Category Archives: Telecom

Telecoms’ troubles

The telecom industry is in a funk. S&P recently said that their “global 2017 base-case forecast is for flat revenues” and other analysts are predicting little growth in traditional telecom’s top line over the coming years across most developed markets. This recent post shows that wireless revenue by the largest US firms has basically flatlined with growth of only 1% from 2015 to 2016. Cord cutting in favour of wireless has long been a feature of incumbent wireline firms but now wireless carrier’s lunch is increasingly being eaten by disruptive new players such as Facebook’s messenger, Apple’s FaceTime, Googles’ Hangouts, Skype, Tencent’s QQ or WeChat, and WhatsApp. These competitors are called over the top (OTT) providers and they use IP networks to provide communications (e.g. voice & SMS), content (e.g. video) and cloud-based (e.g. compute and storage) offerings. The telecom industry is walking a fine line between enabling these competitors whilst protecting their traditional businesses.

The graph below from a recent TeleGeography report provides an illustration of what has happened in the international long-distance business.

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A recent McKinsey article predicts that in an aggressive scenario the share of messaging, fixed voice, and mobile voice revenue provided by OTT players could be within the ranges as per the graph below by 2018.

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Before the rapid rise of the OTT player, it was expected that telecoms could recover the loss of revenue from traditional services through increased data traffic over IP networks. Global IP traffic has exploded from 26 exabytes per annum in 2005 to 1.2 zettabytes in 2016 and is projected to grow, by the latest Cisco estimates here, at a CAGR of 24% to 2012. See this previous post on the ever-expanding metrics used for IP traffic (for reference, gigabyte/terabyte/petabyte/exabyte/zettabyte/yottabyte is a kilobyte to the power of 3, 4, 5, 6, 7 and 8 respectively).

According to the 2017 OTT Video Services Study conducted by Level 3 Communications, viewership of OTT video services, including Netflix, Hulu and Amazon Prime, will overtake traditional broadcast TV within the next five years, impacting cable firms and traditional telecom’s TV services alike. With OTT players eating telecom’s lunch, Ovum estimate a drop in spending on traditional communication services by a third over the next ten years.

Telecom and cable operators have long complained of unfair treatment given their investments in upgrading networks to handle the vast increase in data created by the very OTT players that are cannibalizing their revenue. For example, Netflix is estimated to consume as much as a third of total network bandwidth in the U.S. during peak times. Notwithstanding their growth, it’s important to see these OTT players as customers of the traditional telecoms as well as competitors and increasingly telecoms are coming to understand that they need to change and digitalise their business models to embrace new opportunities. The graphic below, not to scale, on changing usage trends illustrates the changing demands for telecoms as we enter the so called “digital lifestyle era”.

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The hype around the internet of things (IoT) is getting deafening. Just last week, IDC predicted that “by 2021, global IoT spending is expected to total nearly $1.4 trillion as organizations continue to invest in the hardware, software, services, and connectivity that enable the IoT”.

Bain & Co argue strongly in this article in February that telecoms, particularly those who have taken digital transformation seriously in their own operating models, are “uniquely qualified to facilitate the delivery of IoT solutions”. The reasons cited include their experience of delivering scale connectivity solutions, of managing extensive directories and the life cycles of millions of devices, and their strong position developing and managing analytics at the edge of the network across a range of industries and uses.

Upgrading network to 5G is seen as being necessary to enable the IoT age and the hype around 5G has increased along with the IoT hype and the growth in the smartphone ecosystem. But 5G is in a development stage and technological standards need to be finalised. S&P commented that “we don’t expect large scale commercial 5G rollout until 2020”.

So what can telecoms do in the interim about declining fundamentals? The answer is for telecoms to rationalise and digitalize their business. A recent McKinsey IT benchmarking study of 80 telecom companies worldwide found that top performers had removed redundant platforms, automated core processes, and consolidated overlapping capabilities. New technologies such as software-defined networks (SDN) and network-function virtualization (NFV) mean telecoms can radically reshape their operating models. Analytics can be used to determine smarter capital spending, machine learning can be used to increase efficiency and avoid overloads, back offices can be automated, and customer support can be digitalized. This McKinsey article claims that mobile operators could double their operating cashflow through digital transformation.

However, not all telecoms are made the same and some do not have a culture that readily embraces transformation. McKinsey say that “experience shows that telcoms have historically only found success in transversal products (for example, security, IoT, and cloud services for regional small and medium-size segments)” and that in other areas, “telcoms have developed great ideas but have failed to successfully execute them”.

Another article from Bain & Co argues that only “one out of eight providers could be considered capital effective, meaning that they have gained at least 1 percentage point of market share each year over the past five years without having spent significantly more than their fair share of capital to do so”. As can be seen below, the rest of the sector is either caught in an efficiency trap (e.g. spent less capital than competitors but not gaining market share) or are just wasteful wit their capex spend.

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So, although there are many challenges for this sector, there is also many opportunities. As with every enterprise in this digital age, it will be those firms who can execute at scale that will likely to be the big winners. Pure telecommunications companies could become extinct or so radically altered in focus and diversity of operations that telecoms as a term may be redundant. Content production could be mixed with delivery to make joint content communication giants. Or IT services such as security, cloud services, analytics, automation and machine learning could be combined with next generation intelligent networks. Who knows! One thing is for sure though, the successful firms will be the ones with management teams that can execute a clear strategy profitably in a fast changing competitive sector.

Warring Wireless

The M&A permutations being talked about in the US telecom sector are fascinating. The AT&T/Time Warner deal has commentators frothing at the mouth about possible tie-ups, particularly given the laissez faire attitude to regulation of the new FCC Chairman, Ajit Pai. Names such as DISH, Comcast, Disney, Netflix, SiriusXM, Charter are regularly tied to the big telcos and/or each other in the speculation.

Existing wireless revenues from AT&T and Verizon have plateaued and are now starting to decrease due to cut throat competition on unlimited plans from T-Mobile and Sprint, as the graph below shows.

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The T-Mobile/Sprint merger is now been talked about again, after the year long FCC spectrum moratorium on competitors talking has passed. The current bidding frenzy between AT&T and Verizon over Straight Path’s millimetre wave frequencies that can be used to carry large amounts of data over short distances has brought the hype over 5G services to a new high. Verizon’s purchase of XO last year enabled them to lease XO’s 102 LMDS licenses in the 28 GHz and 39 GHz bands so it is somewhat surprising to see them be so aggressive in bidding for Straight Path.

The analyst Craig Moffett believes that the winning bidder for Straight Path will have significant leverage with the FCC in determining how these wave frequencies are repackaged for use by competitors. Although wireless margins are not under significant pressure, as the graph below shows, it is obvious that there is now a full scale war for control of the wavelengths that will be critical to 5G services in the search for new revenues. T-Mobile and DISH are also holders of high frequency wavelengths been touted as suitable for 5G.

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The fascinating thing about the frenzy over Straight Path is that the hype over high frequencies such as the 39 GHz band is not new. The reason such spectrum has gone largely unused in the past is that it has been historically difficult to create reliable, secure, mobile connections in those bands. Variable weather conditions, often something as common as a rainy day, can impact coverage in high frequencies. I wonder what’s changed?

A gaggle of bankers

How many investment bankers does it take to change a lightbulb? Well there are numerous jokes on that. Here’s one: two – one to take out the bulb and drop it and another one to sell it before it crashes!

In the case of the Level 3 (LVLT) and Centurylink (CTL) proposed merger (see previous post), it took no less than five investment banking firms according to the recent S4 filing to get a deal agreed. Centurylink had Bank of America Merrill Lynch and Morgan Stanley as its main advisors with Evercore added for another fairness opinion. Level 3 had Citi as its main advisor with Lazard for another fairness opinion.

The S4 also reveals that there was no auction process. Although both sides have no doubt talked to many potential partners about deals (both telecom firms have extensive M&A experience) in the recent past, this merger proposal really got started after discussions with the CEOs in May, initially about a LVLT purchase of CTL’s business segment and a tracking stock on the consumer business. The tracking stock idea quickly got dumped with the cash and share purchase of LVLT by CTL discussed in principle in September with the details agreed in October. Given the breakup fee is only around $2 a share for any alternative bidder, LVLT decided it was best to nail down the deal with CenturyLink rather than look for other deals. The S4 stated the following:

In light of the premium being proposed by CenturyLink, Level 3 management’s view of the relatively low likelihood of any potential alternate bidder being willing to make a superior proposal within a short time frame and the risk of potential leaks raised by pursuing such a pre-signing market check, coupled with the ability of any potential interested bidder to submit a competing offer following the signing of a definitive agreement with CenturyLink and the ability of Level 3 to terminate any definitive agreement with CenturyLink post-signing to accept a superior proposal from another bidder, the Level 3 Board determined at that time to continue pursuing the transaction proposed by CenturyLink without approaching other parties.

Relying on investment bankers to give fairness opinions could be viewed with scepticism by anybody with a memory and a sense of humour. However, in this case, I believe that the strategy is a sensible one for shareholders. The business segment of CTL and LVLT clearly makes sense as a match up with the possibility of significant synergies (more I think than has been assumed). The consumer side of the merged entity can always be offloaded at an opportune time in the future. Also, any other potential bidders of LVLT, such as Comcast or a technology firm like Goggle or Microsoft, will be forced now to act if they want the unique assets of the firm. My sense is that the possibility of another bidder emerging over the coming months remains low.

The financial projections, shown below, from management of each firm on a standalone basis are presented in the S4 and make for interesting reading.

click to enlargecenturylink-level3-projections

The projections for LVLT show higher capex figures for 2016 and 2017 than analyst estimates. From 2017 onwards, LVLT’s estimates of revenue are higher than analyst estimates whilst the resulting EBITDA is lower. This suggests a slower progression in EBITDA margins than analysts’ expectations with a figure closer to 35% and stable over the medium term. For CTL, the longer term revenue growth figures from the firm are more aggressive than analysts with EBITDA margins drifting down to the 35% level and below over the medium term.

It is unclear how many adjustments have been made by advisors to the figures provided by management of both firms. I am not that familiar with CTL’s figures but the LVLT figures look reasonable enough. The fairness opinions generally state that they reviewed the figures provided and the assumptions behind them without actually coming up with their own figures. The valuations of a standalone LVLT in an M&A context, and the assumptions behind the methods used, outlined in the S4 are shown below.

click to enlargelevel-3-valuations-from-s4-december-2016

The valuations are generally consistent around a $60 per share level, varying from $50 to $70. Most include the value of the NOLs with Citi estimating their value separately at approximately $7 per share. A number of the bankers also valued the targeted synergies of the deal assuming 100% of these were assigned to LVLT shareholders. These estimates and the valuations of a standalone CTL are shown below.

click to enlargelvlt-and-ctl-valuations-from-s4-december-2016

Comparing the average LVLT standalone valuations and those including the synergies shows a value of $25 per share (i.e. $84-$59), assuming shareholders get 100% of the synergies. That assumption is clearly unrealistic. If 50% of the synergies were assigned to LVLT shareholders (who will get 49% of the combined entity), than a reasonable expectation in the longer run would be a value equivalent to $72 per share. As can be seen below, this is equivalent to a share price of $32 per share for CTL under the merger terms. BofA Merrill Lynch and Morgan Stanley in the S4 calculated a proforma value of CTL after the merger (with the synergies realised) of $34.75 which would put the value of the deal to LVLT shareholders around $76 per share, as below.

click to enlargecenturylink-level-3-merger-deal-2

With CTL’s stock still trading just over $24, there is obviously a lot that can happen before this proposed merger closes. And even more time before the deal synergies are realised. One thing is for sure through, the investment bankers are making out well as the exhibit on their fees below shows. $25 million alone for a few week’s work to provide the fairness opinions is outrageous.

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The amount of such fees investment bankers get away with charging always boggles the mind and shows what a closed shop the business still is. Whatever happens to LVLT and CTL shareholders, these masters of the universe always make out like bandits.

Confused but content

As regular readers will know, I have posted on Level 3 (LVLT) many times over the years, more recently here. I ended that post with the comment that following the firm was never boring and the announcement of a merger with CenturyLink (CTL) on the 31st of October confirmed that, although the CTL tie-up surprised many observers, including me.

Before I muse on the merger deal, it is worth looking over the Q3 results which were announced at the same time as the merger. The recent trend of disappointing revenue, particularly in the US enterprise business, was compounded by an increased projection for capex at 16% of revenue. Although the free cash-flow guidance for 2016 was unchanged at $1-$1.1 billion, the lack of growth in the core US enterprise line for a second quarter is worrying. Without the merger announcement, the share price could well have tested the $40 level as revenue growth is core to maintaining the positive story for the market, and premium valuation, of Level 3 continuing to demonstrate its operating leverage through free cash-flow growth generation.

click to enlargelvlt-revenue-operating-trends

Level 3 management acknowledged the US enterprise revenue disappointment (again!) and produced the exhibit below to show the impact of the loss of smaller accounts due to a lack of focus following the TW Telecom integration. CEO Jeff Storey said “coupling our desire to move up market, with higher sales quotas we assigned to the sales team and with compensation plans rewarding sales more than revenue, we transitioned our customers more rapidly than they would have moved on their own”. The firm has refocused on the smaller accounts and realigned sales incentives towards revenue rather than sales. In addition, LVLT stated that higher capex estimate for 2016, due to strong demand for 100 Gig wavelengths and dark fibre, is a sign of future strength.

click to enlargelvlt-q3-revenue-by-customer

Although these figures and explanations do give a sense that the recent hiccup may be temporary, the overall trends in the sector do raise the suspicion that the LVLT story may not be as distinctive as previously thought. Analysts rushed to reduce their ratings although the target price remains over $60 (although the merger announcement led to some confused comments). On a stand-alone basis, I also revised my estimates down with the resulting DCF value of $60 down from $65.

Many commentators point to overall revenue weakness in the business telecom sector (includes wholesale), as can be seen in the exhibit below. Relative newcomers to this sector, such as Comcast, are pressuring tradition telecoms. Comcast is a firm that some speculators thought would be interested in buying LVLT. Some even suggest, as per this article in Wired, that the new internet giants will negate the need for firms like Level 3.

click to enlargebusiness-telecom-revenue-trends-q3-2016

However, different firms report revenues differently and care needs to be taken in making generalisations. If you take a closer look at the revenue breakdown for AT&T and Verizon it can be seen that not all revenue is the same, as per the exhibit below. For example, AT&T’s business revenues are split 33%:66% into strategic and legacy business compared to a 94%:6% ratio for LVLT.

click to enlargeatt-and-verizon-business-revenue-breakdown

That brings me to the CenturyLink deal. The takeover/merger proposes $26.50 in cash and 1.4286 CTL shares for each LVLT share. $975 million of annualised expense savings are estimated. The combined entity’s debt is estimated at 3.7 times EBITDA after expense savings (although this may be slightly reduced by CTL’s sale of its data centres for $2.3 billion). LVLT’s $10 billion of NOLs are also cited by CTL as attractive in reducing its tax bill and maintaining its cherished $2.16 annual dividend (CTL is one of the highest yield dividend plays in the US).

The deal is expected to close in Q3 2017 and includes a breakup fee of about $2 per LVLT share if a 3rd party wants to take LVLT away from CTL. Initially, the market reaction was positive for both stocks although CTL shares have since cooled to $23 (from $28 before the deal was announced) whilst LVLT is around $51 (from $47 before) which is 13% less than the implied takeover price. The consistent discount to the implied takeover price of the deal since it was announced suggests that the market has reservations about the deal closing as announced. The table below shows the implied value to LVLT of the deal shareholders depending upon CTL’s share price.

click to enlargecenturylink-level-3-merger-deal

CTL’s business profile includes the rural consumer RBOC business of CenturyTel and nationwide business customers from the acquired business assets of Qwest and Sprint. It’s an odd mix encompassing a range of cultures. For example, CTL have 43k employees of which 16k are unionised. The exhibit below shows the rather uninspiring recent operating results of the main segments.

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CTL’s historical payout ratio, being its dividend divided by operating cash-flow less capex, can be seen below. This was projected to increase further but is expected to stabilise after the merger synergies have been realised around 60%. The advantage to CTL of LVLT’s business is an enhancement, due to its free cash-flow plus the expense synergies and the NOLs, to CTL’s ability to pay its $2.16 dividend (which represents a 9.4% yield at its current share price) at a more sustainable payout rate.

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For LVLT shareholders, like me, the value of the deal all depends upon CTL’s share price at closing. I doubt I’ll keep much of the CTL shares after the deal closes as CTL’s post merger doesn’t excite me anywhere as much as a standalone LVLT although it is an issue that I am still trying to get my head around.

As per the post’s title, I’m confused but content about events with LVLT.

Level3 hiccup

I have posted on one of my major holdings Level 3 (ticker LVLT), a facilities-based provider of a range of integrated telecommunications services, many times before, most recently here. One of the features of LVLT is its volatility and the past weeks have proven no exception. LVLT broke below $50 in late June to $47 before being buoyed to above $56 by a unsubstantiated rumour that the firm was “reviewing strategic alternatives to maximize holder value, including outright sale or large buyback”. After the quarterly report on the 27th of July when LVLT reported disappointing revenues but beat on the bottom line, the stock is now down below $50 again without any news from the firm on buybacks or M&A.

The revenue figures, particularly the increase in CNS monthly churn to 1.2%, was disappointing with the loss in accounts been driven by SME enterprise customers. One possible reason for the lack of focus was the temporary absence of the CEO due to a heart issue earlier in the year. As the chart below shows, LVLT does have form with revenue dips after initial successful M&A integration. Many, including me, thought that the current management was more on top of the issue this time around.

click to enlargeLevel3 Operating History 2005 to 2017e

Despite this disappointment, the revenue impact is likely to more contained this time around and I believe the case for LVLT in the longer term remains strong. I have reduced my revenue estimates in the graph above but the free cashflow that LVLT’s business is throwing off makes the bull case. My PV cash-flow analysis still has a price target of over $65, which represents a 2018 EV/EBITDA multiple of slightly below 10. Although the multiple is high compared to the incumbent US telcom giants, I think it is warranted given the quality of LVLT’s assets in an ever data hungry economy. The current favourable, albeit political, regulatory trends (net neutrality and the ban on lock-up agreements) are another plus factor.

I estimate that the FCF generated by LVLT could, in the absence of any M&A, mean the firm could afford $1 billion of buybacks in 2017, rising by $250 million a year thereafter. An aggressive buyback programme over a five year period, 2017 to 2021, could amount to approx $7.5 billion or approx 30% of current share count at an average price of $65.

In terms of M&A, management are obviously keen although they did emphasis the need for discipline. An interesting response to an analyst question on the Q2 call that any potential M&A fiber targets for LVLT trade at higher EV/EBITDA multiples was as follows:

“So as we look at M&A, and you mentioned fiber companies, we look at fiber companies post-synergies and believe that we are very good at acquiring and capturing synergies and moving networks together, combining networks, and creating value for shareholders through that. So I don’t feel that the M&A environment is necessarily constrained.”

One of the firms that the analyst was possibly referring to is Zayo, who interestingly just hired LVLT’s long time CTO Jack Waters. Zayo currently trade at over 10 times its 2017 projected EBITDA compared to LVLT currently at a 2017 multiple in the low 9s. Obviously a premium would be needed in any M&A so the synergies would have to be meaningful (in Zayo’s case with a 50% plus EBITDA margin, the synergies would likely have to be mainly in the capex line). COLT telecom is another potential M&A target as Fidelity’s self imposed M&A embargo runs out after 2016 (see this post).

A significant attraction however is for LVLT itself to become a target. One of the US cable firms, most likely Comcast, is touted as a potential to beef up their enterprise offerings to compete with the incumbents. Other potential candidates include the ever data hungry technology firms such as Google or Microsoft who may wish to own significant fiber assets and reduce their dependence on telecoms such as Verizon who are increasingly looking like competitors.

As ever with LVLT, the ride is never boring, but hopefully not ever ending….