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Monday, May 28, 2007

C&W UK – Still a Disaster Zone

C&W released their results last week and it looks to me as if C&W UK had a complete nightmare of a year, despite dispatches to the contrary.

The presented results looked as if the revenues were holding up with a reported £2,119m in 2006/7 vs £2,028m in 2005/6. However 2005/6 included only 4 months of Energis figures. If we included the full year of Energis revenues (£709m), the comparison would be £2,119m in 2006/7 vs £2,471m in 2005/6 or a drop of 14%.

A drop of 14% in revenues sounds a lot, but when the stated policy is the axing of as many so-called unprofitable customers as possible, it could be justified. However, the drop in revenues has been accompanied by an even greater fall in EBITDA. Again on the surface all looks good with declared EBITDA growing from £149m in 2005/6 to £159m in 2006/7. It is necessary to strip out the 4 months Energis EBITDA of £35m and replacing with full year EBITDA of £93m.

We also have to add in the less than transparent attempt of reducing staff costs by £17m by placing the LTIP charge below the EBITDA line. So the net EBITDA for 2006/7 was £142m vs £207m in 2005/6 or a truly awesome drop of 31.4% in a single year.

Things do not look much better, when we look at the substantially reduced depreciation charge of £104m in 2006/7 vs £123m in 2005/6. Obviously we have the Energis effect, but we also have to take into account that C&W UK wrote off £237m of assets in the 2005/6 accounts, so of course the depreciation would fall in the following years.

Even stranger rather than cleaning the accounts being a one-off in 2005/6, C&W UK is at it again in 2006/7 this time writing off another £60m which amazingly includes £28m for the exit of the Energis HQ in Reading. Surely someone should have realized at the time of acquisition that only one HQ would be needed and the appropriate charge made then and there.

It is noticeable that C&W is still spending far more on capital expenditure than the depreciation and amortization charge: £204m vs £104m in 2006/7 and this is reflected in cash outflow for the year of £162m. I seriously doubt that C&W UK has much value operationally until this cash burn is reversed.

This would not be too much of a problem if the future was looking really bright, but it isn’t. By C&W UK own admission in the 2H2006/7 figures, 57% of the C&W UK revenues were legacy voice and 9% were legacy data. There is a huge balancing act to accomplish in transitioning these to new wave products and services. Seemingly every operator in Western Europe apart from BT with a huge legacy base is struggling to make this transition. Personally, I see zero evidence that gives me even the slightest confidence that C&W UK will manage to jump the growing void in anything other than a painful manner.

The future risk is made even worse with the forthcoming event of the whole of UK interconnect regime being reworked with the advent of the BT 21CN. I don’t think anyone is seriously analyzing how much this could cost the UK altnet sector and specifically C&W UK. Also, I suspect that BT is far more advanced in analyzing the profit opportunity (for BT) than the regulator OFCOM or the altnets.

C&W UK are forecasting a leap in EBITDA to £210-£220m in 2007/8, however for me the important metric is that a cash outflow of £80m is still planned. Admittedly, this is less than in 2006/7 but this still means that operationally C&W UK is worth very little.

Things look even worse at C&W Access with EBITDA losses of £75m in 2006/7 and a forecasted drop to £35-45m in 2007/8. The first thing that is mysterious about the C&W Access business is the Pipex contract. At the time of the deal on 7th Sept 2006, it was announced to be worth £250m over 5 years. However in 2H 2006/7, which represented a full six months of the deal, total revenues at C&W Access were only £14m which is a run rate of £140m over 5 years. Of course, if the Pipex broadband business were to grow things would look better: but Bulldog is not being marketed as a brand, Pipex is unbundling its own exchanges independently of the C&W wholesale deal and the company is on the auction block. Pluthero even admitted to the Guardian that there was very little protection if a takeover takes place and C&W would probably lose the business. This does not attract a lot of confidence in the new management’s ability to negotiate contracts.

The next problem is the new latest and greatest contract with Virgin Media. Pluthero admitted that the revenues from this will not kick-in until 4Q2007/8 which sounds a long time to get ready to me. The other thing that surprises me is that C&W UK seems to be planning to still be putting more capital into C&W Access – approx £30m. This could either be for more coverage or new equipment and the only possible equipment that I can think of Video-On-Demand or IPTV kit. My hunch is committing more capital is seriously questionable, especially given the force of the competition that Virgin Media is going to be facing in the future. I just hope that C&W UK have negotiated a better contract than with Pipex.

To me the writing on the wall for C&W Access was when they lost the Vodafone and Post Office contracts to BT. I also guess that given the historical links between Pluthero, Freeserve, Energis and Orange that there was a lot of effort to convince Orange to use C&W wholesale services rather than build out their own LLU network.

Theoretically, C&W UK could get the access business to pay with an assault on the business market. But, I suspect they don’t have a strong enough reseller channel to attack the SME market. Also, the problem with the larger corporates is that they want guaranteed bandwidth, something that is unknown until an ADSL circuit is provisioned. ADSL is a difficult sell for the CIO.

I don’t see a light at the end of the tunnel for C&W Access.

However all is not lost for C&W shareholders. There is £3.8bn of tax losses which has a potential benefit of £1.1bn for some acquirer who is paying a big tax bill and I suppose puts a floor on the value of the UK business. Unfortunately, the obvious purchaser – Virgin Media - has tonnes of its own tax losses. This leaves the remaining possible purchasers as Vodafone and O2 who could potentially utilize the tax losses.

In the valuations used for the LTIP estimates, the UK business was valued at £1,620m and the international business at £2,140m. Obviously I think the UK business is overvalued, however I have a hunch that the International business is undervalued.

In 2006/7, International net cash inflow was £220m after proceeds of £256m for the Bahrain disposal. I suspect that the assets in the Caribbean would demand a high price from Vodafone’s partner, Americas Movil & Carlos Slim, if they were put up for sale. In fact, I wouldn’t be surprised if more than one investment bank was exercising their slide rule in trying to solve the conundrum that is C&W.