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