The US congress has rarely made Wall Street investment bankers as happy as it did when it passed the telecommunications bill on February 8. A competitive free-for-all in long-distance and local telephone services, as well as in the cable, broadcast and radio industries, has been unleashed by the legislation. That means a lip-smacking fee bonanza for investment bankers.
Until this liberalization, the seven Baby Bell local telephone companies, created after AT&T’s break-up in 1984, were excluded from the $60 billion-plus long-distance market and from local markets outside their designated regions. Conversely, long-distance service providers such as AT&T, MCI and Sprint were barred from the $100 billion local phone market and had to pay the Bells access fees to offer their customers long-distance services.
Now the barriers are down and no telecoms market is off limits to any company. Bells can offer long-distance services outside their home regions immediately on cellular networks and by purchasing them at a discount from long-distance providers and onselling them with a mark-up to their customers. They will also be able to offer long-distance calls on networks within their own regions once they have satisfied the authorities that these have been opened to competition.
Long-distance companies can provide local telephone services, either by buying from existing providers at a discount and onselling, by developing their own wire lines or by using wireless systems such as cellular-phone networks.
Once technology glitches have been ironed out, cable companies and electricity and gas utilities will also be able to carry local and long-distance telephone services. Long-distance and local phone companies and cable operators will be able merge in certain cases, forge alliances or take strategic investments in one another to offer every form of communication, information and entertainment that can be beamed or wired into homes and offices. The legislation also substantially lifts restrictions on broadcast TV and radio ownership.
As a result, billions of dollars worth of M&A, advisory business and underwriting has been announced or is in the pipeline. It includes joint ventures for long-distance operations between Bell giants Nynex and Bell Atlantic, and a $10.8 billion acquisition in cash, stock and accumulated debt of Continental Cablevision by US West Media Group. Broker’s analysts have even suggested that MCI will eventually be taken over by a Bell.
“There is a belief among industry players that they have to have an integrated strategy, offering a bundle of telecoms, information and entertainment products delivered through wireless and wire-line transport mechanisms to be a major player in the future,” says Michael Price, managing director and head of telecoms investment banking at Lazard Frères. “If you subscribe to that view, the question then is: in offering these packages to consumers and businesses, do you need to acquire, partner or rent to get there? And in what combination?”
The expectation is that ultimately all US domestic and global communication wireless and wire-line networks transmitting voice, data and video products will be controlled by a handful of mega-communication/entertainment conglomerates.
“What you are seeing in the US is an attempt by the Bells and the long-distance phone companies to build a nationwide system; to create a brand name under which they will try to sell a bundle of local, long-distance, cellular, cable-TV and internet services all on the one bill to homes and businesses,” says Mark Maybell, co-head of telecoms, media and technology investment banking at Merrill Lynch in New York. Adds Price: “Ten years from now in the US, we will have five or six major integrated companies that will have local, long-distance, wireless and broad-band products.” These will be built around names like Bell Atlantic/Nynex, AT&T, MCI and Sprint.
These giants will also attract partners in peripheral sectors, such as software developers, satellite-broadcast providers, and internet access and on-line service companies. Microsoft, for example, has aligned itself with MCI, which in turn has taken a strategic investment in News Corporation and entered a joint venture with that company to develop a satellite television and communications system in the US similar to the UK’s BSkyB.
Buying in expertise
Control of access to the internet is also up for grabs. In February AT&T signalled its intention to seek a dominant position in consumer internet access by giving its long-distance customers five hours of fee-free access each month and 1-800 (freephone) dial-up at all times. Any internet access providers that are able to survive such an onslaught will probably be acquired by telecom giants.
“It wouldn’t surprise me if the Bells were to pick up some major internet access providers or some smaller companies,” says an internet company analyst. “They’ll just buy the expertise and forget about developing it. I’d say that within two years, internet access as we now know it won’t exist. It will come with call forwarding, call waiting, voice mail or other conventional services. Internet access will be just another option in standard household services.”
The fear of being crushed by the biggest players has already spurred acquisition activity. US West Media Group (the cable arm of the Baby Bell US West) acquired Boston-based Continental Cablevision for $5.3 billion in cash and stock and the assumption of $5.5 billion in debt in what is so far the biggest M&A announcement since the Telecommunications Act 1996 became law.
The deal creates the third-largest cable company in the US and gives US West the ability to encroach on the territory of its fellow Bells by using the cable distribution network in other regions for telephone services. For Continental, however, the move was a do-or-die effort: “It’s going to be a waltz of elephants, and you want to be sure you don’t get stepped on,” says its chairman, Amos Hostetter.
The trend is global. “I think you will see four or five global carrier networks emerging out of all of this international deregulation of the telecommunications industries,” says Ian Clark, managing director of telecom and media investment banking at JP Morgan in London.
Already the biggest telecom companies have banded together. Unisource, a consortium of Dutch, Spanish, Swedish, and Swiss telecoms companies, has affiliated with AT&T World Partners, which is AT&T’s global carrier. MCI and British Telecom announced a strategic alliance, called Concert, several years ago and Sprint is affiliated with France Télécom and Deutsche Telekom in a venture called GlobalOne. “These sorts of groups will ultimately dominate the end-to-end global communications business,” says Clark. “That doesn’t mean the local carriers will disappear, but it does mean that they will be affiliated in some way with these global carrier groups. As you get competition in the local markets you will see tighter affiliations.”
This US and international consolidation provides Wall Street with two huge revenue components: domestic and cross-border M&A and advisory work, and the financing of the tens of billions of dollars to upgrade and extend distribution networks. Asset sales by combined entities will also be a major source of revenue for the banks.
Currently the US market is in a frenzy of alliance and merger activity as would-be major brand names look to secure comprehensive wireless and wire-line networks and the associated voice, data and video telecom, information and entertainment products that are transmitted along them.
“There are many pieces of the puzzle,” explains Maybell. “You are seeing companies like AT&T, Sprint and US West moving quickly to secure the local and long-distance pieces, as well as the the cable, satellite and PCSs [personal communication service licences for cellular services].”
The objective is to put together a larger “footprint” of consumer reach across the nation and then to provide the customers within that footprint with a bundled package of products. Much of the investment banking advice devoted to telecommunications currently centres on analyses of the different opportunities to expand footprint and provide a bundled package of products and how best the strategy might be executed. “You buy that which is strategically critical to control, which is customer ownership,” says Price. “You partner or establish strategic investments for that which is probably too expensive to buy and you rent things like software and programming.”
Some of the combinations under consideration border on the bizarre. Long-time foes AT&T and MCI, for example, are talking about joining forces against the Bells by sharing the cost of building local telephone wire-lines. Bankers say the talks are as much as anything a scare tactic on the part of AT&T as it files applications to provide local services in all 50 states and begins negotiations with Bells to buy discounted local phone capacity to on-sell.
Other alliances under consideration are potentially huge. Two Bells, Bell Atlantic and Nynex, are negotiating a joint venture to enter the long-distance business and possibly execute what would be the biggest merger in history, creating a $50 billion giant dominating more than a third of the long-distance traffic in its combined regions.
To ensure it has all distribution bases covered, AT&T has announced a $137.5 million strategic investment in US digital satellite service DirecTV. Cable companies TCI, Comcast, Cox and Continental are all investors in Primestar, a competitor to DirecTV. Recently, TCI has held talks with the Direct Broadcast Satellite (DBS) venture between MCI and News Corp, which plans to launch its own direct-broadcast satellite service in the US.
Many smaller deals in the telecom and media industry are being forged. Among them are Dallas-based Chancellor Broadcasting Co’s $395 million purchase of 19 radio stations from Shamrock Broadcasting Inc and the $770 million buy-out of media company Citicasters Inc in Cincinnati by Jacor Communications, another Cincinatti-based company.
Wall Street firms reaping the rewards include Salomon Brothers, Goldman Sachs, Merrill Lynch, Morgan Stanley, Bear Stearns, Lehman Brothers and Lazard Frères. They have distinct approaches to this business and can boast various client-winning attributes. Salomon is a formidable competitor in the domestic telecoms M&A sector and is ranked the domestic leader by Securities Data Corp.
Goldman Sachs is often considered the largest international player. Merrill Lynch, apart from having one of the biggest global investment banking teams dedicated to telecommunications, media and technology, is also clearly an underwriting giant and the firm which has managed more international telecoms equity mandates than any other house. Morgan Stanley also has a very strong reputation in the telecoms industry for its M&A and financial advisory services and is co-lead with Goldman Sachs in the $3 billion initial public offering of AT&T’s technology arm Lucent Technologies this month.
Lucent is being spun off to reduce conflicts of interest it foresees arising in the provision of new and old AT&T rivals with telecoms equipment. That deal alone will generate more than $150 million in fees for syndicate members.
Lehman has a strong client list, including a co-financing advisory role with Merrill Lynch for Sprint Spectrum, the wireless joint venture between Sprint and cable companies TCI, Comcast and Cox. Originally Sprint Spectrum was to have developed the four partners’ wireless network as well as a local telephone system nationwide so that Sprint could provide the ultimate package of local and long-distance wireless, wire-line video and data products under its brand name. The financial and managerial complexities of such a deal, and the wider range of deal opportunities now open to all four partners, forced Sprint to alter its plans in February.
Although the joint venture’s notion of providing every service under the Sprint name is still intact, Sprint Spectrum will now only develop a wireless network. Rather than forging one agreement to upgrade cable lines for telephony with each of the three cable partners, Sprint will now come to three individual agreements with them.
Lazard Frères has also become a major telecoms and media M&A house, having quietly amassed an impressive client list. This included MCI, which it advised on its strategic investment in News Corp to provide information and entertainment services to business and consumers. The new venture will use MCI’s newly won DBS spectrum, which MCI bought for $682 million. Lazard also advised Continental on its merger with US West. US West was advised by Lehman.
Fee bonanza
The advisory business in telecoms and media has been hot for several years in anticipation of liberalization. Deals announced in the past two years include Walt Disney’s $19 billion acquisition of Capital Cities/AB (approved just a day after the telecommunications legislation was signed), Time Warner’s $7.5 billion acquisition of Turner Broadcasting System and Westinghouse Electric’s $5.4 billion purchase of CBS.
Investment bankers expect the next five years and beyond to be even more lucrative. “With the advent of this bill we think 1996 and 1997 are really going to take off,” says Maybell.
Any one of the biggest billion dollar plus M&A deals might generate a $25 million to $30 million fee to an investment bank.
Total telecom equity proceeds in 1995 were $13.8 billion. Although it varies from deal to deal, the rule of thumb is an average gross spread of 3% for deals above $1 billion, an average gross spread of 5% to 6% for deals in the $150 million to $1 billion range and an average gross spread of 7% for an initial public offering or deals under $150 million in size.
Eduardo Mestre, head of investment banking at Salomon Brothers, says telecoms, media and technology should provide at least 20% of investment banking revenues for the firm into the next century.
At Merrill Lynch the telecoms, media and technology investment banking group accounts for more than 20% of the firm’s foreseeable investment-banking revenues. It has 85 bankers worldwide and expects to have a 100-strong group by the year-end.
Last year telecoms, media and technology generated $250 million in financing and investment banking revenues for Merrill Lynch. And Merrill generated more than $30 million of investment banking revenue in the media industry alone in the first five weeks of this year.
Jeff Williams, Morgan Stanley managing director and head of global telecom investment banking, says he is always on the look-out for investment bankers to expand his 40-strong global telecommunications team. “There are just not enough qualified people to fill demand. Every year has been up in terms of deal volumes and financing volume, so it’s been a good growth business for us.”
Maybell’s team at Merrill follows about 175 telecoms companies globally and more than 300 technology companies and several hundred media companies as potential acquirers, M&A targets, recipients of financial advice and firms eventually needing to come to the capital markets for funds. Maybell calculates that about 65 telecoms companies globally are potential equity issuers of a total of $87 billion over the next three years. In the same period it is estimated that 35 to 50 telecoms firms will be potential issuers of high-yield debt in deal sizes greater than $200 million. High-yield fees per deal are in excess of 3%.
Each alliance carries with it a wide variety of financing needs, as the Sprint Spectrum deal demonstrates. Sprint and its partners purchased PCS licences covering a population of 180 million to build a national wireless network. “We are now in the process of building the network, which in round numbers is a construction project that will cost in excess of $5 billion over the next three to five years,” says Robert Neumeister, chief financial officer of Sprint Spectrum. The four partners committed $4.2 billion of equity into Sprint Spectrum and now it is in the process of organizing about $2 billion to $3 billion of vendor financing to support the build-out phase over the next few years.
“We are looking at all of the capital markets, but the critical initial start-up phase is being financed by raising funds from our vendors,” says Neumeister. Vendors’ capacity to supply financing for constructing networks is taken into account when they bid for the supply contracts. Sprint Spectrum vendors Lucent Technologies and Northern Telecom will raise funds from the loan and capital markets and provide Sprint Spectrum debt similar to a loan. Telecoms companies prefer vendor financing over bank loans for the initial phases of construction because lenders are intimately involved in developments and are more sympathetic to the many complexities of the process.
Vendor financing is also a much cheaper form of borrowing than the high-yield market. “We expect vendor financing to be somewhat cheaper than the high-yield market would be for us right now, which would be an all-in cost of somewhere in the range of 10%,” says Neumeister. Vendor financing will finance a substantial portion of capital expenditure over the next five years and will be drawn upon in that period as needed.
Neumeister is also trying to secure bank lines of credit. A mixture of about $2 billion of bank lines of credit and high-yield debt will be sought to finance Sprint Spectrum’s start-up expense, a sizeable portion of which will be for an intense marketing phase. Much further down the track the company may consider a public offering to realize some of the value of its investment, but an equity issue is not in its plans at the moment.
Wall Street bankers will do favours for the major players in the hope of snaring much more lucrative mandates in the future. “The way to work this business is to try to service an appropriate number of clients so as to be involved in what they are doing strategically,” says a banker. “Frankly in the best situation we rarely do business on a fee scale. It’s all negotiated because, in the best relationship, you do some work for free in anticipation of getting an adequate share of other business to make it worthwhile.”
To the delight of bankers, telecoms firms need very little arm-twisting to see the benefits of aggressively pursuing growth, whether it be from scratch or through M&A or alliances. Studies of the market show that the more products a company bundles together on one bill, the less a consumer is likely to flit from one carrier to another.
Bundling products cannot be done without alliances or acquisitions. “Each Bell has a different viewpoint on what they have to do to get into the long-distance market,” says Gordon Rich, managing director and head of telecoms investment banking at CS First Boston. “There’s no unanimous view but alliances in one way or another will have to be formed.” Also, both the local and the long-distance companies have no choice but to develop multiple revenue streams to compensate for loss of market share as competition increases.
Although telecoms sector players don’t dispute the need to grow, it is debatable whether outright acquisitions will be the dominant strategy. There are managerial, dividend and cultural problems peculiar to the industry that could complicate and possibly deter many from seeking mergers. Many of the Bells, for example, need to determine how best to transform themselves from yield stocks paying high dividends to aggressive, highly leveraged growth stocks paying relatively low dividends without causing a plunge in their share values. “Some Bells have huge payouts in dividends,” says Stephanie Comfort, telecom equity analyst at Morgan Stanley. “Measured as a percentage of their cash, Pacific Telesis’s dividend payout is more than the cash it generates.”
Bells’ problems are exacerbated by the fact that in some cases more than half their stock is held by retail investors wanting a yield stock rather than by institutions and mutual funds. “Many of these people are either retired or relying heavily on the dividend income that they get from their phone stocks,” says Williams. “It’s logical to assume that the prices of these stocks are supported by people buying the stock to get the dividend and if you cut your dividend your stock price is likely to reflect that.”
Mergers and acquisitions
The maintenance of a good stock price is crucial if the Bells are to expand. “People that have a highly valued equity will have a distinct competitive advantage,” says Price. “A strong stock price is critical because you need to use it as acquisition currency.”
The Bells have other distinct problems that lessen acquisition opportunities. “The free cashflow of the Bells after dividends and capital expenditures is small relative to the apparent might of their market capitalizations,” says Price. “Further, given their historical desire to have strong credit ratings their willingness to take on significant leverage is limited. Those that prosper will figure out how to deal with the dividend, likely through some restructuring such as US West has done.”
About six months ago US West dealt with the dividend problem by splitting itself up into two publicly listed companies – US West Media Group, the no-dividend, agressive-growth stock and US West Communications, the dividend-paying local-telephone yield stock. “US West never could have contemplated the Continental deal without the availability of a targeted stock [US West Media Group],” says Price.
Another impediment to mergers is the fact that the Bells have been independent for only a short time and have young chairmen unlikely to want to give up control. Morgan Stanley’s Williams says the bank merger between Chemical/Manufacturers Hanover is an example of a way of getting around the problem. In that merger the chairman of Chemical stepped back, even though Chemical was clearly the surviving group, and became chief operating officer of the merged company. The head of Manny Hanny became chairman and chief executive officer but agreed that two to three years later he would retire and hand over the reins to the Chemical chairman.
There are also cultural problems that could hamper some mergers. Take for instance a Bell buying MCI, which some analysts consider a possibility. Bells have been luxuriating in a competition-free environment since their inception and are often accused of having a bureaucratic, public utility style of management. MCI, meanwhile, is reckoned to be one of the US’s most aggressive entrepreneurial firms and is now the biggest threat to AT&T after having clawed its way back from near death in its early years.
Telecoms analysts such as Salomon’s Jack Grubman argue that the complexities of some mergers could result in such lengthy approval procedures by the authorities that they would not be worth the time and effort.
“A merger of the magnitude of Bell Atlantic and Nynex would take a minimum of two years to be approved,” he says. “We frankly believe more shareholder value could be created at Nynex from simply continuing its impressive rate of change versus distracting management time on a very lengthy merger process.”
