Mergers and acquisitions: what's the magic number?

In the end, the mergers and acquisitions outlook could all boil down to a simple numbers game.

In cash-strapped Europe, all eyes are on the competition authorities and how they will rethink the ‘magic number’ of competitors they insist upon championing in small and often crowded local markets after approving Hutchison Whampoa’s €1.3 billion purchase of Orange Austria.

In the US, meanwhile, the emphasis is on the number two – and specifically whether Verizon, the US’s second largest phone operator by stock market value, might look to capitalise on a woeful year at Vodafone to finally unravel their complicated wireless joint venture with an audacious move on the UK giant.

And in Asia, the spotlight shines on Masayoshi Son, the so-called “Bill Gates of Japan”, and his now not-so-risible ambitions to build Softbank into the world’s number one phone operator.

But it is, of course, another set of numbers that will ultimately drive M&A activity over the coming months – bottom line earnings – and these make for some gloomy reading, especially in Europe. According to the European Telecommunications Network Operators’ Association, total revenues in 2011 fell for the third year in a row to €274.4 billion. Meanwhile, net debt across the sector jumped to €272 billion according to Deutsche Bank.

Mobile revenues, which make up just over half of telecom operators’ total revenues, racked up their first ever decline, falling 0.6% over the year and compounding an 8% plunge in traditional fixed-line revenues. Only broadband income, up 4% against 2010, bucked the depressing trend, helping to shoulder a 4.6% jump in capital expenditure.

The early estimates suggest that 2013 will be another year of decline, fuelled in part by an unprecedented collapse in the European prepaid mobile phone market. Customers – both retail and enterprise – have been moving ruthlessly to optimise their telecoms spend, prompting some operators, notably Vodafone, to write down the value of key assets in Italy, Spain and Greece by billions of euros.

For the first time, analysts are starting to moot the previously unthinkable possibility that mobile data revenues might not, on their own, grow fast enough to take up the slack in the declining voice and messaging markets.

So if 2012 is to be remembered for anything, it might well be as the year in which a fundamental tenet in telecoms was turned on its head: namely, that the industry is no longer quintessentially recession-proof.

On the contrary, Europe’s operators in particular have found themselves to be prone to the economic slump and the reason for that, at least according to Darren Ward, a veteran stock market analyst with the London-based independent research firm Echelon, is down to poor planning.

“Europe’s larger operators should have been following their rivals in the US – they should have been investing heavily into fixed and mobile bandwidth so that they could differentiate themselves from the price-led strategies of smaller competitors by offering huge bundles of faster usage.”

Instead, they have neglected to accelerate the necessary network investment – preferring to hand out cash to shareholders – and now, he says, many of them are in a financial mess.

Unlike stock analysts at most large investment banks, who often find themselves researching companies that are also fee-paying clients, Echelon is entirely independent and Ward does not pull his punches. “In my view, the managements of many large European telcos have made some huge errors in their stewardship of these companies. They have paid out too much to shareholders for too long at a time when investment in networks was, presumably, crucial in the hope that a recovery in the markets would eventually come along to rescue them.”

In the meantime, core profits have been squeezed on the one hand by intense competition in pricing and bundling and on the other by the rise of over-the-top (OTT) players. And if all that wasn’t bad enough, several operators, including France Telecom, Telecom Italia, KPN and Telefónica, are operating under a mountain of debt that is skidding out of control.

Now, says Ward, the day of reckoning is upon them: companies must somehow find the cash to invest in their networks or face a continued rapid decline in profitability.

One obvious solution is to explore the disposal of non-core assets. In recent months, there has been a flurry of deals in the European sector as companies start to reshuffle their portfolios. Last year, for example, France Telecom sold its Swiss business to Apax, the UK-based private equity firm for a higher-than-expected €1.6 billion and a 35% stake in Orange Austria to Hong Kong’s Hutchison Whampoa.

Meanwhile TeliaSonera is mooting the sale of its 76.6% stake in Yoigo, the fourth largest mobile operator in Spain.

And Telefónica, whose €57 billion debt mountain exceeds its stock market value by more than €10 billion, is reviewing the possibility of selling shares in up to 14 of its Latin and South American affiliates and is also seeking a buyer for its stake in Portugal Telecom.

The Spanish operator has already had a busy few months, selling a 4.5% stake in China Unicom back to the Chinese operator’s parent company for €1.1 billion and a one-fifth stake in its German business, which trades under the O2 banner, for around €1.5 billion to German investors.

Philip Kendall, a consultant with Strategy Analytics, sums up the mood thus: “I genuinely believe that no deal is off the agenda. We are in a very pragmatic era where every asset is for sale at the right price.”

Arguably, this stream of deals would have already turned into a flood, were it not for uncertainties surrounding the position of competition authorities and their implicit insistence on a so-called “magic number” of players in key markets.

Regulators first drew a line in the sand back in 2010 when France Telecom was blocked from merging its Orange Switzerland business, the second largest player in the market, with the number-three competitor, Sunrise.

However, the trading environment has deteriorated considerably since then and late last year, the European Commission approved Hutchison’s proposed acquisition of France Telecom’s Orange Austria. The combined company, with a market share of 24%, barely scales up to its next largest rival, number two-placed Deutsche Telekom’s T-Mobile, which commands a 30% share of the market.

However, the authorities thought very long and hard before approving the deal, mindful that it is now likely to trigger consolidation efforts in Spain, where the top-three players have all expressed an interest in buying the number-four operator Yoigo, as well as in Italy, France (where local reports have suggested that SFR and Free Mobile would be keen to explore a merger), Germany and Greece.

Tellingly, Joaquin Almunia, the EU Competition Commissioner said in a statement: “The risks posed by more concentration in national mobile telephony markets cannot be ignored.”

Another catalyst might emerge in the unlikely shape of Vodafone. In comments that were mostly lost amid an irrepressibly gloomy set of earnings figures late last year, Vittorio Colao, chief executive, let slip that he was not averse to acquiring fixed-line operators, or “bandwidth”, as he put it. He also professed himself to be open to buying fibre assets.

While Colao’s major competitors have shown themselves to be very adept at bundling up total telecoms packages to retain customers, Vodafone treads an increasingly lonely path as a mostly wireless-only provider. If the mobile giant is indeed looking to build on its £1.1 billion acquisition of Cable&Wireless Worldwide (CWW) last year, then it will need a ready supply of cash.

“Vodafone has one of the better balance sheets in the EU sector, but the company has large payout expectations to meet. If the group were to sell its 45% stake in Verizon Wireless, Colao could sort out his fixed-line issues in pretty much every major market in Europe and still have change to hand back to shareholders.”, says Echelon’s Ward. More than that, he could turn Vodafone into the total communications business that he has often said he wants the company to be.

If the Vodafone chief doesn’t sell, he might find himself in the unusual position of being a target himself. The ever-shifting dynamics of the Vodafone/Verizon relationship twisted noticeably last year: analysts have never really held out much hope that Vodafone would ever wrest control of the wireless venture away from Verizon, but there has often been talk that Vodafone might at some point consider a full-scale do-or-die bid for its US partner. That looks unlikely given Vodafone’s current financial troubles in Europe.

But the same might not be true of Verizon, whose shares outperformed those of Vodafone by as much as 20% in 2012, and who might view a cross-border merger as an attractive avenue for growth, given that US competition authorities are likely to block any meaningful acquisition in its own back yard.

The prospect of a Verizon/Vodafone deal, however remote, might keep alive hopes of a mega merger at a time when most observers believe that the age of the game-changing deal has well and truly passed. “As far as European operators are concerned, geographical expansion per se looks to be completely off the table”, warns Ward: “Any CEO that went looking for a transformational acquisition outside the company’s current footprint would face hugely skeptical shareholders.”

It’s not just that deal-makers have lost their nerve, say analysts, although the telecoms sector hasn’t exactly got the best of reputations when it comes to making mega mergers work – Bernstein, the US investment bank, estimates that European telecoms companies have written off €134 billion against ill-considered mergers since 2000.

“For one thing, it’s difficult to see where that transformational move comes from”, explains Adrian Baschnonga, a senior analyst in Ernst & Young’s London-based Global Telecommunications practice. “Companies aren’t really in a ‘land-grab’ frame of mind – they are far more focussed on getting to grips with the footprint that they have already built up.”

Rather, a more conservative rationale now hangs over the market: “There is neither the risk appetite nor the cash to throw at a transformational deal in the current climate”, Baschnonga says. “Instead we are seeing innovative partnering models evolve as companies look for a low-risk way into adjacent markets such as the machine-to-machine (M2M) arena or the cloud.”

A case in point was Verizon’s $612 million purchase of Hughes Telematics, an Atlanta-based firm specialising in in-car diagnostics and fleet management last summer. Analysts at Machina Research, the London-based M2M consultancy, estimate that Hughes will contribute as much as $3.2 billion to Verizon’s bottom-line over the course of the next seven years.

But while the transformational deal may be off the agenda, continuing rationalisation will still nudge competitors into each other’s arms. For now, the US market is waiting for regulators to clear T-Mobile’s reverse merger into MetroPCS, the US’s fourth and fifth largest network operators respectively.

What happens to the enlarged entity is likely to be the source of fevered speculation. Integration talks continue while Softbank moves to consolidate its $20 billion acquisition of a 70% stake in Sprint, the US’s third largest operator.

Softbank’s gregarious chief executive, Masayoshi Son, has made little secret of his ambition to become the world’s biggest telecoms company (see box-out) and he readily accepts that this is likely to pit him against Verizon and AT&T sooner rather than later. The underdog, he told analysts recently, can often have a sharper bite than the leaders of the pack.

And if the fires of speculation were not burning brightly enough, further fuel comes from Dan Hesse, Son’s opposite number at Sprint, who is a staunch advocate of further consolidation among the lower ranking operators in the United States. Indeed, Hesse has already had a good look at MetroPCS’s books, having launched an $8 billion bid for the company last spring.

That valuation, which is around one third higher than MetroPCS’s current worth, coincidentally chimes with the amount of cash sitting in Hesse’s new war chest, prompting the rumour mill to notch up another gear.

In a research note published late last year, Oppenheimer, the US investment bank, set out a well-reasoned vision for the future suggesting that Sprint might first move to snap up Leap Wireless and then seek a tie-up with a fully integrated MetroPCS/T-Mobile in around two years.

Such a concerted round of consolidation will only gather momentum, of course, if dealmakers can challenge the conviction that US regulators, like their European counterparts, have in mind a minimum number of competitors they wish to see underpinning competition in the market below which they are not willing to go.

If Son can break that, he really will show his magic touch.

Source: mergermarket.com. Notes: Based on announced deals, excluding lapsed and withdrawn bids. Based on dominant geography of target being global. Based on dominant sector of target being telecommunications carriers. Data correct as of 04-Dec-2012. Activities excluded from table include property transactions and restructurings where the ultimate shareholders’ interests are not changed.

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How do you make a small fortune investing in KPN, the former Dutch phone monopoly? Start off with a big one. Since Carlos Slim – thankfully, the world’s richest man – bought a near 25% stake in the company last year, the shares have almost halved, wiping more than $1 billion off Slim’s admittedly sizeable $69 billion fortune.

Like Sawiris, Slim, who bought his first shares at the tender age of 12, sees value in Europe’s under-loved incumbents. Bagging a bargain, however, is proving somewhat difficult. In fact, it’s taken five attempts to establish a toehold in the Old World. Last summer, the 79-year-old Mexican finally snapped up Sawiris’s Telekom Austria stake and he has since been reported to be keen to break into Poland and Switzerland.

But it was his aggressive move on KPN, aimed at building a 27.7% stake through a E3.5 billion hostile share tender that raised the most eyebrows – and not just in response to the speed at which Dutch shareholders jumped at his controversial bid. In the end, investors, accounting for 40% of KPN’s shares, wanted to take Slim’s €8-a-share offer, despite KPN’s efforts to scupper the deal with a plan to merge its E-Plus unit with Telefónica’s operations in Germany. That proposal collapsed and KPN eventually opened its arms to the Mexican billionaire.

In the US, Slim is thought to be keen to continue building scale in his mobile business through Tracfone Wireless. Last May, Slim snapped up Californian network operator Simple Mobile for $100 million, consolidating Tracfone as the US’s fifth largest virtual network operator.

Would like to… Possibly take another shot at Telecom Italia, thereby settling a few old scores and underscoring his credentials as a long-term value investor to rival Warren Buffet in one fell swoop.

Will settle (for now) for… a slightly more risk-averse portfolio of pan-European stakes that could give Telefonica, arguably Slim’s greatest rival on his home turf in Latin America, a run for its money.

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The 58-year-old son of Egypt’s richest man, known as the ‘Pharaoh’, is once again stalking the rich hunting grounds of Italy’s beleaguered telecoms sector. Late last year, Sawiris, who made his fortune building Orascom into the Middle East’s biggest mobile phone operator, offered to underwrite a new issue of shares in Telecom Italia to help fund a turn-around at the debt-stricken operator.

Sawiris has, of course, done it before. In 2005, he bought Wind, Italy’s third-largest mobile phone operator from Enel, the utility group, in what was at the time Europe’s biggest ever leveraged buy-out. Under his stewardship, Wind notched up 20 million wireless subscribers and emerged as Italy’s second largest fixed-line operator. In 2011, he sold most of his telecoms assets to Russia’s VimpelCom for $6.5 billion in a deal that created the world’s sixth largest mobile operator by subscribers.

Sawiris sparked a flurry of speculation last summer when he gathered together his old team from Orascom and Wind in his private equity firm, Accelero Capital. The group is actively shopping for bargains among Europe’s debt-laden incumbents.

In January 2011, Sawiris sold a 50% stake in Tunisiana, the Tunisian mobile phone operator for $1.2 billion to Qatar Telecom. Last June, he sold a 21% stake in Telekom Austria, which he owned together with Ronny Pecik, the Austrian financier, to América Móvil. And last May, he closed a deal to sell most of his remaining stake in Mobinil Telecom, the Egyptian wireless operator, to France Telecom for about $2 billion.

Accelero has already struck a deal with Telecom Italia to buy Matrix, which owns the Virgilio website for €88 million.

Would like to buy… A trophy French asset: “If there is an opportunity in France, I am there. But unfortunately the French only want French investors”, he complained recently. “A poor Egyptian like me has no chance.”

Might settle for… Telecom Italia: To date, the Italian establishment has warmed to Sawiris, but a proposal to dilute a clutch of existing institutional shareholders including Assicurazioni Generali and Mediobanca – not to mention Telefónica - is likely to ruffle some feathers. Any deal would also scupper the Italian incumbent’s plans to spin off its fixed-line network to Cassa Depositi e Prestiti, the state-backed lender.

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“I’m a man – it’s part of my male ego to strive to be number 1”. So explained the 55-year-old chief executive of Softbank when he vowed recently to swell the Japanese mobile phone group’s annual profits one hundred-fold by the time he retires. There was a time when analysts would have laughed Son, the so-called “Bill Gates of Japan”, out of the room.

But many of those same analysts will have been present in 2006, when Son accompanied his purchase of Vodafone’s Japanese mobile phone business with the promise that he would topple NTT DoCoMo from the top slot within a decade.

If Son’s $20.1 billion bid for a 70% stake in Sprint Nextel clears US regulatory hurdles, he will create the world’s third largest mobile phone operator with 96 million subscribers and revenues of $81 billion. On the way, Son has amassed a personal fortune of $6.9 billion, making him Japan’s third richest man.

While Son’s peers are on the hunt for cheap assets among Europe’s cash-strapped telcos, the Softbank chief is gambling on the US market, affirming his reputation as a high stakes roller. Son has vowed to be a hands-on chairman of the enlarged group and is keen to close the gap with AT&T and Verizon. The group has already moved to resolve uncertainties over Clearwire, the heavily indebted wireless network operator by lifting its holding to a majority stake.

Like his business idol, Steve Jobs, Son has known ups and downs. Shortly before the dot.com bubble collapsed, Son was worth $90 billion. A year later, he was down to his last $1 billion, making his come back all the more remarkable.

Would like to… pursue further acquisitions in the US. The question is whether Son takes a shot at an enlarged T-Mobile/MetroPCS or whether he opts instead for Leap and looks to scoop up MetroPCS at a later date.

Will settle for… Actually, by his own admission, Son probably won’t settle for anything other than the number one slot.