Private Equity Rummages in Europe’s Telco Bargain Bin

(Bloomberg Opinion) -- The telecoms sector is proving a rich hunting ground for bidders and bankers. Surely stock-market investors can put up more resistance.

Reliance Industries, the Indian conglomerate led by billionaire Mukesh Ambani, denied a report it was mulling an offer for BT Group Plc on Monday, but the U.K. telco remains the subject of speculation after the Mail on Sunday said private-equity suitors were crunching the numbers on a possible bid for its Openreach broadband unit. Billionaire telecoms entrepreneur Patrick Drahi amassed a 12% stake in BT earlier this year.

Meanwhile, U.S. buyout firm KKR & Co. has proposed a deal to buy Telecom Italia SpA, having made a failed attempt at another national icon, Royal KPN NV of the Netherlands.

Private buyers are enticed by the prospect of steady cash payouts once broadband networks are upgraded, whereas that long-term potential hasn't been reflected in current share prices. In fact, investors have punished listed telecom firms for spending on a rosier future.

Vodafone Group Plc shares tumbled in May after the company upped capital expenditure plans. Iliad SA's buyout came after the stock sank on the announcement of higher capex. Conversely, BT rallied in November when it said it wouldn't spend as much as previously indicated on its fiber broadband rollout.

You can see why investors may fret about telcos spending on a broadband arms race that might never pay off. Telecom Italia has been one long disappointment. BT faces potential competition from Virgin Media O2 (owned by Liberty Global Plc and Telefonica SA). Vodafone risks getting sucked into a capex tit-for-tat with Deutsche Telekom AG in Germany.

But stock-market short-termism is at work too. It's notable that the entrepreneurs and buyout firms sniffing around have longer investment horizons. Indeed, most telecoms analysts are confident in the future pay-off judging by their high price targets for many of these stocks.

Take BT. Its enterprise value (including pension deficit) is roughly 40 billion pounds ($53 billion). Estimates for the value of Openreach vary from around 15 to 30 billion pounds. Say it's 20 billion pounds. That would imply the company's customer-facing businesses trade at around four times expected earnings before interest, tax, depreciation and amortization — a sharp discount to European peers, as analysts at Goldman Sachs Group Inc. have pointed out.

The default remedy for this problem is to sell a stake in one of the firm's undervalued businesses to specific investors who will pay up for it. Vodafone's initial public offering of its mobile masts business, Vantage Towers AG, did this in March. Still, the slimmed Vodafone just carries on being punished.

The parallel opportunity at BT would be a sale of a minority stake in Openreach to an infrastructure investor. That would be a tricky operation, as BT's pension trustees would want a payment into the plan to reduce its deficit. The price for a deal would have to be exceptionally strong and, as with Vodafone, there's no guarantee that investors would put a high value on what remained.

Such technicalities are one obstacle to private equity nabbing some of the most desirable telco network assets. Politics are another. But high stock-market valuations generally are not.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

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