Business Analysis: Consolidation becomes name of game as telecoms' nuclear winter eases

Yesterday, C&W announced it was buying Energis, the first acquisition of a UK fixed-line network by a rival since the telecoms and technology bubble burst and the sector's sky-high valuations came to an end.

The Energis network is to be closed down, as is C&W's, with the enlarged customer base migrated on to a new network being developed by C&W that will route voice calls and data over fast broadband internet connections.

But while Francesco Caio, the chief executive of C&W, and John Pluthero, his opposite number at Energis, were making confident promises yesterday about a brave new future for the telecoms industry, many investors are still coming to terms with the harsh lessons meted out by the ending of the telecoms boom.

The C&W and Energis deal has been two years in gestation as the respective management teams have grappled with the difficulty of merging their businesses. Without consolidation, the alternative networks stand little chance of competing effectively with BT Group, the former state monopoly that still dominates the UK telecoms industry.

Malcolm Fallon, the chief executive of Kingston Communications, one of BT's smaller rivals said: "Everyone got hooked on the idea of the internet. What it was going to do was drive phenomenal growth in communications, particularly in bandwidth. You got the dot.com bubble and there was this huge expectation of phenomenal consumption, but what its actually done is open up new channels to market for existing businesses, it has provided a productivity tool. It has decreased the cost of delivery for companies. Many traditional branded businesses use the internet as a productivity driver."

But although people are making more calls and communicating more, there have been big changes that were simply not factored into the models of analysts and investment bankers in the 1990s.

What no one foresaw was a huge substitution of calls carried over the fixed-line networks by calls carried over mobile phone networks. A decade ago half the dialled calls made were faxes, carrying large documents, being sent largely by businesses. That no longer happens; the e-mail has taken over

"You had a period of low interest rates and very low inflation starting to build up in the late 1990s," Mr Fallon said. "In that environment, when analysts built their models they were able to give future cash flows a massive present value. The high values of future cash flows in the 1990s meant equity values were also huge and institutions said 'we need some of that', and a spiral developed."

The high value placed on their equity meant telcoms companies found it fairly easy to raise capital for expensive acquisitions and investment projects. And it was not just equity capital. The telecoms boom was carried on a great wave of debt.

By October 2000, when excitement about the telecoms industry had already started to wane, banks across the world had lent a stomach-churning $343bn (£190bn) to telecoms companies in the form of syndicated loans, with a further $87bn of bonds in issue.

Demand, however, did not grow at the rate that analysts had forecast. The industry was left with network capacity it did not need and the only way to fill it was by slashing prices, a move akin to slashing the commercial wrists of fixed-line businesses dependent on a build up of call volumes.

The bloodletting was rapid and painful. BT had to turn to shareholders and raise £6bn in an emergency rights issue and sell off its mobile phone business, now called O2 which is itself a bid target and valued at £13bn, to get its £30bn debt mountain under control.

NTL, one of the UK's two cable operators, went into US Chapter 11 bankruptcy protection to give it sufficient breathing space to sort out its $10.6bn of debt. Telewest, its cable counterpart, went through a debt-for-equity swap to save it from its £5.3bn of debt, and only now are the two talking about a merger. C&W itself came close to implosion, having blown £4bn on value-destroying internet acquisitions in the US.

Once-mighty corporations such as Global Crossing also filed for Chapter 11 bankruptcy protection having bought UK fixed-line networks such as Racal Telecom in the UK for £1bn in 1999. So why has C&W finally made a move on Energis? First, under new management, it has spent the past two years fixing the financial mess left by Graham Wallace, the previous chief executive. Its US businesses have been sold at less of a loss than had been feared and legacy issues such as a £1.5bn tax bill have been settled.

But a crucial reason, and one that may well see more deals to come, is a change in the regulatory environment. Until recently companies such as C&W and Energis built core telecoms networks but still had to pay BT for access to business and residential properties through the so-called "local loop" or access network. Mr Caio said: "Alternative networks like us have to pay BT. We have built core networks but have to pay BT for connecting customers. So putting alternative networks together was never the answer. That has changed now."

However, the telecoms regulator, by imposing price controls on BT and ensuring rivals get equal access to BT's local loop, has made it possible for alternative groups to build their own access networks, reducing costs significantly and making mergers a rational option.