Telecoms companies of every stripe have recently been so thumped by the world’s stock markets that many are trading at ridiculous fractions of their 52-week high-water marks. Yet the plain fact is that the world’s requirement to pump ever larger volumes of data through every conceivable network looks irreversible. So we have a conundrum in which a strong underlying market is now being serviced by a massively undervalued sector.
Normally the market has a voracious appetite for this kind of imbalance and a feeding frenzy rapidly restores the equilibrium, so things must be more complicated than they look. Many telcos don’t think so. The temptation in the sector is to put it down to “market swings”, which, by definition, it seems, don’t have much to do with the practical world, but quite a bit to do with lemmings and cliffs.
John Doherty, director of investor relations at Colt Telecom puts this view clearly. “Right now, it doesn’t matter what kind of telco you are. We all get tarred with the same brush. You have a decoupling between what the financial markets are saying and what we in the telco world see as the real nature of things,” he says.
Doherty makes the point that there have been some spectacular swings in market sentiment which illustrate how large the gap opened up by this kind of decoupling can be. First, there was the astonishing inflation of the dotcom bubble, which kept growing long after everyone said it should have collapsed, until many began to believe that old-fashioned business practices didn’t exist any more, and that, like quantum mechanics, the new rules for the dotcom market were somehow irreducibly other. Then the collapse came and kept on coming, and those who’d ridden the NASDAQ up lost their shirts, ties and sundry other items on the slick-as-glass down slope.
Somewhere among all this heady excitement, the fun moved to the telecoms sector. And, at the height of dotcom mania the UK government had the wonderful idea of cashing in on the bonanza by instituting one of the fiercest auctions the world has ever seen.
There were endless warnings from sensible folk that gouging tens of billions out of the telecoms sector for third generation mobile licenses was not sensible. It would, they pointed out, massively handicap the uptake of wireless data services and wireless internet access (since telcos would have to over-price services to consumers and businesses to recoup their license and infrastructure rollout outlays). But the politicians had their eyes on jam today and an election tomorrow, so the future and the sector would have to roll with the consequences as best it could (which, many would say, it is now doing, with considerable pain).
Further auctions took place in other countries until the markets had begun to lose their appetite for the whole sector. The money folk had been hit by a double whammy. They had underwritten what now, with the benefit of hindsight, looked like dodgy multiples of what consumers might conceivably pay for the privilege of getting e-mail on the hoof. Plus, they had funded some extremely large acquisitions of telcos by telcos, which had soaked up more of the sector’s financial credibility.
Tim Hardley, chief financial officer at privately-owned, UK-based carrier Neoscorp, blames exactly this combination of circumstances (overspending on 3G licenses and the acquisition frenzy) for the crunch that the whole sector is now experiencing. “The way it has been put to me is that there is only a finite appetite in the markets for any sector, and these things have just sucked capacity out of the market. Everyone knows that the cost of 3G infrastructure is going to be huge and that it is going to be very tough to sustain the level of investment required,” he says.
Neoscorp has got nothing to do with 3G wireless or building 3G wireless infrastructures, but it faces the same tough fund-raising environment as everyone else. Hardley worries that the market is losing its ability to discriminate between different kinds of player. “Our model is to go for dense network capacity in a limited geographic region. This contrasts sharply with players with global ambitions which are building long, thin networks across multiple countries and continents. These guys have the problem of winning sufficient corporate business in each country to justify their huge infrastructure costs, and this is another thing that is worrying the markets,” he says.
The problem for the pan-everything players is that business logic dictates that they all focus on the same commercial clusters. Routes like London to Paris or Brussels get massive amounts of fibre running between them, which forces the pan-everything players to compete hugely on price, which, in turn, knocks the stuffing out of the revenue projections that they originally used to raise the debt to build their networks. This too, has not escaped the notice of the money folk.
“The problem many telcos have right now is that they are either already breaching, or are in danger of breaching their covenants, which makes it impossible for them to draw down the debt they have secured for themselves. So they have to turn to the equity markets, which have little appetite for their stock,” Hardley says. Moreover, at present values, these telcos have to give away rather too much of themselves in order to raise the kinds of money they require to continue their build outs.
The covenant issue is an important accelerator in the present downturn. Bankers like to hedge their debt offers with covenants that commit their clients to achieving certain milestones before the next tranche of debt can be drawn down. These may be revenue targets or x thousand fresh kilometres of cable laid – basically, anything which shows the bank’s money is being spent in the right way.
When the climate turns sour and these milestones are missed, a telco can find itself with a gigantic historical debt, massive present interest payments and a revenue stream that requires further expansive growth for the circle to be squared. This is the kind of thing that warms the hearts of receivers and fills the skies with circling vultures. It also makes investors decamp the sector at high speed.
Yet we come back again to the fundamental reality that this is a growth sector, however twitchy and hysterical the market’s current mood may be. Doherty says: “If you take the broad span of the sector and look at it over a 50-year period you will see that the annual growth is consistently two to three times GDP growth. That denotes a growing industry sector, whatever the markets think.”
Graham Cove, managing director of Redstone Telecommunications, another UK-only telco, agrees that the market has lost its ability to tell fish from fowl in the sector. Despite what he sees as an excellent business case, Redstone shares were trading at 60p at the time of going to press, massively down from their 52-week high of #10.00. “Unlike our rivals, we will be taking advantage of BT’s unbundling of the local loop by placing our equipment in cabinets outside BT exchanges, which is far and away the most cost-effective way of rolling out new DSL services. But our share price does not reflect this at all.”
Cove says there has been a total turnaround in the market. “From wanting to fund potential growth and potential profits, everyone now wants to focus only on today’s profits,” he says. He admits this has been tough for Redstone, but the company has responded by ditching growth plans and focusing instead on achieving profit in its new fiscal year.
Paul Rees, a partner in PricewaterhouseCoopers’ telecoms group, reckons that the figures for the European telecoms sector show some EUR250bn of debt, of which at least EUR150bn has been added in the past year. On top of this, he argues, is the fact that the telcos are justifiably seen as over optimistic. “All the telcos talk a wonderful story about massively increasing demand, but so far the demand wave they are predicting has steadfastly refused to materialise,” he says.
Rees’ argument is that the fall in telco shares isn’t half as surprising as the telcos would like to think. When any sector is as indebted as telecoms, and when everyone in it has built their business models on forecasted, rather than actual, demand, eventually it has to hit the wall. Of course, it might be that a demand wave will sweep over the horizon, drenching the telcos with much needed cash. But, until it does, the markets are going to remain ultra cautious and the telcos are going to continue to experience a great deal of pain.
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