So you've sold Telstra... Now what?

Remember the Tech Media Telecom (TMT) bubble of the late 1990s? Australia didn’t participate because of an absence of such companies on the ASX, but elsewhere it produced a frenzy of deals and some ludicrous valuations which mostly came unstuck. Although it eventually got out of hand with crazy valuations, and a subsequent bursting of the bubble, there was clear logic to the excitement it generated. Much of the infrastructure we use today, and some of the companies we know today, were built and cut their teeth, during the TMT bubble and subsequent burst.

Indeed, with the advances in smartphone technology and the growing importance of social media these forces have only strengthened. The younger generation especially expect to find TV, internet, video and social media all on a smartphone and delivered in one bundle or billable package. Latest evidence shows that the younger generation rarely watch a large TV in the home! Furthermore, further pressure has been put on incumbent telecom providers in most western markets, as regulators have forced them to share their infrastructure with other potential telecom providers.

Party like it’s 1999?

Due to this demand for bundling, and the downward pressure on margins imposed by the regulators, corporate deals have been on the rise – TV providers moving in to Telecoms (Sky providing internet, mobile and fixed line services) and Telecoms providers buying media companies (AT&T buying DirectTV and trying to buy Time Warner; Verizon buying AOL and, eventually, Yahoo). Just recently there was a bid for Scripps Interactive (owner of such awesome entertainment as The Food Network and Travel Channel) by Discovery Communications (Animal Planet). This brings a female and male content provider together in a cable TV package but it is not going to be enough to save the Cable TV business from the threat of a better internet and the 5G buildout by AT&T and Verizon and other Telecoms. In all probability, once this Scripps deal is consummated, it will make the enlarged group an even more attractive target for a Telecoms or Social Media giant company to acquire. Even a sector giant like Walt Disney with a market value of US$172bn cannot be immune given its relatively modest valuation these days trading on 16x earnings for next year. We note with interest that Disney have just told Netflix that they are no longer going to be an offering on the Netflix platform. It seems that content providers now have more choice as more platforms gear up, or it may be that Disney have just stated they are willing to talk strategically to all comers as an independent content company? 

Deals cost

We also understand that Apple and Google are talking about an increase in price of $2bn for the iPhone to use Google’s app as the default for search. In 2014 Google paid Apple $US1bn for this! Some price increase! Verizon’s purchase of Yahoo may have been brilliant IF (and a big IF) they can reinvigorate that community to monetise it.

It’s not just party time in the USA. SKY in the UK, which owns satellite TV platforms in the UK and a number of other countries, and also moving in to mobile, fixed line and internet services, is currently in the middle of a takeover from Rupert Murdoch’s 21st Century which already owns just under 40% of SKY.  Liberty Global (USA) continues to raise its stake in ITV (UK) and is widely seen as a prelude to a full bid.  Altice, the large Dutch based telecoms operator, is rumoured to be looking to put a bid together for Charter Communications which is the 3rd biggest pay TV company (Spectrum) in the USA serving 25m customers.

Great content costs! Look how much Sky TV in the UK has to pay for premiership football rights - over £4bn for a three year deal!  So, to pay for great content, you need scale and deep pockets! A large potential customer base with sufficient discretionary income is scale. You also need a strong balance sheet or high free cash flow to be able to finance such a deal and continued investment in the infrastructure.

It appears that there is more activity building in the TMT space. Given that investment bankers all talk the same concepts to the same companies it is likely these deals continue. This time the Telecoms companies seem to be on top of this and are aggressively playing in this space to become more vertically integrated. We believe these Telecoms have the distribution bandwidth, the customers from their telephony business (fixed line and mobile) and, are now hunting for content - think Optus buying the rights to live broadcast of the English Premier League football in Australia - to add more services to existing customers, more subscribers and, most importantly, the advertising $. 

A second chance for Telecoms?

When we think back to what the incumbent telecom companies owned, what resources they had, and the strength of their balance sheets in 2000, it is extraordinary to think that they let the likes of Facebook, Google and Netflix in and to take from them so many potential subscribers and advertising $. These Telecoms had a vast customer database on which much detail was known, they had a comprehensive billing system that dealt with millions of customers, they had a network of engineers on the ground, and a high street presence through the mobile telephony shops, and they had the technical infrastructure to deliver a wide range of services. They also had great cashflow from their business and nicely mixed the need for dividends with acquisitions, debt repayments and capital expenditure. They still have these attributes and while they were asleep at the wheel they are not now and the competition with Google, Facebook and Netflix is hotting up. Given the discrepancy in P/E multiples between FANG stocks and Telecoms, we think that some telecom stocks especially in the USA are an attractive proposition right now. They have the bandwidth, the hardware, know the customers directly, and good technicians. They just perhaps need a new management culture to deal with this opportunity?

Meanwhile in Australia…

So where does Telstra the Australian incumbent fixed line and wireless company go? Can it join this revolution? Probably not without cutting its dividend (as it has done today!), or using leverage on its balance sheet, or, entering a JV. It actually has a big problem. Its dividend yield may be high which is attractive to investors, but as a result it has little money left over, or limited retained earnings, to expand organically. Also, its home market is small in comparison to say the USA or Europe and therefore it has fewer potential subscribers in which to spread the cost of expensively acquired content. Its home market is also fabulously competitive in both fixed line and mobile telephony so margins are under pressure and the new National Broadband Network (NBN), which is effectively Telstra’s own infrastructure is now open to all entrants. Telstra will have to compete with new comers on content and service but has no free cash flow after the dividend to pay for content or build a community to be monetised. Despite its attractive high dividend yield Telstra has significantly underperformed both the Australian stock market and its global telecom peers, as investors have recognised its limited scope to grow. Of course, it can continue to buy in rights to content but it is more of a price taker in such situations.

For a full delivery of a range of services you need the technical capability to deliver the media (which the Telecom companies have), the content itself (which the pure media companies like a Disney provides), and ideally then end distribution mechanism (a TV channel or these days just the internet will do). These developments look a lot like a move to vertical integration, which is a logical strategy given that ‘net neutrality’ laws may be revoked in the USA, allowing an internet service provider to narrow the range of services and content via its portal to only those subscribers it bills.

So, there is a lot of activity in this whole TMT space right now across the globe throwing up lots of potential investment opportunities. As more deals get done it will put more pressure on those who haven’t participated, who feel sub scale and vulnerable, and force them in to doing deals. Sadly, Telstra  is being left behind and Australian investors need to be looking to their global equity portfolios for quality exposure to the TMT sector.