valuation drivers in the telecommunications industry

Valuation drivers in the telecommunications industry

Telecommunications operators are facing the challenges of growth, convergence, business transformation, technological change and regulatory pressures in increasingly difficult economic conditions. Operators choose Ernst & Young because they value our industry-based approach to addressing their assurance, tax, transaction and advisory needs. They know that they have much to gain from our clear understanding of the opportunities, complexities and commercial realities of the telecommunications industry — wherever in the world they’re operating. What gives us this understanding is our Global Telecommunications Center. Operating from Paris, Cologne, Johannesburg, Riyadh, Delhi, Beijing, and San Antonio, the Center brings together people and ideas from across the world, to help our clients address the challenges of today — and tomorrow. Our clients benefit from our insights on key trends and emerging issues. These may relate to the economic downturn, next-generation services, infrastructure sharing, outsourcing, revenue assurance, operational efficiency, regulations, future growth markets or mergers and acquisitions. We help our clients react to trends in a way that improves the financial performance of their business. Learn more about our approaches and services by visiting our website: www.ey.com/telecommunications

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3 Valuation drivers in the telecommunications industry

Foreword

The number of mergers and acquisitions (M&A) declined in recent years due to the economic turmoil and a lack of financing in the market. However, M&A activity in the telecommunications industry has now resumed.

The consolidation trend is not about to stop: the markets in the US and Western Europe are maturing, and have never been more competitive; revenues from fixed-line services are falling; technology is driving significant investment programs (e.g., Fiber); and regulatory pressures are increasing.

It is within this context that operators are pushing to buy or sell telecommunication assets.

This report, written by Ernst & Young’s telecommunications valuation professionals, explores a number of sizeable industry valuation issues that are at the top of the agenda for M&A and finance departments: key value drivers, valuation multiples, and different methodologies. It looks at many questions that are often not explained clearly by the transactions teams and their advisors, and it is intended to help operators communicate their strategies more widely, and explain how valuations are derived.

We hope you will find this summary an informative introduction to some of the approaches that are used, and no doubt this will raise further questions that my team and I would be delighted to answer.

Many thanks to all my colleagues who worked on this report.

Nicolas Klapisz Global Telecommunications Valuation & Business Modelling Leader


M&A activity in the telecommunications sector has resumed, led by transactions in emerging markets.

Valuation multiples are higher for players in high-growth markets than in mature markets.

There is a consensus on the nature and average weight of the assets recognized and valued as part of purchase price allocation (PPA).

Subscriber relationships are generally the primary intangible asset in PPA, with a weight of around 33% of the enterprise value (EV).

Goodwill remains significant, with a weight of 60% of the EV, thus reflecting the growth potential of certain targets, as well as the importance of synergies expected from any successful integration.

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5

Key messages

ContentsForeword 03Financial trends in the telecommunications market 06Valuation drivers in the telecommunications industry 10Purchase price allocation (PPA) in the telecommunications industry 16

Financial trends in the telecommunications market

1.

Valuation drivers in the telecommunications industry 6

1. Recent M&A activityTelecoms operators have to grow through acquisition if they are to win the challenge of acquire or be acquired.

Figures 1 and 2 show the global telecommunications deal volumes and values from 2000 to 20101, with figure 3 detailing the main strategic drivers behind acquisitions in the sector. In research earlier this year, we surveyed over 50 senior executives in the telecoms industry about why they were looking to acquire. ‘To enter new geographic markets’ came top, followed by ‘to strengthen the core business’.

Footprint growth has featured heavily in the last decade, where transaction levels peaked twice: the first peak was due to the building of scale during the technology bubble of 1999-2000, which launched the global footprint growth in the mid-2000s. Regional consolidation phases (e.g., US mobile market and European broadband sector) led to the second peak of deal activity from 2005 until the slowdown in 2007, predating the financial crisis.

During this period, large European operators increased their exposure to emerging markets, with Africa outperforming developing Asia as a target market for footprint growth.

“The bloodbath has started to happen. There is enough of it now. Market caps have

halved. Companies are making losses. There will only be a

few players: 6, 7 but certainly not 12. [Consolidation] is

inevitable.”

Bharti Enterprises Chairman, Mr. Sunil Bharti Mittal,

during the World Economic Forum 27 January 2010

1Source: EY survey Why capital matters — building competitive

advantage in uncertain times — telecommunications survey snapshot, 4 February 2010.


Source: EY Survey Why Capital Matters (2000-2009) and Thomson SDC Platinum (2010 data)

Deal

val

ue (U

S$m

)

250,000

400,000350,000300,000

200,000150,000100,000

50,0000

Local market deals Cross-border deals2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Figure 2 — Deal values by transaction type 2000–2010

Figure 1 — Global telecom deal volumes/deal values 2000–2010

Source: Thomson SDC Platinum

Deal

val

ue (U

S$m

)

Num

ber o

f dea

ls

250,000

400,000450,000500,000

350,000300,000

200,000150,000100,000

50,0000

1,000

1,6001,4001,200

8006004002000

2000 2001 2002 2003 2004 2005 2006 2007 2009 20102008Deal value Number of deals


“I can’t tell you the names of the countries we are working on. There will be a few more acquisitions

on the African and Middle East footprint in the next couple of months.”

Gervais Pellissier France Télécom Chief Financial Officer

Reuters Insider TV, 22 May 2010

Operators in emerging markets have built regional scale over the past few years, and contributed to the increasing numbers of deals in those regions, from 16% of the global deal value in 2007 to 33% in 2009, as seen in figure 4. They now have the technical and financial capacity to develop and adopt external growth strategies, and therefore the acquisition of targets in emerging markets is no longer the exclusive domain of mature operators. For example, Bharti Airtel acquired Zain Africa in March 2010, for US$10.7 billion.

In 2009, there was a sharp downturn in cross-border deals, whilst activity in any single country (‘in-market deals’) remained flat. This reflected reduced opportunities in cross-border footprint growth, whilst in-market deals helped operators reduce costs and position themselves for convergence.

What is your current rationale for considering acquisitions?

Source: EY Survey Why capital matters — Building competitive advantage in uncertain times — Telecommunication survey snapshot, February 2010

Rank Rationale1 To enter new geographic markets2 To strengthen the core business3 To achieve economies of scale4 To eliminate or reduce competition5 To acquire new technology6 To enter new product markets7 To acquire liquid assets8 To take advantage of low valuations/distressed assets

Figure 3 — Main strategic reasons for acquisitions — Answer from telecom operators

Source: Thomson SDC Platinum

Figure 4 — Telecommunications deal values by region 2000-2010

(deals in emerging markets as % of all deals that year)

Deal

val

ue (U

S$m

)

250,000

400,000350,000300,000

200,000150,000100,000

50,0000

Deals in emerging markets All deals (global)

450,000500,000

2000

21%

14% 34% 20% 10%21% 23% 27% 24% 41%

59%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010


2. Impact of the recent financial crisis on telecommunications operators The telecommunications industry is usually presented as a fairly stable sector, focused on the long term. However, the sector did not prove to be particularly resilient to the recent crisis.

General economic indices fell on average by 58% between October 2007 (when indices peaked) and March 2009 (the bottom of the market). Telecommunications sector indices followed the general economic trend, falling by 49% over the same period.

However, not all operators suffered from the economic crisis in the same way, and many have recovered in line with their local economy. We have found that we can achieve a more accurate view by analyzing developed and emerging markets separately.

As illustrated by figures 5 and 6, operators in developed markets have been slightly less volatile than global economy indices2. Operators in emerging markets lagged behind the recovery in the emerging market economies: telecommunications indices for emerging markets have increased by 31% since March 2009, whilst general economic indices of emerging markets have risen by 139% over the same period.

Nevertheless, the impact of the economic downturn on the share prices of the emerging market telcos (-53%) was somewhat consistent with that of their developed market peers (-47%).

“Uncertainty is one of the most important

characteristics of our current environment.”

Mr. Jean-Claude Trichet, President of the European Central Bank,

18 November 2009

2The following general economic indices were included in the

analysis: CAC 40, S&P 500, DAX, FTSE 100, BSE SENSEX 30, SHANGHAI SE COMPOSITE, BRAZIL BOVESPA, RUSSIAN RTS $, MEXICO BOLSA, FTSE/JSE AFRICA ALL.

Figure 6 — Developed telecom industry market capitalizations versus average developed economic indices from 01.01.2007

Figure 5 — Emerging telecom industry market capitalizations versus average emerging economic indices from 01.01.2007

Source: Bloomberg

Source: Bloomberg

501 Jul 071 Jan 07 1 Jan 08 1 Jul 08 1 Jan 09 1 Jul 09 1 Jan 10 1 Jul 10

70

90

110

130

150

170

Emerging operators Emerging economy indices

Developed operators Developed economy indices

1 Jul 071 Jan 07 1 Jan 08 1 Jul 08 1 Jan 09 1 Jul 09 1 Jan 10 1 Jul 1050

70

90

110

130

150

170

Valuation drivers in the telecommunications industry

2.


The purpose of our analysis is to identify the key valuation drivers for telecom operators, and to consider the impact of their activities (size, exposure to emerging markets, etc). We have asked the following questions:

• How do investors measure and value growth? • What are the criteria used by investors in an initial valuation of targets? • Do these criteria accurately reflect an operator’s unique profile?

We have analysed the financial data of 57 large publicly-listed telecom operators: 25 in emerging markets and 32 in developed markets. We have also divided them according to their annual revenue (see figure 7).

Our analysis of the financial aggregates, geographical market shares and forecast stock-based multiples in the telecommunications industry was based on Bloomberg projected estimates.

In addition, around 70 recent transactions of public and private telecommunications targets were reviewed and analyzed.


> 25 billion US dollars

15–25 billion US dollars



< 5 billion US dollars

Figure7 — Split of the 57 telecom operators by annual turnover

Source: Company financial disclosures, FY09

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6

16

18

6

12Valuation drivers in the telecommunications industry

The main valuation criteria used by investors in the telecommunications industry in their initial valuations are shown in the table below.

We have identified the following key differentiators, which affect valuations at this stage:

• Sales: we have analysed telcos in the ‘larger tier’ (highest sales within our set of 57 operators under analysis) and ‘smaller tier’ (lowest sales within this same set)

• Market type (emerging vs. developed): we have defined ‘emerging operators’ as telcos with more than 85% of annual revenues from emerging markets

*ARPU: Average revenue per user*SAC: Subscriber acquisition costs*SRC: Subscriber retention costs

Valuation criteria

Common valuation criteria

Telecom-specific Ratios and Key performance indicators (KPIs)

EV/Sales

EV/EBITDA

Price Earnings Ratio (P/E)

Price-to-Book (P/B)

Beta coefficient (ß)

ARPU*

EV/Number of subscribers

EV/Line installed

SAC*

SRC*


Key findings

Within the large tier, emerging telecommunications operators have higher EV/EBITDA multiples than their developed market peers.

This trend shows their ability to benefit from market growth rates and better margins, which are typical of less mature markets.

However, this trend does not apply to the small tier operators, as the markets place a premium on a diversification of risk, which is supported by the size of the business.

Large telcos that operate in emerging markets have higher valuation multiples than their peers in mature markets. Investors place a premium on growth prospects, so long as they are well monitored and diversified.

Additional risk is reflected by higher betas (and hence higher costs of capital) for operators in emerging markets.

1.

2.

The greater the exposure to emerging markets, the higher the EV/EBITDA multiple, provided the operator is large enough

Source: Bloomberg

5.0

8.0

7.0

6.0

4.0

3.0

2.0

1.0

0.0

Emerging companies Developed companies2009 2010 2011 2012

Figure 8 — EV/EBITDA multiples of larger emerging operators by geographical exposure

5.9x

4.8x4.4x 4.4x 4.4x

5.5x 5.2x 5.0x


The smaller the company and the higher its exposure to emerging markets, the higher the betaThe beta coefficient (one of the key components of discount rates) contains valuable information about the company’s risk profile. Typically, the telecommunications industry is now considered to be slightly less risky than the overall market, with beta coefficients within the 0.75-1.0 range.

Smaller telecommunications operators usually have a higher beta as their stocks are more volatile. Their operations are considered to be riskier than a larger comparable business, and therefore they would normally yield higher returns on investment.

Exposure to emerging or mature markets also influences the operator’s risk. The market type differentiator provides a measure of this.

The higher the exposure to emerging markets, the higher the price-to-book ratioPrice-to-book (P/B) ratios of large telcos operating in emerging markets are higher than those of their peers in developed markets.

This shows that the market expectations of high growth (i.e., anticipated return on equity) have been built into their share price, thus boosting their P/B ratios.

Source: Bloomberg

P/B — Larger Tier

Emerging companies Developed companies

Figure 10 — P/B of Larger-tier companies between 2007 and 2010 by region

00.51.01.52.02.53.03.54.04.55.05.5 6.9x

2.9x3.4x

2.0x

3.3x

2.2x

3.0x

2.0x

1 Jan 08 1 Jan 09 1 Jan 10 30 Sep 10

Beta Weekly 1.5 — Larger vs Smaller Tiers

Source: Bloomberg

Figure 9 — Beta

1.25

1.5

1.0

0.75

0.5

0.25

0.0

Larger tier Smaller tier1 Jan 08 1 Jan 09 1 Jan 10

0.810.94 0.95 0.97

0.87 0.84


Lower P/B ratios observed for large tier developed and mixed-market operators might be explained by:

1. Economic factors

Past performance was positive and relatively stable, and is not expected to grow significantly in the future (past return on equity is approximately equal to the future return on equity).

2. Accounting factors

Acquisitions reported via PPA led to the recognition of part of the intangible assets in the acquirer’s consolidated accounts, increasing the book value of equity.

Thus the book value of these companies better reflects their market value, leading to lower P/B ratios.

The higher the exposure to emerging markets, the higher the implied transaction multiples The implied multiples of acquired emerging targets were significantly higher than those of developed market operators.

This is consistent with the conclusions derived from the P/B analysis: companies with higher P/B were judged by investors as presenting higher growth potential.

Source: Merger Market

14

18

16

12

10

8

6

4

0

2

Emerging markets Developed marketsEV/Sales EV/EBITDA EV/EBIT

Figure 11 — Recent transaction-based valuation multiples (2008–2009)

3.7x

1.2x

11.4x

8.2x

15.6x

12.6x

Purchase price allocation (PPA) in the telecommunications industry

3.


It is vitally important for acquirers to communicate clearly to the market about the value of assets acquired and liabilities assumed as part of an acquisition.

Therefore, the telecom-specific assets of the target should be identified and valued using robust valuation techniques and methodologies. Estimated asset values are reported as part of a PPA analysis, performed in accordance with IFRS requirements.

Furthermore, IFRS 3 (Revised) has introduced new challenges in terms of purchase accounting. The most critical issues for valuation include:

• Valuation of non-controlling interests• Option to recognize goodwill on non-controlling interests• Contingent consideration measured at fair value

1. Benchmarking of PPA in the telecommunications sectorErnst & Young’s benchmark analysis of PPA results reported by telcos has shown that most companies provide detailed qualitative and quantitative information about intangible assets, their remaining useful lives and the residual goodwill components.

This analysis was based on annual reports of telecommunications companies in 21 countries, disclosing PPA results of 54 telecommunication transactions that were reported by public companies. The results of this analysis were summarized in two reports, Global surveys of purchase price allocation practices published by Ernst & Young in 2008 and 2009.



According to the last study, published in 2009, recognized intangible assets represented — on average — circa 30% of the telecommunications industry3 targets’ EV, while goodwill accounted for about 60% (figure 12).

Typical intangible assets in the telecommunications industry

Among the intangible assets recognized in acquisitions, the most significant value was typically assigned to:

• Customer relationships and contracts • Licenses for mobile operators or technology-related assets for technology

and equipment companies• Trade names

Other intangible assets include agreements, such as distribution, supplier or interconnect arrangements. It should be noted that these results derive from analysis of operators of different size, markets and technologies. We would recommend that an in-depth analysis of each target should be carried out before identifying and valuing intangible assets.

Remaining useful life

Most intangible assets identified in the telecommunications industry would typically have a definite useful life (including in some cases the trade names or trademarks). Customer relationships are amortized, on average, over a five- to eight-year useful life, while the useful life of licenses is often based on their legal term plus foreseeable extensions in some cases.

3Telecommunications industry covering all sub-sectors, besides

telephony, internet and mobile operators, including also service, technology and equipment companies.

Goodwill Brand/Trademarks Customer Contracts/Relationships

Total Recognized Intangible Assets Technology Non-Compete Agreements

Tangible Assets + Net Working Capital Off Market Contracts/Agreements Other Intangible Assets (including licenses)

61% 32% 33%

12%

16%

7%9%

30%

Figure 12 — Intangible assets recognized in PPA in the telecommunications industry (as % of EV); source Global surveys of purchase price allocation practices, Ernst & Young 2009, available via [email protected]


Goodwill components

Our analysis confirmed that telcos disclose information concerning the components of goodwill in accordance with requirements of IFRS 3/3R and FAS 141/141R. The existence of goodwill is generally explained by synergies, additional market share and future services to be offered to the market by the combined business.

Some intangible assets might also be included in the amount recognized as goodwill if their value is not material (such as distribution networks).

In addition, the following components may also be included in the goodwill calculations: customer service capabilities, presence in geographic markets or locations (market power/influence), strength of labor relations, ongoing training or recruiting programs, outstanding credit ratings, access to capital markets, state of relationships with governments or regulators. These disclosures are key for investors, and provide insights about the strategic and financial rationale of the transaction.

2. Asset valuation methodologies for the telecommunications industryAll the acquired assets and assumed liabilities should be recorded at fair value, and their sum compared with the price paid by the acquirer.

According to IFRS 3/3R (Business Combinations) and FAS 141/141R (Business Combinations), the fair value is defined as “the amount for which an asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.”

In addition, standards specify that fair value should reflect market expectations about the probability that the future economic benefits associated with the asset will flow to the acquirer. Therefore, any analysis should reflect assumptions which would be common to any market participant if it were to buy or sell each asset on an individual basis. Thus, the fair value should be determined with reference to market participants in general, but exclude synergistic values that are unique to a particular buyer.

The following methodologies are commonly used to value intangible assets:

• Income approach which allows future economic benefits of the asset to be captured (via the multi-period excess earnings method, relief from royalty method, build-out or greenfield method)

• Market approach based on comparing the asset with similar assets, and prices paid for them (comparable transactions method)

• Cost approach relying on the principle that no prudent investor would pay for an asset more than the cost to recreate it or to reproduce an asset of similar utility (replacement or reproduction cost method)

More than one approach may need to be considered in order to arrive at a supportable valuation range. In the following sections, we explain the choice of the preferred method for each asset valued, and discuss some of the practical challenges.


Trademarks/Trade names: One of the most appropriate methodologies for valuing trademarks is the relief from royalty method, which estimates the expected royalty savings attributable to the ownership of the intangible asset. This approach is based on the concept that if a company owns an asset, it does not have to “rent” one. The owner is thus “relieved” from paying a royalty, which represents valuable cost savings. In this context, the theoretical rent or royalty payment is used as a surrogate for the income attributable to the trademark.

The key assumptions when valuing a trade name are the revenue base, the royalty rate and the discount rate.

For telcos, the challenge arises around the remaining useful life of the acquired trademarks. Specific re-branding and co-branding relating to the acquisition must not be included.

The intention of the acquirer must not be taken into account, unless under specific circumstances where it can be proved that market participants would have acted in the same way, supported by strict documentation.

Royalty rates for the telecoms industry vary widely, between 0.5% and 4%, depending on the strength of the brand, the company’s market position (e.g., low cost vs. premium services or market share), and the operator’s financial performance.


Subscriber relationships The multi-period excess earnings method is commonly used to estimate the fair value of customer-related assets in general, and subscriber relationships in particular.

The key principle of this methodology is that subscriber relationships do not generate cash flows in a vacuum. Rather, they are supported by several other assets, such as fixed assets, working capital and intangible assets.

The operating profit generated by customers is attributed to a set of assets. Excess earnings aims to estimate the value strictly attributable to subscribers over their remaining useful life (e.g., taking churn rates into account), by subtracting from the operating profit a contributory asset charge, which represents the theoretical rent that would have to be paid for the use of these assets were they not owned. The difference between the operating profit and this charge is called ‘excess earning’ and is fully attributable to the subscribers. Discounting these excess earnings over the remaining useful life of the subscribers then leads to an appropriate fair value.

To value subscriber relationships, the acquirer needs a process to remove duplication, such as multiple SIM customers, non-active cards, and machine-to-machine SIMs.

The application of the multi-period excess earnings method is not easy in the telecommunications industry:

Firstly, the nature of the subscriber varies (private/corporate, pre-paid/post-paid, geographic area/country), as each can differ in terms of growth trends, margin levels, useful lives and churn rates. Consequently, even if the valuation methodology is the same for each category, there may be a need to split the subscribers into different categories and value them separately to take these differences into account.

Secondly, the nature of services proposed should also be taken into consideration, to deal with the specifics of mono-service providers (mobile, fixed, internet and TV) or those of operators providing bundled offers (triple play, or quadruple play).

Thirdly, the churn rate significantly impacts valuations, with annual attrition rates varying from 10% to 35%, depending on the subscriber category. In addition, attrition risks based on the potential transfer of technologies or trade names are to be taken into account.

Lastly, the useful life is determined in a way that is consistent with the subscribers’ cash flow patterns. A common rule is to retain a useful life that can capture 90% or 95% of the total value of subscriber relationships.


LicensesThe fair value of licenses may be estimated using a number of different valuation methodologies. The choice of methodology depends on the availability of information, licenses, and the existence of an active market.

The greenfield approach is specifically used to value telecommunications licenses. This approach values the license by calculating the value of a hypothetical start-up company that goes into business with no assets except the asset to be valued (the license). The value of the asset under consideration can be considered as equal to the value of this hypothetical start-up company.

The license value can also be derived via the market approach, which estimates the fair value by referring to purchase prices paid for licenses for similar technologies. Indeed, the market approach results from the recent sale of similar licences, and how their valuation metrics relate to the license under consideration.

Finally, the cost approach might be applied by estimating the license value based on its historical or replacement cost. However, the cost approach results are often limited, as 2G and 3G licenses become rapidly obsolete in today’s fast-moving regulatory and technological environments.

The greenfield approach is highly subjective. In Europe, licenses have finite useful lives, so the value of the start-up company is calculated at the end of the license’s useful life. This takes into account the fair value of the remaining assets, such as networks and customers, with a potential discount, and accounting for some continued use. Given that the assumptions relating to terminal values have a significant impact on the final valuation, they should be chosen carefully, and well documented.

The market approach is rarely used because of challenges relating to the quality of the sample, the quality of tender processes, the comparability of the acquired licenses (technology, territory covered, etc.) and the fee structure for paying for the license (upfront, annual fees as a percentage of revenues or fixed). However, we believe this approach should be used more often because it is a useful cross-reference.

Different fee structures exist, which make comparisons very difficult:

1. One-off fees

• Market set: method used by regulators to estimate an upfront fee using market comparison valuation techniques

• Price floors and minimum bids: method used in auctions where a ‘floor’ price is set to ensure that the starting point for bids is in line with government expectations

2. Annual or recurring fees

• Revenue-based annual fees set as a percentage of annual gross revenues• Annual fixed fee or annually-adjusted fee (non-revenue based periodic fee)• In some countries, additional contributions may include taxes levied by ministries

other than the telecommunications ministry, or may take the form of a small percentage of gross billed revenues to fund national research programs or to support a universal service fund

Main multiples used:

Price/inhabitant

Price/GDP

Price/GDP per inhabitant

Price/MHz

Price/MHz per inhabitant


Contracts IAS 38 defines contracts as intangible assets that have a fixed or definite term agreed by both parties. They provide for contractual rights to receive money or contractual obligations to pay money on fixed or determinable dates. Contracts represent the value of rights that arise from contractual arrangements.

This methodology is useful for assessing such agreements as MVNO network sharing, content and applications or roaming agreements.

The main analysis that should be performed concerns the favorable or unfavorable terms of the contract relative to the market: does this contract provide the operator with a competitive (dis)advantage?

Other characteristics of the contract to be considered include: • Renewal clauses • Historical trends• Exclusivity or similar characteristics

Contracts that might have a favorable or unfavorable nature include:• Lease/rental agreements• Supply contracts• Distribution agreements • Indefeasible rights of use (IRU)

Long-term lease/rental agreements signed in the past at market rates (fixed, non-adjusted rent) might eventually become favorable or unfavorable agreements because of the cyclical nature of the market. The ‘non-market’ part of rents borne or avoided by the acquirer due to the existing rental/lease contract should be valued and booked in the acquirer’s consolidated accounts.

Supply contracts and distribution agreements shall be checked for any off-market terms and conditions as well as for any exclusivity clauses, as these might give rise to an intangible asset being identified, recognized and valued.

IRUs enable operators to use the networks of other telecommunications carriers for an amount that can be compared to a rent. All IRUs are signed for long-term periods and represent a competitive advantage over other market participants, as capacity is limited in the market and, once contracted, they are not available to other market participants. Therefore, these contracts may represent a great deal of value to their owners, and are often included in the PPA.

Non-compete agreements are contracts between a buyer and a seller of a business, restricting the seller from competing in the same industry for a specific period of time, often within a defined geographic area. The principal technique used to value non-compete agreements is an incremental approach, which values the asset based on the difference in cash flows between scenarios with or without the non-compete agreement in place (“with or without approach”). The main limitation of this approach is that it is highly subjective, and the inputs are discretionary in each case.


Tangible assetsTangible assets are generally valued by applying the cost approach. The principle behind this approach is that the value of an asset should not exceed the cost of obtaining a substitute asset of comparable features, utility and functionality. In the context of PPA, the approach is applicable if the market and income approaches cannot be applied.

Two methods might be regarded within the cost approach:

• The reproduction cost method, which is based on the construction (or purchase) of an exact replica of the intangible asset

• The replacement cost method, also known as the greenfield approach, which is based on the cost of recreating the utility of the subject intangible asset, but in a form or appearance that may be quite different from an exact replica of it

To value tangible assets, particular attention should be paid to the acquirer’s/market participants’ intentions (including network downsizing), since certain adjustments might be needed. For example, a network that would be considered “inefficient” by market participants, because it would require some redundant antennas to be disposed of, may justify a discount applied to the network value. Finally, the economic useful life of the equipment should be considered versus its accounting useful life.

Replacement cost new and reproduction cost new may follow changes in the prices of new equipment. Indeed, for infrastructure assets,replacement/reproduction cost new may be higher than historical values, while for technological equipment assets, replacement costs new are often lower than historical values. It should be noted that the target’s marketplace may also impact the value estimation using the cost methodologies.

Further considerations, such as functional obsolescence (capacity, rapidity, etc.) and asset retirement obligations, can also have a significant impact on values.

Discount rateWhen using income as a basis for the valuation methodology, such as the relief from royalty method or the multi-period excess earnings method (MEEM), a discount rate has to be applied.

The discount rate should be specific to each asset and reflect its risk profile. It should also be consistent with the overall company weighted average cost of capital (WACC). The weighted average return on assets (WARA) analysis estimates the average rate of return of the company’s economic assets, based on their own discount rate, and calculates their respective weight in the total enterprise value (EV).

Network assets and working capital are considered to carry relatively little risk in Telecoms, whereas licenses, customer bases and trade names demand a higher rate of return. Goodwill considers synergies whose realization often proves difficult and therefore risky.

The WARA analysis aims to check that the rates used are consistent with the respective risk profiles of the assets, and reconcile those with the operator’s WACC.


GoodwillGoodwill is estimated as the residual between the value of the business as a whole (the purchase price) and the sum of fair values assessed for identifiable tangible and intangible assets of the business, less the fair value of liabilities assumed.

Goodwill in the telecommunications industry often includes the following elements:

Post-acquisition subscriber base developmentAny post-acquisition subscriber growth that cannot be assigned to existing subscribers might only be captured in goodwill.

Bundled offers (convergence synergy)The emergence of “quadruple-play” offers — bundles of fixed telephony, broadband internet, mobile telephony and TV — are likely to lead to gains in market share and average ARPU, and a reduction in churn rates. Mergers in the telecom sector tend to build on existing “triple-play” offers. As a result, goodwill may integrate the future benefits of bundled services.

Access to powerful distribution networksAcquiring an operator which owns sales outlets enables the acquirer to offer its services to a wider population.

Geographical expansionWinning new markets for the acquirer will enlarge its geographical coverage, and enhance its brand value.

Buy vs. build Acquiring a profitable business with a large, established network may lead to future growth, saving time and money that would have been required to build a similar network from scratch.

Defensive strategyAcquiring a competitor may enable the acquirer to reduce price wars in certain geographical areas, or to protect itself against acquisition by a larger operator.

Vincent de La BachelerieGlobal Telecommunications [email protected]

Jonathan DharmapalanGlobal Deputy Telecommunications [email protected] Marc ChayaGlobal Telecommunications Markets [email protected]

Nicolas Klapisz Global Telecommunications Valuation & Business Modelling [email protected]

Robin JowittGlobal Telecommunications Transaction Advisory Leader [email protected]

Serge Pottiez Global Telecommunications IFRS Advisor [email protected]

Steve LoGlobal Telecommunications Center — [email protected]

Holger ForstGlobal Telecommunications Center — [email protected] Prashant SinghalGlobal Telecommunications Center — [email protected]

Serge ThiemeleGlobal Telecommunications Center — [email protected]

Wasim KhanGlobal Telecommunications Center — [email protected]

Mike StoltzGlobal Telecommunications Center — San [email protected]

Contacts

Global Telecommunications Center

Ernst & Young

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