Recapturing Lost Value

Posted: 08/1999

Recapturing Lost Value
By Casey Freymuth

Industry forecasts rarely provide third-, fourth- and fifth-tier long distance service providers with much to smile about. Shrinking margins, bundling woes (such as anemic local and wireless resale markets) and the inevitable entry of the Bells into the long distance market have done little to lift the spirits of the thousand or so entrepreneurs whose companies have been built around a core base of long distance users. To top it off, the Telecommunications Act of 1996 did not bring about the much-anticipated out-of-region Bell acquisition campaigns that entrepreneurs, brokers and investment bankers had hoped for. In short, long distance company values have been on a downhill slide.

However, new market developments may give these entrepreneurial firms something to smile about.

Domestic Long Distance Provider Values Stabilize

In 1997 and 1998, the big question in the long distance market was: When will domestic long distance provider valuations bottom out? By mid-1998, Phoenix-based Group IV Inc., publisher of the industry valuation guide "Telecom Service Provider: How Much is it Worth?" predicted that values had stabilized as the revenue multiples of most transactions appeared to fit within standard discounted cash flow (DCF) models built upon common industry churn and margin statistics. Research for the Year 2000 Edition of the report proved this to be the case. However, while valuation ranges have stabilized, value drivers are migrating with the data revolution as providers downmarket have been impacted by the values of upper-tier providers (see chart, below).

Image: Perceived Values in Retail Service Plays

Massive Consolidation Reinforces Niche Opportunities

Large companies are slower and less nimble than smaller players, which is how small and mid-sized providers have thrived despite more than a decade of "death on the horizon" predictions from a host of industry experts. Thus, if an industry giant is unable to effectively serve niche markets because it is too large, logic dictates that such a player will become less equipped to serve niche markets through growth by acquisition.

The same logic applies to alliances, which have proven themselves to be largely ineffective. MCI WorldCom Inc. Chief Operations Officer John Sidgmore (former UUNet Technologies Inc. CEO) says his company has pursued end-to-end connectivity on its own network because getting the company to move is difficult. "In our experience," he says, "getting two large companies to move is really difficult, and three is impossible."

Additionally, the niche opportunity is further reinforced by incumbent preoccupation with young public companies that have comparable market caps, relatively low operating costs (in actual terms) and no obligation to pay dividends to shareholders anytime in the foreseeable future. In an international example, Deutsche Telekom AG, Bonn, Germany, lost 20 percent to 30 percent of its long distance market share in 1998. However, with investments flowing into the Internet and e-commerce sectors, the company is more concerned with Dulles, Va.-based America Online Inc.'s threat to its T-Online business unit than it is with players competing for long distance revenues (see chart, below). Although competitors tell horror stories about dealing with Deutsche Telekom, the company's massive loss in market share indicates that competition is working. Comparatively speaking, it took 10 years for AT&T Corp. to lose 40 percent of its market share, which indicates competitive penetration in a rapidly accelerated timeframe.

Image: Online Market Share - Germany

Bundling Does Have a Payoff

The July 1998 PHONE+ article, "Follow the Yellow Brick Road: Looking for a High-End Revenue Multiple," noted how difficult it is to achieve significant revenue and, in particular, to make the jump from Tier 3 to Tier 2 through bundling. In brief, a company easily can invest $2 million in the establishment, marketing, personnel, etc., of, say, Internet access services, to gain a similar amount of new revenue. This equation has caused many executives to become sour on the bundling proposition. At a telecom finance conference, for example, one flustered executive vented that only consultants like bundling.

That may be true, but companies that have endured the headaches now are being rewarded for their efforts. Buyers don't want to go through the bundling headaches either, so the ability to pick up the services turnkey holds some value. At the very least, bundling provides long distance companies insurance against hitting the floor of the value range. At the most, it represents the ability for individual providers to recapture the value that the long distance sector holds at its peak.

A Word of Caution

Long distance players should keep their eyes on the basics and carefully study and pursue strong performance in key value drivers. A company that allows attrition to get out of hand, for example, would do better to focus its efforts on retention than on deploying new services. Note that although bundling often is associated with increases in customer retention, typical penetration rates of add-on services indicate that only a small block of customers can be impacted through bundling. When attrition problems occur, the majority of customers need attention to solve the problem.

Casey Freymuth is president of Group IV Inc., a Phoenix-based strategy consulting and publishing firm that publishes "The Telecom Service Provider: How Much is it Worth?" a comprehensive report on values and drivers in the telecom sector. He can be reached at cfreymuth@group-iv.com