There are three levels to Value. Some businesses create value by transforming their inputs into valuable outputs for their customers. Other businesses capture this value by building on top of this output and turning it into a profitable stream of cash flows. Very few of them are able to do both. As the saying goes, even if you create the pie, does not mean you get to divide it.
We’ve witnessed similar dynamics in the world of technology. Telcos, the original creators of the pie back in the 90’s and early 2000’s, built these vast barriers to entry in the communications services business by continuing to invest billions in fixed and mobile connectivity networks. They captured a decent amount of value they created initially when the world was introduced to the Internet. However, their share of incremental value capture has been on the decline for more than a decade since we started to move towards faster connectivity and network technologies, mobile, social, and digital applications. Trust me, their shareholders can tell.
Almost all of the value has been increasingly captured by technology giants that dominate the ecosystem now, by building on top of the “Digital superhighways” laid down by the telecom operators.
Diminishing investment returns
European telco groups have invested more than EUR500bn over the last decade to upgrade their network infrastructure in the last decade. Financially, they have not been able to capture much value and the difference between their market-cap as compared to other tech companies is stark. Total shareholder returns lagged massively and re-investment needs in the business have remained high.
As we moved from basic internet access to high-speed access, higher capacity mobile networks and complex applications, the underlying products and services which telcos provide became increasingly commoditised. Fundamental growth in the business has been hard to come by and additional value created at each new technology inflection point has been captured mostly by other tech giants.
A classical definition of value creation states that you must earn returns above your cost of capital consistently to be able to reinvest at higher returns. For telcos, the ROIC – WACC (the difference between return on capital and its cost) has been consistently falling and is now barely higher than the cost of capital. Given that it is a regulated industry, telcos have had to invest billions in Capex for their network infrastructure with increasing competition and have been unable to offset any of it with higher pricing.
Unsurprisingly, the sector has lagged most other major sectors in total shareholder returns.
Now that the cost of capital is on the way up, and you cannot create and capture enough value anymore, you might as well try and unlock it.
Carving out to unlock value
Globally, telecom companies invested more than USD2.4tn in the business since 2013. However, the returns on invested capital from 14% in 2013 to around 10% in 2020, due to which the growth rate in operating income has fluctuated between a measly 2-4% annually.
With lower operating income growth and higher capex needs, the debt/equity ratios have steadily climbed to 55% from 40% in 2013 with large capex projects being increasingly financed more with debt and less with operating cash flows. You got low fundamental growth opportunities in the business, increasing debt burdens, higher competition from other sectors from the tech ecosystem and dwindling share prices. It was tough to be a telecoms shareholder in the last decade.
2020 like an was inflection point for the sector where demand for high-speed high-bandwidth applications was pulled forward in dramatic fashion. Remote work became the norm, data traffic spiked to all time highs and the world realised the need for digital infrastructure to facilitate not only the societal changes of today but also the promises of tomorrow.
Large and small telecom operators, who had invested billions in their network assets saw this as an opportunity to carve out non-core assets, invite large private investors for future growth projects and raise cash to bring down their debt and strengthen their balance sheets. European TMT assets attracted a lot of demand from global infrastructure investors in the last two-three years, some of which I was fortunate enough to be a part of with my current employer Fide Partners.
For investors, this was a classic “picks and shovels” strategy. Buy buying and increasing exposure to the underlying connectivity infrastructure, they wanted to buy the picks and shovels in the tech gold rush of 2020. Infrastructure investments are also seen as inflation resistant given the presence of pricing structures indexed to inflation, along with higher competition, a non-discretionary demand and lack of large number of players in the market. Win-Win.
While large telcos did unlock some value via these carve outs, it still remains to be seen how will operators reallocate present and future cash flows that were previously tied to these assets. Given the increasing cost of capital everywhere, some of it might be put towards reducing the large debt burdens and strengthening the balance sheets.
Industry executives and shareholders are aligned on the view that the industry needs more consolidation. Some operators are keen on selling out of underperforming markets and carve-out their assets to local rivals.
The increasing demand for these assets from both strategic and financial buyers might finally give more flexibility to the telcos to get them off their balance sheets, enhance their business models adapting to the changing demands of their customers and of course, give their shareholders some reprieve by unlocking more value. We shall see.
Until next time,
The Atomic Investor