PA’s analysis of a sample of European companies looked at their over/undervaluation (horizontal axis) and their liquidity (vertical axis). A score of more than one on the horizontal axis represents an undervalued company and less than one is overvalued. On the vertical axis, a company with a score of below one raises cause for concern.
The horizontal axis assesses the level of over/undervaluation by the market using a simplified (and intentionally conservative) form of discounted cash flow which assumes that long-run return on equity (ROE) will be close to the average ROE over the last three years and long-run growth will be around 3 per cent per annum. On this axis, more than one represents an undervalued company, less than one is overvalued.
On the vertical axis we have assessed liquidity, determined by the weighted average of a number of factors: primarily interest cover, dividend cover and the ratio of debt to equity. On this axis, a company below one is likely to have substantial difficulties in covering its debt payments and therefore refinancing its operations.
What will the impact of the credit crunch and recession be on companies in the communications and media sector: will it be a fight for survival, just a difficult patch or the opportunity of a lifetime, and whatever scenario plays out, what should the industry players do to ensure they emerge stronger at the other side?
Communications and media businesses face a particular challenge; it is a capital-intensive industry that traditionally has been a major user of debt capital, currently the scarcest resource in the global economy.
Within the sector there are two very different business models and the impact of the recession will vary significantly between them. Many companies operate like utilities, using a common infrastructure to deliver simple packages of services (voice, internet access and television) to their customers at relatively stable prices. The more conservative of these have reasonably strong balance sheets and cash flows.
At the other extreme, more aggressive companies have expanded rapidly or have been purchased at top dollar and, as a result, their balance sheets are loaded with debt. In Europe alone, Moody’s ratings agency says that more than €30bn of refinancing will be required by the sector in 2009.
To assess the exposure of the sector, PA Consulting Group (PA) analysed a sample of European companies in terms of their over/undervaluation and their liquidity. PA looked at the companies’ positions at the end of 2007 and in the middle of 2008 and found the sector had become increasingly undervalued over that period. The analysis also revealed a wide range of results with media businesses generally in better shape than their telecommunications-focused peers.
Three broad categories of company can be identified from the analysis: endangered, exposed and secure.
These businesses are in danger of bankruptcy and urgently need to rebuild balance sheets and improve cash flows. Several privately owned businesses, primarily fixed network and cable operators but also incumbents, are members of this group.
The management teams of these businesses need to act like turnaround specialists: raising new finance; closing, selling or outsourcing operations; as well as aggressively reducing operating and capital expenditure. They need to address the issue of revenue leakage, where modest investment to plug the holes in the relevant systems and processes can bring significant short-term rewards.
They also need to manage working capital effectively, for example, by increasing the proportion of pre-pay to post-pay customers and introducing schemes such as auto top-up. Some fixed-line operators have already introduced this mechanism for residential customers. In addition, they need to look at contractor costs. Internal accounting rules can make contractors look cheap when in reality they cost the same or more than in-house staff.
Ultimately, the price of survival for these businesses may be high: they may be forced to sell their crown jewels (as anything else may be impossible to sell) or even to put the entire business up for sale but these dramatic measures could be the only options open to them.
These businesses have reasonable liquidity but are substantially undervalued and they may therefore be attractive targets for cash-rich buyers. Shareholders perceive them to be risky so building trust will be necessary, and that means more than share buy-backs (indeed buy-backs, at a time like this, may not be a low-risk strategy).
Remedies for companies in this category include searching for a suitable partner. For smaller players, carefully selected mergers may be an option but the availability of cost synergies must be certain and it needs to be clear that the merger should not destroy too much revenue. These companies will also need to close or divest the most unprofitable lines of business and reduce associated staff.
At the same time, finding ways to generate better returns from their assets will become even more important. As many media organisations fit into this category, exploiting owned content for distribution across new media channels, something they have been slow to do until now, may become a priority.
These businesses are fortunate in that their conservatism in the good times now provides them with a once in a lifetime opportunity. They can exploit their new-found position of strength by purchasing weaker competitors. It is likely that several communications and media companies will be available globally for acquisition in the next 12-18 months and, if they choose, companies in this category can, in Warren Buffett’s words, be “greedy when others are fearful”.
Seeking acquisitions needs to be accompanied by more aggressive marketing. Customer confidence is key during this period and exploiting the weakness of the competition by investing in targeted marketing during such times can be a cost effective way of capturing market share.
When the dust has settled, perhaps in two or three years, it is likely that the corporate landscape in the communications and media sector will look very different. PA’s analysis identifies the characteristics of the winners and losers, and what they have to do to maximise their chances of surviving. It is clear that all players in the market have the same three critical priorities. They need to make sure they really understand the impact of the financial crisis on the sector, and on their business specifically; they need to maximise their liquidity; and when liquidity is secure, take bold steps to take advantage of the unprecedented opportunities offered by the crisis.