THE COLLAPSE of Lehman Brothers in 2008 and the ensuing credit crunch that threatened to topple investment banks around the world has been cited by all and sundry for driving down profit margins and suffocating growth. But for Paul Simpson, chief financial officer of telecommunications group KCOM, the problems in the banking sector were more telling than most.
Speaking to Financial Director at KCOM’s offices in the heart of the City, Simpson remembers how the company was buffeted by the shockwaves caused by Lehman’s demise.
“If you go back to that period we had a business where our principal customer segment was investment banking and at that time the investment banks were starting to withdraw some of their IT budgets and starting to run into one or two challenges and for us that culminated in the loss of Lehman Brothers as a customer,” Simpson says.
“We had a big project creating some of Lehman Brothers’ infrastructure that we were halfway through. So not only did we lose the business but we lost some of the progress activity as well.”
Simpson, who joined KCOM in 2004, concedes that period was a very challenging time for KCOM and one that shook the company’s business model to its core – the share price plummeted from 75p at the end of 2007 to its nadir of 12.5p at the end of 2009, while the business slumped to a pre-tax loss of £103m for the six month period ending 30 September 2008.
KCOM had a model where a lot of the business it did was in distribution and the provision of Cisco products. Therefore it was easy for customers to stop by cutting back on their activities which left the business model with some challenges.
The loss of a key customer segment and the reduced spending power of remained clients combined with the general economic environment that saw a surge in the liabilities associated with the company’s defined benefit pension schemes while its net debt position spiralled to a position approaching three times EBITDA.
“We had our scheme 60% invested in equities and equity markets were quite clearly taking a pounding at that time and that put a big increase on the funding deficit,” Simpson says.
“We had three pretty significant factors that meant when people looked at the business they said ‘hang on a minute, covenants appear to be deteriorating, core verticals seem to be reducing expenditure, and actually there is this big pension scheme challenge coming up.”
In such a situation Simpson could be forgiven for losing heart. Instead it was time to knuckle down and conduct a thorough strategic review of the business, one that would dramatically alter the company’s business model.
KCOM runs a telecommunications network across the UK, but that was an investment it was struggling to get a return on. Simpson says that running a network is a ‘scale game’ and the businesses that tend to make money from running infrastructure tend to be the likes of BT and Virgin.
Competing at that level was requiring a lot of investment but wasn’t generating a return, yet remained critical to the ongoing viability of the business.
“One option would have been to sell the network and become a pure reseller but that was a poor option in the sense we wouldn’t have had the value the network dynamic to our customers,” Simpson says.
The strategic review resulted in KCOM combining with BT in a ‘unique’ strategic partnership, which effectively left KCOM retaining ownership of its network but BT managing it on KCOM’s behalf, while KCOM was able to enter into an enhanced relationship with BT and gain access to all their products and services and network infrastructure on different terms to that which it would have been able to previously.
“It changed the nature of what we did, it improved our economics and it meant that we could now target a whole range of different businesses across the UK. It took away the capital burden we had of owning network infrastructure which was a massive event for us,” Simpson says.
“Transformation is a horribly overused phrase but actually the BT relationship for us was genuinely transformational. It completely moved what our focus was. We were much less ‘we build networks and a we operate networks business’ and we moved into a very different space almost immediately and it actually changed the opportunity in front of us in the market almost overnight.”
The second thing Simpson had to address was exiting from some reducing profitable activities. KCOM stopped being a direct distributor of hardware, but the business still had to support the installed base of that hardware of its customers.
This led to the company’s second strategic relationship with Phoenix IT Group in February 2010 to outsource and transfer part of its support and field maintenance business.
“We changed the business fundamentally from having to do everything ourselves to having two very important partnerships to work alongside existing relationships,” Simpson says. “We have retained a lot of the intellectual capability and managerial capability that manages BT and Phoenix and we have been very specific about the governance and reporting.”
Despite the progress made on changing the business model there was still a significant pension fund deficit to deal with and a debt position that needed to be refinanced.
The business had numerous pension schemes around the group that had significant funding requirements, which Simpson says was not an ‘equitable situation’ across the business.
Effectively KCOM closed all of those schemes and put everyone in the business into one defined contribution one; closing the final salary schemes, ceasing future accruals which consequently minimised the volatility of the risk that sat in the schemes.
“That allowed us to put some certainty into our funding requirements. We sought early agreement with the trustees about the valuation and the recovery plan that we had so we able to give the banks certainty about what our cash commitments were. That was fundamental in making sure we could refinance the business as we also had a refinancing to do,” Simpson says.
Resolving the network question, putting strategic supply arrangement in place, resolving questions about where margins were declining and clearing up the pension schemes to the extent that the business was able to get clarity on its funding arrangements put KCOM in a “really strong arrangement to go back to the lenders in good time and say we were ready to refinance the business” Simpson says.
However, Simpson was not immune to the human element involved.
“When you are closing pension schemes it is not always an easy sell to people that had to understand why we made that decision. That decision had to put into context of the business has changed, the circumstances around the obligations we have to our employees as an employer have changed, the financial capability we have to support all of the things we do has changed,” he says.
Simpson says the hard decisions paid off. According to KCOM’s latest results for the half year ended 30 September 2011 the company posted pre-tax profit of £27m, revenue of £198m and net cash inflow from operations of £35.3m, up 65%.
“Over the last three to four years we have had phenomenal cash generation. In all of the arrangements we have entered into we have had a very strong focus on what those arrangements did for our cash position, so we were obviously seeking to maximise the cash terms of that,” he says.
As a result of the company’s cash generation – a combination of being able to not carry stock – Simpson was able to release a lot of working capital tied up in the business. That cash has helped cut the company’s net debt position to £111m to £75m.
“We have reached the point now where we have one of those nice challenges where we are very comfortable with the level of debt we carry. It is about one times our EBITDA which gives us a huge amount of headroom in the facility and it also means that we are not in a position where we have to manage the business around the covenants,” says Simpson.
“With no further debt pay down we have further scope to invest in the business, so we have been through a period where we have stopped doing a lot of things. We have obviously stopped some investment in things like network but there are some other things we were looking to invest in. In east Yorkshire, the KC part if the business we are investing in fibre roll, we are looking how we get the best out of what is quite a fragmented IT environment in our business.
“We have grown our dividend quite considerably. In terms of payout of earnings that 60/65% of paid earnings. The dividend is well covered and is a strong statement of our confidence to continue this level of performance.”