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Do investors value telco transformation?
Telecoms investors span public and private capital markets, equity and debt, and different geographies. They use a variety of strategies and hold diverse opinions that tend to fluctuate, with capital markets often extrapolating from recent experience. This excerpt from our recent report, Cloud and automation: Changing CSPs’ OpEx outlook, examines the impact CSPs' digital transformation process has had on investors’ views of the telecoms sector.
During recent decades, investors have learned to expect cost reductions, with processes gradually becoming more efficient particularly at telcos that were privatized in the 1990s. For example, Deutsche
Telekom had 201,060 employees in its German division when the group was privatized in 1996, but by the end of 2019 the number had fallen to 60,501. CSPs also have saved by cutting overlapping functions in areas such as sales, marketing, customer care and operations in fixed-mobile convergence deals (initially by the integrated telcos and more recently by cable-mobile deals, led by European investment group Altice). So, the savings generated through digital transformation is really just the latest form of cost cutting in a multi-decade process. Historically, telco investments have been disappointing, with the sector’s performance lagging the rest of the stock market over the last 20 years. There are exceptional stocks that have bucked this trend – Verizon, for example, has shown steady gains in share price. But overall, cost cutting by CSPs has failed to lead to share price outperformance. This is partly because cost savings are usually offset by a mix of negative factors including competition, regulatory pressure, rising CapEx and occasional large spectrum costs, leading to disappointing revenue and earnings trends overall. Few telco stocks have managed to offset these headwinds through cost cutting – even the exceptional level of cost cutting at Altice Europe slowed after two years. Malaysian operator group Axiata was one of the first to discuss digital transformation with investors. CEO Tan Sri Jamaludin Ibrahim outlined a plan in late 2016 to cut $355 million in costs from fiscal year 2017 to 2019, which amounted to 17% of 2016’s OpEx base. Axiata saw two components to transformation: digitization of processes followed by the introduction of new services such as mobile advertising, digital commerce and digital entertainment. However, the company did not publicize many details at the time.
In February 2017, Norway-based Telenor, which also operates in Asia, highlighted the digital transformation opportunity in a way other telcos had not, with CEO Sigve Brekke presenting a three-year plan at the company’s Capital Markets Day. As a result, Telenor became known in the stock market
as the leader in transformation – and the benchmark to use for assessing the opportunity for other CSPs. Unfortunately, Telenor’s investment story lost some momentum in 2019, with slower net cost cutting as network costs rose in Asia because of increasing energy prices and network expansion costs. But the stock remains up 12% since February 2017 compared to a 25% decline in European telco stocks overall during the same period. Telenor’s transformation plan therefore has been a success from a telco investment point of view, and changed investors’ views about the potential for cost cutting to drive share price performance. Telenor announced a plan to cut OpEx overall by 1% to 3% annually from 2018 to 2020 and to grow revenue organically by low single digits. This guidance may not seem like much, but it was a big deal – few CSPs had managed to grow revenue and shrink costs at the same time over a multi-year period. So, this guidance suggested a break with the past. Telenor got off to a good start, with OpEx falling a net 3% per year in 2017 and 2018. Underlying revenues were up slightly, and earnings before interest, taxes, depreciation and amortization (EBITDA) was up 6% annually. At this time, European telcos were known for flat or declining EBITDA. The Telenor share price duly rose 46% over the first year of the company’s plan, while the wider telco sector index was flat. This increased the credibility of digital transformation as an investment theme, and analysts and investors in Europe started to ask other CSPs if they had similar plans.
British multinational operator Vodafone Group has been successful with its digital transformation strategy, but the company’s share price has not risen as much as Telenor’s and Spark's. In May 2018 Vodafone announced that $9.5 billion of its annual operating costs were in areas open to savings from digitization. The company followed up in November 2018 with an explicit plan to cut OpEx in Europe by approximately $1.4 billion a year by fiscal Q3 2021. Vodafone cut it by about $475.5 million in Q3 2019 and Q3 2020, with Group EBITDA margins rising 1.5 percentage points as a result and EBITDA remaining flat despite 2% revenue erosion per year. Unfortunately, the stock performance has been disappointing, down 36% since May 2018, whereas the sector is down 20%. Vodafone’s revenue trends have been disappointing due to price competition in Spain and Italy and more recently the impact of Covid-19. Furthermore, the company’s plan was not such a positive surprise to investors as Vodafone had already cut costs significantly from 2016 to 2018. Because investors understood the company’s transformation story, some level of continued cost cutting was already priced into Vodafone’s share price by May 2018.
Australian incumbent CSP Telstra announced its transformation plan in June 2018. At the time, the company’s stock price was under significant pressure, halving over the prior two years as the threat from the government broadband network, NBN Co, grew. Telstra CEO Andrew Penn announced a three-year plan to cut annual OpEx by about $762 million, aiming to cut two layers of management, reduce staff by 8,000, reduce customer service calls by two thirds and trim product offerings from 1,800 to just 20. This was the most aggressive transformation plan announced to date, reflecting the particularly strong revenue pressure on the Telstra business. OpEx fell a net 3% per year over the first two years of the plan, and revenues fell a larger 5% annually. Profits therefore have continued to fall, but at a slower pace than expected by investors prior to June 2018. Telstra’s stock has climbed a creditable 13% since June 2018, despite this considerable revenue pressure. Investors learned that ultra-aggressive transformation still wasn’t enough to drive profits up when revenues were still falling significantly, but it was enough to turn the share price around in this case. For example, transformation is a core part of the outlook for KPN and Orange, and AT&T has also discussed transformation-led cost cutting in the US. In contrast, CSPs with somewhat faster-growing businesses, such as Comcast, Charter Communications, T-Mobile US and Verizon, are much less vocal about their cost cutting plans.
Despite all this, the digital transformation process has not had as much impact on investors’ views of the telecoms sector overall. While transformation leads to fundamental change in how telcos are run, their cost bases and relationships with customers, investors have not changed how they view the sector for several reasons. Firstly, bond yields have continued to fall in recent years, leading investors to favor growth stocks (companies with significant revenue growth) over companies with low growth but higher cashflow like telcos. The good news is this may be about to change, depending on how fast the global economy recovers from the pandemic. As the outlook for economic growth improves, long-term bond yields would rise, with investors then paying less of a premium for growth stocks and relatively more for other stocks like telcos’. Secondly, the investor experience with CSPs’ cost transformations is still quite stock specific. Maybe Telenor was a special case in that transformation allowed the company to move departments to its lower-cost Asia operations. Telstra and Spark are not on the radar for many investors, and Vodafone’s stock is down since unveiling its plan. Also, tracking the progress made on cost cutting is not straightforward for investors. Most operators do not break out costs, typically reporting only three or four categories such as direct costs, labor costs and other OpEx. How costs are allocated between these different buckets is obscure, varies by company and can change. Continued changes in accounting standards have also muddied the water significantly, making analysis of cost trends over the last three years difficult. This lack of visibility also makes it harder to gauge how much more cost cutting potential remains. Transformation leaders like Telenor have been extending the program three years or so. But it is very difficult for investors to judge whether the program can last beyond that, which holds them back from buying telco stocks with more enthusiasm and in turn limits the impact of the transformation theme on share prices. Other factors continue to dominate the outlook for telco earnings, in particular the prospect (or not) of revenue growth. Few operators are growing, and Covid-19 has weakened revenues, meaning that despite many CSPs realizing three years’ worth of digitization in just six months as customers work from home, EBITDA didn’t surge. The $81 billion recently spent on 5G spectrum in the US has also reminded investors that years of hard-fought cost cutting benefits can be spent quite quickly elsewhere in the business. Finally, few CSPs guide an overall net decline in OpEx the way Telenor did. AT&T plans $2.37 billion run-rate savings by fiscal year 2022 on a gross basis, meaning before other cost factors. BT targets $1.38 billion gross savings by fiscal year 2023, while DT aims for $1.78 billion gross saving and Orange for $1.42 billion net savings in indirect OpEx. The savings described are significant but not quite enough for the companies to guide an overall decline in costs. Hopefully some of these factors will improve as the economy recovers.
Interestingly, the CSPs with the poorest revenue outlook appear to be transforming the most. This is evident in stock market consensus. The graphics below show consensus forecasts for EBITDA margin expansion for some of the largest quoted telcos globally, compared to forecasts for revenue growth.
CSP margin growth should naturally correlate with revenue growth, due to the operating leverage of telecom networks – that is, a high mix of fixed costs. Indeed, analysts expect decent margin expansion at the relatively high-growth US cable companies. However, the operators with the highest expected margin growth are those with the worst growth prospects. These forecasts largely reflect guidance from the companies themselves and show that CSPs’ cost transformations are examples of necessity being the mother of invention. As many CSP executives have described, digital transformation is time consuming, painful and risky. Consultancy A.T. Kearney sees transformation as a four-phase process, during which operators gradually become more confident and ambitious with their digital transformation plans. Operators start with projects to meet divisional cost targets and end with a complete change in the way the business is run. Each stage is more challenging and requires a bigger time commitment from the leadership team. Executives at companies with flat or declining revenues are incentivized to take the risk, but if the business is growing quickly, there is less reason do so. Ultimately, this is a bullish conclusion, suggesting significant potential for cost cutting for most of the other operators in the sector, once they are ready to commit. Unfortunately, cost cutting alone likely will not be enough to drive telco share prices up significantly without a recovery in revenue growth. In this way, a transformation project that lifts ARPU and drives sustainable revenue growth is going to be worth more to the stock price than all the work done on cost transformation. Right now, digitization does not appear to be lifting revenues, leaving CSP executives to focus on costs. But perhaps it is too early for revenue benefits to emerge. Transformation resets the relationship with the end customer and disintermediates factors that have undermined ARPU in the past, particularly dealer-driven churn, bill shock and very poor customer service. There is still potential to lift ARPU, for example by upselling customers to unlimited data bundles, for which customers appear willing to pay a premium. If digital transformation helps deliver ARPU growth and changes the telco business, then it will change the telco stock price as well.
