EOH M&A Pic

EOH, The Most Prolific M&A Company in the SA ICT Sector

EOH Holdings Limited (EOH) is the most prolific M&A company in the SA ICT sector. Analysis of the revenue streams over the period 2011 to 2016 shows that by FY2016, EOH had earned 63% of its revenues from the cumulative acquisitions it had made over this period. The EOH challenge, however, is how to continue to deliver such impressive revenue growth over the coming years.

The Competition Commission Announcements in November 2016

The Competition Commission recommended to the Competition Tribunal that two proposed transactions by EOH, be approved without conditions. These transaction are the acquisitions by EOH of PIA Solar South Africa (Pty) Ltd (PIA) and Scan RF Projects (Pty) Ltd (Scan RF).

These announcements caught our attention as they highlighted EOH’s ongoing and relentless M&A strategy, a strategy that has been part of the EOH “DNA” going back to the year 2000.  This commentary provides an assessment of the EOH M&A activity over the period 2011 to 2016.

EOH Revenue Analysis

EOH reported revenues of R12.76 billion for its financial year ending July 2016. The 2015/2016 annual revenue growth was 31%, while the five-year compound annual growth (CAGR) was 39%. The following graph shows the EOH revenue reported from 2000 to 2016.

EOH Revenue 22.11.2016

Source: EOH Annual Reports 2004 to 2016

Revenue earned from M&A

A cautionary note –  EOH does not provide a detailed revenue breakdown of its individual subsidiaries, therefore we needed to make some assumptions. The value of this analysis serves to illustrate the revenue impact of the M&A strategy, as compared to accurately accounting for the different revenue streams.

We set-up the following revenue model to estimate the acquisition revenue contribution over the period 2011 to 2016:

  • We modelled the 2011 organic revenue per year from 2011 to 2016, this is defined as the “Core Revenue”;
  • We modelled the 2011 acquisition revenue per year from 2011 to 2016 + incremental acquisition revenue per year, with each year projected to 2016, this is defined as the “Cumulative Acquisition Revenue”; and
  • For simplicity, we assumed all revenue streams grew at the same annual growth rate per year.

Using this modelling approach, we calculated that in 2016, EOH had earned 63% of its revenue from cumulative acquisitions made over this period. The balance of 37% was earned from the growth of the 2011 organic revenue.

The following graph shows the two revenue streams.

EOH Revenue Analysis 22.11.2016

Source: Africa Analysis modelling of revenue streams

The CAGRs over the period 2011 to 2016 are as follows:

  • 2011 organic revenue          19%
  • 2011 acquisition revenue   77%

As shown, EOH’s revenue has enormously benefitted from its M&A strategy.

Two Year EOH M&A Track Record

The following diagram shows the M&A activity over the past 24 months. The M&A activity is shown in the quarter that the transaction was completed (as compared to the date when the transaction was announced). The M&A activity underlines EOH’s position as the most prolific M&A-driven ICT company operating in the SA market.

EOH Two Year M&A 22.11.2016

Source: Africa Analysis assessment of the M&A reported by EOH (2015 and 2016)

Shown in the M&A timeline are the transactions undertaken outside of South Africa. International M&A is to be expected as it is unlikely that EOH can continue to grow revenue, through M&A undertaken in the South African IT sector, at the rate that it has grown its revenue. There are just not enough companies that EOH can buy to continue to demonstrate the impressive annual revenue growth that it has shown.

The following figure shows a high-level application of the Africa Analysis M&A diagnostic model. This model determines the strategic intent of the acquisition regarding scale, customers, revenue and markets.

EOH M&A Analysis 22.11.2016

Source: ©Africa Analysis M&A Diagnostic Analysis 2016

Overall, EOH has driven the growth in finding new customers either in existing markets or new markets. EOH has also driven the acquisition of new capabilities that can be used to serve new and existing customers. The analysis also shows the drive to expand into adjacent markets.

Diversification Strategy

These acquisitions demonstrate the ongoing EOH diversification strategy. A review of some of the acquisitions made over the past 24 months shows the scope of diversification:

  • SCAN RF                          : Wireless infrastructure
  • PIA Solar                          : Alternative energy
  • JOAT Group                   : Civil engineering – water infrastructure
  • Mehleketo                       : Rail infrastructure
  • Paterson Candy           : Civil engineering – water infrastructure
  • Grid Control                  : Energy management services

EOH is building capacity in infrastructure technology – water, electricity and transportation.

Can EOH Sustain such revenue growth?

The key question is whether EOH can sustain such aggressive revenue growth? First, let’s explore possible revenue growth and M&A scenarios:

Scenario 1: If we assume the same CAGR of 39% for the next five years, and FY2016 core revenue grows at 19% per annum, then:

  • By 2021, EOH would reach R67 billion, or 5.3x its FY2016 revenue.
  • EOH will need to buy companies that contribute R27 billion in new revenue over this period
  • On average, EOH will need to add the equivalent of 15% in new revenues through M&A each year. EOH has shown an average of 15% new revenue growth per year over the five -year period. However, in 2016, the new revenue contribution from M&A was 10%.

Scenario 2: If we assume the average 2016 revenue growth of 31% for the next five years, and FY2016 core revenue grows at 19% per annum, then:

  • By 2021, EOH would reach R49 billion, or 3.9x its FY2016 revenue.
  • EOH will need to buy companies that contribute R14 billion in new revenue over this five-year period.
  • On average, EOH will need to add the equivalent of 9% in new revenues through M&A each year. EOH has shown an average of 15% new revenue growth per year over the five -year period. However, in 2016, the new revenue contribution from M&A was 10%.

Scenario 3: If we assume the FY2016 revenue growth of 10% for the next five years, and FY2016 core revenue grows at 10% per annum, then:

  • By 2021, EOH would reach R35 billion, or 2.7x its FY2016 revenue.
  • EOH will need to buy companies that contribute R12 billion in new revenue over this five-year period.
  • The assumption is that EOH adds the equivalent of 10% in new revenues through M&A each year. EOH has shown an average of 15% new revenue growth per year over the five -year period. However, in 2016, the new revenue contribution from M&A was 10%.

These scenarios show the outcome of revenue and M&A activity assumptions. Based on the scenarios, EOH will need to maintain an aggressive M&A strategy over the next five years to deliver similar revenue growth as it has shown over the past five years. Depending on how aggressive EOH sees its growth, it will need to add new revenue derived from M&A of between R12 and R27 billion of the next five years.

This is quite a challenge, and we expect that EOH will need to either seek international M&A targets and/or diversify into adjacent markets in the SA market.

Conclusion

The revenue analysis shows that EOH has successfully grown its revenue through an M&A strategy. Indexing revenues to FY2011, shows that by FY2016, EOH had earned 63% of its revenues from the cumulative acquisitions it had made over this period.

The EOH challenge, however, is how to continue to deliver such impressive revenue growth over the coming years.

 

M&A Pic 1

Vumatel/Fibrehoods deal underlines the FTTH Economics of Scale Factor

Summary

Economics of scale is a critical success factor for open access fibre networks. Achieving scale gives open access network providers a strong competitive advantage. Mergers and acquisitions (M&A) is a critical tool used by fibre network operators in achieving scale. The Vumatel acquisition of Fibrehoods represents the latest M&A deal in the open access fibre market. This deal continues the fibre M&A trend seen in 2016.

Vumatel buys Fibrehoods

In 2014, Vumatel entered the Fibre To The Home (FTTH) market. While there were existing fibre network operators, the entry of Vumatel kick started the entry of many new operators to the market. This in turn triggered a rapid fibre land grab. By March 2016, we estimate there were 196 thousand houses passed. Note this number excludes VDSL subscribers, as in some markets VDSL, who use FTTC, are included in the reported FTTH numbers. The figure below shows the rapid growth in FTTH houses passed over the last two years.

FFTH Market Oct 2016

Scale is critical for an open access fibre network operator

Fibre network scale is a critical success factor for an open access network provider, with scale being measured by the size of its FTTH network. The network operator’s expanding network footprint drives sales momentum among retail service providers using its network. In effect, the open access network operator offers more opportunities for the retail service providers to sell retail services.
The key benefit is that FTTH scale also translates into economic scale in that the operators balance sheet grows stronger. Economic scale means that the operator can access cheaper capital with better terms than smaller operators. This is a strategic competitive advantage as building out FTTH networks is a capital-intensive business.

Open access operators can gain scale through a combination of a build and/or buy strategy:

  • Build strategy: In terms of building out FTTH networks, we foresee a total of R12 billion being invested in open access FTTH networks over the next three to four years. This estimate is based on market announcements and our assessment of capital required to deploy the announced fibre networks. This strategy works well when an operator deploys fibre in areas where there is no existing fibre network to compete against.
  • Buy strategy: We have seen the buy strategy exercised over the past two years, with a significant ramp-up in 2016 MA activity.

M&A is part of the fibre network strategy

“M&A is a key tool used by fibre network operators to expand their networks”

Fibre network operators typically start out as niche operators, who focus on a specific high-income geographical residential area. As the operator gains market traction, it seeks new areas to deploy fibre thus driving the scale of its business.
In doing so, it faces two challenges: (1) funding the network expansion, and/or (2) deploying fibre in an area where there is an existing competing network.

  • Funding: Network operators either sell equity or take on long term debt to fund network expansion. We have seen both options exercised in South Africa. For example, Investec acquired an equity stake in Vumatel and Rainbow Capital acquired an equity stake in Metrofibre Networx.
  • Competitive: The operator can choose to (1) buy the existing network operator, (2) reach a network sharing agreement, or (3) decide to not enter that geographical market. Typically, we see options (1) and (3) being taken. Network sharing and co-build strategies are seen on long-haul fibre routes.

In SA, we have yet to see a new FTTH entrant build FTTH infrastructure in areas where another new entrant has already built out their FTTH network. We have seen new entrants build-out in competition to Telkom’s DSL network. Part of the reason is that there are enough attractive geographic areas for new entrants to choose from. This has led to an explosion in new FTTH players over the last two years that in turn has resulted in a fibre land grab.

There are a limited number of early win attractive areas wherein to deploy fibre. To gain scale and to enter these attractive markets means that the SA fibre operators must move into the M&A phase, and the market has done just that.

The following table (as at 25 Oct 2016) lists the M&A activity in the FTTH market. As can be seen, we have moved aggressively into an M&A phase. Note that the table excludes the establishment of fibre network operators and only focuses on M&A.

FTTH M&A Deals

Source: Company press releases 2015 to 2016, the Date column represents the year in which the deal was completed. It is not the deal announcement date. The Not Complete comment implies that the deal is still awaiting final regulatory/competition approval.

Here are noteworthy fibre deals that were terminated:

  • Vodacom offered to buy Neotel, the deal was terminated in Q1 2016 given the regulatory hurdles that the deal encountered.

The table shows that the year 2016 will be remembered as the year that FTTH M&A commenced.

The FTTH M&A activity seen in SA is reflective of global trends. Global market observations show that consolidation is a natural part of the FTTH market. Examples of such country markets are the UK and USA.

Fibre Network M&A Outlook

Long term sustainability in the open access FTTH network market is defined by one key word “scale”. Scale is generated through network expansion. Operators drive scale through a combination of a build/buy strategy. To date, we see little evidence of operators building competitive fibre networks in the same geographical area.

Furthermore, the South African National Integrated ICT Policy White paper (Oct 2016) promotes open access networks with the objective of limiting duplicate infrastructure build. We therefore expect that M&A will continue to be an important tool to grow network scale. In addition, we expect that more private capital will be attracted to the fibre market.

In 2017 and 2018, we expect further consolidation in the FTTH market. Small open access network operators, who cannot generate enough scale, will ultimately close or be acquired.

The M&A fibre market theme for network operators will be: buy or be bought.

Cell-C

Blue Label Telecoms – Cell C Deal Update

In October 2016, Blue Label Telecoms announced that it had increased its offer to R5.5 bn for 45% equity in Cell C. In December 2015, the company offered R4 bn for 30% equity. The new offer does not change the fundamentals of the refinancing deal. We expect that the new deal will not bring any new added benefit to Cell C.

October 2016 Announcement

 In a SENS note (5/10/2016), Blue Label Telecoms announced that it had increased its proposed equity purchase in Cell C, and now offers to buy 45% for R5.5 billion. The acquisition will be made through its wholly owned subsidiary The Prepaid Company Proprietary Limited (“TPC”).  The R5.5 billion will be made up from the following cash sources:

  • R2.0 billion via a vendor consideration placement with NET1 UEPS Technologies Inc, through its South African subsidiary Net1 Applied Technologies South Africa Proprietary Limited, at a price of R16.96 per share, which represents a 10% discount to the 30 business day weighted average traded price; and
  • R3.5 billion from available cash and funding facilities.

New Refinancing Structure

Under the new deal, the equity structure will look as follows:

  • the subscription by TPC (The Prepaid Company Proprietary Limited) for shares comprising 45% of Cell C’s total issued share capital for a subscription consideration of R5.5 billion;
  • the subscription by MS10 (senior management of Cell C) for shares comprising 10% of Cell C’s total issued share capital;
  • the subscription by MS15 (Albanta Trading 109 Proprietary Limited) for shares comprising 15% of Cell C’s total issued share capital; and
  • the subscription by 3C (3C Telecommunications Proprietary Limited) for shares comprising 30% of Cell C’s total issued share capital, for a subscription consideration equal to an amount which will result in Cell C’s net borrowings being reduced to a maximum of R8.0 billion at the time of receipt by Cell C of the respective subscription considerations.

In the December 2015 deal announcement, Cell C staff were going to buy 29.42% equity, split in two tranches of 11.77% and 17.65%. Under the current deal, we assume that MS10 and MS15 refer to these two tranches of equity purchases for the Cell C Staff. The Cell staff will now own 25% equity in the operator.

Similarly, according to the December deal announcement, 3C was going to retain 35% equity. Under the new deal announcement, 3C will only retain 30% equity in Cell C.

The following diagram sets out the proposed new shareholding of Cell C:

Blue Label Telecoms - Cell C - October 2016.jpg

Source: Blue Label Telecoms SENS 5/10/2016

Deal impact on Cell C

This deal is about refinancing Cell C, reducing its long term borrowings to a maximum of R8 billion, while providing a strategy for the 3C Telecoms shareholders to reduce their risk and exposure through Cell C. The deal offers the opportunity for Cell C management and staff to participate at an equity level, while it provides Blue Label Telecoms an investment opportunity in an industry they understand.

The deal will improve Cell C’s profit after tax (PAT) margin by reducing interest payments. However, it will have no significant impact on the operator’s operational performance. The deal gives Cell C better access to future funding through Blue Label Telecoms.

Deal impact on the market

We don’t expect the deal to radically change Cell C’s strategy. Cell C has already embarked on an aggressive subscriber acquisition strategy.

The challenge for Cell C is that it has not translated its successful subscriber acquisition into revenue market share. Cell C has grown its market share, but its share of the mobile revenue has not grown in proportion to its subscriber growth.

Over the coming year, we expect Cell C to focus on growing its revenue market share by attracting the higher value customers to its network. Cell C is using new product innovation and pricing to draw in high value customers.

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