Structural separation - back on the agenda?

Martin Venzky-Stalling, Managing Director, Peter Mackie, Associate Director, and David Vrancken, Principal Consultant - Ovum Consulting (www.ovumconsulting.com)

Recently, news about private equity funds buying into telecoms has increased. Blackstone bought a small stake in DT - highlighting that various PEs (increasingly involving new players such as funds from the Middle East) are circling operators including large European incumbents. In July 2006 the Australian-based investment fund Babcock and Brown bought a controlling interest in Irish incumbent Eircom. Last year Apax Partners led the purchase of TDC in Denmark, although in Spain, France Telecom beat two rival offers from investment groups for Amena. Other PEs came close to buying NTL and various operators in Eastern Europe are at least partially owned by PEs.

Investment houses are interested in telecoms for several reasons. They see the potential to:

• unlock value through restructuring including structural separation or securitisation of assets (the 'sum of parts being more than the whole' rationale)
• remove the remaining operational inefficiencies (improving processes, rationalising product sets and getting better returns on marketing expenditures) incumbent operators may have been reluctant to address
• play a consolidator/restructuring role in the industry that the telcos themselves are either unable or unwilling to play.

The reliable cash flow of large incumbent telcos coupled with relatively high historical rates of return in the sector are additional attractions underpinning these potential upsides. For funds specialising in infrastructure, telecoms can provide better yields than other utility sector investment options.

Of course, such investment is not without risk and challenges. Aside from complications with regard to how to physically separate the access network (where is the line?), organisational and IT issues, pensions funds, employee and union concerns, there are major regulatory issues to consider. While most regulators are finding it difficult to regulate resource-heavy incumbents, they may also be concerned about the consequences of a national incumbent being split up.

Indeed, the European Commission has already demonstrated a certain wariness about structural separation. Recent studies, though not accepted by all, supported the view that incumbents themselves might be best placed to make the significant investment in core and access infrastructure.

In addition, regulators might be concerned about comments by investment funds that question whether these new investments are justified and provide good returns (not unreasonable questions to ask, of course, particularly given the historically technology-centric behaviour of the industry). Economic analysis has also demonstrated that, in theory at least, an integrated operator model is the most efficient approach to serving the public (that is, generating the greatest economic welfare). Moreover, structural separation might be seen as a risky step - if the experiment fails, it is difficult to revert. Furthermore, regulators may also take differing views of the appropriate rates of return that may be applicable following a structural separation, thereby affecting one of the key value driver assumptions on which the business case might rest.

The opportunity to create and unlock value is just too significant for investment funds to ignore at the moment, but they have to do their numbers carefully and think through the technical, organisational and regulatory challenges that they may face.

What view will the operators take?

Structural separation will meet some scepticism. Incumbents value the access network as it provides their primary connection with the customer. However, the option to unlock value through a securitisation effort might be compelling (assets are value depreciated though they are still useful - securitisation provides the venue for a revaluation of these assets). Furthermore, with securitisation the incumbent might also retain some control. Beyond securitisation, the response or position will depend on the market situation, particularly competition and regulation. It might be tempting to escape the scrutiny of the regulator and just get on with it.

However, telecoms is different to other infrastructure industries. Technology is at the core of it and it is getting more and more complex - convergence of fixed and mobile networks and convergence of telecoms with other industries are additional complicating factors. The introduction of NGNs blurs the dividing line between access and core, and will ultimately make it less relevant. As the industry moves from the 'spaghetti of traditional networks' to the 'layered lasagne of IP-based communications', a horizontal separation at the application layer might make more sense. Apart from the technology and regulatory issues, management and boards will be more aware of the union, pension and other organisational issues than external investors that take a fresh look.

Operators cannot just sit tight; they have to do something. Otherwise they run the risk of the decision been taken out of their hands as the deals that private equity funds can take on are getting bigger and bigger. As the LEX Column of the Financial Times put it on 10 November 2006, 'Telecoms companies are in an exquisite trap: the only thing the market likes is their short-term cash flow yields but in maintaining that cash flow religiously, management jeopardises corporate reinvention. After three years in the doldrums, and with consolidation still distant, there is a growing sense that dying slowly, but profitably, is not the way forward.' The steering wheel for the way forward might be in other hands.

Key issues for investments funds:

• challenge the assumptions that management and the industry may still be consciously or subconsciously attached to, but recognise that telecoms is different to other utility industry infrastructure investment opportunities - it is far more complex
• do the business case, but also realise that the regulator, unions and other stakeholders may want to see a long-term business case - not just a three- to five-year one
• develop a regulatory negotiation strategy and a PR strategy, and define key messages to overcome objections
• understand the impact of NGNs on any separation.

Key issues for operators:

• separation and restructuring can help to unlock value, be it to fill chests for acquisitions, fund investment to reinvent themselves and compete and grow, or simply to reduce debt. Are these potential upsides greater than perceived downsides?
• consider the relative merits of the different ways to leverage the strategic value of their infrastructure
• sell the need for investment in new technologies and services better to investors.

Key issues for regulators:

• aim to achieve the right mix of competition and overall sector effectiveness and efficiency. More competition at all costs does not always lead to better public welfare. Do not interfere with market forces too much, and listen to the cases being made to them.

Martin Venzky-Stalling, Managing Director, Peter Mackie, Associate Director and David Vrancken, Principal Consultant - Ovum Consulting. Ovum Consulting (www.ovumconsulting.com) combines financial expertise and consulting methodologies with insight and research in technology, regulation and markets. Its Regulatory and Strategy & Commercial practices have the experience, people and insights to assist investors, operators and regulators on issues such as structural separation, NGN, valuation, commercial strategies, regulation and economic analysis.