M&A activity in the telecommunications sector
October 2012 | TALKINGPOINT | SECTOR ANALYSIS
FW moderates a discussion on M&A activity in the telecommunications sector between Olivier Lemaire, EMEIA Telecommunications leader at Ernst & Young Luxembourg, and Glenn S. Gerstell, a partner at Milbank, Tweed, Hadley & McCloy LLP.
FW: What are some of the major trends you have witnessed in telecommunications M&A over the last 12-18 months?
Lemaire: Scarcity of capital has meant materially reduced M&A activity. Pressure on margins from regulation (MTRs) and competition (declining ARPUs) is adversely affecting cash generation where there is already a heavy capital expenditure burden to develop next generation networks in fixed line and 4G networks and services in mobile. There is still activity driven by a number of factors. First, portfolio reshuffling – selling in mature markets to make acquisitions in those that are developing, such as Orange’s recent activity in Switzerland and Austria. Second, the search for efficiency – for example, MTN’s divestment of passive infrastructure in Africa and networking sharing in Europe by Vodafone and O2 in the UK. Finally, restructuring for balance sheet or political purposes – illustrated by the ongoing sale of BTC, the sale of assets by KPN and Telefonica, and the activity around Vimpelcom. Investments in Western Europe by AMX would indicate that cash rich investors view Europe as an undervalued opportunity with return potential. I would add that both economic uncertainty in Europe over the euro and the level of operator debt maturity in 2013-14 are having a significant negative impact on operators’ views on M&A, in particular those with exposure to at-risk markets.
Gerstell: As might be expected, the principal trends in telecoms M&A over the past year or so are the result of a blending of factors reflecting the global economic situation and the specific characteristics of the telecoms sector. Clearly, the global economic slowdown – especially pronounced in Europe but also having an effect on emerging markets from China to India to Brazil – sluggish equity markets, and tight credit from financial institutions have all driven deal volumes down. Mergermarket reported that the value of global M&A for all sectors for the first half of 2012 was down 22 percent compared to last year, with the US witnessing its lowest half-yearly total since 2003. The telecoms industry has some unique drivers that establish the M&A trend lines: the inexorable push for consolidation and convergence leads, for example, to telecom operators acquiring each other to reduce the number of competitors in a given market and acquiring cable TV systems or operators in technologically allied fields. The requirement for spectrum has led to deals such as AT&T’s acquisition of NextWave Wireless, and the ceaseless search for new technologies has led to acquisitions such as Verizon’s purchase of Hughes Telematics, known for its automotive communications technology – both recent US deals.
FW: What factors are driving deals in today’s market? Are there any segments or regions that seem to be offering a wealth of M&A opportunities?
Gerstell: The dynamic nature of the telecoms sector – fuelled by incessant advances of technology – generates both the need and opportunity for M&A activity. Telecom operators, faced with declining voice revenues and challenges in harnessing customers’ data usage for maximum profitability, look to consolidation with other operators to diminish competition (thus helping with market share as well as pricing power) and to wring cost efficiencies out of systems and infrastructure. A small but perfect and current example from the wireless industry is Hutchison Whampoa’s acquisition (awaiting antitrust clearance) of Orange Austria – the number three operator consolidating with number four. Cash-rich operators looking for expansion opportunities – often with historically attractive price tags – propel another set of acquisitions, such as América Móvil’s bid for a stake in Dutch operator KPN or Qatar Telecom’s recent $2.2bn bid for the remaining equity of Kuwait’s Wataniya Telecom. The high capital costs of a telecoms business forces operators to shed infrastructure assets and focus on profitable operations, thus yielding the tower sales that have been a major component of telecoms M&A for several years. On the other hand, the costs of new technology, which may be daunting to any one operator, lead telecom companies to pool their resources either to share new infrastructure or invest in new areas such as LTE development (Telenor and TeliaSonera building a joint mobile operation in Denmark for 4G operations) or mobile payments (Project Oscar in the UK, the new mobile wallet venture among Vodafone, O2 and Everything Everywhere).
Lemaire: Key factors driving deals include the availability of capital, efficiency and the quest to preserve and develop margins, resisting the threat posed by the OTT players, and funding the development of the network.
FW: Are you seeing different M&A strategies adopted in developed versus developing countries?
Lemaire: Developing countries offer higher growth, albeit with corresponding risk, and we are seeing consolidation in market as well as outside investors taking opportunities to improve consolidated margins. Independent tower companies are more prevalent in the newer, developing markets and there is evidence now that shareholders in these are seeking to monetise through IPO or trade sale to raise capital for alternate uses. We believe that, common to both developed and developing markets, there will be a trend to greater network sharing and outsourcing of services as operators seek to deliver a better service to their customers more efficiently. Disaggregation of the value chain, allowing the operators to focus time and investment on the end user while outsourcing the ‘delivery mechanism’ to third parties on stringent SLAs, will become more prevalent.
Gerstell: The hallmark of the developed markets is clearly the drive for consolidation, with refinements of business strategy running a close second. Thus, we have seen consolidation principally in the wireless sector in the US (now down to two major players, AT&T and Vérizon) and Europe, and continued tower sales as operators seek to maximise returns on equity. Antitrust concerns and consumer protection goals put the brakes on the extent of consolidation in some markets. In the developing markets, many impediments to consolidation remain for political and regulatory reasons – India being a good example, with too many wireless operators facing declining profits. There are, however, other incentives for acquisitions and partnerships, mostly reflecting lack of access to capital among emerging market companies: pooling resources to build fibre-optic cables that may be too risky or costly for any one operator – the joint project of Zamtel and Botswana Telecommunications Corp. being a good illustration.
FW: What general advice would you give to parties on negotiating and closing telecoms deals? Are there any sector-specific nuances that require a particular approach?
Gerstell: Notwithstanding the newness of the technology, there is no substitute for old-fashioned focus on the fundamentals of M&A: a clearly articulated and well thought-out strategic rationale for the acquisition becomes the yardstick by which to measure individual decisions that arise during the course of a transaction. Without one, decisions are made that end up being costly and inconsistent with the ultimate strategy chosen – or worse, require divestment of the entire acquisition years later as a ‘bad deal’. Perhaps the trickiest deals in the sector are ones based on new or untested technologies: the seller is confident of the value, often aggressively so, and convinced of the utility of its technology; the buyer is eager (occasionally desperate) to acquire some new technology that will enable it to best its competitors and yet is worried about the risks of integrating the technology in its network and getting customers to accept the new device or application. This gap between seller and buyer can manifest itself in many areas in the deal and be difficult to manage. Adroit management of the expectations and negotiations between the parties is critical.
Lemaire: Keep a close eye on the fundamentals and do not get distracted by hype. It is possible to be aggressive and an innovator while still managing risk and good economics. Diligence should be well targeted and in this way the risks can be well understood without delaying a deal through over analysing every area of a target. Economic KPIs and cash flows must be consistent with real value creation. There is no place for speculation, particularly in these variable markets where sources of capital are skeptical, margins becoming tighter, and the consequences of missing forecasts are more direct.
FW: Could you highlight some of the risk-related issues that need to be considered when undertaking an M&A transaction in the telecoms sector? How can acquirers manage those risks to enhance future value?
Lemaire: Risks that are particular to the telecom space would include the future attitude of the regulators and whether regulation will move in a direction that encourages investment infrastructure and platforms that can benefit all. The continued debate around net neutrality and how the operators can share in the success and popularity of the data-hungry OTT players is important in this area. Technology choices can also represent significant risk for the losers, whether because of customer services based on particular handsets, or applications based on platforms or operating systems that fail to remain in the mainstream. Further, significant capex spend over the last two years and the years to come are predicated on long term revenue assumptions around customer numbers growth, ARPU evolution and services of the future. It is important that any evaluation of opportunities includes a strong sense of realism with possible upsides being ‘welcome surprises’ rather than the base case.
Gerstell: A zealous focus on due diligence of all aspects of the target’s business and complete regulatory and market landscape is indispensable. The results of the due diligence investigation are not simply to be memorised in a thick binder to sit on the bookshelf of the deal team, but must be brought directly into the negotiations over the purchase agreement. Conditions precedent, representations of the seller and indemnities – and associated remedies such as holdbacks of the purchase price – all must be carefully crafted to reflect the very risks highlighted in the due diligence investigation. There is no substitute in this process for engaging counsel experienced in not only M&A generally but also in the very industry in which the transaction occurs. Having a law firm associate who has seen a dozen Siemens or Ericsson or Huawei equipment supply contracts conduct due diligence of an operator’s assets is going to pay dividends, not merely in terms of lower legal bills (no on-the-job-training needed) but also in terms of spotting risks that might have otherwise gone unnoticed. A subset of issues, also requiring specialised and experienced legal advisers, arises in purchases in unusual contexts, such as Section 363 sales of assets from an operator in a Chapter 11 bankruptcy in the United States, which can present lots of procedural obstacles that must be thoroughly anticipated but equally can present exceptional opportunities to acquire assets at an attractive price.
FW: To what extent are partnerships a viable alternative to M&A?
Gerstell: While there are obviously some unique aspects of the telecoms industry, it shares in common with all industries the basic elements of business strategy that drive companies toward partnerships rather than outright acquisitions: the desire to conserve capital, the goal of minimising risk especially if the transaction has to be unwound, and the need to avoid legal and regulatory constraints on acquisitions, are all factors that can propel a business combination toward a partnership or contractual form rather than a corporate acquisition. A good, but unfortunately ill-fated example of this, was LightSquared’s partnership with Sprint, which fell apart earlier this year when LightSquared ran into regulatory trouble in obtaining clear spectrum. LightSquared, short on capital, partnered with Sprint, utilising the latter’s already existing infrastructure, in an attempt to piggyback over their rivals to build a nationwide LTE network in the US. The proposed deal made sense for both parties: neither wanted to be sold or acquired by the other, both wanted an LTE network but neither had the capital to build one, and the market demanded that a deal be put together and implemented more quickly than any possible corporate acquisition – a partnership fit the bill perfectly.
Lemaire: In capital constrained times it is worth looking more closely at partnering opportunities. There are clear examples of success in network sharing and network outsourcing where a stake in the TowerCo is retained by the Operator. The difficulty is in ensuring commonality of goals. There have been very public shareholder disputes in Eastern Europe, and while there are examples of private equity partnering with corporates, the different hold lengths and return expectations make the entry point negotiations fraught. We may see a higher number of partnerships in the content and aggregation space in the coming years as operators mount an alternative to the OTT interlopers.
FW: Looking ahead, how do you expect telecoms M&A activity to unfold for the remainder of 2012 and into 2013? What major developments do you predict will shape the industry?
Lemaire: We do not expect volumes to increase materially over the next 6-12 months. There is capital and ambition in the Middle East and China. There are experienced private equity investment teams in the telecom industry with funds. The beginning of consolidation and share out initiatives among African operators is possible, acceleration of the trend to monetise physical networks is likely and we believe that the VAS ecosystem is moving into the mainstream after rapid growth through the ‘start up’ phase.
Gerstell: The trends we have seen over the past year or so will continue to dominate the market picture for the short term: the imperatives of market consolidation, the search for additional revenue opportunities and the need for new technology will all drive M&A activity. Wealthy telcos such as Middle Eastern operators and América Móvil will remain on the prowl for well-priced targets both within and outside of their home markets, and in general strategic operators will outbid private equity players for attractive targets. The continued tension between growth in allied fields (for example, telecom operators acquiring cable TV companies or application providers) versus specialisation in one subsector (telecom operators spinning off cell towers) will also serve as kindling for M&A activity throughout the sector. The twin requirements of nonstop technological advances and ever more capital to pay for them produce an inherently dynamic marketplace that will keep the telecoms industry at the forefront of M&A action around the globe.
Olivier Lemaire is the EMEIA Telecommunications leader of Ernst & Young and has been the global leader of Telecom Revenue Assurance activities since 2006. He has been serving the Telecom industry throughout Europe, Africa and the Middle-East for more than 19 years. As the EMEIA Telecommunications Leader, Mr Lemaire is in charge of supervising and promoting Ernst & Young services provided to telecommunications operators in the 90 countries across the Ernst & Young EMEIA network. He can be contacted on + 352 42 124 8356 or by email: email@example.com.
Glenn S. Gerstell serves as the managing partner of Milbank’s Washington, DC office and heads the firm’s global communications practice. A partner since 1985, he previously served in the firm’s New York and Washington offices, and was the managing partner in the firm’s Singapore and Hong Kong offices. He assists telecom operators, equipment vendors and debt and equity investors in a wide range of acquisitions, financings, and commercial transactions around the globe. Having led some of the most innovative and complex transactions in the telecom industry, he is consistently ranked in the top tier of attorneys by Chambers, Euromoney and other recognised guides to law firms. He can be contacted on +1 (202) 835 7585 or by email: firstname.lastname@example.org.
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Glenn S. Gerstell
Milbank, Tweed, Hadley & McCloy LLP