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Communications Sector M&A Dominated By Infrastructure In 3Q17

Posted on | by Narola

October’s seen a few mergers already, including Airtel-TTSL, a tower sale by Zain and the long-rumored Sprint-T-Mobile transaction (confirmed yesterday). Some interesting deals came out of 3Q17 too, especially in infrastructure markets.

63 M&A transactions announced, including OTT/cloud deals

The communications services sector saw 63 merger and acquisition (M&A) transactions announced in 3Q17. These deals accounted for a total $17.4B in deal value. Infrastructure targets accounted for 56% of deal value across 13 deals. Crown Castle’s $7.1B purchase of Lightower was the biggest by far, and exemplifies the quarter’s focus on towers, data centers, and fiber networks.

Other infrastructure deals announced last quarter include:

  • Equinix: $295M for Spanish data center provider Itconic;
  • Verizon: $225M for WOW’s fiber optic network in metro Chicago;
  • Iron Mountain: $128M for Colorado-based MAG Data Centers;
  • Keppel DC REIT: $78M for a colocation data center in Ireland, from Dataplex;
  • Zayo: $3.5M for a data center in Colorado.

Several small deals involving fiber optic and related assets were announced without valuation: FirstLight Fiber’s acquisition of 186 Communications; Neural Path-Infinity Fiber; Ufinet-IFX Networks; and EQT Infrastructure-Spirit Communications. Also, South Africa’s Dimension Data Holdings decided to sell its fiber & wireless business to Vulatel; Dimension’s view on the network assets is that they are no longer core to its “value proposition”.

Fixed-mobile-integrated services: 28 deals totaling a modest $5.2B

3Q17 also saw 28 deals targeting fixed and/or mobile service operations: 18 fixed, 7 mobile, and 3 for integrated (fixed & mobile) assets. There were no very large (>$10B) telco deals announced in 3Q17, though several earlier ones are still pending (including AT&T-Time Warner and Vodafone-Idea Cellular).

Two sizable deals in 3Q17 were international in scope: Vodacom South Africa’s $2.6B purchase of a 35% stake in Kenya’s Safaricom, and Omantel’s $846M acquisition of a 10% stake in Kuwait-based Zain. Most other significant deals were domestic in nature, including:

  • USA: Cincinnati Bell-Hawaiian Telecom ($650M, July 10); T-Mobile US-Iowa Wireless (value unknown; Sept. 26)
  • South Africa: Blue Label Telecoms-45% stake in Cell C ($424M, July 27)
  • Hungary: DIGI-Invitel ($164M, July 11)
  • Russia: Renova Group-AKADO ($120M, July 11)
  • Austria: Hutchison Drei Austria-Tele2 Austria ($112M, July 30)
  • Thailand: AIS-CS Loxinfo ($79M, September 14)
  • Australia: Superloop-NuSkope ($12M, Sept. 10)

Lowering network & selling costs (relative to size) are common dominators across most transactions. Some transactions markedly improve competitiveness through more scale or better access to a customer segment; for instance, Hutchison Drei bought Tele2’s Austria operation to jump into a strong #2 overall position in the market, behind America Movil’s Telekom Austria.

OTT/Cloud network operators also buying companies

Notably, Alphabet/Google made five notable acquisitions in 3Q17, Facebook 3, and Alibaba 2. Their targets are spread across a range of sectors, in line with their business scope. Lots of action centered around Artificial Intelligence in 3Q17, something OTT/cloud operators anticipate having a role in their networks. Alphabet acquired two firms in this space: Bangalore-based Halli Labs, and Belarus-based AIMatter. Baidu acquired Seattle-based Kitt.ai, and Facebook bought conversational AI startup Ozlo.

Infrastructure demand rising, or unstable?

With all the infrastructure deal activity in 3Q17, some wonder if this indicates rising demand for basic network assets. Does it suggest a strong growth outlook for the “neutral network operators” (NNOs) focused on neutral operations of towers, data centers and fiber networks?

The sector is growing, to be sure, especially member companies like Equinix with aggressive M&A strategies. Private equity (PE) is driving much of the deal activity in this sector. That was the case with 3Q17’s biggest deal: Crown Castle bought Lightower from PE owners including Berkshire Partners and Pamlico Capital. This quarter, there’s an even more audacious deal underway in the sector, with a PE consortium looking into an $11B Indian cell tower deal. That is motivated, at least in part, by high debt among many Indian operators & tower companies.

Which brings us back to the market outlook. In telecom, PE firms tend to buy, reorganize, and sell assets – they’re generally not in it for the (very) long-haul. Publicly traded NNOs like Crown Castle provide exit opportunities for the PE investors – as it did for Lightower last quarter. The fact that several PE firms are raising big infrastructure funds now is a positive for telecom dealmaking.  Telecom network operators seem almost certain to continue slimming down their asset base in light of weak top-line growth. PE firms will surely be around to pick up some assets when the price is right.

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Third Quarter Earnings Season Around The Corner (And Yes, It’s Cloudy)

Posted on | by Narola

Over the next 3 weeks, companies across the communications sector will begin reporting third quarter (3Q17) results.

Watch for telco progress

The world has never been so reliant on secure communications, but the underlying market is in a bit of turmoil. The cloud and its key providers keep on growing, but many large telcos are treading water. They’re trying to cut costs (both operating & capital), and use modest investments and partnerships to tap revenue growth in areas like video/content and IoT. Many are also involved in M&A deals, which can help competitiveness if integrated well, but it can also make you lose a step. Nearly all telcos are under some level of competitive pressure from the cloud world, some extreme. As such, the most interesting earnings ahead lie in November, when most telcos report. But we’ll learn a thing or two in October.

Economic outlook stabilizing

The IMF’s Managing Director, Christine Lagarde, gave a relatively optimistic speech yesterday on the global economic outlook. Lagarde noted that the IMF’s last (July 2017) forecast projected 3.5 and 3.6% GDP growth for 2017 and 2018, respectively, adding that the forecast to be released next week “will likely be even more optimistic…Measured by GDP, nearly 75 percent of the world is experiencing an upswing; the broadest-based acceleration since the start of the decade.” She also noted some important risks, “from high levels of debt in many countries, to rapid credit expansion in China, to excessive risk-taking in financial markets.” The broadly positive tone was a plus for the communications sector, though, where revenues tend to be closely linked to overall GDP.

Wide range of companies play into the communications sector

The communications sector’s supply chain is long & complex, from chip vendors selling into networking & data center markets (e.g. Intel, Micron, Amphenol), to infrastructure vendors supplying hardware, software & related services directly to network operators (Ericsson, Huawei, Ciena); to services & software specialists (Amdocs, Mavenir, Nutanix), to the network builders & operators themselves. These can be telcos (Orange, Softbank, Verizon), cloud providers (Microsoft, Amazon, IBM), infrastructure specialists (Equinix, Zayo, Crown Castle), or part of another vertical market building large carrier-scale networks (finance, energy, government).

Most of the suppliers along this chain sell into other markets beyond communications; that’s most obviously the case at the chip level, but also for others, including IT services vendors. Some cloud providers (IBM, HPE, SAP, and Oracle in particular) are also large suppliers of IT equipment & services to telcos, who they compete with in some areas.

Another layer of complexity is manufacturing: few big tech vendors actually do this themselves nowadays, so electronics manufacturing services (EMS) players (e.g. Benchmark, Flex, Jabil) are also relevant. Note that some companies in the cloud (e.g. Facebook, Alphabet/Google) develop their own product designs, and contract with EMS/ODM partners to manufacture and ship to site.

Look for the cloud effect in October results

Despite the IMF’s endorsement for overall growth, the communications sector is less certain. Many big players are struggling with changes wrought from the cloud, and finding top-line growth isn’t easy. The growth of “the cloud” will be seen across earnings, sometimes indirectly. Cloud is motivating business strategy shifts, new investments, mergers, and layoffs. The latter subject will surely come up at Ericsson’s 3Q17 call, set tentatively for October 20.

Many semiconductor players selling into communications markets report earnings later this month, starting the 19th of October (TSMC) to the 30th (Cavium; estimated date). One of the early (19 Oct.) reporters, Maxim Integrated, also illustrates the impact of the cloud.

Maxim’s 2016 revenues were about $2.2B, flat from 2015 and down slightly from 2014. Last month, it announced a “business model update“. One goal was to increase operating margins, another to reduce dependence on individual large customers. Also important, though, is the need to better address cloud applications. Maxim does this through its “Comms & Data Center” unit, focused on data center optical connectivity & power.

When Maxim crafted its strategy shift, Intel’s dedicated “Data Center Group” (DCG) may have been on Maxim’s mind. Intel’s DCG revenues were $17.8B in the 12 months ended June, from $13.4B 3 years prior (3Q13-2Q14). That’s attractive growth, when it’s (mostly) organic and comes with above average margins: in the first half of 2017, 42% of Intel’s operating income came from DCG, which contributed only 29% of revenues. Intel reports on October 26th.

Some positive early news from an unusual reporter

Not all companies follow a calendar year-based fiscal year, and some also stagger their quarters. Accenture is an example. Its fiscal year ends in August. The benefit of this, for a market watcher, is that Accenture already reported its equivalent of 3Q17 (June-August 2017).

The results, published on September 28, are positive for the company’s “Communications, Media, & Technology” (CMT) vertical market. Accenture’s CMT revenues were $1.82B in 3Q17, up 7% YoY; CMT revenues for the 12 months ended August were also up, by 4%, to $6.88B. This is good for Accenture, but it’s too early to tell what it means (if anything) for the sector. Accenture provides a wide range of software & services to CMT players. Its growth could be driven by market share gains, or an expanding market: telcos are leaning more on vendors/partners (e.g. Accenture) in certain areas, which can expand the addressable market. Digital transformation is one area. Importantly, Accenture is offering a number of services geared towards new service rollout & management.  That hits what telcos need most of all: new revenue streams.

(Photo credit: Diego Jimenez)

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Cloud R&D And Network Investment

Posted on | by Narola

A little accounting background: To expense or capitalize R&D

There’s an ongoing debate in accounting circles (yes, they argue) about whether R&D spending should be expensed or capitalized.

Under US GAAP, R&D is expensed. Another set of reporting standards, IFRS, require development-related spending to be capitalized. Once an internal project has met certain criteria, mostly related to technical feasibility, capex rules apply. For instance: let’s say Tencent spends $1M researching new data center cooling systems, all for basic research – no actual design or prototyping. That spending shows up in opex under IFRS. If Tencent then spends another $1M on a small-scale trial based on its research, IFRS says this spending is capitalized. Digital Marketing Agency

Most cloud providers report in US GAAP, but not all. And some that do report US GAAP results, report non-GAAP (e.g. IFRS) results for comparison sake. That may just be to pretty up earnings, in some cases, but there’s also sound reason to push some R&D into capex. If you want companies to spend more R&D, in general, you would let them pay for it over time. Fluctuations in capex are much easier to deal with than operating expenses.

Selling tech to cloud providers

Vendors of all stripes, including those from the telecom world, are eager to sell to cloud providers. They have enormous technology budgets. Much of that is internal, but the external spend share has been climbing due to network investments. In the cloud space there is a fairly direct link between internal R&D and (mostly external) capex.

For telecom service providers (aka telcos), there is also a link. But few telcos have big R&D budgets to rely upon. There are notable exceptions to this, such as NTT, Verizon, AT&T, Telefonica, China Mobile, China Telecom, China Unicom, etc.). But they’re exceptions. Even NTT’s R&D spend is just over 2% of opex, and this is high for a telco. In the cloud space, Priceline –  a travel website with a small cloud – also spends about 2% of opex on R&D. The average spend in cloud is well over 10% of opex, and has been rising.

Moreover, telco R&D spending is weighted towards the “R” part of “R&D”. They tend to lean heavily on vendors for products that are already fully developed.

The R&D-capex link

The chart below hints at why it’s worth watching R&D budgets carefully, if you’re trying to sell tech to a cloud player.

mtnconsulting employee-rd.png

Higher levels of R&D spend, as a share of total opex, suggest higher capex levels on a per-employee basis.

This is just correlation, not causation. But much R&D spend (even when expensed) spills over directly into capex. The lag depends on the project. Some cloud provider R&D is focused on practical near-term issues, such as server design. Artificial intelligence R&D has a longer time horizon.

The cases of Facebook & Microsoft

In many ways Facebook is a standout, even outlier (as in the figure above, top right bubble). Its R&D spend is no exception. Facebook spent 46% of its 2016 opex on R&D, the highest among large cloud players (it was 36% in 2012). The company spends big on product development, innovates quickly, and has high labor costs. It also recorded the highest capital expenditures (capex) per employee in our group, at over $250,000 per employee. And this is nothing new; Facebook’s capex has been high since the start, averaging a telco-level 16% of revenues since 2006.

Microsoft makes for an interesting comparison. This is an older, more established company than Facebook – a tanker in the ocean, which takes some time to change directions. On an absolute level, Microsoft’s total capex last year ($9.1B) was more than double Facebook’s, but Microsoft spends far less capex per employee (about 30%). Given Microsoft’s legacy, though, its cloud commitment has been serious: capex per employee at Microsoft was just over $30K in 2012, it is now just under $80K. On a per revenue basis, capex also rose, from 4% capital intensity in 2012 to 10.6% in 2016. During this growth, Microsoft’s R&D spend was a steady ~20% of opex on R&D. Its R&D emphasis has shifted to cloud though; now, one of three stated R&D goals is to “build the intelligent cloud platform” (June 2017 10K).

Cloud employees don’t work cheap

R&D is conducted by people, still (sorry AI fans), and they require competitive salaries. In the cloud sector, R&D employees tend to be highly skilled and expensive. Apple is a standout in our database. In CY2016 its operating expense per employee (ex-D&A) worked out to just under $1.2 million. Facebook, Alphabet, and Twitter – other household names in pricey Silicon Valley – also recorded high opex, in the $700-900K per employee in CY16. At the other end of the spectrum is Cognizant, an India-based IT services vendor with its own cloud; its annual opex per employee was just over $40K last year.

Capex always includes a healthy share of labor costs, across sectors; telco and cloud are no exception. In a given sector, though, the amount of labor in capex can vary dramatically by company. Labor might be just 20% of total capex for a cloud provider based in Asia, but over 50% for one based in Silicon Valley. If you track capex, then, being able to assess the relative contribution of internal labor costs is important.

More to come on this topic soon.