leaving as few as a dozen US players owning fibre assets. Veroxity Technology Partners, American Fiber Systems, Fibernet, Kentucky Data Link (KDL) and Norlight have all been snapped up. Alpheus Communications and Fibertech Networks are also on the auction block. 

With the exception of nTelos, which paid about $170 million for Fibernet, financial terms have not been disclosed. But as a starting point, the valuations come in at around five times the target’s earnings before interest, taxation and amortisation (EBITDA). Other factors that also come in to play include the uniqueness of the target company’s routes, the make-up of its fibre network in terms of regional, long-haul and metro assets, the number of buildings that are connected and, of course, the quality of revenues.

It’s something of a perfect storm for the mid-tier growth funds, which have greater access to the funding markets and time on their side to watch investments flourish. Metro assets are scarce and there is little opportunity left to build new networks from scratch. Moreover, there is plenty of scope to expand through acquisition, stripping out costs and generating economies of scale. At the time of its purchase of Q-Comm’s subsidiaries KDL and Norlight, for example, Windstream said that it expected to make around $25 million a year in synergy savings.

All this comes against a backdrop of very strong underlying growth, fuelled by the surge in demand for data transport. As one banker who has worked on several acquisitions in the arena notes, private equity buyers are putting all this into their pricing models and coming out with valuations that trade buyers are struggling to match. According to the New York-based banker, nine out of the 12 initial expressions of interest for one metro operator came from financial buyers. “Frankly, some of the valuations I have seen in the last few months are out of this world, but the justification always comes back that assets are still cheap compared to the growth potential. You can’t argue with that.”

Which is not to say that bidders are going into auctions with rose-tinted spectacles: “Never underestimate the amount of due diligence that a private equity buyer will do into the stability of revenues, growth profile and capital expenditure requirements,” says the banker. Typically bidders will want to hear first-hand how the management plans to deliver customer growth, as well as pricing strategies to cope with the competitive backdrop. “The businesses that have achieved the biggest premiums are those that have been extremely transparent in their pricing mechanisms and very candid as to their plans for expansion. Don’t forget that many of these metros still produce negative cash flow, so buyers need to be comfortable with the amount of money flowing out in maintenance capital and expansion capital.”

In the US, acquisition finance is relatively easy, though not necessarily cheap to come by. Some players continue to baulk at the risk premiums that lenders are charging and bank debt continues to be pricey relative to base rates. Additionally, credit committees continue to be both cumbersome and time consuming. However, most deals in the metro market tend to be financed through syndicated revolving credit facilities where the main lender keeps a chunk of the loan and sells the rest on to institutional investors such as hedge funds and pension funds. “It’s pretty much business as usual,” the banker says, “with the caveat that companies with very high negative cash flows have more of a sell job to do with lenders.”

While North America will continue to be the cradle for most activity, the outlook for Europe is encouraging: “I am particularly excited by the opportunities in Germany, where private equity houses are beginning to find their feet, and in Scandinavia, which continues to be a crucial base for innovation,” says Oakley Capital’s Godsmark.

Trade buyers, too, are shrugging off the slough of despond. There will always be a market for technology-driven acquisitions – especially among wholesale operators who are finding organic growth in their core businesses increasingly difficult to generate. “Do they stay as a pipe or do they seek to provide new services on top – that’s the crux of the question,” says Godsmark. “There’s resurging interest in fill-in deals where operators are looking either to upgrade their capacity or tap into new opportunities – be they technology-related or geographical. We haven’t really seen enough deals to test the market, but all the signs are that valuations are creeping up.” 

However, potential buyers are refusing to enter into bidding wars: “The age of the strategic premium is pretty much dead for all but the most specifically targeted acquisition,” says Godsmark. And that, perhaps, is the crucial point. Financial backers may not yet have forgotten how companies destroyed shareholder value by overpaying for assets at the top of the market – shares in Vodafone, for example, are still lower than they were in 1998 and more than half their March 2000 high of 399p – but it would appear that they are, at least, willing to forgive. As one veteran dealmaker in the sector comments: “If there’s one thing that matters above all else to these guys, then it is size. This is a very competitive arena, and if you don’t have scale, you don’t have a future. Period.”

But not everyone believes in the longevity of the mega-merger model. According to Paul Cuatrecasas, of Aquaa Partners, a specialist M&A advisory firm, carriers need to change their M&A strategy – and fast. He says: “From a strategic viewpoint, mergers should almost always be about the customer.” Historically, the justification for many deals was that growth through consolidation would always benefit the customer. But now that many of those deals have had a chance to bed down, the rationale doesn’t always stand up to close scrutiny.

BT’s tortuous experiences with its Global Services venture is a case in point. Despite a string of acquisitions, most notably the purchase of Radianz, the network arm of Reuters, network operator Infonet, and managed security services provider Counterpane, the business has struggled to find favour with investors. Says Cuatrecasas: “Beyond scale, which is important, and perhaps diversification, what benefits do you get through a major acquisition – nothing. And if there’s no positive for the customer, why do it in the first place?” 

Cuatrecasas believes a step change in strategic outlook is called for: “For me, it’s all about applications – all the things that you bolt on beyond the cost of transportation. In other words, all the clever stuff that the operators are already doing. If the operators get smart about this, go out of the box and take action, then they can build a lasting competitive advantage.”

Even here, the execution risks are marked, as Vodafone found with its £33 million acquisition of Wayfinder, the Swedish mapmaker in 2009. A year later, the business was wound up after Google launched a free turn-by-turn navigation system. “It serves to remind carriers of the extent to which they must keep Google in their sights,” explains Cuatrecasas. As the world moves more and more to IP, all telcos, not just wholesale carriers, should be looking at the technologies surrounding security services – issues such as payment processing and authentication, ID fraud and email management, he says.

But the real driver for M&A, Cuatrecasas believes, will come from a different corner altogether. “You need to follow the money, and the technology sector is where the money is at. Microsoft, Google, Facebook are all aggressively acquiring assets in the telco space. If you really want to get excited about the potential for mergers, look at Apple,” he adds. “Steve Jobs has a $50 billion war chest that is growing every day and he has made little secret of his intention to spend it if the strategic imperative is there.”

The drive to strike deals is echoed throughout the wholesale sector and points to an interesting trend, says Robin Jowitt, a London-based M&A partner at Ernst & Young. “If we are at the onset of another land grab, it is not so much among the giants, but more specifically targeted.” France Telecom, for example, has committed to doubling its emerging market revenues over the next five years and aims to make Africa and the Middle East priority targets.

And in some cases, the drive to tie up a deal might flow from the other way as some of the more advanced emerging markets drive breathlessly to maturity. “The evolution we have seen in India, for example, is remarkable. The jockeying for market share through acquisition has been playing out for some time and what we’re expecting now is a drive to extend and expand service provision as the market reaches maturity,” says Jowitt. And this is where the wholesale sector is expected to benefit strongly as the focus shifts to bolstering capacity.

Bharti Airtel’s acquisition of Zain Africa, the Kenyan mobile operator, is a case in point: India’s largest telecoms operator paid $10.7 billion for the African business in a deal that is expected to reverberate around the wholesale sector. The Bharti board is expected to make a series of what it calls “network-related” announcements throughout the coming months after paying down close to $1 billion of debt relating to the acquisition last November.

Meanwhile, back at Vodafone, the problems are particularly unique: Calao’s 45% stake in Verizon Wireless, the largest wireless carrier in the US by subscribers, accounts for anything up to 40% of the mobile giant’s potential earnings per share but contributes nothing to cash. This is because the majority owner, Verizon, has suspended dividend payments. Verizon wants to try to force Vodafone to sell, but the British giant would face a £10 billion tax bill on any disposal and would therefore prefer to draw the two parent companies together through an agreed merger.

For their part, both Vodafone and Verizon, prefer to dampen speculation about the prospects for a merger, confirming only that there has been an ongoing dialogue between senior executives for months. But bankers are ever-hopeful and at least one London-based adviser believes in the rationale for what would be the largest merger ever seen in the telecoms market: “In Vodafone and Verizon, you have two companies well adept at consolidation in what is a very aggressively consolidating marketplace. Watch this space.”

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A year of mergers and acquisitions

In January 2010, Ciena bought Nortel’s Metro Ethernet Networks (MEN) business, paying a total consideration of $769 million for the assets. Network integrator GT&T bought a number of customers and assets from Chicago-based Global Capacity, which went into Chapter 11 bankruptcy protection later in the year. US rural telco Windstream acquired Iowa Telecom for $1.1 billion. Hibernia Atlantic acquired Mediaxstream, a provider of managed network services for the media and broadcast industries, adding 17 PoPs to its US footprint.   In February, Bharti Airtel agreed to acquire a 70% stake in Bangladesh’s Warid Telecom, taking its overall investment in the company to about $1 billion. The UK’s PacketExchange acquired Mzima Networks in the US to meet demand for Layer 2 Ethernet services and cloud connectivity. Vodafone agreed to acquire Turkish operator Borusan Telekom. In March, Zayo Group agreed to purchase AGL Networks, adding 795route miles and 182,000 fibre miles to its network. In April, Centurylink and Qwest announced they would be joining forces in a $22.4 billion merger. The combined company boasts a 173,000-mile fibre network and revenues of $20 billion.   In May, Cincinnati Bell said it would buy Texas-based data centre operator Cyrusone for $525 million. Turk Telekom announced it would acquire Invitel International. In June, AT&T raised $1.4 billion, selling Sterling Commerce to IBM. GTS Central Europe bought Romanian player Datek and Hungarian data centre provider Interware. Middle Eastern operator Zain sold its African assets to Bharti Airtel. In July, Japanese operator NTT bought South African IT services company Dimension Data for around $3.2 billion. In September, Neutral Tandem agreed to acquire Tinet for $94.9 million and France Telecom Orange announced it would buy a $640 million stake in Moroccan operator Medi Telecom. GTS Central Europe bought Slovakian metro network company Dial Telecom. Danish telco TDC sold its Swiss subsidiary Sunrise for $3.3 billion. In October, Russian operator Vimpelcom agreed to buy most of the telecoms assets of Egyptian billionaire Naguib Sawiris, including Orascom and Wind, in a $6.5 billion deal. In November, Etisalat signed a preliminary agreement with Zain’s shareholders to acquire a 46% stake of the company for $12 billion. MTS offered Russian Sistema RUB13.39 billion ($427 million) for a 100% stake in Sistema Telecom. In December, Cable & Wireless Communications agreed to buy a 51% stake in Bahamas Telecommunications Company for $210 million.