The digital premium

Telecom operators are now facing real challenges in today’s digital age, where revenues from core businesses are stagnating. There is a big push for monetisation of data services, and return on invested capital (ROIC) for new investments is not forthcoming. Some telecom operators have been investing in the digital space to extend the reachand influence across the value chain, potentially tapping into alternative revenue streams. While the increasing valuation of “digital businesses” in the financial markets has overshadowed the valuation of some telecom groups, other groups have started to define their digital strategy and invest into the space.

See graphs on the sector dynamics here.

Telecom operators’ investments in the digital spaceis a hot topic trending over the past few years. However, only a few operators have truly embraced the digital economy, most of them through acquisition of stakes in new ventures.

The prime examples of this strategy are Softbank, as an early investor in Alibaba, Kinnevik, a reference shareholder for Tele2 and Millicom, and early investor in Rocket Internet, and SingTel, as an investor of mobile advertising solution company Amobee andone of the first telecom operators to set up a digital business unit (see illustration above right).

These digital companies are bridging the gap between being a traditional telecom operator and a digital player by investing, developing and learning from internet companies.

Incumbent mindset, available growth, especially in emerging markets, and relatively limited competition have not incentivised more telecom operators to move into capturing the service revenues adjacent to their value chain, such as social media platforms, e-payments or e-commerce services. Meanwhile, according to Delta Partners estimates, telecom service revenues globally are expected to amount to $4.5 trillion by 2015, while services being disrupted by online models – through digitisation – will amount to $32 trillion.

This is also evident in the capital markets. In 2004, the top 10 telecom operators had a combined $704bn market capitalisation, while the top 10 internet companies totalled $137bn. Today, the same top 10 telecom operators have a combined $1.1 trillion market capitalisation, which has been matched by the top internet companies (see lower illustration above).

While the rapid progression and evolution of the digital space spells opportunity, telecom operators need to commit firmly to it. Current telecom groups do not have the internal capabilities to develop the digital products and services which require innovation, disruptiveness and highly entrepreneurial spirit. Swift and bold moves to transform their business operations will need to happen, should a telecom operator pursue the digital opportunity deeply, ultimately leading to value enhancement.

The question is, how does an investment in a digital player affect a telecom operator valuation? Today, the typical telecom operator earnings before interest, taxes, depreciation and amortisation (ebitda) multiple is in the range of five to seven times 2014 estimated ebitda, which implies a moderate growth, declining ROIC – typically 12% to 15% – but tracking closely their cost of capital – 9% to 10%. Looking at some of the digital players, these are trading at much highermultiples. Two examples of this trend are Facebook and Amazon – both trading at 20 to 25 times 2014 estimated ebitda, with revenue growth of more than 20% and 50% respectively and ROIC of 24% and 42%. Looking at these key figures, it is clear that the difference in multiple can be explained as follows.

A much higher return on capital from digital players with leadership positions, given their business model based on software and knowledge rather than hardware and capital expenditure.
Growth above average expected over the medium term. It is easy to figure out how telecom operators, having invested in digital, find their multiples improve as digital increases its weight on the business, and they are rewarded by the capital markets with improving valuation and increase in market caps (see graphs right).

Investors can benefit from the potential symbiotic relationship between telecom operators and digital players.

Investing in telecom groups with digital investmentscan provide exposure to a “crown jewel” asset, which is not otherwise available in the market, public or private. For instance, this is the case for Softbank – today 42% of its market capitalisation is explained by its investment in digital, most of it related to the value of its stake in Alibaba – or Kinnevik – today 51% of its market cap is explained by its internet investments, most of which is due to the investment in Rocket Internet and its underlying assets.

Beyond this, the main reason to invest is to benefit from the further synergies to be captured between the two business models, which can be summarised in three key factors:

1. Telecom operators are becoming true enablers of the digital world, through mediation in key areas, which are monetisable for their business, defend their current market position and improve the top line. Examples of these mediation areas would include providing insights on customer behaviour, cross-marketing and facilitating payments and security, which constitute barriers to the development of the digital world today.

2. Improving the success of an operator’s own digital investments, by reducing the execution risk and generating substantial value creation for their portfolio. A clear example of this is the rationale behind Millicom and MTN investments into e-commerce in Africa – reducing the capital needs for new ventures by providing the access infrastructure required for the roll-outs.

3. Changing the culture of telecom players from their defensive and low-risk stance to the opportunity-seeking and adventurous mindset of digital players today. However, in the future, with the increasing trend of digital players encroaching into traditional services once served only by telecom operators – for example Google Fibre, Whatsapp’s voice-over-internet protocol service – telecom operators will need to become true innovators to change the way thecore business is managed. This will help operators to extract more value from their assets and achieve better success in the marketplace.

If properly executed, the achieved synergies should increase the valuation of telecom operators, leading to greater returns for their investors. By investing in today’s digital space, at the right price, operators will benefit from the evolutionary dynamics of an increasingly digitalised world.

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