CUTTING £4.7bn from BT’s balance sheet in four years between 2008 and 2012 has earned finance director Tony Chanmugam something of a fearsome reputation as an axe man. During his six years as CFO, he has slashed capital expenditure, dramatically reduced BT’s cost base and, within months of taking the role, cut 15,000 jobs.
Yet it is Chanmugam’s success in cutting costs that has brought the group to its first revenue growth in five years and allowed the world’s oldest communications company to make some sizeable bets that have yet to deliver on the balance sheet. And those bets have been pretty big. BT’s spending on football rights – about £2.6bn for rights including the Premier, Europa and Champions League – and its £2.5bn investment in fibre-optic cabling are dwarfed by its £12.5bn takeover of mobile group EE, the joint venture owned by French company Orange and Deutsche Telekom.
“I hope it was a bit more than a bet; more of a considered investment,” BT’s deadpan FD tells Financial Director. “We have written a number of big cheques – hopefully, when the [EE] deal gets legal and regulatory approval, it’s a £12.5bn considered investment.”
The deal is currently being scrutinised by the UK’s competition watchdog. If approved, it will add a new pillar – mobile – to BT’s triple-play strategy of supplying households with a telephone line, fixed broadband and pay-TV. That strategy has seen BT go head-to-head with Sky and, to a lesser extent, Virgin Media in selling bundled internet, landline and television packages.
Under the EE merger, BT would provide all four services – a so-called quad play – putting it in a dominant position in the UK market. The theory is that consumers get lower prices and ease of choice while BT reaps the benefit of increased customer loyalty and less churn. Sky, still Britain’s leading pay-TV group, plans to launch a mobile service from 2016 through a deal with O2 owner Telefónica, ramping up its rivalry with BT.
As far as the triple-play strategy was concerned, sport was an integral part of the broadband offering, explains Chanmugam: “It was a view of wrapping up what we do in terms of calls and lines and getting the bundle. When you look at the consumer average-revenue-per-user, it has gone up by seven points, which is an indication that you sell more by getting a bundle service offering. The mobile play is an extension of that.”
It also protects the existing client base. Prior to the broadcasting play, Enders Analysis estimated that 38% of BT’s retail broadband customers bought Sky’s TV, while a quarter of people with a BT line but no broadband paid for Sky’s programmes.
“You want to secure your existing base which is under threat from players who are giving away materially discounted services. And you want to attract new customers. It’s a combination of them both,” explains Chanmugam.
BT would have struggled to make these investments and secure buy-in from investors, had it not taken dramatic action to alter its cost base. When Chanmugam was appointed chief financial officer on 1 December 2008, a day “etched” in his memory, the business was in no shape to make multibillion-pound investments. Within a few weeks, Chanmugam had to go in sequence to then-CEO Ian Livingstone, the board, the chairman and the markets to explain that there was a shortfall in the profitability of its global services division.
Admittedly, he was well placed to understand the difficulties the business faced. A 20-year veteran of the company, Chanmugam was most recently CFO of BT Retail before moving up to group finance director months after BT has dramatically warned on profits as it emerged that BT Global Services – the division that serves the telecoms and IT needs of multinational companies – had overestimated the potential profitability of many of its biggest contracts. Having already written down £340m from the value of BT Global Services the previous year, the company took a further £1.3bn hit for the three months to the end of March.
“Effectively, our estimate of the future cost of servicing some big contracts had gone up. We were in a position where we had to write down a substantial sum of money, which was close to £2bn. And that’s sizeable in anyone’s books,” he says. The situation was so bad – its share price was less than a third than it is today – that BT was effectively “in play for everyone” as an acquisition target. The “only good thing”, Chanmugam says somewhat wryly, was the size of BT’s pension deficit.
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“The pension deficit by default gave us a little bit of leeway and it insulated us to some extent but when you have got a strong asset base and you have got a low market cap, even the size of the pension deficit we had at the time still meant that the company was under threat,” he says.
It was clear that cost transformation on a massive scale was required and Chanmugam immediately pledged further cost transformation at a greater pace. Thankfully, this was an area where Chanmugam was well versed, having leveraged savings during his stint at retail.
The first tranche of cuts was based on what BT did in terms of capital. Capital expenditure was running at £3.2bn a year and needed to be cut. It now runs at £2.3bn, but the £900m cut in spend hasn’t necessarily equated to a cut in activity. For instance, in addition to procurement savings from changing its super-fast broadband equipment, the efficiency and effectiveness of its engineers have improved.
Then there was the question of taking a lot of low-hanging fruit which was outside the scope of the structure undertaken in retail. Among other things, Chanmugam looked at the consultancy spend as some of that low-hanging fruit.
“We spent hundreds of millions on consultancy. And effectively, the consultancy was no more than body shopping. In other words, it was a lazy man’s way of doing things. There is a time and a place for consultants but it is almost at the top end of the value chain,” explains Chanmugam.
In addition to the tactical initiatives, such as the strategy regarding consultancy, there were changes of a more structural nature in terms of how BT manages capital. Different types of processes were also introduced. For instance, signing on to big deals would require an authorisation process, while the business had to be “very disciplined and very forensic” about what it did.
There were a number of items like that where the team took a top-level view and decided to put more controls in place. At the time, every single pound of consultancy that was spent in the business had to be signed off by Chanmugam, which became an “immediate deterrent”.
“On top of the group-wide initiatives, we tried to replicate what had been done in BT Retail using a methodology which was based on getting a group of young, qualified accountants and MBAs whose remit was to come into the business and look very forensically at the issues. We had to try to change the cost base, but not by saying that we needed to take 10, 20, 30% out, but to look at it and ask where our cost of failure is,” he explains.
“It still happens that we get things wrong. Sometimes, if we do things inefficiently, we might take some costs out but it could have an impact on customer service. I would like to think we have got better, but initially we were wielding an axe and sometimes that axe fell in the wrong place because we hadn’t been forensic enough.”
Indeed, once the low-hanging fruit had been plucked, the need to be forensic – using the scalpel more than the axe – became a pre-requisite to new cost initiatives. For instance, in its Openreach business, savings were generated by cutting the number of repair visits by engineers through improved working practices, new installs and resolving issues in one visit. Fleet costs were cut by reducing fuel usage.
“It’s just how you work through the forensics. Identify service and customer satisfaction first but get it into a situation where it removes unit cost,” explains Chanmugam. “You have to make a compromise. The key question is how you make that compromise. You end up with customer satisfaction being a key driver.”
Nor does Chanmugam rest easy. Further cost reductions have been earmarked for 2015 through to 2017, while the cost transformation team benchmarks against European telcos to identify further opportunities. When BT started this programme back in 2009, it was fourth quartile and, according to Chanmugam, it is now at the top of the pile. But for further opportunities to be found, the group needs to look outside the sector, he believes.
“The sector isn’t always the most efficient. If I look at customer service, I don’t really want to be benchmarked in the sector as a business – I would rather be benchmarked compared with the Amazons of the world. Right now I don’t need to do too much more in terms of benchmarking because we have identified enough opportunity. Once we get there, we may need to do more structured benchmarking outside the sector,” he says.
Just as important as the methodology is the quality of people. Those people have to be forensic in nature, and they have to be willing to make decisions and willing to change the environment, he explains. At the same time, the cost transformation team has proved to be a “great vehicle” for developing inside the business. Out of the first team that was created in BT Retail, a number of those people have become CFOs of lines of business while others have gone on to head up operations at FTSE 100 businesses.
“It became an opportunity for success and became a routemap that people used to develop within the organisation. Ultimately, whether they sit inside finance or outside finance, it’s the people that make the things happen and having high-quality people to help deliver this is important,” he says.
After six years of cuts, “cost fatigue” has crept into the business. At Sandhurst, junior officers have Napoleon’s quote drummed into them: “There are no bad soldiers, only bad officers.” This applies equally when it comes to leading transformational change, especially when radical restructuring and job losses are required.
In the beginning, it was easy to get the business onside, Chanmugam explains: “When you are in a bad situation, it’s easy to get the business on board. There are only two ways to go: either you change the business around or you get out.”
Monetising sports betting
Since it launched BT Sport, its UK sports channel, in August 2013, BT has stormed into the sports broadcasting market in a challenge to Sky’s pre-eminence. A year before, it agreed to buy the British and Irish operations of ESPN, the US sports broadcaster largely owned by Disney, before snapping up the rights to Premiership Rugby and shelling out £738m over three years for the rights to 38 live Premier League matches a season.
At the time of its launch, media analyst Steve Hewlett estimated BT had invested £1bn in the project and was paying £450m to £500m a year on sports contents. Since then, BT has agreed to pay £897m for exclusive Champions League and Europa League action from next season in a three-year deal and, in February, paid £960m for Premier League rights for the three seasons to 2016-17. By comparison, Sky paid £4.2bn for 126 games, almost double the £2.3bn they paid last time for 116 matches per season.
There were a “difficult set of discussions” at board level regarding what should be paid in terms of the outcomes because of the high degree of variability attached to the deal, explains Chanmugam. “We’ve all seemed to be all tarred with the same brush, but the reality is that BT has paid 18% more per game over a three-year timeframe. If you look at the compounding inflation, it’s roundabout 5% per annum,” he points out.
The TV deal is evaluated over a three-year timeframe based on the net present value – the sum of incoming and outgoing cash flows – of the residual customer base, assuming they would churn if it had no content as there is no guarantee what the cost of that content would be, moving out three years. Nevertheless, quantifying the investment posed a challenge. “It all comes together in the consumer business. We said, ‘Measure us against what the consumer revenue and EBITDA was before we started on this’,” says Chanmugam.
“The consumer revenues were going down but now we are in a situation in the last quarter where revenue was up 7% and EBITDA was up 43%. So it’s moved on quite dramatically.”
Unlike the investment in its fibre-optic network – which is unlikely to make a return for another ten years – bidding for broadcast rights is a far less tangible asset to measure.
“You have got an investment that’s in the ground and is going to be there a number of years. That’s an easier investment to evaluate,” Chanmugam says. “You have got something tangible; you have got an assumption in terms of roll-out and take-up. Your variability in that is pretty limited because you know there are only a couple of variants.”
Chanmugam explains that monetisation of the broadcast offering comes five ways. The “easy ones” involve working out advertising revenues and revenues from pubs and clubs. The third level of monetisation is how much customers who don’t take other BT services are paying in terms of subscription revenues. The fourth piece is based on what happens in relation to wholesale revenues, while the fifth and “most difficult” element to measure is the level of churn on BT broadband and the level of new additions on BT broadband in terms of market share.
“Our market share on net broadband additions rose over the first four quarters that we ran this to a market share of 80% and from running 12/13 points behind Sky pre-sport, we are running well ahead of Sky post-sport,” explain Chanmugam.
BT now has about three million direct BT Sport customers and its service is in about five million homes. And while triple-play bundles of TV, broadband and fixed-line services continue to grow in importance, the next evolution will be to seduce its customers with its fourplay offering. The EE deal is key to that.
The merger of the UK’s largest fixed and mobile business carves out about a third of the market for consumer mobile and broadband subscriptions for BT and gives it a 70% share of the wholesale broadband market.
At the same time, BT has also launched a low-cost 4G mobile network under a new BT Mobile arm as it makes a return to the mobile market after a 12-year hiatus, having spun off BT Cellnet, which later transformed into O2, from the wider BT Group in 2002.
When BT divested itself of Cellnet, there was a whole series of financial pressures associated with it. “BT definitely needed the cash at that time,” Chanmugam recalls. And until recently, the business would probably have dismissed talk of owning its own network.
“If you asked us three years ago whether we needed a mobile proposition, the answer would have been, ‘No, we can build something on our own’”, he says. But as time progressed, having the right mobile arm where BT owned the network became increasingly important. The timing proved “ideal”.
“The economics of network ownership allow you to be far more competitive, far more flexible and get a quicker route to market. Those dynamics and the fact that there were two assets in the market at the same time meant that we were in a position where they came at right price,” he says.
But why choose EE when O2 was available for a similar price – the former BT-owned business was snapped up by Three for £10.25bn? “Having an asset that had the quality of network, customer base and opportunity to have synergies that make the case work was vital,” Chanmugam explains.
“If you looked at the key ratios the industry trades at roughly 6.9 the ratio to EBITDA. We acquired an asset that, with the synergies, would allow us to trade at a multiple of 5.9 and that was just with the cost synergies. If you add the revenue synergies, it allows us to trade at a multiple of 4.9. We discounted the revenues synergies because there is a degree of variability but we are totally in control of the cost synergies and we should be able to realise that.”
From the off, Chanmugam earmarked £360m a year in savings from the deal. “We have to be in a position to make those savings quickly. We did due diligence – we put 50 people on board, and got external advisers that have been in this space before to cross-reference what we were doing. And having done that, we came to a conclusion that we could deliver this and have degree of confidence that this was marketable,” he explains.
The “icing on the cake” are the opportunities in the business side. Less than 20% of EE’s turnover comes from business and wholesale and this is something BT can leverage in the sector. “There a big revenue in play there,” he says. ?
IN BLACK AND WHITE
2008 – present Group FD, BT
2003 – 2008 CFO, BT Retail
2007 MD, BT Enterprises
2003 COO, BT Global Solutions
1997 – 2003 CFO, BT Global Solutions