Vice President: Ivan Petkov
Analysts: Rhea Bhasin, Riccardo Vittorio Perego, Vraj Agrawal
Deal Overview
Private equity firm KKR has made a bid to acquire the grid network of Telecom Italia, the Private Equity behemoth values the network at around €20 billion ($22.9 billion), according to Bloomberg. The move is part of KKR's strategy to expand its infrastructure business in Europe, particularly in the telecommunications sector. The deal is part of Telecom Italia's effort to cut its debt, which stood at €25.9 billion ($29.8 billion) at the end of 2022 (1) . The acquisition would give KKR access to one of Italy's largest fixed-line networks, which covers over 200,000 kilometres and has more than 7,500 transmission sites. The Telecom Italia grid network also includes fibre-optic cables and other infrastructure that supports broadband services. KKR's bid is facing competition from state lender Cassa Depositi e Prestiti (CDP) and Australia's Macquarie Group (2), which have submitted a rival bid for the grid (4) . KKR's bid for Telecom Italia's grid network aligns with the firm's private equity strategy of investing in companies that it believes are undervalued and have the potential for growth. Telecom Italia's grid network is a critical piece of infrastructure that is essential for the delivery of broadband and other communications services in Italy. KKR sees an opportunity to generate significant returns by improving the efficiency and profitability of the network.
Transaction Structure & Strategy
The exact details of KKR's bid have not been disclosed, but it is believed that the firm is looking to acquire a significant stake in Telecom Italia's grid network, rather than taking complete ownership. This would allow Telecom Italia to retain some control over the network while still benefiting from KKR's expertise and investment. The transaction would likely involve a combination of debt and equity financing, with KKR and its investors providing the majority of the funding.
KKR's bid for Telecom Italia's grid network is part of a broader strategy to expand its infrastructure business in Europe. The firm has been looking to invest in the telecommunications sector, which is seen as a growth area due to the increasing demand for high-speed internet and mobile services. KKR's expertise in infrastructure investments and its access to capital make it an attractive partner for Telecom Italia, which is seeking to reduce its debt and focus on its core business.
The acquisition of Telecom Italia's grid network would give KKR a foothold in the Italian telecommunications market and access to a valuable asset that could generate stable returns over the long term. The grid network is a critical piece of infrastructure that underpins Italy's broadband and fixed-line telecommunications services, making it an essential asset for any player in the market (3). KKR's investment could also help to improve the quality and coverage of the network, which would benefit both consumers and businesses.
However, KKR faces stiff competition from CDP and Macquarie Group, which have submitted a rival bid for the grid. CDP, which is backed by the Italian government, is seen as a formidable opponent, as it has access to significant financial resources and political support. The government has also been considering a joint bid with KKR, which could create a powerful consortium that would be difficult for CDP and Macquarie Group to compete against.
To counter this competition, KKR has extended its bid deadline and is reportedly considering increasing its offer for the grid network. The firm is also exploring ways to structure the deal that would make it more attractive to Telecom Italia and particularly the Italian Government (11). KKR's experience in negotiating complex infrastructure deals and its ability to leverage its network of investors could give it an edge over its rivals in the bidding process.
KKR will certainly use its financial engineering expertise to create value in the deal. This could involve structuring the deal in a way that maximises tax efficiency or using financial instruments such as derivatives to hedge against risk.
Rationale
The rationale for KKR's bid for Telecom Italia's grid is multi-faceted:
Firstly, as mentioned earlier, Telecom Italia is burdened with high levels of debt, which has put significant pressure on the company's financial performance. The sale of its grid infrastructure would allow Telecom Italia to reduce its debt burden and focus on its core telecommunications business. Secondly, KKR is likely interested in the potential for long-term stable cash flows that the grid infrastructure could provide. Infrastructure assets like grids typically have long-term revenue streams that are relatively stable and predictable, making them an attractive investment opportunity for private equity firms. Finally, KKR's bid may be motivated by the potential for regulatory changes in Italy that could make the grid infrastructure a more attractive investment opportunity. The Italian government has been considering a reform of the country's energy sector, and KKR may see the potential for regulatory changes that could make the grid infrastructure more valuable in the future.
Overall, KKR's bid for Telecom Italia's grid infrastructure appears to be motivated by a combination of financial and strategic factors, including the potential for long-term stable cash flows, the opportunity to support the growth of renewable energy in Italy, and the possibility of regulatory changes that could increase the value of the investment.
Industry Analysis
The Italian Telecom industry was valued at $23.7 billion in 2022. The market is expected to decline marginally at a CAGR of 0.6% during the forecast period of 2022-2027 (27). Nonetheless, significant innovation and R&D investments in the industry by key players such as TIM, Vodafone, Wind Tre, Cellnex and Fastweb brightens the outlook for investors. The Italian telecom industry is fuelled currently by a growing demand for high-speed connectivity, fixed broadband services, and arguably most importantly, the move away from 3G paving the way for 5G (28).
To examine the growth potential of the Italian telecom industry, its services can be broadly divided into three categories – mobile services, fixed services, Pay-Tv. Innovation, 5G in particular, is projected to dominate the mobile services space in the current and near future. Increasing spending on the deployment of 5G is pushing growth in the telecom market. TIM being at the forefront of this move presents brighter prospects in comparison with competitors. With several providers discontinuing their 3G services, migration from 3G to 4G and subsequently 4G to 5G is inevitable. TIM competitor Windtre has already reached a long-term agreement with Ericsson for the deployment of their 5G services with a particular focus on the integration of the service with business models. In August 2022, Fastweb extended its 5G Fixed Wireless Access (FWA) to over 1000 municipalities. Similarly, there is a strengthening demand for fixed broadband services creating new opportunities in the market. There is a bold emphasis on the introduction of broadband in rural areas, introducing an untapped segment of the population that will grow in the future. For instance, in October 2022 Open Fiber signed an agreement with Equal Opportunity Lifestyle Organization to proliferate fixed broadband services in rural Italy. The transition to a work-from-home lifestyle with several offices transitioning to a hybrid model ensures a continuing focus on fixed broadband, making it a permanent need as opposed to a fleeting trend. According to Ookla Speedtest Global Index, Italy ranked 70th with a median fixed broadband download speed of 54.22 Mbps, proving again that there is room for innovation and consequently growth in the market. With smartphone penetration expected to increase to 81% of the population in 2025, OTT services are harnessing growth opportunities. This is particularly significant for service providers as it increases demand for 5G and faster networks.
Company Analysis
Telecom Italia is Italy’s largest fixed-line player with US$17bn in group revenues (US$13bn ex-Brazil) and US$4.6bn in EBITDA (~34% margin) at the close of 2022. Thus, KKR’s US$12bn bid implies a multiple of 1x 2022-revenue and 4x 2022-EBITDA that seem undemanding if revenue and EBITDA were to sustain. In 2022, the company generated low free cash flow with group capex running at ~US$4.4bn and capex ex-Brazil at ~US$3.5bn
The company has the largest market share in fixed line services with 16m fixed accesses and over 72% of these being fibre-based (FTTx). The attractiveness of TIM’s business lies in the fibre-rich nature of its infrastructure that creates room for long-term monetisation. TIM’s key broadband competitors include Windtre, Iliad, Vodafone, Tiscali, and Fastweb.
With 30% market share in the mobile market and 45% share in broadband, Telecom Italia takes the centre stage in Italian telecom. TIM’s service revenues growth, which was more than two times that of the market in 2022, makes it an incredibly attractive target. Furthermore, its strong service revenues growth – with +19.8% YoY in mobile and +7.07% YoY in fixed services make it an optimistic investment (31). However, a 10.6% drop in earnings before interest, tax, depreciation and amortisation (EBITDA) including lease costs to 5 billion euros for 2022 may darken the picture. Plagued by decrease in earnings and sales over the last decade owing to price competition in Italy, TIM’s revenues, which contribute the bulk of overall group sales, fell 3.4% to 10.8 billion euros in 2022.Telecom Italia’s reported gross debt exceeds 29 billion euros, and S&P last week downgraded the company’s credit rating further below investment grade level.
Source: (28)
Post discontinuing its 3G service in October 2022, TIM has made incredible strides in the 5G rollout by introducing the network in 16 new locations across Italy. TIM has also secured a government contract worth EUR 725 million to supply 5G networks in rural Italy. While TIM’s large market hold makes service proliferation relatively easier, it does put the firm at the heart of anti-trust and monopoly lawsuits. In 2013, Vodafone sued Telecom Italia for EUR 1 billion for abuse of power. Still, TIM’s unparalleled emphasis on digitisation and commitment to sustainability set it apart from its competitors.
Italy is an important piece of the digital transformation initiative by the European Commission that contemplates a single digital market across Europe i.e. a single Gigabit Society. The domestic telecom regulator in Italy – AgCom – has announced several initiatives that align with the European Commission’s goals. KKR’s interest in TIM seems well-assessed and in line with growth and strategy targets that are emphasised not just within the company but within Italy’s political and social environment.
Financial Analysis of TIM
In the first three quarters of 2022, TIM Group’s total revenue accumulated to €15.79 million which is a 1.7% increase compared to the first three quarters of 2021. Domestic operations make up the majority (75%) of this revenue and Brazil operations (25%) make up the rest. Domestic operations faced a year-on-year decrease of 6.6 % while the Brazil operations witnessed a rise of 38.5% giving a net increase of €189 million. These figures stand out in the steady decline of revenues over the previous four years. In 2020, annual earnings rocketed up to €7.2 billion but plunged back down in the negative the following year to -€8.65 billion. The EBITDA for the first three quarters of 2022 was € 3,945 million which is a 9.3% year-on-year decrease. In total, €594 million of net non-recurring charges impacted the EBITDA primarily due to the restructuring process and staff leaving (33).
The table below shows some key margins and return on investment relating to the income statement for the trailing 12 months:
The total assets and liabilities have been fluctuating around an average value of €70 billion and €49 billion respectively with a resultant Q3 2022 equity value of €19 billion. The majority of this arises from common stock (€11.6 billion) with additional paid-in capital contributing €2.1 billion to the equity value. Around 63% of the total liabilities (€44 billion) was due to long-term debt (35).
TIM has a debt-to-equity ratio of 2.14 which is typical for a company like itself that has relied on debt to invest in assets and operations in order to fuel its growth. In the third quarter of 2022, TIM has total assets worth €63 billion, 31% of which is captured within the property, planning and equipment segment and another 30% is in goodwill (34).
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Cash has increased at a steady rate of approximately €1.8 billion a year. 2018 witnessed a negative net change in cash of €1.6 billion which resulted from the outflow of cash in investment and financing activities of €4.3 and €1.8 billion respectively but only €4.6 billion cash inflow was generated from operating activities. However, the next two years (2019 and 2020) witnessed an average net cash of positive €1.44 billion and a 83% year on year growth followed in 2021 (with net cash of €2.4 billion). Cash from operating, investing and financing activities didn’t change significantly except for 2021 where the financing activities (instead of incurring an outflow as in 2018 to 2020) resulted in an inflow of €24 billion. As a result, 2021 net change in cash beats all the previous years by a considerable amount (34).
TIM’s closing share price last Wednesday (16/03/22) was €0.2982 with a market capitalisation of €6.57 billion and an enterprise value of €6.65 billion (35). Its 21.36 billion outstanding shares have an EPS ratio of -€0.52. In the trailing twelve months, TIM has a P/E ratio of -0.58 which is significantly lower than the industry (17.69). A negative P/E ratio may raise concerns for investors however TIM has usually reported a positive P/E ratio in earlier years so this doesn’t necessarily imply bad financial health. The TTM price to free cash flow is also negative (-4.4) however if this is evaluated in conjunction with a high debt to equity ratio, it reflects that TIM is investing in future growth.
It has a much lower TTM P/S ratio of 0.43 compared to the industry (5.63) implying that the company is undervalued (34). As a result, CPD and Macquarie, who are competing with KKR to put forward an attractive bid, could be more willing to a pay a greater premium on the traded share price in order to secure the acquisition. DCF model further reinforces that the company is undervalued.
It assumes a Terminal Growth Rate (TGR) of 4.8%. Italy has witnessed an inflation rate (36) of 9.8% (February 2023) and a GDP annual growth rate (37) of 6.7% in 2022. Even though this strongly implies a TGR much higher than 4.8%, the historical annual changes in GDP have not been as dramatic. Additionally, the telecom market globally has grown at a CAGR of 6% from 2022 to 2023 and is expected to increase at a CAGR of 5.8% for the next few years (38). This is a good growth rate but not exceptional as such and with the inflation expected to drop back to stable levels in the upcoming years, the TGR can be conservatively estimated to be around 4.8%.
The tax rate is estimated to be the ratio of tax expense to earnings before tax in 2019 (the most recent year with tax that reflects the typical annual tax expense of TIM of €0.5 billion). Tax recorded in 2020 was significantly lower (-€6.0 billion) and in 2021 escalated to €3.9 billion but has been more stable in the previous years. The market risk premium is assume (39) to be 5% and the beta (35) to be 1.09. 5-year U.S. treasury bill rate is used to estimate the risk-free rate (40) to be 3.7%.
The WAAC calculated for the DCF is 15% which gives an equity value of €6.4 billion with a share price of €0.31. The closing price last Wednesday (16/03/22) was €0.30 which implies an undervaluation of TIM’s stock by 3.3%. The DCF model is presented in the table below.
The assumptions used in the DCF model and the key parameters calculated (including enterprise and equity value) in order to deduce the share price are shown below.
The D/E ratio for the telecommunication industry seems to be on the higher end of the spectrum as further reinforced by Vodafone Group. However, TIM even relative to this base comparison scale seems to be swimming in a considerably big pool of debt. Tessellis has a negative D/E ratio suggesting that it has a greater amount of liabilities compared to its assets. Additionally, it has a much greater negative P/E ratio compared to TIM. Both TIM and Tessellis have negative earnings and Vodafone seems to be having the best financial health. High P/E ratio suggests that investors can envision strong growth prospects within the company. Currently, all three companies seem to have a fairly low P/S ratio however TIM seems to be the most undervalued with a P/S of only 0.43.
Risks
Although KKR's bid for TIM presents several advantages, there are also a number of risks associated with the potential acquisition. Firstly, the Italian government may be reluctant to approve the deal, as it would result in a foreign company owning a strategic asset. This could lead to political tensions and regulatory hurdles. Secondly, TIM operates in a highly competitive market, and KKR will need to invest significant resources to maintain its market position and fend off competitors. Thirdly, the acquisition will require a substantial amount of debt financing, which could put pressure on KKR's financial position, particularly if interest rates rise or the economy experiences a downturn. Finally, there is a risk that KKR's strategy for TIM may not align with the company's existing management team, which could result in conflicts and inefficiencies.
Conclusion
In conclusion, KKR's bid for TIM is a complex and high-risk transaction. While the deal presents numerous opportunities for KKR to generate value, there are also significant challenges that must be overcome. If KKR is successful in acquiring TIM, the company will need to navigate a number of regulatory, operational, and financial hurdles to achieve its strategic objectives. Nonetheless, if executed correctly, the acquisition could provide KKR with a strong foothold in the Italian telecoms market and significant long-term returns for its investors, while also helping to improve the quality and coverage of Italy's telecommunications network. However, KKR faces stiff competition from CDP and Macquarie Group, which have submitted a rival bid for the grid. To win the bidding war, KKR will need to leverage its expertise in infrastructure investments and its access to capital to structure a deal that is attractive to both Telecom Italia and the Italian government.
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