Analyst Note (26/05/10)
Cable & Wireless Worldwide reported mixed results for its fiscal year ending March. Revenues were flat versus the previous year, missing our expected increase of 1.5%. However, revenue growth was solid in the important IP, data, hosting and applications segment, allowing EBITDA to improve more than we had projected. The EBITDA margin jumped to 19% before exceptional items, from 14.4% a year ago. Overall, we think the firm's results show that its restructuring is going well.
Revenue in the firm's traditional voice products business dropped 15% year over year, offsetting growth in the other areas. The recession has hit wholesale demand, and government-mandated cuts on mobile termination rates have also hurt. C&W also discontinued some unprofitable businesses during the year. We expect the traditional voice business to continue to shrink as C&W emphasises its IP, data, hosting, and applications businesses. Sales of these services should grow nicely, as the firm announced that it has won several new contracts including a £40 million five-year deal with Vertex to provide a private cloud network solution, a £207 million 15-year managed outsourcing contract with National Grid, and an expansion of its work with Tesco. These newer services provide significantly higher margins than the traditional voice business--for the most recent fiscal year, IP and data produced a 62% gross margin versus 28% for traditional voice service. The shift in revenue mix, along with ongoing cost cutting, should allow margins to continue moving higher. However, exceptional items will continue, though at a lower rate, as C&W is locked into rental contracts for two more years on several buildings it no longer needs.
Fair Value Estimate: 110p ¦ Economic Moat: None
Thesis (30/03/10)
Cable & Wireless Worldwide has been through many ups and downs in its 140 years, but we think the reorganisation of the past four years is setting the firm up for a more consistent future. In 2006, C&W acquired Energis, a telecom firm focused strictly on the enterprise market, and sold its UK retail operations. This was followed by the acquisition of Thus, which focused on small and medium-size businesses. The reorganisation was completed with the separation of Cable & Wireless Worldwide and Cable & Wireless Communications, which owns the firm's retail operations, mostly in the Caribbean.
The new C&W Worldwide will focus on the business and carrier markets. The main growth area is its data, Internet protocol, and hosting business. Through acquisitions and internal growth, this business now accounts for 52% of the firm's revenue and 71% of its earnings before interest, taxes, depreciation, and amortisation. The firm has had success targeting companies with specific needs, particularly in the retail, utilities, and more recently financial services industries, and picking off select customers. C&W Worldwide has been particularly successful in the hosting market, where revenue grew 30% annually from the first half of fiscal 2007 through the first half of fiscal 2010. However, this growth was off a small base. Hosting now accounts for 8% of total sales, which is double the 4% of three years ago. This is an area with strong growth potential as companies look to move more services offsite, such as storage and Web applications.
The firm's carrier business is solid. C&W participates in 69 global cable systems covering about 500,000 kilometres, with much of the network being undersea cables. C&W traces its ancestry to the company that laid the first trans-Atlantic cable. Laying new cables isn't particularly cheap, that is unlikely to happen in the near future. However, margins are lower here. This business though does have some growth potential and generates solid returns on capital and cash flow. The traditional voice business continues to decline about 5%-6% per year, which we expect to be ongoing.
While C&W has become a solid number two in the business market in the United Kingdom, thanks to acquisitions, it remains much smaller than BT. We think there is a niche in the small- and medium-size business market for another phone company to offer better service than BT has traditionally. However, we also expect C&W will struggle to find new contracts as profitable as the ones it already has. BT has acknowledged it has been struggling in the small- and medium-size business market, and we expect it to become more aggressive in this area, which will probably push down pricing on new contracts for both firms. However, increased scale and more efficient usage of C&W's network should still allow it to increase margins.
Valuation
Our fair value estimate is 110p per share. We assume a rapid decline in the firm's legacy products with an end to that division in fiscal 2013. We expect the traditional voice business to decline about 5.5% annually. Virtually all of the company's growth will be driven from data, IP, and hosting. We think this business can average almost 9% growth for the next five years, with higher growth in the first two years and less in the last two. This would allow the entire firm to increase revenue about 2.3% annually for the next five years. As this business grows and matures, we expect C&W will be able to increase its margins as costs grow slower than revenue. We expect EBITDA margins to increase from 13.6% in fiscal 2009 to 21.6% in fiscal 2014.
Risk
C&W is a relatively small telephone company and is going up against much larger competitors. The big risk is that it tries to grow too fast and compete on price. It doesn't have the scale to undercut BT and others, and if it assumes it can reuse capacity that it builds for one client for others and those other contracts don't occur or it underestimates costs, it could get in financial trouble, particularly now that it has lost the cash flow from its retail business in the Caribbean and Asia that is now Cable & Wireless Communications. The other risk is that the firm overpays for an acquisition, something its former parent was notorious for doing.
Management & Stewardship
With the spin-off, Energis' management team has taken control of C&W Worldwide. John Pluthero was CEO of Energis when C&W acquired it and has been chairman of C&W Worldwide since it was separated into a separate division in 2006. Before Energis, he was founder and CEO of Freeserve, which is now the basis of France Telecom's UK broadband service. CEO Jim Marsh had been CEO of the division since 2006; before that he was business development director at Energis. In May, Tim Weller will join C&W as CFO. He is currently CFO at United Utilities. He has significant finance experience in a number of companies, including involvement in mergers and acquisitions. We are pleased to see a small board of directors, which will allow decisions to be made easier. However, half of the six-member board is from the company. We would prefer to see more independent directors. Pay seems to be reasonable, and a significant amount of management's remuneration is in stock.
Overview
Growth: The firm has increased revenue significantly since 2006, thanks to two acquisitions and moving into new services. However, we expect much slower growth--unless there is another acquisition--as legacy products and traditional voice businesses slow offsetting increases in new areas.
Profitability: Profitability has increased significantly over the past few years, with operating cash flow going from more than £200 million negative to slightly positive. We expect the firm will be continue to cut costs, improving its margins and cash flow.
Financial Health: The firm is in solid financial health with a net cash position. As the firm demonstrates it can generate free cash flow without its former retail side, we expect C&W will begin to take on some debt.
Profile: Cable & Wireless Worldwide is the second-largest telecom firm in the United Kingdom. It focuses solely on business customers, from small and medium-size up to enterprise. The firm's main business revolves around data, IP, and hosting services. It also carries a lot of traffic for other telecom operators over its extensive global network, where it owns part of 69 global cable networks.
Strategy: With the retail business gone, C&W Worldwide is focused totally on the business customer. Its strategy is to find niche markets and companies that it can serve effectively with more attention than its larger rivals would provide. The firm's main focus is on the data, IP, and hosting markets. C&W thinks it can offer higher-quality services to a smaller number of select customers than larger rivals with a vast array of clients to worry about. It is particularly looking at customers in the retail, utilities, and financial services industries.
Bulls Say
1. With its new independence, management should be motivated to show what it can do. Historically, spin-offs are often good investments. There has been some speculation that C&W would make an attractive acquisition candidate for a global telecom player like France Telecom or Deutsche Telekom.
2. The carrier business provides steady cash flow, which should continue.
3. The data, IP, and hosting business has found some nice niches and should continue to grow. Most of these contracts are for multiple years, and over time should provide greater visibility.
Bears Say
1. Former parent Cable & Wireless PLC has a terrible long-term record and has destroyed tons of capital.
2. C&W is going up against BT--which is significantly larger--in a business where scale can be very important. In addition, the firm is looking at more contracts outside the U.K. where there are more large competitors and C&W is even smaller on a relative basis.
3. The separation of C&W Worldwide from C&W Communications removes the steady cash flow from the retail business, which helped stabilise C&W over the past decade.
Allan C. Nichols, CFA is an equity analyst with Morningstar.
