Dialling up returns in telecoms

The communications sector has evolved tremendously over the last decade. In particular, the smartphone has rapidly accelerated the convergence of computing and telephony and democratised consumer access to content. It has also stimulated a wave of innovation in applications and services which are available at increasingly affordable prices; in turn this has triggered a dramatic increase in data consumption on telecom networks.

Whilst network operators continue to provide the infrastructure to support the increased levels of data being consumed, their return on invested capital (ROIC) lags behind some others in the sector such as handset manufacturers and content providers. The illustration below (Figure 1) shows the adjusted ROIC achieved in 2012 compared to 2007 and the return on a £100 equity investment an investor would have made over the period. Collectively, manufacturers of handsets and content owners have significantly outperformed network operators and related equipment providers on this metric.

Figure 1: Adjusted return on invested capital

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In order to make the returns comparable, we have adjusted the ROIC to exclude goodwill and intangible assets and the associated amortisation and impairment charges. This way we can compare the returns of companies that have grown organically to companies that have grown through acquisition on a like for like basis.

To create shareholder value, returns generated need to exceed the cost of financing and at a high level returns generated by network operators have not greatly exceeded the cost of capital. Major drivers for this include heavy levels of regulation and competition (both driving down prices) faced by operators in the markets in which they operate.

So how can network operators increase valuation multiples above recent levels? What innovative ways are they considering to achieve this?  Some are diversifying into adjacent segments such as cable, content, mobile payments, advertising and mobile health. Examples of this include investment in adjacent sectors such as BT's move into sports and other content and Vodafone's proposed acquisition of KDG in Germany.

We may also see a wave of consolidation in Europe, where over 100 telecoms operators are servicing a population around twice as large as the US which has four major mobile operators and a consolidating cable sector. In the US market, valuation multiples of telecom operators have increased over the last two years as they have been successful in increasing average revenues per user following the launch of 4G.

In the current economic environment creating shareholder value is no mean feat. Layer heavy regulation and strong competition on top of this and the challenge for operators is clear. Companies need to allocate capital more efficiently, whether through deals or organic investment, to ensure success. Further consolidation is likely in the sector in order to generate synergies and drive returns up – the challenge is to pick the right investment and pay the right price.

Simon Harris | Director, Technology, Media & Telecommunications
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