EEnnddeerrss AAnnaallyyssiiss 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.