QUALIPORT
Cable & Wireless: More Hope Than Certainty

By Maynard Paton (TMFMayn)
August 13, 2001

Carburton Street, London -- As promised, today's Qualiport continues with the intriguing Cable & Wireless (LSE: CW.). As we saw last week, anybody buying C&W shares gets the company's large cash pile, a diverse set of small telecom companies ("C&W Regional"), plus C&W's global telecom business ("C&W Global") thrown in for free. But in reality, it's not that simple.

While C&W stands out from its debt-laden telecom cousins by virtue of a £6-7b cash mountain, a fair chunk of that cash is to be spent on finishing the group's new, but currently loss-making, Internet Protocol (IP) network. In the short term at least, the asset value of the C&W Global operation is very hazy. Overall, I decided not to build a C&W investment decision on the company's asset base. Instead, any C&W investment lies on the group's future profitability. In other words, how effectively C&W spends the cash hoard.

No free cash

The first valuation issue to note is that C&W is spending more cash than it generates on building the global IP network. On this point, it's difficult to judge whether C&W could switch the capital expenditure (capex) tap off (to produce free cash, the figure the Qualiport uses as a valuation tool) while sustaining its long-term competitive position.

I suspect C&W could stop the capex, but a part-completed IP network isn't going to generate the custom a fully global network would. Given that scale is probably the key to decent returns for a telecom network operator, I'd say the current capex expenditure is more mandatory than discretionary. Therefore, rather than use today's accounts, it's worth looking into the future to judge the present C&W valuation.

To value C&W on future profits, we need to take C&W Regional and C&W Global separately (for the record, I've assumed the planned sale of C&W's Australian Optus business goes ahead and raises the expected £3.9b).

Following sales growth of 9%, the local telecom firms that make up C&W Regional contributed £220m of earnings in C&W's latest financial year. Assuming those earnings grow at 7% per annum for the next six years, we get 2007 earnings of £335m. Place that on an undemanding prospective price to earnings (P/E) ratio of 12.5, and we get a value for Regional of £4.2b (149p per share) five years out.

Tricky business

Valuing C&W Global is far trickier. It comprises three distinct operations -- the fast-growing IP business and the slower growing data and voice telecom activities.

Here's how the three divisions performed last year in terms of sales.

Year to 31st March 2001    Sales    Sales Growth
                            (£m)        (%)

IP                          881         41
Data                        815          8
Voice                     2,268          5

The whole C&W Global division made an operating loss of £222m. While C&W doesn't reveal the profits from the individual sub-divisions, I presume the profits from C&W's traditional voice network are offsetting the losses from the fledgling IP and Data operations.

Global value

A C&W Global valuation comes from forecasting growth in its three operations, applying a suitable profit margin to those projected sales, and then multiplying the resulting profits by an appropriate P/E ratio.

The valuation is further complicated by acquisitions. Following the recent £238m purchase of Digital Island (which brought £100m of extra annual sales), it's a racing certainty that C&W will continue to use their cash pile to mop up some of the other small IP players.

Anyway, using the following scenarios (and assuming C&W's tax rate is 30% in 2007 and that C&W's whole £6-7b cash pile is spent)...

Annual Sales Growth   Acquired  Operating  Prospective  Prospective
    (2001-2007)        Sales     Margin        P/E         value
 IP   Data   Voice  (2001-2007)  (2007)       (2007)      (2006)  
 (%)   (%)   (%)        (£b)       (%)                      (p)

 20     12    7          2.0       15          20           723
 17.5   10    6          1.5       12.5        17.5         464
 15      8    5          1.0       10          15           276

...we can arrive at different values for C&W Global five years down the line.

Adding the value of C&W Regional then gives us the following estimated returns at today's C&W share price of 335p: 

 <----- Prospective value (2006) ---->     Annual investment return 
  C&W Global   C&W Regional   C&W Group           (2001-2006)
    (p)           (p)           (p)                   (%)

    723           149           872                  21.0         
    464           149           613                  12.8
    276           149           425                   4.9

Any investment in C&W hangs upon numerous assumptions. How fast will IP services grow? What margins will they produce? How will the stock market value that growth in years to come? How will acquisitions impact the forecasts? How much will the expansion eventually cost? While all these types of questions are inherently uncertain at the best of times, there's just nothing concrete to back up any assumptions for C&W.

When I've done similar five-year extrapolations in the past, they've been conservatively performed on companies with a proven, superior record.  At least with PizzaExpress (LSE: PIZ) and Carpetright (LSE: CPR), there's history to help judge the sales, margins and profits from future expansion. What's more, both of those two companies demonstrably generate plenty of free cash today. At C&W, the record is too short (in terms of the ongoing businesses) and too complicated to accurately gauge the group's financial history.

For a worthwhile C&W investment, you need faith in two parts of the business. Firstly, that decent growth rates (is organic IP growth of 20% per annum over six years possible?), margins and returns on capital can be achieved in C&W Global. And secondly, that the management have the talent to accomplish the necessary financial expectations. There's no degree of certainty with either.

Remain faithful

In summary, the Qualiport should remain faithful to its investment criteria. In other words, to stick to buying solid, dominant and proven companies, where the shareholder returns are generated up-front in the form of an attractive free cash flow yield. While C&W has unquestionable growth prospects, the company doesn't come up to scratch in the predictability of its future cash flows. And in terms of industry presence, I'm not entirely sure C&W can ever become the equivalent of a London Stock Exchange (LSE: LSE), Imperial Tobacco (LSE: IMT) or Johnston Press (LSE: JPR) in its IP market either.  

If the necessary growth rates and profits appear, then C&W could well reward investors who have greater foresight than myself. And I could have been tempted with a small C&W side bet if a decent annual return looked achievable without relying on racy projections (e.g. 15-20% annual IP sales growth for six years).

In general, I prefer to be reasonably certain of a good result from a proven performer, rather than be hopeful of a great result from a mostly unknown quantity. At the moment, C&W is just not Qualiport material.

More: Cable & Wireless: A Qualiport Asset Play? | Cable & Wireless discussion board | Barling6 gives the C&W lowdown

Disclosure: The author owns shares in Carpetright.