Posted: 07/1998
Follow the Yellow Brick Road
Looking for a High-End Revenue Multiple?
Put on Your Ruby Slippers
By Casey Freymuth
Roll-up strategies among interexchange carriers are generally the same and sound like this:
- Carrier A wants to achieve a high-end revenue multiple by becoming a Tier Two carrier ($100 million in annual revenues).
- Carrier A plans to achieve this goal by acquiring smaller carriers.
- Carrier A acquires carriers B, C, D and so on until in reaches its revenue goal of $100 million.
The reality is this:
- Carrier A's strategy is conceptually achievable and has been implemented before (both successfully and unsuccessfully).
- There are risks associated with growth by acquisition, especially in billing areas. Carrier A needs a strong chief financial officer and a well-experienced mergers and acquisitions team.
- If Carrier A plans to acquire smaller players with stock, owners of the smaller carriers need to be convinced that Carrier A is strongly positioned to be rolled into a larger carrier.
Most certainly, attempting to achieve a higher multiple through acquisition-driven growth is a worthwhile cause for companies. Long distance multiples are down among smaller players and are showing no signs of rebounding (see Table 1). Thus, the only options for lower-tier domestic long distance service providers to significantly boost their values are expanded sales efforts, product diversification and acquisitions of other carriers. By most standards, the latter option is the simplest to employ. But, as was indicated earlier, there are risks associated with growth by acquisition. So, if a company is considering a roll-up strategy, or if it has an offer by a competitor that's employing one, should the company go for it? This question can't be answered in a 2,000-word article, but we can take a look at the basics of roll-up strategies to provide some background information on those that have worked and those that have not.
Historical Acquisition-based Growth in the Interexchange Marketplace
There have been numerous successful growth-by-acquisition strategies in the interexchange marketplace. WorldCom Inc. is the benchmark for such strategies, growing from $110 million in revenues for the year ended 1989, its first year as a public company, to a projected $32 billion by the end of 1998 (assuming the successful completion of the merger with MCI Communications Corp.). This strategy also has been the foundation for its remarkable success on Wall Street. Based on its projected $60 billion market cap for 1998, the overall historical value the company has delivered to shareholders is $1.88 in market value for every $1 of revenue growth since 1989, the overwhelming majority of which has been generated through acquisitions. And this statistic is heavily diluted by the acquisition of MCI revenues and market values. Looking at WorldCom's performance through 1997, the company's growth in market value was $4.44 for every dollar of revenue growth. This remarkable performance has been driven almost solely by acquisition-related growth.
WorldCom may be the benchmark, but the strategy of building value through acquisition is a commonly employed practice in the telecom industry. Among large carriers, mind-boggling market caps fuel large-scale consolidation.
Just as the WorldCom/MCI merger is propelled by WorldCom's $32 billion market cap (year-end 1997), $697 million Qwest rode its $4.4 billion market cap in its bid for $1.6 billion LCI (see Table 2).
You Don't Have to be WorldCom
Regardless of whether or not a company is a Tier I carrier, it needs to grow at 30 percent per year in order to attract attention and position itself as a desirable acquisition target. Thirty percent per year revenue growth is a relatively easy goal to achieve for Tier Four and Five providers, but it becomes a challenge to maintain that level of revenue growth in Tier Three. The primary reason for this is customer churn. Regardless of a company's rate of customer attrition, its customer base eventually will reach a point where the number of customers dropping out of its customer base are greater than the number of customers being added. We call this "treading water," and the problem is compounded by the sizable revenue jump from Tier Three ($15 million) to Tier Two ($100 million) that is necessary to achieve higher valuation multiples. At this point, a company's choices for growth are to diversify its product offering (and hope it can sell a lot of new product to its existing customer base); expand and intensify its sales efforts; or acquire the customers of other companies. (Exception: Companies with serious customer attrition problems, defined as greater than 10 percent per month, can achieve significant growth by focusing on customer retention. Companies with large-scale marketing efforts also can achieve significant growth by minor curbs in customer churn, but such companies likely would be in upper tiers. For the purposes of this discussion, we'll assume that neither is the case.) All three options are actively employed in the industry, sometimes in tandem.
Although there is much ado about bundling and diversification, and it is a necessary step for survival in this industry, making the leap from Tier Three provider to Tier Two provider through bundling and/or greater sales efforts is a tough row to hoe. (See inset: Hypothetical Growth Scenario). The good news about the acquisition strategy, which is the quickest means to the end, is that a company doesn't have to be WorldCom to do it successfully.
Network Long Distance, for example, had a longtime goal of achieving Tier Two status through acquisitions. In December of 1997, having realized its goal through a successful acquisition strategy, the company is now positioned to be acquired by IXC Communications Inc. for $135 million, or a revenue multiple of 12.47 times monthly. At the time Network began its acquisition strategy, it hoped to sell for 16 times to 18 times monthly revenues. Nonetheless, its efforts kept the company's values from deteriorating and ultimately provided the company with a solid return on investment. Based on the company's historic acquisition efforts, IXC's bid equates to a 24 percent premium over its historic acquisition costs (see Table 3). (Note: IXC/Network LD Merger was not completed as of this writing.)
Risks vs. Reward
The reward has been established. However, there are risks associated with acquisition-based growth strategies. Major risks include billing problems, shock attrition and diluted capital resources.
Billing: MIDCOM, for example, went into bankruptcy after billing problems related to its numerous acquisitions shattered the public's confidence in the company. Back in 1992, when WorldCom (then LDDS) recognized this area to be a field of landmines that needed to be expertly navigated, the company made the decision to outsource its billing functions to Electronic Data Systems (EDS). A company heavily engaged in acquisitions would do well to learn from these examples--especially if multiple products are involved, which is highly probable in the bundled services area. There is no room for ego in this area.
Every company with a proprietary billing/information system thinks its system is the best ever created. At the very least, an outside consulting firm specializing in information systems should evaluate the system for potential weaknesses before it is put to duties that will make or break a company.
Shock Attrition: When a customer base is acquired, the purchasing party will see a certain number of customers immediately drop away as a result of the transaction. The causes for this range from intensified customer scrutiny of the new provider to fall-outs with agents. Generally speaking, shock attrition ranges from 10 percent to 30 percent of the acquired base, but can spike to more than 50 percent. Buyers sometimes attempt to protect themselves from shock attrition by subjecting final compensation to certain post-transaction conditions that tie in retention and other key performance areas. Sellers, of course, are wary of having their compensation tied to conditions they cannot control. Usually, employment agreements and performance-based stock participation are employed to find the middle ground between the buyer and seller. Regardless, it is crucial that a buying party has a well-developed plan for retaining acquired customers in place when it assumes control of a new customer base. A few examples of such strategies follow:
- Make available add-on services. In addition to snaring customers with additional hooks, additional revenue can be gained. Ideally, a buyer could offset revenues it loses through shock attrition with additional revenues sold to the customers it keeps.
- Offer some form of monetary incentive right away. What better way to make customers feel good about a new provider than to have a rate reduction or free value-added service offering announced in conjunction with the new provider?
- Don't rock the boat if it's sailing smoothly. Companies that acquire bases with exceptional customer retention or are well-established (community involvement or longevity) have achieved success by maintaining the acquired party's identity and slowly migrating the two parties' identities together.
LCI employed this strategy with Corporate Telemanagement Group (CTG), which had customer churn levels of less than 2 percent, by keeping CTG as a wholly owned subsidiary.
Diluted Capital Resources
The risk of diluting capital resources through acquisitions is self-explanatory. Most companies that aggressively pursue acquisitions attempt to do so with the backing of the investment community, and most attempt to make stock-based acquisitions. It stands to reason that a strong financial officer is a must for companies pursuing acquisitions.
The challenge for buyers, especially if they're pursuing stock-based acquisitions, is to convince sellers that their company is the ticket to long-term value. Specifically, the buyer should be able to provide evidence as to how it is differentiating itself from other carriers and why such differentiation will make it a valuable entity. Size alone won't cut it. There needs to be some type of differentiation through location, network or customer type, or something unique (or at least unusual) that will make the company a viable entity. And, it is just as important that the buyer's team is capable of seeing the company's plan through to completion.
Hypothetical Growth Scenario
Tier Two is a Long Jump
Growth by bundling certainly is beneficial to customers and providers alike, but is not effective for large-scale growth. Let's look at a hypothetical scenario wherein a Tier Three carrier wrestles with growth:
XYZ Telecom is a $25 million interexchange carrier (IXC) that serves retail customers spending an average of $100 per month in long distance services. Based on its 3 percent monthly customer churn rate and its customer acquisition rate of 1,000 new accounts per month, XYZ will grow to $29.5 million in revenues.
XYZ management, recognizing that the company needs to reach $100 million in revenues in order to achieve a high-end revenue multiple, evaluates the company's options for growth. The following describes management's experiences:
Suppose XYZ deployed local, Internet and paging services to its customer base. Let's say the company was wildly successful in its efforts to deploy local services, converting 25 percent of its customer base to local resale at an average $35 per customer, per month. Additionally, the company converted 15 percent of its base to Internet access customers at $20 per month, and 10 percent of its customer base to paging services at $10 per month. This deployment boosts XYZ's revenues to $33.4 million, or about $112 per customer; a significant jump, but nowhere near the momentum necessary to carry the company to Tier Two status.
Now, let's assume the company did all the bundling we just described, plus increased its sales efforts by 50 percent. The company's revenues would then reach $40 million. Again, this is a substantial gain but leaves the company well short of creating a vehicle to drive it to $100 million.
Casey Freymuth is president of Group IV Inc., a Phoenix-based consulting and publishing firm to the telecommunications industry. He may be reached by e-mail at info@group-iv.com
