Value Ideas Blog
Kabel Deutschland and an evaluation of the German broadband market
Today I would like to present you a long post and the work of the team from the European Business School for the German CFA Research Challenge Final. The team members are Vincenzo La Banca, Yun Du, Attila Menyhàrt, Jan Werst and me.   We were one of four teams which reach it to the Final round, unfortunately we did not win (perhaps this was due to our low price target of around 63€ per Kabel Deutschland share (ca. 40% lower), but we still think that this price is much more reasonable than the takeover price of 87€ per share and it is not the first time taht vodafone paid to much for a german company(Mannesmann AG)). At the Moment the Valuation of Kabel Deutschland is at a staggering 51x Equity Value/FreeCashflow. Foodballfield   But let us now go into the details: History: Kabel Deutschland (KD) is the largest cable services provider in Germany, operating in 13 of the 16 Federal States of Germany, all but Baden-Wuerttemberg, North Rhine-Westphalia and Hesse. KD was founded in January 1999 by the former German telecom monopoly Deutsche Telekom (DTEL) operating as Deutsche Telekom Kabel Services GmbH (DeTeKS) in order to spin off its entire Cable Television business as required by regulatory terms. The cable network was established from the mid-1980s on by the German federal post office, and predecessor of Deutsche Telekom, Deutsche Bundespost. KD was split into nine regional companies. From February 2006 to September 2010, KD was majority-owned by Providence Equity Partners and Goldman Sachs.   On March 22nd 2010, KD was taken public by a consortium of Deutsche Bank, Morgan Stanley, JP Morgan and UBS for an initial price of EUR 22.00. The stock started trading at EUR 22.50. Providence collected EUR 759 Mio by selling off 34.5 Mio shares, remaining with a share of 61.7%. Prior to the biggest IPO in Germany since 2008, Providence tried to exit the investment via a trade sale to a second Private Equity company which failed due to the high offering price. abccc Three years later in summer 2013, Vodafone Group issued a takeover offer of EUR 87.00 per share. Over four years the shares of Kabel Deutschland hat quadrupled in value. Vodafone purchased 76.57% of outstanding shares.   Operation   With approximately 8.4 million connected households at the end of fiscal year 2012/13, KD had approximately 3,700 employees and it reported revenues of EUR 1,830 million and an Adjusted EBITDA of EUR 862 million.   KD offers television, broadband internet, telecommunication and mobile phone services. As addition to public available analogue television channels, KD provides the platform for receiving public and private channels over digital television. KD enriched its services with “Kabel Premium HD” and “Premium Extra”, offering high definition channels as well as programs in nine different languages. Additionally, KD launched the video-on-demand “Select Video” supply, taking on the competition of several online providers and its main competitor DTEL. The cable technology also enables clients to use their existing connection for internet devices, as an alternative to DSL. Subscriber Observing declining profits from basis TV services, KD reacts by focusing on Premium TV. Consequently, KD expands its supply of HD and PayTV, providing state of the art technologies in DVR and VOD, and thereby accelerates growth rates of Premium TV, the main ARPU driver. Furthermore, KD tries to connect entire housing associations to its existing cable network, by simultaneously advertising bundles including internet and mobile services. The efforts are backed by long-term contracts, providing a sound and predictable operating cash flow.   Program Alpha: Capex of EUR 300 Mio to upgrade fiber cables to Docsis 3 and further fiber expansion   The 2013 announced capital expenditure program Alpha is composed into three parts: 15% on positive NPV projects, 15% on the cable upgrade to Docsis 3 and 70% on further fiber deployment. The increased fiber network will substitute the use of wirings of DTEL, thereby swapping lease payments to maintenance and depreciation expenses in KD’s P&L. The network increase is another move setting off the cuts in basis TV growth and increase in Premium TV demand, by providing the infrastructure for HD and VOD devices as well as additional channels.   The cable upgrade to Docsis 3 is a response to the ascendency of LTE, which enjoys support by the German government, as well as VDSL, the premium DSL product offered by DTEL. The alternative of cable is only able to compete with these devices by providing a mature high-tech network for a broad range of the German citizens. KD aims at upgrading 95% of the existing cable to the Docsis 3 standard. Given the importance of mobile hotspots nowadays, the upgrade might draw government’s attention and consequently foster KD’s outlook in the competition against LTE and VDSL devices.   But despite the obvious technique improvement, the financial benefit of Project Alpha remains questionable.   Despite the unquestionable technological improvements introduced by a wide-spread Docsis 3 network, the German government prefers VDSL and LTE in its attempt to broaden the availability of high-speed internet connection, due to the cost-effective expansion process. KD encounters the government’s reasoning by offering connection with twice the speed of current devices and obtaining price leadership for network devices, naturally putting pressure on profit margins.   The margin pressure could be offset by the cross-selling opportunities introduced by the broader network availability. These opportunities include Premium TV ads such as VOD, DVR and PayTV, i.e. the main ARPU drivers.   While government’s plans foresee a broader coverage of high-speed networks, a market analysis by Dialogue Consult, reveals that merely 1.3% of German households are in need of a connection enabling data transfers of more than 50Mbit/s, consequently for 98.7% of households the upgrade is out of scope. According to their research, 49.6% of households require a connection rate of 2-6 Mbit/s and 12.5% demand 16-50 Mbit/s. Furthermore higher box costs have had a negative impact on the financial performance, each Euro of revenue has cost 1,5 Euro in increased CAPEX and each Euro of EBITDA has  costs of around 5.5 Euro of incremental capex. But you have to keep in mind that around two-thirds of increases in CAPEX of cable business has been success-based, which means linked to customer additions. With this being said, the pay-off of the EUR 300 Mio CAPEX is more than questionable.   The German telecommunication industry – A highly competitive and mature sector   The German telecommunication is dominated by DTEL with a market share in 2013 of 43.8%, though the competition is continously increasing. Together, 10 companies account for 96% of market size. According to the Herfindahl-Hirschmann-Index, a popular measure of competiton within an industry, the degree of competition has increased over the last three years by approximately a fourth.   In 2012, the total market size of the German telecommunication market reached EUR 60 billion, in terms of revenues. Revenues in cable TV achieved the highest growth rate. As a consequence, revenues in cable TV account for 12.5% of the entire market size. Throughout the industry we observe a decline in profit margins, which is well explained by the increasing level of competition.   According to a study of the ”Bundesverband Informationswirtschaft, Telekommunikation und neue Medien e.V.” (BITKOM), the future revenue growth rates will reach around 3% p.a. KD operates in the broadband and television industry, introducing the requirement for a detailed market analysis for each of them which shall be portrayed in the hereafter.   Ambitious plans for the German broadband industry   The broadband industry is divided into DSL and cable supplier. While DTEL is the largest service provider in terms of DSL, the cable market is penetrated by KD, Vodafone, Kabel BW and Telefonica.   As the broadband industry is a rather mature one, the average quarterly growth rate equals 0.56% and is thereby below the nation-wide average. Consequently, the most important players are constantly searching for investment alternatives assuring higher growth rates or profit margins. Following this, DTEL invested around EUR 10 billion in new technology between 2010 and 2012, while KD introduced program Alpha.   In 2009, 92% of German households were linked to a broadband network, while only 20% of connections were entitled to high-speed internet devices via VDSL with a transfer rate of up to 50 Mbit/s. In an attempt to assure high-speed access to a broader range of citizens, the German government issued the ambitious aim of providing 75% of households with transmission rates of at least 50 Mbit/s. However, the necessity remains debatable.   The main issue is and will be the importance of a cable network given the presence of VDSL. According to statistics by Point Topic, DSL has an outstanding coverage ratio in entire Germany, while the importance in rural areas is especially pivotal given the lack of alternatives. The introduction of VDSL to cities occurred rather late given the ascendance of cable; however this might be a reason for its high growth rates. Furthermore, VDSL is considered to be the leading broadband technology in the next decade. The main reason for the high relevance of VDSL is the use of already existing networks, while alternatives such as Docsis 3 cables require the establishment of new networks. Nonetheless, currently standard and Docsis 3 cable reach a significant availability in cities and portray growth rates of 10%.   A second competitive technology is given by LTE. With an increase of coverage from 21.5% in 2011 to 51.7%, the future relevance of this technology is undebatable. Currently, licensees for expanding the network are preferably awarded for rural areas. With this being said, the presence of two well established alternatives in forms of VDSL and LTE imply the need for KD to provide a fast and functional network at a reasonable price.   On the gate to an essential change – the German television industry   It is very likely that the German television industry will undergo a significant change. Still, cable remains the most important applied technology. However, industry research revealed that merely 56% of households accessing via cable rely on a digital signal.   Simultaneously, the introduction of interactive services for satellite devices and DTT imply an additional wave. Furthermore, we observe a tendency for private channels, such as RTL, ProSieben or Sat1, to switch from classical free TV to a PayTV business model, i.e. offering additional content or HD for a fee. A field research revealed that approximately 18% of TV users are prepared to purchase content via PayTV. Liquidity   On the same time, the public broadcasters ARD and ZDF refuse to pay carriage fees to the cable operators KD and Unitymedia. The reasoning of the public channels is that broadcasting their contents is mandatory. Currently the parties seek for a settlement in court. Regardless of the outcome, the implication introduces negative signals about the carriage payments.   The preference of services from one source forces a market convergence   As the available products and solutions themselves are almost exchangeable or at least comparable, convenience plays an important role in deciding for a particular purchase. We can observe similar situations in other network-related industry, such as electricity. Here, changing suppliers partly leads to significant cost savings, yet customers are reluctant to compare the different suppliers and their services. Consequently, customers prefer straightforward solutions that require low research and paperwork. Following this, customers prefer services from one source in case prices and services are reasonable. As a consequence, suppliers bundle TV, Internet and mobile phone services as so called “Triple Play” offerings, following the clients’ demand for convenience. This development causes a convergence in the telecommunication market. KD itself is well positioned in terms of cross-selling, however since only 16% of their TV subscribers use internet and phone services, there is still potential for issuing bundles.   Value creation of the German Telecommunication Market   A model to estimate the created valued by an industry is given by the profit pool analysis for the year 2010 and 2013 that compares the profitability (ROIC-WACC) to the market share of a company. In a graph, the x-axis denotes the market share while the y-axis portrays the profitability. Consequently, the area of the rectangle for a company states the total value added by the company. Observing the plots, one can conclude that the total value creation by German telecommunication companies is negative. Since the Telecommunication industry is highly dependent on the CAPEX, the relatively high cost of capital in this industry is not a surprise. Given this and the increasing competition within the industry (decreasing value of the HHI index), the value destruction of the market players is reasonable. Even though the low interest rates (EURIBOR) might decrease the average WACC, it cannot offset the impacts of the decreasing profitability. marketshare 2010Marketshare 2013 profit pool graph 2010profit pool graph 2013   Financial Statement Analysis   The analysis of KD’s liquidity position unveils a severe need for action. Until FY2013, none of the most common ratios reached a value equal to or higher than 1, i.e. short-term liabilities have not been covered by current assets. We see a clear improvement in FY2013; however, the cash ratio is still too low. The comparison of Operational Cash Flow to current liabilities shows that these payables can be settled by the operational inflows. Still, the OCF is an aggregate of CFs over one year while the average payables conversion period in 2013 was 89.76 days, so the OCF just covered a fourth of the cumulated short-term liabilities over a year.   However, the rather weak liquidity standing is not connected with deferred payments since we find the cash conversion cycle, i.e. the maturity from purchasing goods or services to the customer’s payment is negative. In other words, KD receives cash for sales before it accounts for a purchase. This is a very comfortable position for a company, since any trade liability may be covered by operating proceeds. In our case, KD receives payments 49.04 days before the settlement of own payables while DTEL only obtains these payments 19.63 days in advance.   A comparison of sales per employee reveals that KD’s sales staff seems to be more efficient than that of its main competitor DTEL. This is well explained by a higher number of back-office personnel at DTEL and the supply of wirings, which requires respective employees. However, this comparison does not account for the fact that KD employs third party sales agents and sells products in wholesale stores and online, while these sales are imbedded in the income statement whereas the respective sales personal are not accounted for in the number of employees. We expect this spread to decline given the CAPEX plans for own wirings.   From 2009 to 2013, KD almost constantly increased its debt ratio, peaking in 70% in FY2013. Considering book values, KD’s equity is negative, i.e. the debt ratio would exceed 100%.   Given the currently low average tax rate of 9%, the tax advantage given by the tax subsidy is negligible. We believe that the debt ratio will increase due to the investment in fixed assets. Furthermore, giving replacement of lease payments, we expect the maturity scheme to change towards an increase in long-term debt.   As we observed partly low liquidity ratios and an increasing debt ratio, we analyzed the interest coverage ratio. However, we found that KD is still not able to honor debt obligations out of its earnings since the current ratio is 0.2, yet the effects on KD’s credit rating are rather limited. Nevertheless, given KD’s growth plans and the connected plans for raising capital impose the necessity to achieve a higher coverage by holding liquidity.   The profitability ratios of KD fluctuate mildly, except for the net profit margin, which increased from -10.60% in 2009 to 13.49% in 2013, clearly outcompeting DTEL that suffered a loss. The same applies to all other profitability ratios; KD seems to be more profitable than DTEL.   This circumstance seems to affect the share price. An indicator for this is the P/E ratio. For KD in 2013 this ratio amounted 25.80, while its main competitor DTEL was trading at 14.57. The DAX average value is around 12 to 15, depending on the overall state of markets. Together with the questionable benefits from program Alpha, the rapid growth of the stock price after the IPO and the failed trade sale prior to the IPO this introduces an indication for a possible overvaluation in the share price.   During our analysis we found an interesting anomaly in KD’s CF statement. In general, the free CF to equity does not contain interest payments since shareholders are not entitled to receive interest payments. Consequently, interest charges are deducted from the free CF. However, KD adds back those expenses to its operating CF. Under US GAAP this approach is mandatory to follow, while IFRS allows a choice between including interest charges in operating or investing CF. With this being said, there is no explicit mistake in KD’s CF statement. While one might consider this as a simple accounting issue, a paper by Gordon, Henry, Jorgensen and Linthicum (2012) states that firms with a higher risk of financial distress and a greater probability of default tend to undertake measures to artificially enhance their OCF. Given this, the approach used by KD might be understood as an implicit warning signal.   Another questionable position is the depreciation of level 3fiber cable. While the official guideline “Afa” suggests a lifetime of 20 years, KD depreciates these cables over a period of 30 years. Thereby KD increases both the net income figure and the profit margin. With this being said, the profit margin derived by relying on the P&L is too high. To be consistent with our observation, we incorporated this finding, along with other, in form of a decreasing profit margin in our DCF model   Looking behind the curtains – The Valuation   For our valuation, we relied on a multiple analysis, comparing KD to similar publicly traded companies and established a DCF model, including all the assumptions and observations explained above. In addition, we screened analyst valuations of KD; however they include effects of the takeover and future plans of Vodafone Group and therefore differ significantly from our research, which is supposed to exclude all these influences. Multiple Analysis For our multiple analysis we derived appropriate multiples by comparing the market capitalization of comparable companies to the respective revenue, EBITDA, EBIT or income figures. For our analysis, we used companies such as CableVision, Time Warner Cable, Comcast, Liberty Global, DTEL, Vodafone, Swisscom and Telekom Austria. By excluding outliers, we derived a range from EUR 59,29 to EUR 60,94, i.e. concluded a significant overvaluation of KD’s shares. As mentioned earlier, according to the P/E ratio the stock seems overpriced. The detailed analysis reveals a median P/E multiple of 17.68 and a price range from EUR 46.30 to EUR 46.53, Kabel Deutschlands P/E multiple is around 50. While a multiple analysis is a straightforward and relatively fast approach to value a company based on the market valuation of competitors, this approach neglects the individuality of each company, which is why we executed further research to determine a final target price.   Discounted Cash Flow Valuation   A DCF analysis is one of the most scientific approaches, for sure the most popular scientific approach, to derive a fair company value. Every DCF model is composed by the forecast of free cash flows over a certain period and as perpetual stream as well as by a risk-adequate discount rate, i.e. the weighted average cost of capital.   Weighted Average Cost of Capital As the discount factor in the DCF model, the WACC is an essential ingredient in a business valuation. Starting with the cost of debt, the following shall reveal the WACC for KD. KD’s long term interest bearing debt is composed of two callable bonds maturing in July 2017 and June 2018. Both bear a coupon of 6.5% p.a. paid semi-annually. To exclude the effects of the imbedded call options, we derived the YTM by calculating the yields for straight bonds of DTEL maturing in January 2017 and January 2021. To match the maturities, we used a linear interpolation, while being aware of the linked simplification. However, given the historically low interest rates, we consider the estimation error as to be negligible. With this approach we derived YTMs for the bonds in 2017 and 2018 of 1.280% p.a. and 1.518% p.a., respectively. The bonds account for EUR 1,102 mio. Besides these instruments, KD uses a credit facility over EUR 2,150 Mio. at a floating rate of 1ME plus 2.75%. After weighting the respective positions with their magnitude in the balance sheet, we derived a pre-tax weighted average cost of debt of 1.781% p.a. Due to the average tax rate of 9.34%, the after tax rate is at 1.61% p.a. ccc For the cost of equity estimation we used different established techniques starting with the most common model, the capital asset pricing model. We computed the beta factor by running a regression of KD’s excess returns on excess returns of its relevant benchmark, the MDAX. Thereby we obtained a beta factor of 0.49, leading to an overall cost of equity of 5.21%. However, given KD’s shares short period of public trading, we considered this outcome as unreliable. The second generally accepted approach is the dividend growth model, yielding a cost of equity of 10.86%. Again, this approach is also biased by the limited listing time and, due to the low number of observations, volatile dividend payments. Aside, the huge spread between the two outcomes underlines our findings. Consequently, we tried to derive an appropriate cost of equity by relying on comparable companies in Europe, namely Vodafone, DTEL, Groupe Orange, Belgacom and Iliad. We also accounted for the two sectors telecommunication and television by splitting the benchmark according to those in order to reduce our model risk. To include the effects of different leverage levels, we also delevered the companies’ beta factors and relevered the weighted beta of asset according to KD’s debt/equity ratio. For our weighting scheme, we used the revenues. However, since KD is by far smaller than most of the benchmark’s components and the observation of higher beta values for the rather small companies in the benchmark, we used an inverse weighting scheme, i.e. put more weights on beta factors of smaller companies. In conclusion, we derived a beta factor of 0.5879, which lead to a cost of equity estimation of 5.76%, so approximately 10% higher than the estimate relying on the standard regression output.   With this estimates given the current debt/equity ratio of 0.407, we computed a relativly small WACC of 4.719%. Against the background of extraordinary low tax rate and the current state of interest rates, we modeled dynamic WACCs for the following periods, linearly declining to 4.666% in 2018. The decline is due to the strong impact of interest subsidy and our assumption of increasing long-term debts due to the CAPEX program Alpha and the resulting increase in fixed assets.   Free Cash Flow Forecast   A key ingredient in the free cash flow is the  EBIT; consequently we need to model the future net income figures. In order to derive those, we modeled future revenues and applied a historical profit margin to those. cccc For deriving future revenues we assumed that KD maintains traction in its business and keeps growing. A second underlying assumption is the decay of revenues’ volatility over time. From our market analysis we concluded that after the rapid growth in prior periods, the broadband market reached a level of consolidation with a saturation of demand and a quite fierce level of competition. In its second quarterly report 2013, KD announced future growth rates of 5 to 6% while earlier forecasts predicted 8% and stated that an offset of the first quarter’s revenue shortcoming is relatively unlikely. The Vodafone transaction triggers certain events which will negatively impact Kabel Deutschland’s net income by approximately EUR 205 million in this fiscal year. The biggest portion relates to the loss of deferred tax assets which are either at risk due to change-of-control regulations or no longer effective after completion of the intended domination and profit-and-loss transfer agreement with Vodafone. The other effects include financing related costs as a result of the prepayment of the existing senior credit facilities and other transaction costs. Our forecasts also include slight positive effects on revenues triggered by program Alpha, the ascending Premium TV market as well as the decline in the broadband industry.   As share price movements are driven by idiosyncratic as well as macroeconomic factors, we also included macroeconomic perspectives in our forecast. Given the macroeconomic outlook of an increasing GDP, we expect revenues to grow as well. The revenues should also be positively correlated to the price index. However, economists predict a declining price index, which will consequently negatively affect the revenue figures.   For our model, we used historic growth rates and included GDP growth and the change in the price index as variables as well as a random variable. By running a multivariate regression on historic growth rates we obtained factor loadings that we used for the forecast. As an outcome of our analysis, we expect the revenues to grow further but with a lower rate. To account for different possible future developments, we introduced three scenarios.   In order to derive net income figures from those we applied the historic cost of sales ratio of 49%. For the SG&A, we modeled a constant increase of the 2013 figure of EUR 429.1 mio. Following CAPEX plans, we modeled an increase of financial expenses in accordance with the growth of long-term debts.   As an assumption for the D&A figures, we again applied the historical average of sales/d&a, which is equal to 20%. However, given the newly initiated CAPEX program Alpha over EUR 300 mio, we added a linear depreciation scheme for the additional investment over a maturity of 12 years.   Finally, we derived net income forecasts of EUR 296.49 mio and EBIT forecasts of EUR 567,23 in FY2014, declining to EUR 249.20 and 630,70 mio in 2018.   For the change in net working capital, we relied on efficiency rates, such as the inventory turnover. However, the net working capital is neither an essential figure for assessing companies’ balance sheet in this particular industry nor for the DCF model. For the cash flow from investing activities, the CAPEX figures are the most important measure. CAPEX figures have been forecasted on base of the historical CAPEX/revenues ratio of 24% and an adjustment for program Alpha.   Combining Multiples and DCF   Both valuation methods include different shortcomings. While the DCF includes all the company specific data, it is highly reliant on assumptions on growth rates or the WACC. As mentioned before, multiples fail to consider the individual circumstances for the assessed company. With this being said, we believe that by combining the two estimates, we are able to derive a sophisticated target price.   After we run the DCF model on the different scenarios we obtained a price range from EUR 28 to EUR 75.05; consequently the model is of limited use without further adjustments. Subsequently we introduced a weighting scheme, leading to a DCF target price of EUR 65,35, which is in line with the multiple targets mentioned before and thereby questions the current share price. For the multiple values we also used a weighting table; however here he preferred EBITDA and EBIT multiples as the classical measures. In a final step, we established weights for the DCF and the multiple analysis, clearly focusing on the DCF as customized model.   Combining the two approaches with their respective weight, we derived a share price target of EUR 63. Given the current share price of EUR 97.05 (opening January 6th, 2014), our target reveals a downside potential of 38.17%. Consequently, we issued a strong “Sell” recommendation.   From our perspective, the investment risk in KD is rather low in comparison to other mid-cap companies once the share price reached our price target. This finding is underlined by the low beta factor we revealed before.   Furthermore we have evaluate the risks, but as we have already 4500 Words  I leave this unmentioned.  

Leave a comment.

Your email address will not be published. Required fields are marked *

* *