Follow the Yellow Brick Road
Looking for a High-End Revenue Multiple?
Put on Your Ruby Slippers
By Casey Freymuth
Illustration by Mike
Roll-up strategies among interexchange carriers are generally the same and sound like
The reality is this:
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:
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
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 email@example.com