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BT Global Services June 2003 Junkyard or jewel? [Ref: 2003-26]
Executive Summary
BT recently renamed the Ignite division, calling it Global Services (GS). The name change was necessary: Ignite had struggled to explain itself to customers, employees and analysts. At the recent 2003 results presentation, CEO Ben Verwaayen said confidently that Global Services, once BT's 'hidden jewel', should now be seen by analysts and markets as 'the jewel', pure and simple. Global Services is expected to provide the growth in revenue and earnings that will elude the more mature parts of BT's business. But Global Services remains complex and extremely hard to understand and value.
This is one of the longest reports we have ever published – largely because of the huge gaps in understanding of the division. It is divided into two main sections. Section 1, starting on page 6, covers Global Services' history. This section explains how the business acquired its current characteristics. In Section 2, starting on page 18, we move to discussing the prospects of each part of the division. Readers simply seeking our rationale for the financial forecasts summarised on page 46 can start here. But the early pages have substantial interest to those seeking to understand Global Services today.
The division is, in a sense, a living memorial to the various corporate strategies followed by BT in the 1990s. Sir Iain Vallance and Sir Peter Bonfield, the architects of BT's strategy during that roller coaster decade, may now be gone but the effects of their decisions will remain with BT for years to come. Global Services is now responsible for the various orphans and love children of BT's polygamous corporate relationships. Unsurprisingly, they are a mixed bunch. Some parts look to have real potential while others act as a drag on performance. They also compete in very different segments of the market for international services. Top- down appraisals of the division's prospects can obscure these differences. We think the careful examination in Section 2 of each Line of Business is a better way to build a robust view of whether Global Services is truly worth more than the sum of its parts.
At the headline level Global Services has just turned in very encouraging results. A year ago it was in disarray. Since then it has been turned around, reorganised and given a narrower but more realistic strategic focus, one better aligned to its strengths and asset base. Sales channels have been energised to deliver significant growth in Europe. Turnover in FY2003 was £5,251 million ($8,139 million; €7,255 million)1, up 17% from £4,472 million in 2002 ($6,395 million; €6,179 million). Operating EBITDA before leavers’ costs showed similar improvement, up 21% to £243 million ($377 million; €336 million). At the same time, tight control of capital expenditure (28% down on 2002) improved Operating Free Cash Flow (FCF) by £202 million ($313 million; €279 million). Operating FCF was still negative at £261 million ($465 million; €361 million) but this was 44% better than the previous year.
The trends, therefore, all seem to be heading in the right direction. Can this encouraging performance be sustained? Will BT shareholders – for the first time ever – enjoy steady and increasing returns from their international investments? We argue that such a happy outcome depends crucially on whether management, led by divisional CEO Andy Green, can accomplish two key goals: • First, capital expenditure has to be kept extremely tight – without compromising the division’s revenue growth, its strategic programs and routine operations. This is a difficult balancing act at the best of
1 Throughout this report GBP-USD conversions use the average annual FX rate from the BT Annual Report from the relevant year. All GBP-EURO conversions use a Bloomberg May 2003 rate of €1.38/pound.
1 BT Global Services June 2003
times. We expect the howls of pain from Global Services engineering teams to be audible from all points of the compass. But capex has to be kept low if the cash is to flow. In fact, Green and his team need to achieve levels of capex as a percent of revenues that would be unprecedented in BT’s history – sustained below 10% until the end of the decade. • Second, the management argue that the combination of their Solutions business with the service platforms managed by Global Products is unique and a real differentiator. This is plausible, but to make any sort of difference the revenue growth in Solutions needs to be converted into earnings yield in Global Products. To do this requires operating efficiency, an area where Global Services is presently weak. We expect this to get fixed.
In outline, Global Services has four main Lines of Business. These are a system integration shop (Syntegra), a telecommunications outsourcing business (Solutions), a corporate networks unit (Global Products), and an international wholesale voice and data business (Global Wholesale).
Syntegra (system integration)
Syntegra faces strong competition and is profitable but sub-scale relative to its peers. Its margins have averaged about 5%. It currently generates some 70% of its revenues from the UK. Growth in its main markets is still sluggish and there is little prospect of near-term improvement, so we expect steady but undramatic future growth at 5%, with margins remaining static.
Solutions (outsourcing)
This is a more interesting business and BT has shown that it is able to compete effectively by a series of recent contract wins. Solutions offer a tailor-made management and outsourcing service, usually for large corporations. Its revenue base is UK-centric, but the intent is to export its proven business model to Europe. This should succeed. However we expect margins to stay mid-range as the business is people- intensive and its contracts require BT to transfer assets, customers and risk from the client. BT’s annual reporting does not allow us to accurately judge historic margins, but we think that the business will be able to sustain growth rates of 7% in the UK and 42% elsewhere at an average margin of 9%.
Global Products (international corporate networks)
This part of Global Services builds and operates enterprise networks and runs the direct country operations. BT has trumpeted its healthy order book and recent success in turning the division EBITDA positive, but we think that the latter reflects careful husbandry, rather than an improved competitive position. The problem is that, on close examination, its ‘global’ offer is shown in fact to be a regional offer and a patchy one at that. The business is also having to invest in recreating a Single Operating Environment, something its competitors already have. Although BT insists it will now only ‘build to order’, it will still require sustained capital expenditure to address these weaknesses. Given the tight envelope for overall capex spend, this will force reductions in spend in other areas of the business. At the EBITDA level, Global Products is a ‘yield’ business. If and when its service platforms obtain sufficient scale then the healthy sales pipeline will translate into improved margins. Depending on the extent of pull-through from Solutions we expect margins to be raised from 3% to between 10-15% of sales.
Global Wholesale (interconnect)
This part of the division was a formidable cash generator until the late 1990s. Since then, its fortunes have been radically changed by the advent of huge amounts of surplus voice and data capacity. Both revenues and margins from the traditional business have been on a sharp downward trend and this looks set to continue. BT has developed new wholesale offers in segments such as mobile transit to offset this decline. But, in part because of the obscure way Global Wholesale’s results are reported, it is not clear whether this will be enough to turn the business around. We are dubious. Best case, we think the business could stabilise at useful revenues and EBITDA margins in the 20% range. Worst case, it could turn into a cash drain, in which case BT will have very few options left.
2 Enders Analysis June 2003 BT Global Services
Our financial forecasts for Global Services (on page 45) project steady overall growth rates at about 9% a year by 2008, as summarised in Table 1. By the end of the forecast period, Global Services raises its contribution from 28% to 37% of BT Group revenues.
Table 1 REVENUE AND EBITDA ACTUALS IN 2003 AND OUTLOOK IN 2008
(£m) 2003 actual 2008 end of period forecast Av change YOY Rev EBITDA Margin Rev EBITDA Margin Rev EBITDA Syntegra 623 34 5% 800 43 5% 5% 3% Solutions 2,042 172 8% 3,840 328 9% 12% 13% Global Products 1,883 -73 -4% 3,375 511 15% 12% 90% Global Wholesale 1,007 157 16% 820 169 21% -4% 19% Eliminations/other -304 -47 -705 -94 GS total 5,251 243 5% 8,130 957 12% 9% 10%
[Source: BT; Enders Analysis]
On the face of it, this outlook looks healthy. But, as Sir Christopher Bland continues to point out, cash is king, and the international business requires significant capital. How strongly do these revenues and earnings translate into cash? We discussed various scenarios for Operating FCF with Andy Green. With a cheerful smile and a glint in his eye, he assured us that ongoing capital expenditure would be subordinated to the need to generate positive FCF. This year’s performance adds credibility to such statements, even if history suggests it will be difficult. After all, if the divisional CEO cannot enforce financial discipline, who can? If we accept this intention as achievable, our model produces this ‘best view’ of FCF.
Table 2 EBITDA, CAPITAL EXPENDITURE AND OPERATING FREE CASH FLOW, 2002-2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 GS revenue 4,473 5,251 5,916 6,355 6,955 7,555 8,130 'Best view' forecast EBITDA pre-leavers 25 243 380 520 651 794 957 as pct rev 1% 5% 6% 8% 9% 11% 12% Capex 609 439 390 455 585 645 690 as pct rev 14% 8% 7% 7% 8% 9% 8% Op FCF -584 -196 -10 65 66 149 267
[Source: BT; Enders Analysis]
On June 16th Andy Green predicted that BT Global Services would become cash flow positive during FY2004. Our model has the division marginally negative at £10 million ($16 million; €14 million). This is only a fifth of one percent of net turnover – which is ‘in the noise’ for a business of this size. Aggressive collection of receivables would be enough to close the gap between our model and Green’s target.
Yet as our detailed discussion shows, there are good reasons to be cautious. The market for international services is much riskier than BT’s domestic business. In the past BT’s execution has been consistently inconsistent. If capital expenditure on routine network maintenance is not cut, but held at this year’s levels, it pushes positive FCF back to 2007. And, if at the same time margins in Global Products fail to benefit from pull-through, then the division never goes cash positive. It is easy to envisage circumstances which might produce such a negative outcome.
Global Services is indeed the crucial part of BT to understand. Most forecasts see the rest of BT as struggling to grow its revenue. The remainder of BT is clearly a utility with a large pension fund attached. Global Services is the only portion of the company that can offer substantial prospects for growth. In this report, we attempt to provide a realistic appraisal of the division’s prospects.
Enders Analysis 3 BT Global Services June 2003
CONTENTS
Executive Summary 1
How did Global Services get where it is today? 5 • An expensive decade 5 • BT – the rock and roll years 7 • The platform 14 • Maintaining forward momentum 17
The Lines of Business 17 • Syntegra (systems integration) 19 • Solutions (outsourcing) 23 • Global Products 27 • Global Wholesale 36
Capital Expenditure 43
Summary Financials 45
Appendix I: Forecast Methodology and Assumptions 52
4 Enders Analysis June 2003 BT Global Services How did Global Services get where it is today?
An expensive decade
We think it is helpful to begin any assessment of Global Services’ prospects with an overview of the recent past. The division’s customer and asset base are the legacy both of BT’s history as a domestic monopolist and of the attempt to break out of the UK market during the 1990s. We’ll argue that this legacy is a decidedly mixed blessing. The operational challenges facing several of the Lines of Business will act as a drag on overall growth, especially Syntegra and Global Wholesale. There is also a crucial balance to be struck between restraining overall capital expenditure and holding down headcount and SG&A without compromising sales growth. Analysts looking at the division often miss these issues, mesmerised as they are by the complexity and opaqueness of the division.
One theme remains constant throughout the past decade: BT remains trapped in the golden cage of its incumbent inheritance. In FY2002, 92% of its turnover and 94% of its operating profit were generated by customers in the UK. The years of international venturing have produced little in the way of return. By contrast, BT’s public stance is that international expansion will enable the company to escape the stagnant UK domestic market.
Little changes. Readers old enough to remember the rotary dial on the home telephone will know that BT was in exactly the same position in 1992. As the company’s management looked for new sources of growth and earnings, the international market seemed a mouth-watering prospect. The business trading voice minutes between incumbent operators had always been profitable. Demand continued to rise despite high prices: every time a new transatlantic cable was laid it reached maximum capacity far earlier than forecast. Businesses were trading more and more across borders. Companies like IBM and EDS had shown how IT companies could trade and prosper on the same global basis as Shell or Boeing. Closed markets were being prised open. The deregulation, which had begun in the US in the 1980s under Judge Harold Greene, was coming to Europe in the shape of Single Market legislation. BT, as a recently privatised PTT, knew full well how bureaucratic and inefficient its counterparts were likely to be. An agile, focused market entrant could compete and win.
At the same time there was capital available from BT’s own resources. The huge programme to digitalise the UK transmission and exchange network was well on its way to completion. By 1994, three quarters of the exchanges had been upgraded to digital and the old Strowger electro-mechanical switches had almost completely gone. The financing requirements in the five years it would take to complete the modernisation were declining and predictable. So cash was in hand. But the profit stream from the domestic monopoly was certain to erode as domestic competition increased. The strategy was simple: invest that cash internationally to create an entirely new line of business. It was an unprecedented opportunity. What’s more, BT could enjoy first-mover advantage.
We can see with hindsight that, although the forecasts for international growth in telecommunications were indeed correct, all the growth was in volume and turnover, not in earnings. The traditional correspondent business between PTTs remained a lucrative cartel but every single one of the operators who entered the market for transborder services has lost money on its investment. Only one (Infonet) has come close to making a sustained positive contribution to EPS, albeit a small one. Every other business is still running its international businesses at a loss, despite having invested hundreds of millions of dollars. The sector’s total capital expenditure on international expansion runs into billions of dollars. But shareholders have not earned a single cent.
On top of all this, investors in the telecommunications sector have lived through the inflation and bursting of the market bubble. Many of the investment decisions that have shaped Global Services were taken amidst that frenzy. These in turn contributed heavily to the over-gearing that provoked a financial crisis for the BT Group in 2001. Financial gearing, which between 1992-1999 had averaged 14%, hit a peak of 192%. This led
Enders Analysis 5 BT Global Services June 2003 directly to the replacement of the group’s senior management. The new Chairman, Sir Christopher Bland, first outlined his ten-point ‘fix it’ list, and then implemented it.
My checklist
Demerge wireless business Appoint new Chief Executive Rights issue Reshape Group board Sell Yell Property sale & leaseback deal Sell Japanese stake Unwind Concert Sell Spanish stake Agreement to sell Cegetel stake
Q2 results 2002/03
It is noticeable that half of these actions involved the group’s non-UK businesses. The list refers to BT’s fixed line and wireless interests in Germany, the Netherlands, the Republic of Ireland, France, Spain and Japan as well as its Cellnet business in the UK. A significant proportion of the Group’s debt had been incurred acquiring the fixed line interests; it wasn’t just the 3G wireless licenses that absorbed the group’s cash. Furthermore, Concert, BT’s international joint venture with AT&T, had gone from breakeven to an operating loss of £342 million ($503 million; €473 million) in just one year. In short, the international strategy was a large part of BT’s problem and now needed to be part of the solution.
Even when the unwinding of Concert and the sale of assets had been decided upon, the balance sheet still required surgery. A series of exceptional charges reveals how much damage had been inflicted on shareholders by the Group’s international strategy. To give only two examples: the unwinding of Concert incurred exceptional costs in FY2002 of £172 million ($246 million; €238 million), all but wiping out Global Services’ trading EBITDA that year of £201 million ($287 million; €278 million). Meanwhile, the write down (impairment) of goodwill and tangible assets in Europe and Asia resulted in charges of £3,243 million ($4,767 million; €4,481 million) in 2001 and a further £2,202 million ($3,149 million; €3,042 million) in 2002 – a grand total of £5,445 million ($7,786 million; €7,523 million).
Given this history (not to mention negative market sentiment towards the whole telecommunications sector2), shareholders may be forgiven if they now regard Global Services with some suspicion. The capital losses of the past are sunk costs. But why should the BT Group throw good money after bad? Are operators in this segment of the market ever going to turn a profit? What is the justification for trying again? Can BT, still burdened by its culture and by its pleasant bureaucratic values, ever succeed in markets populated by the likes of IBM and buccaneering bandwidth traders?
Andy Green, the CEO of Global Services, was formerly BT’s Group Director of Strategy and Development. In private he must know that the division’s competitive position is not particularly strong. And even though the trends are now heading in the right direction, it will take consistent execution over several years for
2 It is worth emphasising that other operators made very similar decisions to overpay for assets. For example, in 1999 AT&T bought IBM’s Global Network business for $4,991 million cash (£3,025 million; €4,822 million), a multiple whose carrying-value is likely since to have been significantly impaired. Similarly France Télécom’s purchases in 2000-2001 of Orange and Equant raised their gearing to higher levels than BT’s. In this land of the blind no one had one eye.
6 Enders Analysis June 2003 BT Global Services
Global Services to generate meaningful cash flows for the BT Group. But history shows that these are disruptive markets: despite best-laid plans it has always been ‘jam tomorrow, never jam today’ for BT’s shareholders. So there is plenty of downside risk. If – for whatever reason – the business underperforms, then it will revive the simple cash-based argument that BT should get out of this market once and for all.
But Green also knows BT’s position in its home market. Without an international capability, BT would be less differentiated relative to local alternative providers such as Colt, Kingston and Energis. And competitors like AT&T would be able to attract the international business of UK-based multinationals and use this toehold to expand into domestic business. The strategic logic is uncomfortable. BT has to stay in the Global Services business to keep its firm grip on the high-end business market in the UK– whatever the implications for cash flow.
The stakes are therefore high. However straightforward the strategic logic, if investors don’t like the outlook they will vote with their feet and the Group’s Total Shareholder Return will continue to underperform the FTSE-100, as it has done since 2000-2001. What are the prospects that Green and his team will deliver? Here some history will help the assessment. (This section can be skipped by the reader anxious to get to our future-oriented analysis, but the Line of Business analysis from page 17 onwards will use it to highlight the key strengths and weaknesses of Global Services’ platform.)
BT’s international capabilities go back a long way. The first international telegraphy cable was laid between Britain and France in 1850: the first transatlantic cable in 1858. BT’s headquarters remain on the site of the old Central Telegraph Office, from where the first international telephone service was operated between London and Paris in 1891. As Queen Victoria’s Empire reached its zenith, the British Parliament legislated to give the Post Office a monopoly over domestic and international telegraphy.
A century later BT inherited that monopoly and, as a PTT, its services have always included international voice, telex and private circuit traffic originating and terminating in the UK. These services were (and still are) delivered through bilateral commercial agreements with other PTTs. Historically BT has also been a major investor in the underlying infrastructure required to support such services, such as satellite consortia like Inmarsat and Eutelsat, its satellite earth stations (including Goonhilly in Cornwall, the world’s largest), and transatlantic cable systems. Until 2000 these services were managed as part of the UK business, but in that year were contributed to the Concert joint venture with AT&T. When Concert was dissolved, Global Services inherited this line of business (see below for the discussion of Global Wholesale).
BT – the rock and roll years
BT’s first large-scale investments in non-correspondent international business services began in 1989 when it acquired the Tymnet data network from McDonnell Douglas for $355 million. Rebranded Global Network Services (GNS), Tymnet became the nucleus of the company’s sales and service capabilities in the US and the vehicle for international expansion. GNS was rolled out in Europe and Asia in the early 1990s as a way of entering otherwise protected markets. (Data network services were regarded as value-added services and hence fell outside the legal monopoly on basic services maintained by most PTTs.) BT was thus able to establish a small sales and service presence in 23 of the world’s major economies.
Shortly afterwards BT began to overlay its Tymnet/X.25 data network with new high-speed Frame Relay routers, using equipment manufactured by Stratacom. In 1996 Stratacom was bought for the equivalent of $4 billion in stock by another fast-growing company called Cisco. This was the start of BT’s important relationship with Cisco as both vendor and customer.
In 1991 BT established a new subsidiary company called Syncordia in Atlanta, Georgia, which was intended to become the vehicle for outsourcing and managing the communications networks of the world’s largest companies. Syncordia aimed to replicate the success of companies like EDS in outsourcing corporate computing facilities. By April 1993 the new company had won over $200 million of business. Yet it was a commercial failure for reasons that provided a pointer to future problems. The PTTs still controlled the
Enders Analysis 7 BT Global Services June 2003 prices for the transborder circuits required to construct and operate such networks. Competitive wholesale markets for infrastructure did not yet exist. So, with the exception of routes to and from the UK, Syncordia was buying circuits on the same commercial basis as the customers whose networks it was trying to outsource. At the same time, Syncordia tried to offer a customised, managed, end-to-end, ‘best-in-class’ service at prices which would reduce the customer’s overall costs. This combination of a ‘buy retail, sell retail’ commercial model, a Rolls Royce service offered at Chevrolet prices and the lack of domestic capability in major markets was fatal to the business plan.
Nonetheless, BT learned important lessons. Tymnet was first and foremost a technology acquisition that was then bootstrapped into a global capability. Syncordia was its first major essay in designing services from scratch to meet the needs of multi-site, multi-country corporate customers. Global Services still maintains its focus on this segment, albeit now pared back to BT’s European heartlands. Global Services also retains the original Syncordia headquarters in Atlanta as one of its principal Network Management Centres (NMCs). And Syncordia’s contracts and its emphasis on customised managed services have been metamorphosed (via several reorganisations) into today’s Solutions line of business – Global Services’ Great White Hope.
The international strategy shifted up a gear in 1993 with the formation of a joint venture with MCI in the US. BT had concluded that any service offering for major corporates required a full portfolio of services – voice as well as data – and a major capability in the US, home to 40% of the world’s largest companies. But its ownership of a 20% stake in McCaw Cellular had shown that, as a foreign operator, BT was unlikely to be able to take control of a common carrier (BT divested its stake in 1995). An alliance with AT&T was impossible on regulatory grounds, as it and BT were both classed as dominant operators. But feisty, growth- oriented MCI, the market entrant par excellence, was an ideal partner. BT invested directly in MCI, acquiring 20% of the common stock. The two partners formed a new service company (‘Newco’) with BT holding 75% and MCI the remainder. Newco was to be a wholesaler. It would develop, build and operate networks and services and sell these on an arms-length, transfer price basis to its two distributors – its parents. The distribution agreements divided up the world, with MCI providing sales and service on an exclusive basis throughout the Americas, and BT in the Rest of World (i.e. the UK, Europe and Asia). As part of this agreement, BT sold its domestic North American sales and service infrastructure to MCI (this was largely the Tymnet US business acquired four years earlier). Consistent with this wholesale/retail approach, BT also transferred Syncordia’s global network and operations infrastructure into the venture, while retaining its retail contracts. The GNS international assets were also contributed. Finally, BT provided the new company’s name. As part of an earlier, failed attempt to develop an all-singing, all-dancing network management system, it had registered ‘Concert’ as a worldwide brand. With a wave of the marketing wand, Concert became the title for the venture.
BT and MCI had thus assembled in Concert a global product shop that could offer data and voice services in the majority of the world’s major markets (although it did not obtain a Type 1 license in Japan for some years). The commercial model for Concert was, however, still a halfway house. Concert services were sold on a wholesale basis to its two distributors, who contracted with the customers and set end-user prices. But Concert’s costs, like Syncordia’s, were still largely based on retail prices for infrastructure. This was to cause big problems. In essence there was not enough margin to go around. Either Concert could make an adequate profit or its distributors could, but not both. This was tolerable as long as BT and MCI controlled all the sales channels, because, as parents, they could recognise the profit margins wherever they preferred. But when, as soon happened, third parties acquired distribution rights to Concert services, the model broke down. BT and MCI then wanted to take their margin in Concert: the third parties then complained their retail margins were too thin to be interesting, and sales penetration and growth in major markets like France, Germany and Italy became anaemic. To the dismay of account and bid managers, it also led to slow, complex, bureaucratic costing, pricing, transfer and billing processes. It proved very difficult to replicate MCI’s American success in other markets. In sales terms, the UK and the US remained the engines of growth.
8 Enders Analysis June 2003 BT Global Services
The Concert joint venture received a warm welcome from customers and secured a market-leading position. In the second half of the 1990s, Concert had some 30% market share in global managed data services (as measured by both revenue and network metrics such as number of port connections and total bandwidth), and routinely won industry awards for its product innovations. By November 1998 Concert had more than 4,400 customers in 52 countries. Around 40% of Fortune Global 500 companies used Concert services, accounting for nearly $2.75 billion in committed contract revenue. The rapid success of the venture convinced BT that such partnerships were the right way to expand outside the UK, especially in Europe. In a series of deals BT parlayed many of its local in-country subsidiaries into new joint ventures. This now turns out to have been a major mistake.
The internal logic at the time went roughly like this: (a) MCI shows that market upstarts can succeed against incumbents; (b) Syncordia shows that BT needs domestic as well as international reach; (c) financially strong though BT is, BT cannot afford to fund the build-out of full-scale domestic networks; (d) so if BT worked with the right local partners (banks, utilities, railways), BT could share the capital costs while also benefiting from their political connections and existing infrastructures. These arguments were persuasive. Between 1994 and 1998, BT established European joint ventures (‘EJVs’) in Spain, Germany, France, Italy, the Netherlands, Sweden, Finland and Switzerland. In most other European countries, BT established sub- distribution agreements for Concert services with local providers. Belgium and Luxembourg were the only European countries where BT retained a direct, local sales channel. The ownership structures for these ventures varied from country to country, but BT almost always took a minority stake. The EJVs were to combine the roles of sales, support – and, a new twist – supply. They would continue to sell Concert’s international services to their domestic customers, and provide local support for ‘drop-ins’– companies who had contracted elsewhere but had sites in the country. And, as their networks rolled out, the EJVs would be an alternative to the local PTT for supply of infrastructure.
In Asian markets the model differed again. The general lack of deregulation meant that BT always had to work with and through incumbents. BT focused on ensuring it could support its global customers throughout the region. In those markets where it could obtain licenses to sell services, such as Australia and Hong Kong, it did so. It also took a stake in JT-NIS, an alternative carrier in Japan. By the late 1990s, more than 30% of Concert’s network infrastructure was to be found in the Asia Pacific region, but less than 10% of contracts by value were signed in the region. The region remained primarily important for its drop-in business.
By 1997, BT was riding high. But the strategy was becoming harder to execute in a coherent way. By ceding majority control of the EJVs to its partners while granting exclusive distribution rights to those ventures, BT unfortunately surrendered all influence over its sales channels. But it still provided 75% of Concert’s capital funding and operating budgets. If the EJVs missed their revenue targets, the bulk of the cost of underperformance flowed through to BT. But the EJVs had little downside risk, providing they sold contracts at a reasonable end-user price, they could be sure of their margin. No sales, no margin, but no operating loss either.
Meanwhile, the EJVs had been established to penetrate domestic markets. Their priorities were local. If they needed transborder services at all, they wanted cheap, no-frills services that could compete with the PTT’s equivalent – basic international voice and private circuits. These were not the managed services offered by Concert. They also concentrated their resources on those segments and services which would give them an edge over the local incumbent. These included consumer and SME segments, and service bundles which combined fixed line and mobile telephony. Most of the EJVs also rebranded themselves. As an investor, BT had to finance its share of the cost of the domestic rollout plans. But BT saw its own presence diluted and its focus on international corporates blurred. The EJVs began to miss their targets for Concert revenues, but there was little BT could do. Moreover the EJVs were making far more money from supplying infrastructure and support to Concert than they were from selling Concert’s services. So there was little incentive for the EJVs to surrender margin on supply in favour of margin on sales. This made it harder than ever for Concert to achieve its desired position as Least Cost Provider. BT was again compromised: it wanted both Concert and the EJVs to break into profit. Reductions in supply prices would rob Peter to pay
Enders Analysis 9 BT Global Services June 2003
Paul. Despite much hand-wringing, prices remained high. Sales channels protested they were becoming uncompetitive.
Finally the complexity and variety of BT’s interests in the different markets and ventures also began to take its toll. Management was overstretched and found it very difficult to determine which urgent issue should be granted priority. BT began to get bogged down.
Meanwhile, BT’s competitors were proving disruptive. A company called MFS acquired a company called UUNet in August 1996. That December, MFS was itself acquired by Worldcom. In this way, the bulk of the world’s Internet traffic began to be carried by the most aggressive of the new generation of telecoms carriers. In November 1996 BT announced its intention to acquire the whole of MCI. BT and MCI began the lengthy process of gaining regulatory approval for their merger from the FCC, Department of Justice and European Commission. This was granted, but on 1st October 1997 the upstart Worldcom made a higher offer for the whole of MCI. BT agreed to sell its 20% stake to Worldcom, after much agonising, for $51/share or $7 billion. Following the completion of the Worldcom and MCI merger agreement in September 1998, BT acquired from MCI its 24.9% interest in Concert for £607 million ($1,002 million; €839 million).
The exceptional profit BT declared on the deal was scant comfort for the disruption caused to BT’s strategy. Its partner, its principal US infrastructure supplier, and the main source of its non-UK sales growth, had been acquired by one of the most aggressive operators in the world. BT also fell behind in the Internet market. Worldcom-owned UUNet was by now the largest Tier 1 Internet carrier in the world. The company reported that its Internet revenues had jumped from $566 million (£348 million; €402 million) in 1997 to $2,165 million (£1,312 million; €1,567 million) in 1998. BT not only missed out on this quintessential transborder opportunity but its UK retail Internet operation fell behind as well. BT’s Openworld business is the only PTT-controlled ISP in Europe that does not hold the top slot in its home market.
Other trends were equally disturbing. Other European competitors in the enterprise networks segment, such as Equant, were successful by retaining tight control over direct sales channels. Equant’s average annual revenue growth rate during 1997-2002 was 41%, significantly higher than Concert’s flagging growth. Other competitors, such as Colt, were building wholly owned pan-European fibre networks linked to Metropolitan Area Network rings to which customers could be directly connected. Such networks transformed their cost base and the speed with which additional capacity could be provisioned to an existing customer. BT depended upon its complex arrangements with local suppliers to provision access circuits at retail price, which was both slow and expensive. Typical provisioning times were between 90 and 120 days. But a Colt customer already connected could upgrade capacity within 24 hours. The ‘buy retail, sell retail’ model, already struggling, looked doomed. To cap it all, BT’s EJV partners began to get cold feet. Owning and running alternative networks began to look expensive and made for hard work. The luscious profit streams BT had expected receded into the future as market entrants proliferated and prices fell sharply.
There was a silver lining to the cloud. Concert was now wholly owned, which provided a clear line of command. MCI’s consent was no longer required for major decisions. But Concert still depended on MCI Worldcom for the supply of infrastructure in the US and also several key systems – in particular, the intelligent systems used for the managed voice services and the Tymnet data networks. The Worldcom bid had taught BT that Bernie Ebbers (Worldcom’s Chairman and CEO, now disgraced) took no prisoners. It was risky to be dependent upon a piranha (as Worldcome’s shareholders were later to realise). This explains why BT spent some £150 million ($245 million; €207 million) during 1998-2000 building a new American backbone network and replicating key systems. Despite the turmoil, Concert continued to make progress towards breakeven3, a milestone it achieved in 1999.
3 ‘Breakeven’ means different things depending on which measure you select. BT currently tracks EBITDA, EBIT and Operating Free Cash Flow (FCF).
10 Enders Analysis June 2003 BT Global Services
At the same time the trend towards ‘facilities-based competition’ (i.e. owning your own Pan-European core network) could not be ignored. In 1998, BT leveraged its equity relationships with the EJVs to construct a consortium network called Farland (perhaps because it linked together distant countries?). Incorporated in the Netherlands, Farland BV constructed a 9,000km transborder fibre network which linked BT’s wholly- owned operations in the UK and Belgium with its partners in Germany, France, Italy, Switzerland and the Netherlands. When connected into the 36,000km of domestic fibre networks controlled by BT and its partners it became the largest network of its kind in Europe. Farland was a coherent response to several key concerns already highlighted. The 45,000km network (later extended by another 9,000km4) would deliver unparalleled, high-capacity reach (sometimes called ‘density’ or ‘capillarity’) in-country as well as transborder. As a transport network it would allow EJVs to construct basic services such as International Private Leased Circuits (IPLCs) to compete with their local incumbents. Concert (which immediately became the biggest user of the new network) would get access to infrastructure at a proper wholesale rate, thus easing its ‘buy retail’ cost problems. In sales terms, the combination of better prices and better reach would be a strong competitive response to Colt, Worldcom5 and the rest. This all made a lot of sense and still does. Farland is now at the heart of Global Services’ reshaped business strategy. Whether it has proved financially self-supporting is less clear.
By early 1999 BT was also formulating its response to the loss of MCI as its partner by choosing AT&T as its new ally. AT&T was then a participant in another consortium for transborder services, AT&T-Unisource Carrier Services (AUCS), but had experienced many of the same operational frustrations inherent in consortia as BT. The company was also bidding to buy IBM’s Global Network unit (the IGN). Its bid was successful and after completion the unit was renamed AT&T Global Network Services (AGNS). AT&T was thus assembling assets with a view to establishing itself as the pre-eminent global service provider for enterprises. For this reason, it was very interested in Concert. AT&T had often been bested by MCI when the latter had sold Concert’s services. For its part, BT had two priorities. First, to rebuild its US sales and infrastructure capability. Second, to fix the weaknesses in its global business model. Both companies also recognised the potential of their position in the market for basic services across the Atlantic. They owned large amounts of subsea cable capacity and were exchanging huge volumes of international call minutes. The existence of rival operators such as Worldcom and new infrastructure providers like Global Crossing would have demonstrated to regulators that these types of business were provided in a competitive market. If the regulators would allow it, the combination of their international correspondent business could reap huge economies of scale. These considerations shaped the structure and assets of the new venture.
BT and AT&T decided to keep the Concert name after some market research. But everything else looked very different. The venture was to be owned 50/50, giving each party an equal stake in its success (and equally, providing an exquisite deadlock should disagreement arise). Each would have three seats on the Executive Board and the Chairmanship would alternate between BT and AT&T. As dowry, BT contributed its existing transborder operations (now referred to as ‘Concert Classic’), but not Farland and not its stakes in the EJVs. AT&T pulled out of AUCS but kept AGNS separate. Both parties contributed the entirety of their international infrastructure assets (e.g. their stakes in cable systems, and their lease obligations on other transport services), and the revenue and settlements for all their international switched voice traffic and IPLCs. This was a huge traffic stream – together BT and AT&T handled some 15 billion minutes of voice traffic. The two parents also drew up a list of some 300 Global Accounts that were to be managed directly by a Concert sales force. These accounts were the ‘highest of the high end’ – the biggest global corporations, in sectors with the greatest concentration of transborder activity. The perfect example was Hong Kong & Shanghai Banking Corporation (HSBC), with substantial international and domestic businesses in the US, UK and throughout Asia. Crucially these sales teams would also account for the revenues from their customers’ domestic services in the US and UK. This, it was believed, was a winning formula. The new Concert would: (a) have a best-in-class wholesale asset base; (b) huge volumes to drive down unit costs and give its business managers negotiating power when doing interconnect deals; (c) a direct sales force for its
4 Judging by the fact that the BT 2002 Annual Report states its length to be 56,000km. 5 Worldcom was still distributing Concert services but had announced its intention to migrate as many customers as possible to its own end-end services. Psychologically they were now seen by BT as the enemy.
Enders Analysis 11 BT Global Services June 2003 key accounts on top of its indirect distribution channels; and (d) a turnover of more than $7 billion. In short, the Concert Global Venture (GV) would be the Big Gorilla of international telecommunications.
Even at the time, the Concert GV seemed staggeringly ambitious. Previously discrete lines of business – domestic, correspondent, transborder, wholesale, carrier, retail – were being melded into a single entity. Each had their own sales channels, competitive pressures, revenues, costs and margins, each based on different systems, processes and technologies. It was a management and accounting ‘challenge’. In the heady flush of their new relationship, BT and AT&T rapidly compounded this complexity. Their wedding present to each other was a commitment to construct the ‘world’s largest IP network’. Cisco’s sales teams easily made their targets that year as Concert deployed multiple Cisco 12000 Series gigabit routers. At root, this was an attempt to change perceptions and reclaim leadership of the Internet/IP services market from Worldcom and UUNet. The infrastructure build was authorised without much thought being given to whether current volumes justified the expenditure6. As such, the launch announcement may well qualify as the most expensive corporate press release in history.
It is no consolation to BT and AT&T shareholders that other operators like Global Crossing were peddling exactly the same ‘Build It And They Will Come’ logic. The basic insight that exponential growth in volumes (true enough for IP traffic, though not for voice) did not mean an equivalent growth in revenue – let alone profit – seemed to have escaped Michael C. Armstrong and Sir Iain Vallance. The early phases of the partnership turned into a money-is-no-object exercise in catching up with the upstart newcomers. BT joined AT&T as an investor in Rogers Cantel in Canada; AT&T joined BT as an investor in Japan Telecom; and both parties authorised Concert to acquire extra Indefeasible Rights of Use (IRUs) – long-term leases on circuit capacity. Finally BT and AT&T announced their intention to become world leaders in Managed Hosting. This entry into the computing-based, application services market went well beyond both partners’ traditional areas of competence in voice and data. But the world had come to believe in the imminent convergence of telecommunications and computing and BT’s strategy was unchallenged by commentators and analysts.
It is important to stress that the Concert GV, which came into existence on 1st January 2000, was not the sole vehicle for its parents’ global strategies. AT&T kept its AGNS business separate. It had its own customer base, market strategies, investment program and product set. But, in a gesture of solidarity, Concert was appointed a reseller of certain AGNS services. In the same way, BT consolidated Farland, its EJV stakes and sundry other investments into a separate business unit then called Ignite. The EJVs were also diverging, as each pursed their local domestic strategies, developing different channels to market, infrastructure, systems and processes that suited their local situations. Such independence was understandable but had many unintended consequences. Essentially similar issues were being solved over and over again in slightly different ways. There were few synergies across the EJV portfolio, and even if there were, local pride could frustrate their exploitation.
For example, choices about CRM, HR or Finance systems made by the Dutch EJV took no account of what was happening across the border in Belgium. The same thing happened with network decisions. Cegetel Entreprises in France decided to build its Frame Relay network using Cascade equipment, not Cisco (Concert’s vendor). Meanwhile the Dutch built their domestic Frame network using Alcatel equipment. This meant that domestic-transborder services from France to Holland via Concert could not be managed end- to-end. To solve this required the development of network-to-network interfaces (NNIs) and application program interfaces (APIs) for the associated management systems. This was complex, expensive and time- consuming and delivered no discernible market advantage. As such it was a poor use of capital – a duct-tape fix to a basic procurement mistake.
Whatever might be said in public, there was no disguising the fact that both Ignite and AGNS were parallel organisations that in many respects competed with Concert. It is not hard to understand why neither parent company wished to put all their eggs in one basket. AT&T had just spent $5 billion acquiring AGNS
6 The intention was eventually to carry all the international voice traffic over IP, but it was absolutely obvious at the time that this platform shift away from circuit switched technology was still years away.
12 Enders Analysis June 2003 BT Global Services and was not minded to give BT any rights to its acquisition. In any case, why would BT agree to pay AT&T its asking price for such rights? It had spent seven years investing in Concert Classic and did not need a lookalike. On top of these tensions, there were personality issues at senior management level. AT&T’s Business Solutions chief, Rick Roscitt, appeared to have a visceral distrust of the British and saw Concert as a threat to his organisation. Similarly BT’s head of International, Alfred Mockett, who held responsibility within BT for both Concert and Ignite, had a well-groomed style of management that did little to suppress rivalries between his various teams. Both men were soon to leave their organisations (on generous terms), but by then much damage had been done. During 2000 and 2001, the relationship between AT&T and BT began inexorably to deteriorate.
This was not BT’s only problem. In the UK and Europe it faced twin demands for cash. The first came via its multi-domestic strategy, which included a commitment to mobile services. Fixed-line and wireless services were converging, especially in the consumer and SME segments. But the UK Government’s auction of 3G licenses in May 2000 had delivered an extraordinary result: BT’s Cellnet paid £4.03 billion ($6.5 billion; €5.6 billion) for License C. The effect was to raise dramatically the expected cost for licenses in every European country where they were due to be sold. BT was slated to be a participant in bidding in France, Spain, Germany, Ireland, Italy and the Netherlands. The cumulative outlay was going to be huge. Nonetheless, having had to play catch-up on Farland and the Internet, BT was in no mood to lose out again. BT committed its share of the monies and its ventures secured 3G licenses everywhere except Italy, where the mobile consortium Blu imploded in a spectacular public display of Anglo-Italian manoeuvring and acrimony.
BT, more or less simultaneously, was in negotiations with some of its EJV partners to buy out their stakes in the ventures. The company had reflected upon the merits of direct control and had decided to bite the bullet. It paid cash at the top of the market to buy out its partners in Germany, the Netherlands, Ireland, Sweden and Finland. It had already taken full control in Spain in 1998. As an offset BT sold its interests in Switzerland. This left France and Italy as its remaining EJVs. Even so, the dizzying rate of change and its huge financial commitments did not prevent its continued expansion in other areas. In 2000 BT paid £213 million ($343 million; €294 million) to acquire Control Data Corporation, a US-based systems integration and electronic commerce business. It then merged this business into Syntegra. We will show later that even this relatively successful business will never give BT shareholders an adequate return.
As the world now knows, less than 12 months after the launch of the Concert GV with AT&T, the stock market, several major players in the telecoms sector and BT’s global strategy all collapsed. What went wrong? AT&T’s Rick Roscitt, by now CEO of ADC Telecommunications, gave an interview in 2001 which summed it up. “Everybody was either fat, dumb and happy, or [the slowdown] happened more quickly than anyone anticipated. It hit everyone like a ton of bricks. I think it's unprecedented in the history of the industry. What do you do? You can moan and groan a lot or you can take action.”
In public, BT blamed Concert’s failure entirely on ‘market changes’. This was economical with the truth. The market certainly did change. But BT and AT&T had also let their ambitions and arrogance get the better of them. The Concert GV was unwieldy and cost-heavy. Its business mission was confused. The two shareholders were all too often unable to reconcile their different interests and were also maintaining their ‘insurance policies’ – Ignite and AGNS. The management politics quickly became poisonous. When Concert collapsed no one in the industry was very surprised.
“You can moan and groan a lot or you can take action.” Action was called for, and Sir Christopher Bland arrived to deliver it, together with Philip Hampton as his new CFO. Checklist in hand, the new Chairman pushed though his priorities: a new Board and CEO, the sale of some prime but ‘non-core’ and minority assets and two intricate untanglings. First, BT Wireless was carved out both from the UK business and those European operations where BT had majority control. The demerger gave BT shareholders new shares in a standalone, ‘pure play’ wireless operator branded mmO2. Second, the Concert GV was unwound and a large part of its assets reabsorbed into BT. Both of these restructurings had a significant impact on the future shape of Global Services.
Enders Analysis 13 BT Global Services June 2003
Some aspects of the unwinding of Concert were painful but straightforward. A big layoff program was announced and the survivors went back to BT and AT&T largely on the basis of who they had worked for previously. Likewise it was not difficult to determine the provenance of many of the network and service assets, especially the correspondent services. All such assets returned to their previous owners. Other purely financial joint investments, such as Rogers Cantel, also had to be unwound – here the issue was largely one of valuation and was eventually settled by negotiation.
The trickier part of the Concert unwind required the division of the indivisible. Prior to the GV, both parents had separate sales teams for companies like Merrill Lynch or Cisco, but had now merged them, along with international and domestic revenue streams, into single Global Accounts. These were reassigned by disaggregating the accounts back down to the individual service contracts, which were then assigned according to ‘contract letterhead’. The GV had also bought several expensive IRUs, the long-term leases of capacity, which were carried as assets on the Concert balance sheet and needed to be apportioned. These were corralled into a jointly owned single-purpose holding company. Most importantly, the old Concert Classic data network had evolved into a very large, unitary network platform that supported Frame Relay, Asynchronous Transfer Mode (ATM), Internet and IP Virtual Private Network (VPN7) services, all managed by a common suite of Operational Service & Support (OSS) systems. In particular, the Order Entry & Provisioning (OEP) system was used to manage workflows and the inventory of network resources, and was linked tightly into finance and billing systems. It was thus integral to both service quality and cash flow. How was this combination of services, infrastructure and systems to be split?
In the end, by a complicated fudge. AT&T handed its entitlement to a share of the European assets to BT; BT did likewise to AT&T in Asia. In future, each would depend on the other for supply in those regions, and made reciprocal Minimum Revenue Commitments to each other until the end of 2005. Each thus controlled a domain of the divided network. Where would the boundaries between the domains be drawn? In America, but differently for each service. The Frame and ATM boundaries were placed on the East Coast, while the boundaries for the Autonomous Systems (AS) used in IP networking were placed on the West Coast. It was a clumsy division but at least with physical infrastructure it is possible to say where the equipment is actually located, and hence on which side of a notional boundary it sits. But how to do this with the OSS, the core tools that enabled the business to be managed? By definition such systems manage processes from end to end. They have to reach across the line. Both AT&T and BT understood the function and value of the systems. Neither wished to cede control to the other. The solution was to outsource the systems to a third party to maintain and develop (at a price and upon request). After a vendor appraisal the relevant OSS were transferred to Computer Sciences Corporation (CSC). For at least the next three years, BT and AT&T would be mutually dependent, both on each other and on third parties. Given the disappointment and acrimony engendered by the failure of the Concert GV, this did not seem terribly promising.
Concert ceased trading in April 2002. The assets that returned to BT were almost all vested in Global Services (some of the former Global Accounts were passed back into BT Retail). Andy Green, the new CEO of Global Services, then settled down to try and make sense of the complicated inheritance that we have described in this section.
The platform
Certain elements of the Global Services portfolio were definite assets. Others had question marks over their status. In other areas there were not so much liabilities as simply absences – elements Global Services no longer had, but was likely to need in the future.
On the asset side: • BT had previously decided to make Ignite the focus for its UK enterprise data and value-added services as well as for International. So the Syntegra systems integration, UK IP network and UK Solutions
7 The VPN services use Cisco’s Multi-Protocol Label Switching (MPLS) technology.
14 Enders Analysis June 2003 BT Global Services
businesses were included in the division. The latter two in particular were profitable, well supported in the domestic sales channel and growing strongly. This was a model of what the European subsidiaries might become. Earnings from the UK businesses would also give the new division some air cover while the Concert assets were integrated and turned around. • The Farland network was a major infrastructure asset, combining reach and density. It was also largely a sunk cost in capital terms, although some extensions to the network were planned. The better utilised the network, the stronger its contribution to EBITDA, even if lower down the cash flow statement its EBITA and EBIT numbers were still coloured red. • The past nine years had taught BT that an ability to sell direct to the customer, rather than through unwieldy joint ventures, had genuine market benefits. Global Services now had a core of wholly owned, fully deployed operations, including in Germany, Europe’s largest economy. The UK, Ireland, Germany, Spain, Belgium, the Netherlands, Sweden and Finland amounted to a decent European footprint. • ‘Global Services’ staff, which now included some 2,300 returnees salvaged from Concert, were as bruised and confused as anyone by the strategic zigzags. But on the plus side they had plenty of experience.
Elsewhere some question marks hovered: • BT’s ex-partners, Worldcom and AT&T, had been vital sources of revenue growth. Both companies were now shifting their global managed services customers as fast as they could away from Concert services onto their own platforms. On top of this, the two carriers were by far and away the world’s number one and two correspondent operators. In 2001 they carried 24.5 billion voice minutes, five times as much as BT’s 4.6 billion minutes. Any shift of their traffic streams away from BT in favour of other operators would have significant effects on both volumes and revenues. Such revenue declines (already visible in run rates) meant Global Services would have to work hard just to stand still. • Farland plus the other international infrastructure returned from Concert were fixed-cost assets in a wholesale market now swamped with capacity. What were the chances of operating them at or above break-even levels? The implication was either that depreciation charges would continue to suppress EBIT, or BT should take an impairment charge against infrastructure that was less than three years old. Neither prospect had great appeal8.
There were also significant liabilities and absences: • All of the European wholly owned subsidiaries had negative EBITDA in FY2002. Immediate action was needed to turn this around. Divisional headcount in the year was cut by 2,400. The majority of the cuts occurred in Europe and the benefits started to show up in cash flow in the current year. During FY2003, Global Services has announced that all its European country operations are now EBITDA- positive. • Global Services now had only a tiny sales force in the brutally competitive US market. But this was still a vital territory given the substantial presence maintained by American companies in Global Services’ European heartland. • The same was true in other major markets. BT’s direct sales capabilities in France, Italy, Canada and Japan were smaller in 2002 than they’d been in 1994. In fact Global Services could claim to have decent channel capabilities in only two of the G7 economies – the UK and Germany and, of those two, the British sales channel was by far the stronger. The conclusion is surely that Global Services will have to recruit heavily in its sales channels to bring them up to strength9. This will increase operating expenses
8 BT in fact wrote down the value of its Concert capacity assets by some 80% or £825 million ($1,207 million; €1,134 million) in FY2001, as part of the ‘big bath’ it took during the Concert unwind. In FY2002 BT also took an impairment charge on its European “goodwill and tangible fixed assets” of £2,202 million ($3,149 million; €3,042 million); tangible assets accounted for £263 million ($376 million; €363 million) of this total (see notes 20c and 21 to the Accounts). It is not stated whether this impairment included Farland. 9 On 4 June 2003 BT announced that it was doing just that in France. In announcing new management appointments it stated its aim was to “grow aggressively revenues in France from the current level of just under €100 million (£71 million; $110 million) per annum.” This compares to 2003 revenues for the direct European operations in Germany, Spain, Ireland, Netherlands, Belgium, Sweden and Finland of £1,021 million ($1,583 million; €1,411 million). This is a tiny revenue stream (only 7% of the direct total) given that France is the second largest economy in Europe. It shows just how far behind BT has slipped in that market – but at least
Enders Analysis 15 BT Global Services June 2003
(opex) in the SG&A line. It also takes time for new sales teams to win incremental business. On top of this there is a lengthy book-to-bill cycle. Typically it takes four to six months between a customer placing an order and issuing the first invoice, at which point the revenue can be recognised. So the SG&A costs go up the same month a new salesperson goes on payroll, but revenue benefits may take 18-24 months to appear. • There is a similar exposure on infrastructure. The unwinding of the old strategy has left major gaps. AT&T now owns the Asian data networks. The network BT had built in the US after the break-up with MCI is functional but small. It has nine main Points of Presence (POPs)10 and uses a commercial agreement with AT&T to offer another 50 customer access POPs. The bulk of supply costs for the Global Services network platform are therefore set by one of the division’s primary competitors throughout Asia and America. This is not ideal. • The tradeoffs here are subtle. The history recounted earlier shows how the entire industry has cycled through extreme positions in terms of how to obtain its infrastructure. The decision is always whether to ‘make or buy’. In the early 1990s all non-correspondent transport infrastructure was rented at near- retail price from locally-dominant operators, while network hardware was purchased. In the second half of the decade the trend went to the opposite extreme. Vendor financing meant that manufacturers supplied new entrants with their equipment, but the enthusiasm for facilities-based competition meant operators spent their capital instead on constructing transport networks. Global Services’ current approach is a prudent middle way. In Europe it prefers to Make, elsewhere to Buy. In the short term this has allowed the division to make striking reductions in its capex. In FY2003, Global Services’ capex was £439 million ($680 million; €607 million) or 8% of turnover. This is less than half the £937 million ($1,377 million; €1,295 million) or 27% of turnover spent in FY2001 – a total which did not include Concert’s capex. This year’s spend is also dramatically lower than the BT Group’s historic average capex of 19% of turnover. Is such thrift sustainable? • We look in detail at this question later in this report. The proliferation of wholesale operators and specialist suppliers (such as telehousing and co-location providers) makes it possible to get supply on attractive terms. This avoids a lot of the capital expenditure that would have been thought necessary even five years ago. Renting capacity is useful, particularly in smaller markets. But the description earlier of the fudged network splits agreed with AT&T shows how much complexity such agreements can introduce into business processes. In general, directly owned infrastructure is operationally more efficient (with many fewer points of handoffs to third parties), gives direct control of costs and allows more flexibility in bid pricing. By contrast, when Global Services’ customers need network in, say, France or Malaysia, Global Services’ buy-in costs are strictly determined by the supply agreements it has with Cegetel-Telecom Development, AT&T and/or Telecom Malaysia Berhad (the Malaysian PTT). Unsurprisingly, Global Services struggles to be competitive. • Complexity is a cost; it also makes all aspects of delivering services very slow – which customers hate. Direct control allows BT to manage these issues. So Global Services has already decided to recreate its own data infrastructure in four important Asian markets – Japan, Hong Kong, Singapore and Australia. (In the same way AT&T has already aggressively recreated a wholly owned European data network to eliminate its dependency on BT as soon as the Unwind agreements expire.) As noted, it has also announced a re-expansion in the US, adding 14 new POPs to its footprint. We believe that Global Services will (a) in the short-term be hindered in its sales drive because of complexity and a buy-in cost base higher than its rivals; and (b) in the medium-term be forced to push its capex back up towards 15% of turnover as it extends its direct operations in primary markets. The idea that Global Services can build its business without significant increases in capital expenditure is flawed – a point not understood by most commentators. • The final liability faced by Andy Green in early 2002 was the general organisational shambles left by Alfred Mockett’s ‘two of everything’ approach, the dismembered systems and procedures handed back from Concert and the failed strategy of competing using domestic partners in joint ventures. In early 2002 the Ignite division had virtually nothing by way of common systems and procedures – no common with such a small base there is plenty of upside. Expect future announcements to trumpet very high growth rates in France – anything less would be feeble. 10 On 8 May 2003 BT announced its intention to roll out another 14 IP VPN MPLS POPs in the US, taking the total to 23. This is still a small footprint relative to AT&T and Worldcom.
16 Enders Analysis June 2003 BT Global Services
HR, Finance, CRM, ordering, pricing, billing or management tools in any of the Global Services countries. The organisational plumbing needed by any multinational business to run itself well did not exist. Instead there was a patchwork quilt of disparate systems and procedures, cobbled together with the help of Excel spreadsheets. This was in sharp contrast with the situation in Europe prior to the ill- fated EJVs when the BT subsidiaries all used the same tools and even with Concert, which likewise had had unitary systems. Global Services rapidly launched an initiative called the Single Operating Environment (SOE) to tackle the problem. There is no alternative to doing this and the division has reported reasonable progress. But the stark facts are that: (a) the SOE program takes up a lot of time, money and resource in an environment where they are all in short supply; (b) until the problem is fixed, the business stays sluggish and inefficient; (c) when the SOE is completed the division will simply be back to where it was 10 years ago; and (d) competitors like Infonet do not need to do this – they already enjoy the benefits of agility and lower costs. The SOE program is necessary but not sufficient. Compared to companies like Cisco, with its legendary ability to close out a quarterly return in a single day, Global Services is close to ‘worst in class’. Improving the quality of the management systems will take sustained effort and expenditure. The scale of this challenge is simply not understood outside the organisation.
Maintaining forward momentum
BT’s review of the Global Services platform determined initial priorities and these were: • Abandon pretensions to world domination and focus the business on the more realistic objective of providing ‘managed services and solutions for multi-site corporates operating in Europe’; • Shuffle the inherited business units into some semblance of order – four main Lines of Business underpinned by a matrix of Country Organisations, Centres of Excellence and Functional Responsibilities; • Galvanise the sales teams towards a target of 15-20% revenue growth; • Get the European connectivity business EBITDA neutral, largely through job cuts in back office functions; • Launch the SOE program (see above); • Start to harmonise the disparate country and transborder product portfolios (a few small products for SMEs such as point-to-multipoint broadband wireless services were eliminated); and • As a windfall, exploit the collapse of Global Crossing, KPNQwest and the fraud-shocked Worldcom to win over customers to a ‘stable, clean’ BT.
The bulk of these priorities have been achieved in FY2003 or reached major milestones on schedule (e.g. SOE). Turnover of Global Services was up 17% to £5,251 million ($7,509 million; €7,255 million). Reported EBITDA was up 22% to £178 million ($255 million; €246 million). Overall, these results are substantially above early-year expectations. Based on the current performance, Global Services has the necessary momentum and is even picking up speed. But what do the longer-term prospects look like? To assess these we need to look at the competitive dynamics and relative performance of Global Services’ four main Lines of Business.
Here we move from history to the future. How will the four operating entities – Syntegra (systems integration), Solutions (outsourcing), Global Products (corporate networks) and Global Wholesale (wholesale voice and data capacity) – work together?
The Lines of Business
Global Services sees its Lines of Business as an integrated chain, as illustrated in the diagram below (dated January 2003, before the division was renamed Global Services).
Enders Analysis 17 BT Global Services June 2003
What is BT Ignite?
GlobalGlobal GlobalGlobal CarrierCarrier Solutions SyntegraSyntegra Products
ConnectivityConnectivity Outsourcing,Outsourcing, Managed Network SystemsSystems IntegrationIntegration && Access ServicesServices && ApplicationsApplications && Consulting
! Backbone access ! LAN/WAN/IP-VPN ! Consulting and ! InternationalInternational services professional services connectivity ! Network integration ! Systems integration ! Carrier ! Storage & security ! Outsourcing / training ! Applications Hosting
We take a different view. The Lines of Business are actually very separate and distinct. The picture’s smooth progression from Global Wholesale to Consulting does not map onto reality. Global Wholesale has little to do with Global Products and nothing to do with Solutions. Syntegra is also essentially stand-alone. The businesses operate through different channels in different markets, assume different risks and their growth prospects vary markedly. To summarise these differences: • Solutions provides communications outsourcing and management services, and builds customised, higher-margin services around the core products managed in Global Business. Its capex burn is relatively low, and there is a large addressable market, particularly outside the UK. As a people business, Solutions’ costs scale with its revenues and it also assumes contract risk from its larger clients. • Global Products is the originator of new products for enterprises and is the line of reporting for Global Services’ country operations, such as its business in Germany. Its performance is reasonably healthy and EBITDA-positive, although it will continue to need to spend capital to grow its business. • Syntegra, the systems integration house, operates at the high-value added applications end of the market. In this it resembles Solutions – but is primarily multi-domestic rather than pan-regional in focus. It also lacks scale and there are few synergies with the rest of Global Services. It is profitable but does not earn a sufficient return to justify the capital BT has spent on funding a strategy of growth by acquisition. • Global Wholesale – the international interconnect business – was once a lucrative cash cow, but no longer. Over-capacity and competition has pushed revenues down relentlessly. Margins have also eroded and are poised to fall further, although BT has already taken action to turn this around.
Note: Global Services also has a Media & Broadcasting unit. It is not shown on the ‘value chain’ slide above, nor is it ever referred to in Results presentations. Perhaps it is too small to be of much interest?
Readers interested in free cash flow will also want to understand the capital expenditure characteristics of each Line of Business (LOB). The division does not report its capex by LOB, and manages the bulk of its platform assets in a global pool. For this reason, only about a fifth of capex can be directly attributed to the LOBs. Our main discussion of this subject therefore comes under the heading of capital expenditure, after our review of the four Lines of Business, and before the Financial summary (page 45).
The next sections review each LOB and its competitive position in more detail. This review establishes the assumptions that lie behind our long-term projections of their revenue and earnings potential.
18 Enders Analysis June 2003 BT Global Services
Syntegra (systems integration)
BT created Syntegra in 1993 in a parallel initiative to its invention of Syncordia (see potted history above). They were prongs of the same strategy – in essence Syncordia would provide outsourcing and management of companies’ telecoms infrastructure and Wide Area Networks (WANs), while Syntegra would provide integration and management of the same companies’ IT systems and Local Area Networks (LANs). The business unit was managed for 10 years by Bill Halbert until February 2003, when he was promoted to a role in BT Group responsible for the company’s overall strategy in the Information & Communications Technology (ICT) market space.
Syntegra now bills itself as ‘the brains behind the scenes’ and ‘BT’s expert in business transformation and change management’. This is a grand (and faintly absurd) way of describing a business unit which is a disparate collection of different activities: • At its core, Syntegra is a classic software shop, a systems integration business. It has a roster of blue- chip clients, predominantly in the UK, including BT itself. It consults on business processes and then develops, customises and integrates IT and software components to support those processes. As such, Syntegra competes with an alphabet soup of companies and consultancies such as LogicaCMG, Atos Origin KPMG, CGE&Y and Accenture. • Early on in its life, BT merged a specialist hardware manufacturer into the unit. BT City Business Products (CBP) made high-end trading systems for the financial services industry in the City of London. Originally this was seen as a way of retaining the voice and data communications traffic that sit behind such systems. This has evolved into a sophisticated product line (dubbed ITS) in a fast-moving and very specialised segment based around the world’s main financial centres. Although the best-known players are companies like Bloomberg, Reuters and Bridge, Syntegra’s primary competitor is the US-based IPC. IPC reported revenues of $291 million (£203 million; €281 million) in 2002. Syntegra’s guidance is that ITS makes up some 25% of its total revenues which implies an ITS turnover in 2002 of circa £150 million ($215 million; €207 million). ITS and IPC are thus similar in size. Alongside there are a dizzying array of other specialist hardware and software providers.
Syntegra has grown both organically and by acquisition over the past few years, as it tried to expand its footprint outside its UK base. In the mid-1990s Syntegra acquired the French integrator Europe Informatique, the Dutch group Rijnhaave and the Australian group First State Computing. In January 2003 it added the French arm of KPMG Consulting when the rest of the consultancy was acquired by Atos Origin. Its largest single acquisition came in August 1999 when BT paid $343 million (or 1.9 times revenues) for the Minnesota-based Control Data Systems Inc., an integrator with particular strengths in electronic commerce. That year CDS had revenues of $180 million (£112 million; €174 million) and made a pre-tax loss of $59 million (£37 million; €57 million). Now renamed Syntegra US, this subsidiary has since become a key component of BT Americas, when that entity was hastily revived in the wake of the collapse of BT’s relationship with AT&T. Some 700 employees of BT Americas work for Syntegra out of a regional total of about 1,400.
These various businesses are presented as part of BT and Global Services’ overall ICT strategy, exemplifying the company’s ability “to access all parts of the value chain”. This vapid phrase betrays BT’s irresistible desire to do a little bit of everything not especially well. The result is a collection of sub-scale units – a small media business, a small hosting business11, a small integration business, etc. – which add complexity but rarely amount to more than the sum of their parts.
Syntegra now positions its cluster of activities as a spectrum which goes from ‘contribute elements’ through ‘deliver systems’ to contracts based on ’use of systems’. The latter includes long-term contracts like the CHIEF system for the UK’s Customs & Excise. Such contracts are extremely similar to the outsourcing deals done by Solutions and to the Hosting/ASP offers from Global Products. There are other examples of
11 By way of comparison, IBM has stated its Web Hosting business passed the $1bn revenue mark in 2001 and in 2002 grew at 35%. IBM’s Hosting business is thus larger than the whole of Syntegra. BT’s ASP and Hosting business is not separately reported but is believed to have annual revenues of some £150 million ($233 million; €207 million).
Enders Analysis 19 BT Global Services June 2003 overlap. Solutions and Syntegra both provide CRM and managed messaging services, while Syntegra, Solutions and Global Products all boast managed firewall and security offers. The nice thing about ‘accessing all areas of the value chain’ is that you can do it so many times! Or is this duplication just confusing?
Syntegra has indicated it wants to do more business of the ‘use of system’ kind, presumably because it builds an ongoing revenue base. This should help maintain growth rates. Over the past six years Syntegra has averaged 12% YOY growth in revenues. Annual revenues, which were £356 million ($587 million; €492 million) in FY1998, reached £623 million ($891 million; €861 million) in FY2003, up by three-quarters in six years. The business has also reported a strong fourth quarter in FY2003 with an order pipeline up by a third on the previous year.
However it is useful to set these positive results in context. Table 3 below shows how Syntegra always has a strong fourth quarter – in fact, this is true across Global Services. Like most businesses with an eye on their year-end, the division has a big Q4 push to complete projects, catch up on back billing and recognise as much revenue as accounting conventions will allow. But it would be misleading to suggest that fourth quarter growth rates translate into YOY progress. In Syntegra’s case the trend line suggests that growth is actually slowing slightly.
Table 3 SYNTEGRA’S REVENUE BY QUARTER, 1997-2003
200 180 160 140
(£m) 120 100 80 60
1 97-982 97-983 97-984 97-981 98-992 98-993 98-994 98-991 99-002 99-003 99-004 99-001 00-012 00-013 00-014 00-011 01-022 01-023 01-024 01-021 02-032 02-033 02-034 02-03 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
[Source: Syntegra] NB: All quarters are financial year quarters unless otherwise stated
These revenues produced ‘reported profits’12 of £34 million ($51 million; €50 million), a margin of 5.5% – neatly in line with the six-year average margin on revenues of 5.4%.
This, then, is a growing, profitable business in reasonable health. But we still find it hard to get excited about Syntegra’s future for a number of reasons: • The systems integration market has slowed sharply, with little prospect of an early return to growth. • Syntegra is much smaller than its peers. On bids for bigger contracts, Syntegra will struggle to match the resources of its competitors.
12 This is the term used by Syntegra in its quarterly reports. BT has commented that Syntegra has very low levels of capital expenditure, being primarily a people business. It also prefers (unlike other parts of GS) not to capitalise a portion of its development costs and books such costs as an expense. Its depreciation charge is thus effectively nil. It is not known whether GS amortises any goodwill arising from acquisitions at the level of the LOB — we assume not and therefore that “reported profits” is an EBIT measure. We also note that if Syntegra’s depreciation and amortisation is effectively zero, then their EBIT number can be compared to the other LOBs EBITDA numbers. This helps assess the overall divisional earnings outlook.
20 Enders Analysis June 2003 BT Global Services
• Despite the presentational gloss, there is in fact little synergy with Global Services’ Solutions business. This is a distinct weakness relative to Syntegra’s competitors who operate their systems business in the same business unit as their outsourcing activities. • Syntegra’s footprint is also concentrated on five countries and requires a very different kind of sales channel from the rest of Global Services. • The unit is still heavily dependent on the UK for its revenues. • Syntegra’s historic return for shareholders has been disappointing especially when its acquisitions are taken into account
Taking each of these factors in turn, the overall market slowdown has followed a late-1990s boom in work caused by high levels of corporate IT spend and one-off work on the Y2K/Millenium date-fix. The bursting of the market bubble also had a big impact on the IT industry, although not quite as dramatic as in telecoms. All players have struggled, including giants like EDS. Syntegra’s growth rate has slowed to a crawl – down to 2% YOY in FY2003. At present there is little sign of a market upturn. Our medium-term outlook for annual market growth is 5%, which is much slower than the overall growth targets for Global Services. So even if Syntegra performs at market rates, it will act as a drag on the division.
Of course, Syntegra could out-perform its market. But this looks unlikely. The unit is in fact a minnow in relation to competitors (Table 4). The chart on the left compares Syntegra to its true peers – mid-size systems integration companies like LogicaCMG and Misys, with a strong presence in a few countries. The right-hand chart compares these regional operators to some of the global giants, such as IBM’s Global Services division.
Table 4 SYNTEGRA’S REVENUE RELATIVE TO ITS COMPETITORS
MID SIZE GLOBAL 2000 30000 25000 1500 20000 1000 15000 10000 500 5000 0 0 2002 revenues (£m) 2002 revenues (£m)
a s a s s r y G r y G re ' S g s g s u ln G e i M e i M t o t M C t M C n S M n a n a e B ic ic c S I Sy Sy c D og og A L L E
[Source: Company Annual Reports]
It can easily be seen that Syntegra is only a half to a third the size of its peers, and these mid-size players are in turn dominated by global giants three to five times bigger. At the extreme end of the scale IBM’s Global Services unit, with FY2002 revenues of over £24 billion ($35 billion; €33 billion), was more than 40 times the size of Syntegra.
This lack of scale is especially significant in times when markets are slow. Syntegra’s competitors have weathered the downturn in new business by selling upgrades and enhancements to their existing contract base. Syntegra does the same, but it has a smaller base of contracts from which to extract such revenues.
This is compounded by the structural separation enforced on Syntegra by BT and Global Services. Most systems integration companies combine the integration role with outsourcing. But, within Global Services, the primary outsourcing vehicle is Solutions13. The two units do collaborate in a prime/sub contractor fashion and have agreed a process to determine who will take the lead on any given opportunity. But the distinctions between ‘business transformation’ and ‘ICT and outsourcing’ are nebulous and hard to explain.
13 In 1999 BT actually announced the merger of the two units. But it was never implemented.
Enders Analysis 21 BT Global Services June 2003
Most of their collaboration appears to be on an arms-length basis, which is fine, but does not amount to ‘synergy’. Tellingly, when Syntegra needed a partner capable of outsourcing large data centres to bid for the huge UK Inland Revenue contract currently held by EDS, they teamed with CSC. We feel this separation is a distinct weakness relative to Syntegra’s competitors which operate their systems business in the same business unit as their outsourcing and consulting activities.
As a result, it is hard to identify any major deals won by Solutions in the past five years where Syntegra has played an integral role, and vice versa. The much-trumpeted global contract with Unilever announced earlier this year is largely based around communications management – routers, PBXs and WANs. Given the jealousies and petty disputes that crop up in any organisation with strongly demarcated Lines of Business, it seems unlikely that Syntegra will profit much from Solutions’ successes.
Allied to this are channel issues and differences in footprint. We’ve already discussed how Global Services’ sales channels are weak in major markets outside the UK. The division is likely to need to beef these up. Will this benefit Syntegra? Unlikely, in our view, for two main reasons. First, however much the boundaries between LAN and WAN have blurred, the sales and technical skills required for IT and communications remain very different.
Second, systems integrators are essentially multi-domestic businesses. They need to have critical mass in specific national markets. In Syntegra’s case, these markets are the UK, US, the Netherlands, France and Australia (although the latter three are quite small). And the bulk of their customers operate in only one market. Edinburgh City Council, for example, has little interest in Syntegra’s capabilities in the Netherlands. By contrast the Products and Solutions business focus is truly pan-regional. Sales and operations are geared to provide consistent service across multiple territories. This means that resources can rarely be shared between Syntegra and Solutions – their customers need very different kinds of support.
Syntegra has also indicated that it remains heavily dependent on the UK for its revenues. Some 70% of its income in 2003 (circa £430 million) came from its home market. This is in marked contrast to earlier years when the revenue balance was nearer 50/50. The balance has shifted back because Syntegra has profited from substantial investment in IT by the UK’s national and local government sector. This has been good news at a time when global IT spending has been in recession. But it serves to emphasise how different the unit is from Global Services’ other LOBs, where the trend has been in the other direction.
Overall the absence of synergies between Syntegra and the rest of the division is more a disappointment than a handicap. But it suggests that Syntegra should be evaluated effectively as a stand-alone unit. Like all integrators, it is largely a people business. Its headcount tends to scale with its business. A crude measure of efficiency is thus revenues per employee. Syntegra has approximately 5,000 employees worldwide, yielding revenue of £122,000/employee ($175,000; €169,000) in 2002. This is exactly the average ratio of the six companies compared earlier. So Syntegra is respectably efficient but does not excel. (Again, IBM Global Services is the clear leader with revenue of £188,000/employee ($267,000; €260,000), 50% higher than the average.) Syntegra have also indicated that their ‘occupancy rate’ (jargon for how busy their staff are) is running at about 85%. In effect, there is zero slack. Given its sub-scale size, Syntegra will be challenged to raise this staff/sales ratio towards best-in-class levels, because it will have to hire more people to win and implement new and bigger contracts.
These concerns explain why we are lukewarm about the unit’s future prospects. It is a small, moderately efficient performer in a market trending to single digit growth. As such it will not be Global Services’ growth champion. Our five-year outlook is as follows:
22 Enders Analysis June 2003 BT Global Services
Table 5 SYNTEGRA’S REVENUE AND EBITDA OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Revenue 610 623 650 690 720 760 800 Reported profit 3114 34 36 37 39 41 43
[Source: BT; Enders Analysis]
Such performance is unlikely to excite shareholders. As noted above, Syntegra’s historic average operating margins on revenues has been 5.4%. Historic data plus this forecast suggests it will take seven years simply to recoup the initial £213 million ($343 million; €294 million) purchase price for Control Data Systems (cumulative profits from 2000-2006 are forecast to total £228 million ($326 million; €315 million)), not counting the cost of the other acquisitions. This is a poor return on investment.
Given this, what might Global Services do about Syntegra? Its options include: • Do nothing. At least the business contributes to both top line and bottom line. • Try to energise the organic performance and achieve greater synergies. The appointment of Tim Smart (Global Services’ chief ‘shaker-upper’) to replace Bill Halbert suggests this is the current plan. • Fund more acquisitions to create scale. On past track record, shareholders should be unhappy about this. • Sell the business to a competitor. This is probably the most rational option.
Despite these options, Global Services appears unlikely to contemplate radical changes to Syntegra in the near-term.
Solutions (outsourcing)
The outlook for the Solutions LOB is more positive. The unit is the lineal descendant to Syncordia, the Atlanta-based outsourcing subsidiary of long ago. (For a short time the UK managed network services business even rebranded itself as Syncordia.)
The unit’s activities range from relatively modest value-added management services to extremely large outsourcing contracts. As such it exists in creative tension with the more standardised products and services developed by Global Products. The relationship and differences between the two units can be sketched as follows.
First, Global Products is a production line; but every offer Solutions makes is customised. The former must produce standardised, reliable, scalable, up-to-date network services at market-competitive prices and, ideally, market-leading costs. It spends capital on infrastructure, development, systems and processes to deliver these to market. As such, fixed costs are high and depreciation charges considerable, so significant volumes are needed to generate free cash flow. But the standardised nature of the technology usually means that competitors offer similar services, which exerts downward pressure on margins. For instance, all of Global Services’ principal competitors offer IP VPN services based on Cisco’s MPLS. So there is a continuous effort to enrich the basic product offers with new service features, such as web-based ordering and management tools.
Solutions exists to go one step (or more) beyond whatever’s currently provided as standard. The offer is customer-centric rather than infrastructure-centric. Many customers need or want something slightly fancier than an off-the-shelf service – for example, a local help desk, or advanced equipment management and reporting. In other cases a sector-specific business model will need innovative pricing structures and therefore customised billing. Solutions can deliver all these – at a higher price.
14 Syntegra’s website states its ‘reported profit’ as £18 million in FY2002 and £24 million in FY2003 ($28/$37 million; €25/€33 million respectively). Here we have used the BT Group EBITDA numbers.
Enders Analysis 23 BT Global Services June 2003
To give a simple example, most customer data networks use routers for their terminal equipment. These vary hugely in price according to size and configuration, but a typical three-year lease and service contract on a low-end Cisco 1720 router costs can cost approximately $150/month. A medium-sized network will have dozens of these. Each router works using a routing table, which has to be kept up to date. Faults on the equipment are often detected only when something stops working, but can be pro-actively managed using alarm feeds to a monitoring system. The equipment’s components and operating system must also be kept up to date. Solutions can offer to handle all of these mundane tasks for the customer – for an additional charge of between $50-125/month per router. Once the necessary customer service staff and management tools are in place, this significantly enhances the margins on the basic product.
At the high end of the market, there are large-scale outsourcing agreements. These are complex, multi-year commercial agreements. Customers increasingly ask consortia of PTTs, integrators and IT specialists to bid, to ensure that the skills mix is comprehensive and best-in-class across the entire spectrum of their ICT requirements. Contracts often involve the transfer of assets and staff to the outsourcer. Details released by Global Services about their recent outsourcing agreement with Unilever give an idea of the scope of such contracts (Table 6). This is a large deal while many others are smaller, but the important point is that trends suggest that such opportunities are increasing.
Table 6 SOLUTIONS: UNILEVER CONTRACT
Benefits • BT provides all voice, data and mobile communications in 90 countries with a substantial cost saving to Unilever Terms • Worth €1 billion over 7 years to manage and develop the company's entire global communications infrastructure • BT is exclusive network provider for 5 years and preferred supplier for a further 2 years • BT will acquire €20 million of assets, up to 250 people and all the existing supplier contracts (circa 200) With • 500 service blocks supporting 270,000 Unilever staff in 120 countries • 2,200 routers, 600 PBXs, 27,000 mobile, 4,000 data connections in 90 countries • Country by country ‘take-on’ approach agreed • Collaborative rollout plan between BT and Unilever
[Source: BT]
There are several attractions for BT in this kind of Solutions business. • The service offer is by definition differentiated. It is made to measure, not ready to wear. • When well implemented, this customisation builds client loyalty (and dependence) and so creates barriers against defection to rivals. Some telecoms services, especially basic voice, are now so commoditised that customers can change between network providers overnight. The opposite is true with managed solutions. Contracts tend to be longer-term – often three to seven years. • The delivery of such services is people-intensive rather than capital-intensive. This makes the services less scaleable, but allows costs to be fine-tuned in line with the evolution of a contract. If a contract is extended or lost, then headcount can be increased or reduced accordingly. By contrast, Global Products rarely has the latter option – committed capital stays in place even if revenues do not materialise. • When customisation can be provided as a wrap around standardised products, then the management fees can raise overall margins significantly. This creates genuine synergy with the Global Products portfolio.
At the high end, outsourcing plays to BT’s financial strength (especially now the balance sheet has been cleaned up). Such contracts involve considerable risk and, as all insurance companies know, sometimes you must pay out on the risk. Some of BT’s early experiences, such as its deal with NatWest Bank, were unprofitable because the terms were sufficiently loose to enable customers to demand more services than
24 Enders Analysis June 2003 BT Global Services could profitably be provided. BT absorbed the loss and has now learnt many of the obvious lessons – by contrast few alternative telecoms suppliers could contemplate taking on this kind of risk.
Given these attractions, what are the challenges to profitable growth? • As the contract with NatWest showed, agreeing terms is something of an art form. BT has been in this business about seven years (Solutions first reported results in 1997). It still lacks experience relative to companies like EDS. • As already pointed out, channel resources outside the UK are underweight and this will affect the pipeline of opportunities. A senior BT executive once said to us that the company could not handle too many contract negotiations like Unilever, because it had tied up every available person for months. • Outsourcing risk is specific to this LOB and has a direct effect on margins. Such risk derives from the large-scale nature of the contracts, and can be significant. In many respects it is precisely customers’ wish to reduce their technology and/or operational risk and free up capital that leads them to outsource in the first place. Such risk does not disappear but it is being shared with the supplier. There are also the classic project risks – implementation problems, delays, overruns. And there are significant risks in the way such agreements are contracted and priced. The devil (or rather, the costs and exposure) is truly in the details. For instance, under the terms of the Unilever agreement, BT will become the prime contractor for more than 200 underlying supplier contracts, and has committed to price reductions of 20% against current benchmarks. BT’s ability to deliver its pricing commitments and make a return will depend upon its ability to secure ever greater cost reductions from its management for those underlying contracts. It assumes the risk of failing to do so. • Big deals also soak up implementation resource (project managers and the like). Again BT has plenty of such staff in the UK but they are a lot thinner on the ground in Europe and Asia. There’s a limit to the number of elephants Global Services can eat at any one time if customers and other priority programmes are not to suffer. • Growth in outsourcing will drive up depreciation charges as Solutions take over customers’ telecommunications assets as part of the contract.
Nonetheless, the simple conclusion is surely that managed services and outsourcing play to BT’s strengths and that there is plenty of scope for growth in the market. Hence Andy Green’s decision to make it the strategic spearhead of the division.
When questioned on this point, Green is emphatic. He sees Solutions as the differentiator between BT Global Services and its competitors. None of the other providers of global or regional networks have this kind of capability in Europe. This is certainly true for Infonet and Equant, although AT&T with its GEMS (Global Enterprise Management System) capability is a potential rival. But AT&T’s position in Europe is relatively weak. So for BT, the combination of Solutions with the services managed by Global Products (see next) is the key to winning against its rivals. The former grows top line revenues by bringing in big contracts; the latter runs efficient platforms to extract maximum margins.
That said, what are the financial prospects for Solutions?
First, growth rates. Over the years BT has released various revenue numbers for Solutions, not all of which are consistent15. According to these, YOY revenue growth in some recent years has been as low as 10% and, in others, as high as 51%. Average YOY rates during FY1998-2002 range between 19 and 31%.
Some caution is called for. 91% of Solutions’ revenue in FY2002 came from the UK or UK-domiciled customers like the Anglo-Dutch Unilever. This is precisely what we would expect given BT’s sales resources on its home ground. But the UK outsourcing market is comparatively well developed and BT estimates it
15 Between 1999-2002 BT Group reported Solutions as a separate category within Group annual turnover; it is now reported quarterly as part of Global Services, but its results are now adjusted at the divisional level for intra-LOB eliminations. The level of eliminations fluctuates considerably from quarter to quarter. Other data is taken from presentations given by Solutions. The ranges of values for YOY growth and EBITDA are derived from these various sources.
Enders Analysis 25 BT Global Services June 2003 already has 15% share. It is also already operating through a strong sales channel, which means it cannot grow revenues simply by hiring more salespeople – this suggests that Solutions will keep pace with market growth in the UK but is unlikely to outperform it. Outside the UK, it is a different story. It has fewer salespeople, and can deliver growth simply by hiring. (This is exactly the company’s plan.) But, however welcome and productive that increase in sales channel capacity, the new sales teams will compete with relatively limited resources against incumbent PTTs. The lack of progress by BT’s competitors in the UK shows how difficult that can be.
In our base forecast we have assumed a blended overall growth rate which averages YOY revenue growth of 12% (Table 7). UK revenues grow at an average 7% YOY and non-UK revenues at an average 42% YOY. In other words, we agree that Green’s strategy of stretching the business to compete in Europe will achieve success, albeit from a low base. Cumulative revenues for 2004-08 in this scenario are £15,800 million ($22,595 million; €21,830 million).
Table 7 SOLUTIONS’ REVENUE OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Total revenue 1,828 2,042 2,445 2,810 3,175 3,525 3,840 Of which UK 1,661 1,809 2,095 2,310 2,465 2,540 2,500 Non-UK 167 233 350 500 710 985 1,340
[Source: BT; Enders Analysis]
There is considerable variability in such forecasts. A few more monster deals could push up growth rates even further, and vice versa if channel limitations hold the business back. So we have also modelled the revenue impact under higher/lower growth scenarios. If Solutions achieves an average YOY growth of 20% then cumulative revenues rise by £2,290 million ($3,275 million; €3,164 million) and, if only 8%, then they fall by £1,460 million (9$2,088 million; €2,017 million). Put another way, in our model a ±1% change in the overall growth rates affects the unit’s total revenue by approximately ±£320 million ($460 million; €440 million).
Having said that, pinpointing the exact growth rate is not the primary issue for BT shareholders. The real question is how efficiently Solutions can convert such revenue growth into EBITDA.
Average margins (i.e. EBITDA as a percent of revenues) for Solutions in recent years have ranged from as low as 3.2% to 9.0%, depending on which set of BT numbers we crunch. We suspect three possible causes – either the unit is weighed down by its SG&A and allocated overheads, and/or the trading results reflect outsourcing risk, and/or BT does not have significant pricing power relative to its competition, even in the UK.
Neil Rogers, President of Solutions, has already announced it is taking action to drive up returns by focusing on ‘fewer, larger, longer’ deals. Assuming BT can handle the risk, what impact might this have on earnings? We take the baseline revenues projections above and look at EBITDA under two scenarios. First, Solutions’ actions fail to improve margins and they remain within the high/low range of the recent past (9.0% and 3.2% respectively). Second, action is effective and margins rise by 15% a year from their current high to reach 17.2% by 2008.
26 Enders Analysis June 2003 BT Global Services
Table 8 SOLUTIONS’ DIFFERENT EBITDA SCENARIOS TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 EBITDA at 3.2% 58 65 78 90 101 113 123 EBITDA at 9.0% 156 172 209 240 271 301 328 EBITDA improves 156 172 240 317 412 526 659
[Source: BT; Enders Analysis]
Given Global Services’ business plan, it is critical for Solutions to achieve a sustained improvement in margins. Maintaining the status quo at 9% would be a disappointment. Nonetheless, given the risks and lack of pricing power we regard the 9% outcome as 60% probable, and use it as our central forecast. As mentioned, we also expect some pull-through benefits for Global Products, which we review on page 36.
Global Products (international corporate networks and country operations)
This Line of Business performs multiple functions within Global Services. In particular: • As described earlier, it is the product factory. It develops, builds and operates domestic and cross border networks and services for enterprise customers. Services include connectivity products like MPLS-based IP VPNs, ICT services such as managed hosting, plus other capabilities such as billing and web-based service management. • The direct country operations (e.g. Germany, Belgium) report through this LOB. • Global Services’ commercial relationships with indirect sales channels and suppliers are also managed through this LOB. Most of these relationships were inherited from the EJV and Concert era.
As such, Global Products is responsible for a large proportion of Global Services’ capital expenditure and operating costs. Its revenue reporting is complex. Sales between Global Services and another BT division, such as Retail, are handled on an arms-length, transfer price basis. Sales between two Global Services LOBs, especially when Global Products supplies Solutions, are double-counted then stripped out via the eliminations line in Global Services’ reported results. The broad policy is to recognise as much margin into the direct channels as possible. Sales through indirect channels are managed according to wholesale distribution agreements much as they were in the Concert days. The overall shape and functioning of this model is not easy for employees or customers to understand. Likewise it is a challenge to get an accurate end-to-end view of costs.
The competitive positioning for the unit is also complex. It competes with three main types of provider: • Other global operators, such as Equant, Infonet and AT&T; • Other pan-regional and metropolitan providers, such as Colt, Viatel, Interoute and Level 3. Such providers are often significant suppliers on a wholesale basis to other operators as well as managing their own service portfolios; and • Regulated incumbents, such as Deutsche Telekom or Telefonica. BT’s direct country operations compete as alternative network providers against the local incumbent.
Such a diverse array of competitors begs the question of why Global Services is the only European provider to compete in all three segments. Where does it want to be best-in-class? The answer “in all three” may work as a statement of intent, but we do not think it is very realistic. The unit needs very different strengths to compete in each segment. For instance, national sales against incumbents require density in the local access network and skills in regulatory bargaining, while sales in the pan-European wholesale market require access to city access networks, carrier-grade engineering and provisioning skills.
That said, the competitors Global Products most closely resembles are the global operators. Some industry analysts like Gartner Group suggest that BT is no longer a true global operator, given its stated focus on European customers and the degree to which it depends on AT&T for network reach in Asia and the US. But, for the purposes of this discussion, the main comparators for the Global Products LOB are Infonet and
Enders Analysis 27 BT Global Services June 2003
Equant. We argue that overall Global Services has no particular competitive distinction compared to these two competitors. All three are well-established providers and owned by large incumbent telcos. All three are operationally competent, and can claim to be best-in-class in specific attributes – for instance Equant’s country coverage is better, but Global Services’ ‘capillarity’ in its European direct country operations is superior. Consider the following three propositions.
[Note: in these comparisons we use FY2002 numbers as Equant and Infonet have not yet reported their FY2003 results.]
Proposition 1 THE OWNERS OF ALL THREE PROVIDERS ARE FINANCIALLY STABLE
Stability BT Global Services Equant Infonet Parents BT France Télécom 16 TeliaSonera, Telefonica, Swisscom, KPN, Telstra, KDDI FY2002 revenues £4,476 million of £2,079 million of £452 million which Global Products which Network est to be £1,630 Services inc SITA was million £1,595 million FY2002 EBITDA £201 million of which £134 million £48 million Global Products was (£174 million) FY2002 EBITDA as % of 3.3 6.5 10.7 revenue FY2002 EBIT excluding -£353 million -£219 million -£9 million exceptionals
[Source: BT, Equant, Infonet Annual Reports 2002]
16 France Télécom owns 54% of Equant and so has majority control. FT’s perceived financial stability will continue to be underpinned by the French state’s support for its ‘national champion’.
28 Enders Analysis June 2003 BT Global Services
Proposition 2 THE BUSINESS PROPOSITION AND FOCUS OF ALL THREE PROVIDERS ARE VIRTUALLY IDENTICAL
Company Mission Global “BT is the global services provider that helps multi-site organisations master the complexity of Services business communication. Because of our expertise, partnerships and experience, a completeness of a range of services linked to a global BusinessIP network and a culturally attuned human network of professionals, we can deliver for you the promise of integrated communications and IT in a connected world. Working closely with our multi site corporate customers, BT's goal is to deliver inspirational results which fulfil their business needs and tap into their untapped potential. We are in business to earn the status of being "partner of choice" for creative, valued and reliable communications services and solutions.” Andy Green, CEO BT Global Services Equant “Equant is a managed service provider. We do far more than provide bandwidth. We offer a comprehensive range of sophisticated network products and integration services to our customers. Who are our customers? They are a specific set of companies - large multinationals. Our focus customers are the 2,000 largest MNCs in the world. Equant operates in 220 countries and territories, and [is truly] global. At Equant, we recognise that delivering excellent customer service is the antidote to failure in the current global situation of reduced growth trends and shrinking profitability. We are offering a place where stability, excellence in service and attention to customer needs is remarkable. Individual attention, delivered globally is our philosophy for excellence in customer service.” Didier J. Delepine, President & CEO Infonet “Our mission is a simple one. We provide global communications services to thoUSnds of multinational enterprises - empowering them to run their businesses securely and efficiently by connecting their customers, business partners and employees. How we do this is what differentiates us from our competitors. We start by understanding everything about our Clients' business strategies and then tailoring solutions to their specific requirements. After doing this for more than 30 years, we know just about everything there is to know on the subject. Ultimately, we've found that a deep understanding of everything about our Clients' organisations is the only way we can deliver the custom-crafted, fine-tuned, relentlessly efficient global communications network they need.” Jose. E. Collazo, Chairman, President & CEO
[Source: BT, Equant, Infonet websites]
Enders Analysis 29 BT Global Services June 2003
Proposition 3 THE PRODUCT PORTFOLIOS OF ALL THREE PROVIDERS ARE VIRTUALLY IDENTICAL
Product BT Global Equant Infonet Services Number of core countries17 61 55 54 Technology partners Cisco, Ericsson Cisco, Nortel Cisco, Marconi, Nortel IP VPN (MPLS with Class of Service) Yes Yes Yes Frame Relay Yes Yes Yes Asynchronous Transfer Mode Yes Yes Yes X.25 Yes Yes IPLC / Private Line Yes Yes Yes Gigabit Ethernet LAN Some Yes Voice over IP (VoIP) Yes Yes Yes Corporate/Managed voice Yes moved to FT Yes International-800/Contact Centres Yes Yes Yes Conferencing Yes Yes Yes ISP/Carrier IP Yes Yes Yes Corporate IP (VPN, extranets) Yes Yes Yes IP Security/Firewalls Yes Yes Yes Remote Access (dial) services Yes Yes Yes VSAT access Yes Yes Wireless access with Orange Yes Telehousing Yes Managed Hosting Yes Some Yes Messaging via Syntegra Yes Yes Applications Service Provider Yes Yes Business continuity services Yes Broadcast services Yes Consulting services Yes Yes Yes Engineering & maintenance services Yes Managed CPE Yes Yes Yes
[Source: BT, Equant, Infonet websites]
Given these tremendous similarities (and noting that AT&T would also score comparably in terms of all these Propositions) what factors do distinguish the three from each other? We highlight four in particular: • Brand; • Geographical spread of the customer base; • Capex outlook; • Channel strategies, SG&A and gross returns.
The first highlights the shambolic branding strategy (or non-strategy) adopted by BT over the years. A good way to illustrate this is to consider an enterprise customer for transborder services in a European country such as the Netherlands. Who would this customer buy services from? What would the ‘name on the letterhead’ be?
17 Number of countries where customers can access full service portfolio. Beyond these core countries, Equant have low-speed FR X.25 access POPs in 220 countries; Infonet claim customers can access services from 180 countries. Global Services claims 121, achieved in part through a dial-access agreement with IPASS.
30 Enders Analysis June 2003 BT Global Services
Table 9 CONSISTENCY OF COMPETITIVE BRANDING: EXAMPLE
Brand Brand Brand 1992 BT Netherlands SITA Infonet 1993 BT Netherlands & Concert SITA Infonet 1997 Telfort & Concert Equant Infonet 2000 Telfort, Concert & BT Ignite Equant Infonet 2002 BT Ignite18 Equant Infonet 2003 BT Global Services Equant Infonet
[Source: BT; Enders Analysis]
Our view is that in a B2B context brands do not have the same significance as in consumer telecoms. Nonetheless, in an environment where customers appreciate continuity and stability of supply, BT’s service brand has become severely diluted. By contrast Equant and Infonet have maintained their service brands consistently. It should be remembered that to a great extent Global Services’ business plan is built around rapid growth outside its UK home base. This requires raising awareness of the company’s presence and capability on the part of new, non-UK customers. At the very least, this history of incoherent branding cannot help19.
This point is underscored when looking at the geographic distribution of revenues (Table 10). Here it is difficult to make precise apples-to-apples comparisons, especially given Infonet’s atypical ownership structure (headquartered in US; four European and two Asian main shareholders).
Table 10 GEOGRAPHIC DISTRIBUTION OF FY2002 REVENUES
(%) BT Global Equant Infonet Services HQ country(s) excl. US 68 10 28 Other specified European countries 25 56 24 US 3 20 21 Other (inc. Asia & unspecified EMEA) 3 13 28
[Source: BT, Equant, Infonet Annual Reports FY2002; Enders Analysis] NB: Columns do not sum exactly to 100 due to rounding. Notes: Global Services: Derived from BT Group accounts. Assumes all non-UK revenues are booked through Global Services, and subtracts total non-UK from Group reported UK revenues to derive Global Services’ UK revenues. This may understate the degree to which UK-based companies provide Global Services’ revenues, because such companies are often part-invoiced outside the UK. We estimate 90% of the ‘Other European’ revenues come from the wholly owned subsidiaries. Equant: Equant is registered in the Netherlands but for these purposes the HQ country is presumed to be France. Equant has established Ireland as its global centre for invoicing (possibly for taxation reasons) including for its SITA contract. HQ country revenues are from France Télécom inc Transpac. Infonet: Infonet is actually headquartered in El Segundo, California, hence its ‘true’ HQ line is the US line. But Infonet accounts identify revenues from the home countries of 3 of its 4 main European shareholders, and it is these that we show on the HQ line. Revenues from the fourth European shareholder (Spain/Telefonica) are not specified, nor are revenues from the home countries of the other two main shareholders (Japan/KDDI, Australia/Telstra). Infonet presumably includes these in its Other line, which we show here as being Asia and/or Unspecified EMEA.
18 Telfort’s mobile services were hived off into BT Wireless and post-demerger rebranded O2 in the Dutch market. When mmO2 announced in April 2003 their agreement to sell O2 Netherlands to a private equity firm, it was reported that the new owners might bring the Telfort name back into use. If so, more brand confusion. 19 None of the three companies’ parent brands have changed, as they are all incumbents in their home markets. BT believes that the Group brand is “trusted” although after the management zigzags and financial turmoil of the past few years this reputation may have taken a bit of a battering. Certainly the company is no Worldcom. But then neither is France Télécom, Telefonica, TeliaSonera, KDDI, KPN, Swisscom or Telstra (or AT&T for that matter). Most of these operators have been bruised by recent market events, just like BT. We reckon that to a customer outside their home markets, their reputations are on a par.
Enders Analysis 31 BT Global Services June 2003
Two points stand out from this crude comparison: • Global Services is more dependent for revenues on its home base than Equant or Infonet; • Equant and Infonet have a more even distribution of revenues across Europe, the US and Asia.
This explains a paradox in Global Services’ market position. The paradox depends on how you count. First, if (quite properly) UK revenues are counted as ‘European’, it is clear that Global Services is a pure one- region play. 93% of its revenues come from Europe, and if future market growth happens to come from America or Asia, then there’s a risk the division will miss out. Vice versa, if the European market prospers, Global Services’ boat will rise with the tide. But if that happens Equant and Infonet will also be well positioned – they derive some 66% and 52%, respectively, of their revenues from the region. But Global Services’ dependence on the UK means that in respect of Continental Europe its exposure is the lowest of the three. Hence the paradox – Global Services is both over-dependent on Europe and least well established there.
This is substantially the point we made in our earlier discussion of Global Services’ platform. The division’s sales channels are underweight in crucial markets. This primarily affects Solutions and Global Products. We shall return to this theme again in the context of financial performance.
The next major comparator of interest to investors is capital expenditure. Global Services does not release breakdowns of capital expenditure by LOB, despite the fact that different units have very different requirements. Capital expenditure is one of the most important determinants of the outlook for Operating FCF, so we shall discuss the general expectations for division spend separately. But because we believe Global Products has the largest capex requirement of all the LOBs, we’ll begin here.
Why does Global Products consume capital so steadily? For various reasons: • It manages networks and services that are the opposite of the ‘people’ businesses in Solutions and Syntegra. It is a scalable, ‘platform’ business which yields cash rapidly if-and-when20 utilisation goes above threshold points. • Nonetheless these service platforms have much shorter life cycles than the underlying transport assets. Core and edge routers need major upgrades or replacement every 3-5 years. There is constant growth in volumes (driven in part by price reductions, as well as the rollout of DSL access technologies as a substitute for low-speed 64kbps digital access circuits). This means line cards and backplanes must be upgraded even faster. • Market and technology evolution adds to the pressure. The push to support Voice over IP (VoIP) and Gigabit Ethernet forces platform upgrades. Cisco and other vendors constantly push their latest and greatest device. • When innovations are adopted, the larger the platform, the bigger the capex spend. For instance, at some point in the next few years BT (including Global Services) will have to decide if and when to adopt IPv6 – the next-generation version of the Internet Protocol. When it does, implementation of the new 128-bit address format (four times the size of IPv4’s 32-bit format) will require memory and table upgrades to every single router in the network. With its transborder and dense in-country networks, Global Products will have to spend a great deal of money. • In the near-term, we’ve already argued that Global Products will need to fill gaps in its directly controlled infrastructure – especially in the US, France, Italy and Asia. This does not come cheap: a single high-end Cisco 12000 series gigabit router can easily cost $500,000 dollars to purchase and deploy into the network. • Likewise, the need to recreate a functional Single Operating Environment (SOE) affects the whole division but especially Global Products. The SOE has a major impact on service capabilities such as cost management, pricing, billing and the delivery of web-based ordering, reporting and troubleshooting management service tools. Without it, the unit’s expansion will be compromised as management and customers struggle to cope with inconsistent systems across different countries.
20 This is a Big If and an Uncertain When. Some parts of almost all networks never yield cash.
32 Enders Analysis June 2003 BT Global Services
We can hardly stress enough the importance of the SOE, as noted previously. There is precious little opportunity for differentiation at the service level. Some services, such as Multimedia Call Centres using intelligent routing and NIVR (Network Interactive Voice Response), are comparatively differentiated. But by and large product features in data services (and increasingly, in voice too given the shift towards VoIP) are determined by whatever Cisco chooses to deliver.
As such, product differentiation comes from service effectiveness and the quality, convenience and usefulness of information provided to customers. As we have emphasised, Global Services inherited a ragbag of disparate systems and must harmonise them somehow. We understand its preferred packages to include: • Oracle for financials; • Peoplesoft for HR21; • Siebel for sales CRM; and • HP’s Clarify for customer service.
Some of the biggest challenges come in the areas of billing and OSS. Global Services have stated that they intend to merge 52 separate billing platforms into a single architecture. The complexity and risks here are daunting. These are highly specific billing engines, each with their own required data structures. Needless to say, they are central to revenue recognition and performance management. Any flaws in execution show up immediately on the bottom line. The nirvana of one architecture that can do everything will be difficult to achieve.
The same can be said of Order Entry & Provisioning (OE&P) systems. Consider a customer who requires an IP VPN service in the UK, France, Spain, Canada and South Korea. Although the customer may have a single point of contact to place the order, the implementation will be mediated through at least four separate OE&P systems, with customer data often manually rekeyed. This is time-consuming and provides ample scope for errors – which can then flow through into misbilling.
These examples suggest why SOE is such a crucial program. If Global Services is to catch up with its competitors and secure the efficiency gains that come from coherent processes and systems, it cannot afford for the program to fail. The countries and Global Products will be major beneficiaries. But this will further increase capital spending.
Overall, we estimate that Global Products had a direct capital and development budget in FY2003 of approximately £120 million ($186 million; €166 million), or 6.4% on capital revenues of £1,883 million ($2,919; €2,602 million). This is slightly below Global Services’ overall capital spend of £439 million ($680 million; €607 million) or 8% of revenues. This is the lowest level of spend ever. Can Global Products constrain spend at these levels without damaging competitiveness?
Given the factors identified above, we doubt it. We can sanity-check our instincts against Infonet and Equant’s reported levels of capex. All three operators spent heavily in FY2001, in particular Infonet, which is generally thrifty with capital but had committed to the upgrade to the core of its World Network using Marconi ATM equipment. Equant reports separately its expenditure on tangible assets (PP&E); Infonet bundles its report of expenditure on PP&E in with expenditure on Communications links. We have estimated the latter and stripped it out to give the following comparators for capital expenditure over the past three years.
21 By way of illustrating how far GS has to go to achieve its SOE dream, BT’s 2003 Annual Report (published in early June) gives headcount for Global Services as 17,200. But in email exchanges a week later with Global Services, they stated their headcount (after transferring some staff from BT Retail in April) to be 20,500. This is a discrepancy of nearly 3,300 or nearly 20% – non-trivial in terms of managing salary costs and SG&A.
Enders Analysis 33 BT Global Services June 2003
Table 11 COMPARATIVE CAPITAL EXPENDITURE OF THREE PROVIDERS
Capex 2000-2002 BT Global Equant Infonet Services Average annual spend in period (£m) 665 225 75 Average spend as % revenues 16 16 18 Capex as % rev – highest year 27 22 24 Capex as % rev – lowest year 8 11 13
[Source: BT, Equant, Infonet Annual Reports & 10-K filings FY2002]
In its outlook statements, Equant expects the level of capex, which was at 11% in FY2002, to continue to fall. Its network is essentially built. Two things could drive up capex – a decision to upgrade low-speed Nortel equipment in all its 220 markets to the same levels as its 55 ‘core’ countries, or a decision to invest in greater capillarity in select national markets. Given (a) the prudent approach to capex being adopted by all operators, and (b) Equant’s proven skill at negotiating competitive access prices, we think both are unlikely (10% probability).
Almost exactly the same could be said of Infonet. Its relative levels of capex tend to be slightly higher as a proportion of revenues, because its revenue stream is smaller than either Global Products or Equant, and as a smaller customer it may get lower levels of discount from its main vendors. But Infonets’s network is now upgraded and it has not signalled any intention to ‘go local’. Like Equant, Infonet also has no need to invest heavily in its SOE.
This suggests that all three operators should be able to maintain capex within the 10-15% range over the next few years. But we expect Equant and Infonet to be at the low end, and Global Products to be at the upper end of this range. We use this assumption in our overall projections for the division later on.
The final comparative factor of interest is the approach to sales channels. The major similarities and differences can be sketched as follows: • All three companies stress their basic commitment to Global Account Management for their major customers. • That said, Global Products uses a mixed approach to sales – it combines direct and indirect channels. As discussed, it is heavily dependent on the direct channel within the UK. The history of the EJVs also shows that it has never really succeeded in making its indirect channels work. In particular, income from France and Italy has disappointed. It has also lost the benefit of the aggression and market power of MCI and AT&T, its former allies in the US, and has to rebuild a direct capability in that market. Nonetheless, at the level of the Global Products LOB, its mixture of channels has delivered healthy growth in FY2003 of 16% on the previous year. • By contrast, Equant has always emphasised its direct sales channels. Its sales in France are now handled indirectly (and exclusively) through its majority shareholder, France Télécom, and SITA resells Equant’s network services. But its expansion has been driven by an approach to sales that emphasises pre-sales consulting and by tightly defining the type of contracts that it bids for. This has delivered results. YOY revenue growth during 1996-2002 has been a remarkable 41%. This is the best performance among all the large companies in the sector. • Infonet also surprises – for the opposite reason. It has wrung outstanding performance from its indirect channels. The company maintains a direct sales force but direct revenues have been flat over the past three years. Overall the company has delivered aggregate YOY revenue growth during 1997-2002 of 20%. Almost all of that growth has thus come from the indirect channels, which now account for some 70% of total revenues.
These very different approaches feed into our basic comparative measure for sales effectiveness, namely average revenue per employee. Again, like-for-like comparisons require some care and cannot be exact. In particular, note that (a) comparisons are for FY2002 as this is the last year with details available for all three
34 Enders Analysis June 2003 BT Global Services companies; (b) BT numbers are for Global Products only; (c) headcount numbers are estimates, given that BT does not release LOB headcount details; and (d) Global Products revenues are net of estimated eliminations.
Table 12 SALES PER EMPLOYEE AND CHANNEL PERFORMANCE: COMPARISON
Channel performance Global Equant Infonet Products FY2002 revenues (£m) 1,257 2,079 452 Average YOY revenue growth rates (%) 1622 41 20 Employees 6,500 est 10,100 1,600 Revenue per employee (£000) 193 206 282 Compared to Global Products 6% higher 46% higher
[Source: BT; Enders Analysis]
This comparison suggests: • Equant’s direct approach achieves slightly higher revenue/employee but more than twice the growth rates; • Infonet’s indirect approach achieves similar revenue growth rates to Global Services but dramatically higher revenue/employee.
Global Products’ strong performance in 2003 may well improve these comparisons but news reports suggest that its rivals are also enjoying healthy growth. Global Products will probably seek to rebalance its current channel mix to suit its evolving regional strategies. Whatever mix it prefers, the challenge is to raise its overall channel performance to the levels of its competitors.
So how do all these similarities and differences translate into an outlook for Global Products? To begin with, the management deserves credit for current performance. In early 2002 Global Products was in disarray – the European operations were loss-making, the Concert Unwind was barely complete, staff were demoralised, management systems were rudimentary. By the end of the same year: • Headcount reductions had brought the European operations close to breakeven, • Global Products turned EBITDA-positive in Q4 of FY2003; • Some notable sales wins had been scored, with the IP VPN MPLS pipeline benefiting from its aggressive price positioning relative to BT’s mature Frame Relay service; and • Programmes to integrate, harmonise and generally plug the gaps in the platform had been launched and were making solid progress.
This represents a substantial turnaround. So what of the future? Despite all the improvements, we are cautious about Global Products. It is growing, and heading towards EBITDA breakeven. But its basic proposition is undifferentiated in relation to its primary competitors. Its branding is weaker, its revenue base less well balanced, its capital expenditure requirements somewhat higher and its channel mix less effective than the competition. So we have opted for a revenue outlook based on the straight-line trend of an average 12.6% YOY growth (Table 13).
22 The recent formation of Global Services and Global Products means that growth rates are only available for a single year: 2002- 2003. Equant’s growth rates are averaged over 1996-2002, and Infonet’s over 1997-2002.
Enders Analysis 35 BT Global Services June 2003
Table 13 GLOBAL PRODUCTS’ REVENUE OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 GP revenue 1,628 1,883 2,215 2,495 2,785 3,080 3,375
[Source: BT; Enders Analysis]
What of EBITDA? Here we separate the outlook into two parts. First, Global Products considered as a stand-alone unit. The LOB captures the bulk of the operating costs of the global and domestic infrastructures. It has only just become EBITDA positive in the final Q4 of FY2003. It will continue to spend on infrastructure and on ramping up its sales channels in areas where performance needs to improve. It should break even on the full year in FY2004 and move towards double-digit EBITDA in percentage terms steadily to 2008 (Table 14).
Table 14 GLOBAL PRODUCTS’ EBITDA OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 GP EBITDA -174 -73 38 111 170 246 347 as % rev -11 -4 2 4 6 8 10
[Source: BT; Enders Analysis]
On top of this, we expect additional pull-through from sales by Solutions. The two LOBs trade on a transfer-price basis, but the Solutions offer makes heavy use of the platforms managed by Global Products. This is especially true of the IP VPN MPLS service which has featured strongly in several recent European outsourcing wins. When such volumes flow through onto Global Products’ platforms, the scale economies can drive up margins rapidly. We think there is both differentiation and genuine synergy between the two units and as such have ramped our earnings growth forecast to reach 15% of revenues by the end of the period (Table 15).
Table 15 GLOBAL PRODUCT’ EBITDA OUTLOOK WITH SOLUTIONS PULLTHROUGH TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 GP EBITDA -174 -73 38 150 252 373 511 as % rev -11 -4 2 6 9 12 15 YOY % 58 151 300 68 48 37
[Source: BT; Enders Analysis]
This contribution depends heavily on the successful implementation of efficiency programs such as the SOE. Without it Global Products will be unable to translate revenue growth into serious margins.
Global Wholesale (interconnect)
Global Services is never happier than when changing its names, as noted previously, and so recently changed the name of its fourth major line of business from Global Carrier to Global Wholesale. This is perfectly accurate, as the business is pure wholesale. Its customers are other carriers and service providers, whether PTTs, alternative operators, resellers, mobile operators or ISPs. Its staff are mainly commercial and contract managers. As such its revenues fall roughly into three categories: • Traditional correspondent revenues: • Global Services’ trading with AT&T and MCI, including correspondent; and • Revenues from new wholesale service offers such as mobile-mobile transit.
The revenue reporting for the unit is somewhat opaque and the dynamics within these different revenue categories are very different. We shall attempt to disentangle the different strands to provide a balanced
36 Enders Analysis June 2003 BT Global Services outlook. But at the headline level, Global Wholesale is a business under pressure. In FY2003 its overall revenues were 15% down on the previous year, at £1,007 million ($1,561 million; €1,391 million). This is very much in line with long-run historic trends and the key question must be whether new service offers can compensate for this decline.
Before turning to the structural issues facing the business, BT has explained one crucial inter-business trading arrangement which is not reflected in current reporting. We estimate that traditional correspondent traffic makes up some 60% of revenues, or some £605 million ($938 million; €836 million). Of this BT guidance has indicated that about half (circa £300 million) represents revenues from traffic provided to BT’s retail channels in the UK. Here the business objective is to maximise retail margins by delivering the lowest unit cost international terminations per minute. As such, given that international volumes of traffic continue to rise, a decline in revenues is a good thing.
BT would clarify this aspect of its trading if it adopted the same format as BT Wholesale and made the distinction between Internal and External turnover.
With that cautionary note, we turn first to the traditional business, as it remains the bulk of the revenue total. Here the unit’s market position is a direct consequence of BT’s historic role as a national monopoly within an international cartel. This market used to be stable and lucrative. But deregulation, competition and investment in new capacity have transformed its dynamics, and the outlook for the business is now cloudy.
This class of wholesale business is often referred to as the ‘correspondent’ business, a faintly archaic phrase which harks back to the days of the PTT cartel. In the era before deregulation, national operators would enter into bilateral agreements to serve a specific route, say UK-Australia. They would jointly provide capacity and agree to exchange traffic on set commercial terms. Traffic fell into three main types: • International voice: PSTN calls from country to country, often called IDDD (International Digital Direct Dial). These were priced on a pay-per-minute basis, usually in tariff bands according to destination. • International Private Leased Circuits (IPLCs): ‘Clear channels’ of capacity leased for a fixed monthly charge to a single customer (typically corporate) who would use it to send private voice or data traffic. • International data: Originally telex and X.25 traffic (and tiny in volume terms compared to voice) but since the explosion in Internet volumes, data has become the dominant international traffic type.
The original model was also vertically integrated. PTTs – which had plenty of capital available from their domestic monopolies – would invest in mutually owned consortia to construct the underlying physical capacity. These consortia would fund the construction of submarine cable systems, or the launch of satellites. Construction costs were significant – trans-oceanic systems routinely cost in excess of $1 billion to build. Equity in the consortia was proportional to capital contributed and mirrored by the capacity allocated to the participating carrier. In essence the PTTs were pre-purchasing fixed amounts of capacity over the expected life of the system. They put in capital upfront and used their knowledge of volume trends and the cartelised pricing system to predict a breakeven point. Before deregulation, market systems were planned with a 25-year life and were typically assumed to reach capacity after 12 years. The pent-up demand for international communications meant that until recently these assumptions were routinely disproved. For instance, the cable system TAT-12/1323 which came into service in 1996 reached capacity two years later. PTTs carried their pre-purchased capacity as a long-term asset on their balance sheet, depreciated over the life of the system. These assets were referred to as IRUs (Indefeasible Rights of Use). Retail leases for capacity were typically one-year contracts.
Once capacity had been retained on a given route, the interconnecting correspondents would then set prices between themselves. Each would provide a ‘half circuit’ – i.e. meet the notional costs of their owned
23 TAT stands for Trans Atlantic Telecommunications [or Telephony], the numerals indicate its place in the sequence of such cable to be laid (TAT 12/13 was a dual-cable system, hence the odd 12/13 designation). TAT-1 came into service in 1956 and had 48 channels. TAT-14 came into service in 2000 and had 52 billion times as much capacity as TAT-1.
Enders Analysis 37 BT Global Services June 2003 capacity up to a hypothetical mid-point of interconnection. For IPLCs, a retail customer would then buy one ‘half’ of each circuit from the PTTs in country A and country B. Retail prices for each half would be set locally but in practice often converged. For variably priced voice traffic, the correspondents would agree an interconnect rate which each would pay the other to terminate traffic on the far-end network.
Correspondents then use the netting principle familiar from international banking settlements. The total volume of traffic in each direction would be monitored and only the differential between outbound/inbound volumes would be paid, according to the pre-agreed rate. Typically the balance on all bilateral services would be settled via a single payment. Credit risk was minimal, given that PTTs were often government- owned administrations and hence risk was on a par with that country’s sovereign debt.
Once cables were full they became money machines. Under-supply meant capacity was scarce. The capital costs meant there were significant barriers to entry. End-user pricing was cartelised. An introductory technical paper written by David Williams, a physicist at CERN, in 1997 cites some examples of the operating economics:
“To give one example, a 2 Mbps circuit from Switzerland to the US was retailing to end-users at about $500k per year in 1997, while the consortium purchase price, discounted over five years and including annual maintenance and operation, must have represented only some $60k per year. Even allowing for the terrestrial circuits and for operations, overheads and profits, it can be seen that this has been, and still is, a very lucrative market. Another example, using data published in Communications Week International in June 1997, looked at 2 Mbps circuits on the US-Australia route. Typical end-user charges were $98k per month, while the costs incurred by consortium members to provide such circuits were estimated to amount to less than $13k per month.”
Such gross margins (85-90%) provided a handsome return on capital for the participants in consortia. Historically some of the biggest operators in the market were those PTTs with large, open economies and an oceanic seaboard where the submarine systems landed. They included AT&T, BT and France Télécom. Such operators enjoyed extraordinary returns until at least the late 1990s.
Since then everything has changed. • The operating economics of cable construction have been transformed. The expensive electronics needed for submarine repeater systems have steadily reduced in cost. Optical technologies such as Wave Division Multiplexing (WDM) have enabled capacity on fibre pairs to increase by orders of magnitude. Point-to-point cables have been replaced by branching cables that use add/drop multiplexors to diversify the routing options for carriers, which is much more efficient. • Data volumes have far surpassed voice volumes. Voice traffic has been growing steadily at between 5- 10% a year for the past 15 years. Data has enjoyed YOY growth rates of 30-50%, sometimes higher. Industry analysts Telegeography suggest that the voice/data ‘crossover’ occurred sometime in 1998. Since 1996, the PSTN's share of used capacity dropped from 83 to 18%. During 2001, private line deployments (mainly used for data) grew by 34%, while public telephone line capacity increased by a stately 8%. • De-regulation has allowed multiple operators to offer international retail services. For example, by May 2003 the UK Regulator Oftel had issued 686 separate licenses for International Voice Resale. In effect, regulatory barriers to market entry have disappeared. • The proliferation of retail providers has led to the emergence of a genuine wholesale market for trading capacity and voice minutes. There are now a significant number of transit and refile operators. The latter exploit price differentials by routing traffic to points of origination where they can obtain more favourable prices. Transit providers act as intermediary networks to pass traffic from origination to termination in return for a small margin. All these developments have accelerated price competition. • The growth in data volumes has also changed the relationship between the retail pricing of capacity purchased. Historically a customer who bought a 64kbps IPLC to carry private voice traffic might (depending on compression scheme) obtain 6-8 voice channels for about a quarter of the retail price for a single voice call. By comparison, the monthly prices quoted for E1 and OC-3 circuits between London-Frankfurt in February 2002 were as follows: an E1 with 2Mbps capacity was priced at
38 Enders Analysis June 2003 BT Global Services
$1,570/month; an OC-3 with 155Mbps capacity was priced at $5,535/month. In other words, a customer can now obtain 75 times the capacity for 3.5 times the price24. • During 1996-2001, the historic profitability of the wholesale business caused an extraordinary surge in the construction of new capacity. Capital markets backed non-traditional operators such as Global Crossing which built extensive wholly-owned cable networks. Multiple terrestrial networks were also constructed in Europe and the Americas. By way of illustration, the 45,000km BT/EJV Farland network, by some measures the largest European fibre network, represents only a tenth of the total 441,000km of fibre laid in Europe alone. And this is ‘physical fibre miles’, not capacity. In Frankfurt there were no fewer than 28 separate providers in 2002 who could provide a customer with a transborder OC- 3/STM-1 circuit. Data from Telegeography illustrates the equivalent growth in trans-oceanic capacity. Table 16 shows the capacity that will exist when available fibre is fully ‘lit’ as a percentage of the equivalent capacity in 1998 (note the log scale). So, for example on the key Transatlantic routes, capacity will have increased 148-fold over 1998-2004. Intra-Asian capacity will have increased an astonishing 1,900-fold.
Table 16 SUBMARINE CABLE CAPACITY (GBPS) AS % OF 1998 CAPACITY
10,000
1,000
Percent 100
10 1998 1999 2000 2001 1 2002 2003 ia 2004 As ic a- nt Fully Upgraded a fic ntr tl I A ca ri a ns- -Paci e i ns m As Tra A - Tra n ica ti r a Af -L - S. pe U. o Eur
Intra-Asia Trans-Atlantic Trans-Pacific U.S.-Latin America Europe-Africa-Asia
[Source: Telegeography]
• The consequence of such abundant capacity is sharp price declines. OC-3 prices on four prime intra- European routes were 54% down on 12 months earlier in February 2002, and price declines were similar on trans-oceanic routes.
The economic effect of this orgy of capital formation was predictable. The wholesale market went from scarcity to super-abundance in about five years. Over-supply among infrastructure providers led several to breach their financial covenants and collapse, including Global Crossing. The latter’s restructuring under Chapter 11 ‘debtor in possession’ proceedings reveals the extent of over-supply – the company has needed to write-off “at least” $7 billion of the value of its tangible assets plus a further $8 billion of goodwill and intangibles. The second major casualty of the glut (although for somewhat different reasons) was Worldcom – a significant infrastructure owner as well as the largest international carrier in the world, carrying 14.8 billion voice minutes in 2002. The distress among certain providers meant that wholesale prices have showed modest signs of firming on key routes, although it is not at all clear whether this can be sustained.
24 That same single OC-3 capacity provides 2,016 64kbps channels – enough for approximately 16,000 simultaneous voice calls.
Enders Analysis 39 BT Global Services June 2003
We thus have a wholesale market which has been fundamentally transformed: • Barriers to entry have fallen away completely; • There is over-supply of capacity; • Price declines match volume increases, leading to thinner margins; • Commoditised trading and price transparency make revenue streams less predictable – i.e. increases risk; and • Infrastructure remains high fixed cost, low marginal cost. This encourages pricing based on incremental yield rather than full cost recovery.
What are the prospects for Global Wholesale in such a market? Here it helps to look at BT’s historic results (Table 17). The trend is not difficult to spot25.
Table 17 BT REPORTED REVENUES FROM INTERNATIONAL INCLUDING GLOBAL WHOLESALE
2500
2000
1500 (£m) 1000
500
0 1996 1997 1998 1999 2000 2001 2002 2003
[Source: BT]
The data shows that BT’s revenue decline on its traditional business has averaged -9% YOY. (As noted earlier, the swings and roundabouts of internal trading mean that this is a good thing for the UK retail channels.) Although there are some signs that price declines are easing, we remain pessimistic about the outlook. The brute economics of capacity and competition mean that unit prices and hence gross revenues are likely to continue to fall steadily. Our central case scenario is that the historic trend will continue, which would bring down traditional revenues by 40% over the period from approximately £605 million ($938 million; €836 million) in 2003 to £375 million ($581 million; €518 million) in 2008. Our best case sees the YOY rate of decline halve to -4.5%, which keeps revenues up at £480 million ($744 million; €663 million) by 2008.
Next, the divorcees and their associated alimony – BT’s trading with AT&T and MCI.
Our understanding is that BT chooses to manage both its interconnect and its post-Concert interests with these providers through the same commercial unit. This makes sense, as it gives a proper view of the totality of BT’s trading with its former partners. The total revenues from this source were sharply down in FY2003, and this was presented as the explanation for why Global Wholesale’s revenues fell overall by a striking -15%. What then of the future?
25 During the short-lived Concert GV, BT stopped reporting its international revenues, but has resumed with the re-integration of Carrier into Global Services. The numbers for FY2000 and FY2001 are therefore interpolated from the data reported by BT for FY1999 and Global Services for FY2002.
40 Enders Analysis June 2003 BT Global Services
AT&T and MCI (formerly Worldcom) are easily the two largest interconnect operators in the world, carrying just under 25 billion minutes between them in 2001. Given BT’s lock grip on the UK local loop, it is to be expected that the three will continue to trade substantial volumes of call minutes and pricing on these volumes will trend in line with the market. The outlook for other trading is anybody’s guess. Overall we find it hard to believe that AT&T and MCI would choose to increase their levels of business with BT. They will prefer to shift business across to their own assets and partners wherever possible, and bargain supply prices down on the remainder. The AT&T Minimum Revenue Commitments embedded in the Concert Unwind also expire in 2005. So we blend the -9% decline on interconnect with a steadier -4% YOY reduction on other business to give an overall decline of -6.5%. Our estimate of £151 million revenues ($234 million; €209 million) in FY2003 declines by over a quarter over the period to £108 million ($167 million; €149 million) in 2008.
The next question is to what extent such declines might be offset by growth from new service offers? BT is bullish on this count, citing call quality, the capillarity of its European network and the growth potential from servicing segments such as mobile operators and alternative providers. Clearly these non-traditional wholesale customers are an attractive target. BT can offer them cheap transport across its pan-European networks and access to its competitive termination agreements. This will help. But other wholesale providers such as Colt and Viacom will compete fiercely for the same traffic, and there are other risks which Global Wholesale will have to manage: • Many wholesale customers are small resellers and ISPs, without the financial resources of a PTT. This increases credit risk. • Wholesale pricing in the transit market has to take account of ‘termination’ or ‘egress’ charges. A transit carrier must charge the originating carrier a price that includes the onward settlement payments due to any other transit networks, plus the terminating network. If pricing databases are poorly linked, it is all too easy to offer prices to customers that do not cover the egress costs – i.e. to sell at a loss. For example, the Concert GV took an internal $250 million (£170 million; €242 million) charge in 2001 to cover a mispricing that occurred because a Concert wholesale pricing system and an AT&T billing system were decoupled. • There are few structural reasons why market conditions should improve. It is easy to increase capacity (by ‘lighting’ dark fibre) to meet fresh demand, but virtually impossible to retire it, short of digging it up. Meanwhile aggressive competitors are coming back out of administration. • Margins on the transit business are dramatically thinner, as this striking Table 18 from BT Wholesale in the UK makes clear. Transit accounts for 42% of revenue but only 2% of gross margin! The two kinds of business are not exactly comparable, as the UK business is regulated whereas international transit is not. So canny pricing by Global Wholesale may allow somewhat higher margins. But even so, these are unlikely ever to reach the levels enjoyed on the traditional business. The best margins result from terminating traffic on a network that you own.
Enders Analysis 41 BT Global Services June 2003
Table 18 BT WHOLESALE’S EXTERNAL TURNOVER AND GROSS MARGIN
EXTERNAL REVENUE, YTD 2002-03 GROSS MARGIN, YTD 2002-03
42% 94%
53% 2%
4%
5%
Traditional New business Transit Traditional New business Transit
[Source: BT Group Q3 results, FY2002-03]
It would be pleasant to predict a heroic turnaround for the Global Wholesale business. If BT is correct in its optimism, then it may be possible to stabilise and possibly return the business to growth. Hats off to BT if they make it happen. But without much good news in the numbers to date and plenty of competitive pressure we doubt whether growth from new business can offset the decline in the old. We expect new business to grow at 6% per annum, from £252 million ($391 million; €348 million) in 2003 to £335 million ($519 million; €511 million) in 2008, or 34% overall.
Adding these together we arrive at our outlook for the Global Wholesale LOB:
Table 19 GLOBAL WHOLESALE’S REVENUE MIX OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Traditional n.g 604 550 500 455 410 375 AT&T & MCI n.g 151 140 130 125 115 110 New services n.g 252 265 285 300 320 335 Total GW revenue 1,115 1,007 955 915 880 845 820 YOY % -10 -5 -4 -4 -4 -3
[Source: BT; Enders Analysis] NB: n.g = no guidance
What of the EBITDA and FCF outlook on this revenue profile? Here the position is more cheerful. Here’s why: • The bulk of direct costs in Global Wholesale are the termination charges it must pay to third parties. It is reasonable to assume that these will fall broadly in line with revenues – this is what the commercial teams in the unit are tasked to achieve, and as a Top 5 interconnect operator BT has significant negotiating power. • There is a large infrastructure which will require ongoing maintenance spend. BT guidance is that currently such costs are between 10-15% of total costs. As it seems unlikely that BT will indulge in another round of major capacity acquisition, this expense line should not increase in absolute terms. • By contrast, SG&A costs are likely to increase as BT reaches out to more new customers (and assumes some credit risks as it does so). But these are currently less than 10% of total expense.
42 Enders Analysis June 2003 BT Global Services
• BT has already taken its big hit on its long-life infrastructure by writing down the value of the Global Wholesale assets by 80% or £825 million ($1,279 million; €1,140 million) during the Concert Unwind in 2001. This puts it roughly on a level footing with competitors who have had asset write-offs approved by creditors or administrators. The write-down reduces pro rata the impact of depreciation charges on EBIT, which benefits future reported earnings.
Our model suggests that if network costs do not rise significantly in absolute terms (a strong assumption), then falls in underlying termination costs and improving margins from new business can increase levels of EBITDA to 21% on revenues. With low depreciation this means a shrinking business can nonetheless remain cash positive for some time yet. This outlook is highly sensitive to the cost base. In absolute terms EBITDA only improves by about £10 million ($16 million; €14 million) per annum over the period. This could easily be wiped out by, say, a rise in the maintenance cost of the infrastructure. Margins could thin sharply – perhaps even turn negative.
Table 20 GLOBAL WHOLESALE’S REVENUE AND EBITDA OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 GW revenue 1,115 1,007 955 915 880 845 820 EBITDA 57 157 157 162 166 165 169 as % 5 16 16 18 19 20 21
[Source: BT; Enders Analysis]
For BT to achieve this would be a very satisfactory performance under tough conditions.
Capital Expenditure
Finally we need to look at the outlook for capital expenditure. The picture here is extremely murky. The changing shape of Group accounts and the management of much capital spend on transborder by the various versions of Concert make it impossible to develop a coherent historical view of BT’s annual capital expenditure for its international businesses. So we have attempted a bottom-up build of the division’s requirements, crosschecked against sensible comparators.
Broadly speaking, there are two categories for capital spend: • The acquisition of tangible assets i.e. Plant, Property and Equipment (PP&E) to develop, build and maintain service platforms. This can include the capitalisation of long-term rental assets such as IRUs. The routine maintenance capital requirements grow significantly as the platforms increase in size. When capital spending is tightly controlled this can squeeze the funds available for new service development and other customer-facing projects. • Spend on intangibles, such as capitalised development. BT, like many other providers, routinely capitalises a portion of the expense of developing and testing new services. (This is not trivial – in Group accounts it is shown as ‘Own work capitalised’, and over the past decade has averaged nearly half a billion pounds a year. Headline capex figures which focus on tangible assets do not take this additional cost into account.)
Global Services manage their platforms through a single Network Operations unit. In effect, all the service and transport assets, whether owned like Farland, or leased from other providers, are pooled26. This Operations unit, currently headed by Lowry Stanage, will procure and maintain that asset pool. When a Line of Business needs to develop new network capabilities, it will commission the Plan & Provide function within Operations to make it happen. Such commissions will be funded out of a ‘direct’ budget controlled by the LOB. On top of this Operations will also have its own capital budgets. The unit is managed primarily as a
26 Some capital assets, such as outsourced customer equipment, will be treated as part of a contract and booked within the sales channel. Certain other assets, such as IT systems, will be also be managed separately from Network Operations.
Enders Analysis 43 BT Global Services June 2003 cost centre, and its total costs will be apportioned across the LOBs using revenue or some other management accounting principle. Such costs will include both utilised and unutilised capacity.
This explains why capital spend is only loosely correlated to revenues and the LOBs. BT has indicated that ‘direct’ capital expenditure by the LOBs in FY2003 was “very small” for Solutions and Global Wholesale (approximately £50 million ($78 million; €69 million)), and effectively nil for Syntegra, while spend was, in our view, approximately £120 million ($186 million; €166 million) for Global Products – say £170 million ($264 million; €235 million). Given overall capital expenditure in the year of £439 million ($680 million; €607 million), that leaves some £270 million ($419 million; €373 million) of ‘general’ spend, or 62% of the total. Importantly, this includes the expenditure on maintaining the UK IP network. Recent information from Paul Reynolds, divisional CEO of BT Wholesale, indicates that the UK IP network accounts for some £120 million ($186 million; €166 million) or 45% of this general spend.
We have described earlier why we believe direct capex by Global Products will need to rise. Drivers include: • Recreating or expanding direct platforms in key markets like the US; • Technology upgrades like the progressive implementation of DWDM technology in transport platforms and IPv6 in service platforms; • Access layer evolution, to handle wireless and DSL access. • The need to ensure the SOE program succeeds; • Increased maintenance spend as platforms scale; • Accounting for capital elements of outsourcing wins.
Despite the loose correlation, it is only really possible to evaluate overall levels of spend as a proportion of revenues. So we have adopted a twin-track approach. First, we assume that Global Products will need to steadily increase its capital expenditure up to 15% of revenues and then hold it there. Anything less would jeopardise its ability to grow revenues against fierce competition. Earlier we looked at Global Products relative to Equant and Infonet, where average spend across all three has been 16.5% of revenues and historic lows have been 8%, 11% and 13% respectively. Given the need for Global Products to catch up and overtake these rivals, we think this growth in spend is prudent.
But the cash flow imperatives for the business mean that the overall total must remain low. Something has to give, and in this model it is ‘general’ spend. To meet its plan, Global Services will have to cut maintenance capex by one-third in 2004 with smaller reductions in the next two years.
This gives the following outlook for capital expenditure across Global Services (Table 21), also shown as a percentage of revenues after eliminations.
Table 21 GLOBAL SERVICES’ CAPITAL EXPENDITURE OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 GS capex 609 439 394 465 590 650 695 as % rev 14 8 7 7 8 9 9
[Source: BT; Enders Analysis]
Readers should be under no illusions as to how difficult this outlook will be to achieve. The engineering functions responsible for growing the network in line with volumes and maintaining service quality will be screaming with pain at such restraint. It is very difficult to keep a large network infrastructure running smoothly on a standstill budget, let alone one being cut in real terms.
By way of comparison, in the BT Group as a whole, capital expenditure on tangibles during 1996-2003 has averaged 19% of turnover. The lowest it has ever been was in FY2003, when spend of £2,445 million ($3,790 million; €3,378 million) equalled 13% of turnover. This year’s Group spend certainly reflects tight controls, but it may also reflect smarter spending. If ‘own work capitalised’ is added to the spend on
44 Enders Analysis June 2003 BT Global Services tangibles, then the Group spend rises to an average 23%, reduced to 16% in FY2003. Table 22 shows how challenging it will be for Andy Green to restrain capital spend at these levels. If the management team can accomplish this objective, they will show themselves to be world-class. It is an extremely tough objective. In the next section we explore the consequences if it proves impossible to achieve.
Table 22 BT GROUP CAPITAL EXPENDITURE AND GLOBAL SERVICES FORECAST AS % OF TURNOVER
30%
25%
20%
15%
10%
5%
0% 1996 1997 1998 1999 2000 2001 2002 2003 f2004 f2005 f2006 f2007 f2008
BT Group Tangibles & Own Work BT Group capex on Tangibles BT Global Services (forecast)
[Source: BT; Enders Analysis]
Summary Financials
We can now compile our LOB forecasts to give an overall divisional view.
Table 23 GLOBAL SERVICES’ REVENUE OUTLOOK TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Syntegra 610 623 650 690 720 760 800 Solutions 1,828 2,042 2,445 2,810 3,175 3,525 3,840 Global Products 1,628 1,883 2,215 2,495 2,785 3,080 3,375 Global Wholesale 1,115 1,007 955 915 880 845 820 Eliminations -708 -304 -349 -555 -605 -655 -705 Total 4,473 5,251 5,916 6,355 6,955 7,555 8,130 YOY (%) 7 13 10 9 9 8
[Source: BT; Enders Analysis]
[Note: Eliminations for 2005-2008 are assumed to be 8.2% of revenues, which is the average rate for 2002-2004. It would clarify divisional performance if BT reported gross revenues, then the eliminations line, then LOB revenues net of eliminations.]
If Group turnover continues to grow at its straight-line trend rate (unlikely, but projected here as a way of setting Global Services in context) we can see the division becoming more important as a contributor to Group revenues by about 10 percentage points over the period.
Enders Analysis 45 BT Global Services June 2003
Table 24 GLOBAL SERVICES’ REVENUE OUTLOOK AS PERCENT OF BT GROUP TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Group turnover 18,450 18,730 19,240 19,940 20,640 21,340 22,050 GS 4,473 5,251 5,916 6,355 6,955 7,555 8,130 GS as % 24 28 31 32 34 35 37
[Source: BT; Enders Analysis]
In terms of capex, we have explained why we think Global Services will want to keep spend below 10% of revenues. Assuming that BT Group keeps its capex at its historic minimum level and in constant proportion to its own turnover (again, heroic assumptions but let’s keep things simple), then divisional capex will rise more slowly as a percent of Group capex in line with revenues – reaching approximately 24% of Group capex by the end of the period.
Table 25 GLOBAL SERVICES’ CAPITAL EXPENDITURE OUTLOOK AS PERCENT OF BT GROUP TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Group capex 3,723 2,450 2,510 2,600 2,700 2,790 2,880 GS capex 609 439 394 465 590 650 695 GS as % 16 18 16 18 22 23 24
[Source: BT; Enders Analysis]
Next, EBITDA (net of Other costs but before pre-leavers costs27). Here the overall outlook is positive but undramatic. Syntegra will find it hard to make headway against much larger competitors. Global Wholesale is fighting a rearguard action in a declining market. Solutions will prosper but must absorb the upfront costs of new contracts and manage its contract risks efficiently. Global Products is the real star – it makes steady improvement on its own account, and benefits from pull-through from Solutions. Divisional EBITDA reaches 12% of net revenues of Global Services by the end of the forecast period.
Table 26 GLOBAL SERVICES’ EBITDA OUTLOOK BY LINE OF BUSINESS TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Syntegra 31 34 36 37 39 41 43 Solutions 158 172 209 240 271 301 328 Global Products -174 -73 38 150 252 373 511 Global Wholesale 59 157 157 162 166 165 169 Other -49 -47 -60 -69 -78 -86 -94 Total 2528 243 380 520 651 794 957 as % GS rev -1 5 6 8 9 11 12
[Source: BT; Enders Analysis]
27 BT takes the costs of its Early Leavers programme and additional contributions to its pension fund as an expense rather than an exceptional cost, but shows it as a separate ‘Reported EBITDA’ line to clarify the underlying operational performance. For example, in 2002/3 total, Other costs were -£112 million of which Leavers costs were -£65 million which gives the balance of -£47 million shown here. 28 The £25 million EBITDA pre-leavers figure shown here is at variance by £127 million with the £201 million reported by BT in FY2002. However the LOB EBITDA numbers shown here are correct according to BT’s reported results. In its FY2003 results BT also reported an 872% improvement in EBITDA pre-leavers to £243 million. This is a correct percentage if EBITDA in 2002 was £25 million, but not if it was £201 million. The £127 million variance appears to be a (quite large) discrepancy in BT’s reporting.
46 Enders Analysis June 2003 BT Global Services
If we combine this EBITDA outlook with our earlier forecast for capital expenditure this gives us the outlook for Operating Free Cash Flow (EBITDA minus capital expenditure). This is our ‘best view’ of cash flow and assumes that the division delivers on all fronts – revenues, earnings and capex.
Table 27 GLOBAL SERVICES’ BEST VIEW OF OPERATING FREE CASH FLOW TO 2008
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 EBITDA 25 243 380 520 651 794 957 Capex 609 439 390 455 585 645 690 Op FCF -584 -196 -10 65 66 149 267
[Source: BT; Enders Analysis]
This is the outlook BT’s shareholders have been waiting for – positive returns from international investment. But investors are accustomed to regard BT’s international glass as half-empty. How likely is it this time they will see it as more than half full?
To assess this, we crosscheck three ways. First, is the recent cash flow trend consistent? Second, what happens if capex cannot be cut back? Third, how would slower margin growth affect the profile?
Taking each in turn, BT recently presented a rolling 12-month view of cash flow that shows a satisfyingly linear upward trend (Table 28). On this basis the division will likely turn cash flow positive in the final quarter of FY2004.
Table 28 12 MONTH ROLLING FCF
2002 Q4 2003 Q1 2003 Q2 2003 Q3 2003 Q4 0 -50 -100 -150 -200
(£m) -250 -300 -350 -400 -450
[Source: BT]
If, however, the same data is replotted on an actual (i.e. not rolling) basis, then it qualifies the trend somewhat. Overall cash flow is still improving, but only in Q1 through Q3 2003 do we see consistent gains. In Q4 in both years we see a sharp increase, presumably caused by budget holders scrambling to spend anything they have left, and by suppliers helping their own year-end revenues by collecting receivables. This suggests that management’s success in holding down capex cannot be counted upon until the final quarter is declared. So investors should watch the quarterly actuals like hawks.
Enders Analysis 47 BT Global Services June 2003
Table 29 REPORTED OPERATING FCF BY QUARTER
2002 Q1 2002 Q2 2002 Q3 2002 Q4 2003 Q1 2003 Q2 2003 Q3 2003 Q4 0
-20
-40
-60
-80 (£m) -100
-120
-140
-160
[Source: BT]
Second, our Operating FCF forecast accepted BT’s intention to constrain capex. We allowed capex on the Global Products service platforms to rise but inflicted significant cuts on general maintenance spend – a category which includes spend on the UK IP network, where BT faces continued stiff competition from alternative UK providers. What would happen to Operating FCF if, instead of being cut, this maintenance spend was simply held at current levels? It pushes the realisation of positive FCF out by two years to 2007.
Table 30 GLOBAL SERVICES: SCENARIO 2 FOR OPERATING FCF OUTLOOK
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Revenues 4,473 5,251 5,916 6,355 6,955 7,555 8,130 EBITDA 25 243 380 520 651 794 957 Capex 609 439 482 569 703 764 809 Op FCF -584 -196 -102 -49 -52 30 148
[Source: BT; Enders Analysis]
Finally, much has been made of the synergy between Solutions and Global Products. This should deliver both revenue and margin growth. But what if this is wishful thinking? Price erosion in all international markets has been relentless. Operating efficiencies may be harder and slower to realise than first thought. In our earlier LOB discussion we showed two scenarios for Global Products EBITDA, the one ‘steady’, the other ‘pull-through’. Table 29 combines the effect of maintenance capex held flat with ‘steady’ EBITDA from Global Products. Cash flow stays negative throughout the period. We doubt if such performance would be acceptable either to shareholders or the BT Board.
Table 31 GLOBAL SERVICES’ SCENARIO 3 FOR OPERATING FCF OUTLOOK
(£m) 2002 2003 f2004 f2005 f2006 f2007 f2008 Revenues 4,473 5,251 5,916 6,355 6,955 7,555 8,130 EBITDA 25 243 380 481 569 667 793 Capex 609 439 482 569 703 764 809 Op FCF -584 -196 -102 -88 -134 -97 -16
[Source: BT; Enders Analysis]
48 Enders Analysis June 2003 BT Global Services
Any sensible forecast shows a range of possible outcomes. Our bottom-up approach tries to identify those factors which could accelerate or suppress performance. Finally we ask what more could be done to make a positive outcome more probable.
Two cheers for Global Services
At the beginning of this report we queried whether shareholders should support the Board’s continued investment in Global Services. On current performance the answer is a qualified Yes. The FY2003 results were good. Trends are encouraging. But some scepticism is in order. History shows how inconsistent BT’s strategy and performance has been from year to year. To remind readers of only two examples, Concert Classic broke even in 1999; two years later the Concert GV lost £342 million ($503 million; €473 million). And in the last 10 years the European distribution strategy has gone full circle, from Direct to EJV and back to Direct. History also shows just how disruptive the market environment can be. Changing customer needs (mobile and the Internet), technology change (IP, DWDM), competitor actions (incumbents, Colt, Equant, AT&T), the manic-depressive mindset of global capital markets – no one really knows where the next shock will come from. So this is a long-run capital-intensive business in a disruptive environment. This explains why International is significantly riskier than BT’s domestic business, which faces similar pressures but from a position of far greater strength.
What then are the chances that Global Services can deliver? We remain cautious. In our view BT tends to overstate the division’s strengths. Take Andy Green’s view of the then-Ignite’s ‘unique market position’ as expounded in January 2003.
Our existing strengths
ExistingExisting strengthstrength inin targettarget segmentsegment
Built on a deep and BTBT brand and financial Built on a deep and broad retail network strengthstrength broad retail network
BT ignite Unique market positioning DeliveringDelivering next generation IP products GlobalGlobal account and generation IP products to customers now serviceservice managementmanagement to customers now
LeadingLeading providerprovider ofof solutionssolutions andand systemssystems integrationintegration
As we have detailed previously, most of these are at best neutral attributes in competitive terms rather than sources of advantage: • Outside the UK, the brand is diluted and BT’s financial strength may not be the asset it is assumed to be. No customer has yet suffered substantially because of a bankruptcy of a telco. Transfers to new networks have been relatively smooth when required. Many customers have actually stayed with financially troubled companies. Overall, we think BT’s reputation is at par. • Global Services is strong in its target segment in the UK, but is starting from a low base in Continental Europe. It is weak in the US and Asia and generally suffers from underpowered sales channels. It has a regional offer, based on a few countries in Europe, rather than a truly global one.
Enders Analysis 49 BT Global Services June 2003
• Its retail network is ‘deep and broad’ in only two out of the G7 countries – and markets like Eire and Benelux are not really large enough to power the top line. • GS is delivering next-generation IP products now – but so is everybody else. • GS offers global account and service management – but so does everybody else. • GS is a leading provider of solutions and systems integration, but Syntegra looks sub-scale.
Nonetheless: • Global Services may not be best-in-class but its platform is certainly viable. • This year’s results are moving solidly in the right direction. This is a remarkable turnaround from a year ago, and management should be credited for their tight focus on business basics. • As we reported recently in Fixed Line Telecoms [2003-09], BT’s UK business is likely to sustain damage from CPS and, eventually, WLR. A solid platform and financial performance from Global Services will simultaneously help defend the UK corporate base and offset the impact of competitive inroads into the consumer businesses.
In the summary of financial outlooks we concluded with three scenarios – our best view, which sees positive Operating FCF in 2005, and two more sombre outlooks which push positive cash flow out to 2007 or beyond.
What actions might management take to increase the likelihood of delivering positive operating FCF in 2005?
We suggest some questions for the Global Services leadership team that highlight areas which could have a material impact on performance. In many respects their actions will reveal the extent to which BT has absorbed the lessons of the past decade. To not have done so would be very expensive for shareholders. • Can capital expenditure be held below 10% of revenues without damaging competitiveness and service quality? • General capital spend is 62% of this year’s total. How much can this be squeezed to allow increased spend on those ‘vital few’ programmes that will make a difference in the marketplace? • BT has never succeeded in making equity ventures or indirect sales channels of any kind deliver. In certain key markets the direct sales teams are tiny relative to the competition – in the US, we estimate fewer than 500 sales people in total, whereas AT&T on its own has some 5,000 data sales specialists. How much will management spend to rebuild its direct channel capabilities in the US, France, Italy and Japan? • Aggressive cost management and improved service quality typically requires direct control of the service platform. How far is BT prepared to go to recreate a unitary global infrastructure? Will it plan to extend “deep and broad” reach in any new countries, or will it just stick with the networks it has today? • BT is outperformed in terms of sales growth by Equant, and in terms of revenue/employee by Infonet. If it could match its competitors’ levels its sales performance would be transformed. Management will clearly want to do this – but how? • Why does the division not report its SG&A numbers like Retail do? We suspect because they are embarrassingly flabby. The business has poor accounting systems, and carries a lot of overhead. But, alongside capital restraint, tight control of SG&A is critical if margin improvement is to be sustained. How much is GS prepared to invest in best-in-class tools for cost and revenue management? • Headcount reductions were integral to the turnaround of the European businesses. But bolstering the sales and service operations will increase headcount. Is the business prepared to make equivalent reductions elsewhere? • If synergies cannot be obtained, would shareholder value be better served by selling Syntegra to the highest bidder? • Global Wholesale is on a performance knife-edge. If the worst happens and margins trend to nil, what are the options for the business?
50 Enders Analysis June 2003 BT Global Services
• BT’s record in pursuing growth by inorganic means such as acquisition has more often than not destroyed shareholder value. But the BT Group now has a stable balance sheet and expects further progress in debt reduction. Globally, there are still plenty of distressed businesses that would be available at the right price. If Global Services goes shopping, how would it convince the markets that it has not once again overpaid?
Credible answers to such questions could add some welcome sparkle to the jewel.
Enders Analysis 51 BT Global Services June 2003 APPENDIX I Forecast Methodology and Assumptions
• Unless otherwise stated, all data is drawn from company quarterly and annual reports, company and divisional presentations and/or material published on company websites.
• Where there were gaps or inconsistencies in the data we have interpolated results using assumptions which are consistent with performance at that point in time and which aligns quarterly data with annual results.
• Forecast trends were estimated under various scenarios, including: (1) extrapolated linear regression of historical data; (2) YOY growth rates based on high/low rates in past years; (3) growth rates which converge or mimic competitors or market performance. We then selected one of the above based on our view of the most likely performance by the LOB concerned.
• All revenue numbers are rounded to the nearest £5 million; all capital expenditure and EBITDA numbers are rounded to the nearest £1 million.
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