Chapter 23
FiberNet Communicationsa
Norbert Kovacs, a new associate in the London office of Warburg Pincus, was reading an investment report at his desk in early 2004, when one of the firm’s partners, William Knott, walked into his office. Unfortunately, Knott brought gloomy news: it turned out that Kovacs and Knott had just lost one of their deals in a heated auction. Both of them spent many weeks investigating this investment opportunity and were working relentlessly on the financial analysis in order to construct a winning bid. However, now the deal process came to a complete halt, as another firm in the market came up with a higher bid. Kovacs was very disappointed: he joined Warburg Pincus, one of the world’s prominent private equity firms (Exhibit 23.1), several months ago and was very eager to execute a transaction from start to finish. He worked very hard on this transaction and could not even find the time to have a proper telephone conversation with his childhood friend Peter Szepesi, who recently tracked him down and wanted to catch up.
EXHIBIT 23.1 WARBURG PINCUS
Kovacs knew Szepesi from the elementary school in Hungary, where both of them grew up. The two shared a number of interests and stayed in touch, even after Kovacs left the country in 2002 to pursue an MBA. Now, when Kovacs finally had some time, he decided to distract himself from the pessimistic thoughts about the lost deal and finally returned Szepesi’s call. To Kovacs’ surprise, it turned out that his friend had a business proposition: Szepesi’s father was a CEO of FiberNet Communications, a major Hungarian cable company. The original investor in FiberNet was ARGUS Capital Partners—a CEE private equity firm, whose strategy was to quickly assemble together a major cable company through acquisitions of numerous local cable operators. Now the firm wanted to exit this investment because their fund was approaching the end of its life, thereby pushing the firm to seek a buyer for FiberNet and other investments in the portfolio. Since FiberNet was one of the winners in the portfolio, the fund’s asking price for the company was 8.5 × 2003 EBITDA. Szepesi knew that Kovacs was working in the private equity industry and, therefore, wanted Kovacs and his colleagues to review this opportunity. In Szepesi’s opinion, Kovacs could benefit by bringing an attractive deal to Warburg Pincus, while Szepesi’s father would have less uncertainty about the future of his company, as now there would be a personal connection between FiberNet and the new investor. With this in mind, Szepesi sent the background materials to his friend.
Kovacs initially became interested in FiberNet, especially given the fact that he just lost a transaction earlier in the day and was eager to begin working on a different investment opportunity. He knew that the Hungarian cable market was potentially very attractive, as it had been growing explosively over the past several years. Kovacs also realized that FiberNet was a fairly young company that was able to become one of the major cable operators in the industry in a relatively short timespan. In addition, Kovacs knew that his friend’s father, FiberNet’s CEO, was a very hard-working, intelligent, and savvy businessman who conducted a number of successful acquisitions that allowed FiberNet to gain market share.
However, Kovacs hesitated about a number of aspects relating to the potential deal. First, the transaction was probably going to be small for Warburg Pincus. The firm generally invested in companies with a revenue of several hundred million dollars, whereas FiberNet’s revenue was projected to be approximately USD37mn for 2004. A transaction of this size must provide compelling returns in order to capture sufficient interest within the firm. Second, the company was located in a less developed European country, which would complicate the due diligence process and potentially create obstacles in obtaining debt financing. Third, Kovacs was unsure whether the personal relationship with the CEO would prove to be a blessing or a curse: on the one hand, it would allow Warburg Pincus to gain additional transparency on the investment opportunity while, on the other hand, it may give rise to a number of uncomfortable situations that could compromise Kovacs’ relationship with his childhood friend. Kovacs ultimately presented the investment opportunity to William Knott, who became enthusiastic about FiberNet and asked Kovacs to gather information about the industry and the company in order to perform a preliminary analysis of the potential deal.
HUNGARIAN HISTORY AND ECONOMY
From its location at the heart of Europe, Hungary shares borders with seven Central and Eastern European as well as Balkan countries. The Hungarian population was slightly over 10 million in 2003 and could be characterized as relatively homogeneous in ethnic terms when compared with other countries in Europe. Following imposition of a communist regime in 1947 and a crushed revolt in 1956, Hungary began in 1968 liberalizing its economy by increasing the autonomy of enterprises and by introducing competitive mechanisms in the marketplace. After the collapse of communism, Hungary held its first multiparty elections in 1990 and initiated a fully fledged free market economy. It joined NATO in 1999 and acceded to the EU along with nine other states in May 2004.
Hungary’s domestic market is relatively small, although the country’s economy is third largest in Central Europe (after Poland and the Czech Republic). Post-socialist Hungary significantly benefited from the political stability and high levels of foreign direct investment. As a result of an extensive privatization of the mid-1990s, major stakes in the telecommunications, utilities, banking, and television sectors were given to private investors. In 2003 the private sector accounted for almost 80% of GDP and represented one of the highest shares in the region. Service industries had traditionally been neglected under the socialist regime, however Hungary rapidly redirected its focus from manufacturing to services in the early 1990s in order to make its economy similar to those in other EU countries. Hungary’s economy experienced significant growth in the past decade, allowing Hungarians to significantly improve their standard of living, as the country’s GDP per capita became third largest in Eastern and Central Europe by 2002 (after Slovenia and the Czech Republic). A summary of Hungary’s economic data is provided in Exhibit 23.2.
EXHIBIT 23.2 ECONOMIC AND DEMOGRAPHIC DATA FOR HUNGARY, ACTUAL AND PROJECTED
HUNGARIAN TELEVISION BROADCASTING MARKET
Before the collapse of the socialist regime, commercial broadcasting did not exist in Hungary, and the state-controlled Magyar Televízió (MTV—Hungarian Television) enjoyed a monopoly. MTV transmits two channels: its main channel, m1, offers general entertainment programming, while the second channel, m2, provides news and information programming. The Hungarian Broadcasting Act of 1996 paved the way to broadcasting competition and transformed MTV from a state-controlled monolith to a public service channel. Private national terrestrial television did not launch until October 1997; however, when the competition did arrive, MTV suffered extensively from a loss of both viewers and advertising revenues. Moreover, when national private channels launched, m2 was forced to give up its terrestrial frequency and is now available only via cable or satellite. MTV’s market share gradually declined from 83.7% in 1993 to 27.5% in 1998, and further slipped to a mere 14.3% in 2001. Apart from suffering from diminishing audiences and recurring threats of bankruptcy, MTV faces political allegations. Under Hungarian law, MTV’s board must represent both the current government and the opposition equally; however, in the past the ruling coalition used the broadcaster for promoting its own agenda.
In addition to MTV, there are two private national terrestrial channels in Hungary, TV2 and RTL Klub. TV2 was launched in 1997 and is owned by the Scandinavian Broadcasting System (49%), the Hungarian production company MTM Kommunik´ciós (38.5%), and the German productions company Tele-Müchen (12.5%). The channel aims at the younger urban viewer and offers mostly entertainment programming, such as soap operas, chat shows, game shows, and comedy. TV2 is one of the most successful channels in Hungary: its market share approached 31.2% after a year of operation, peaked at 39.7% in 2000, and fell slightly to 38.2% in 2001. Like TV2, the other private terrestrial channel RTL Klub was launched in 1997 and is owned by RTL Group (49%), Hungary’s telecommunications operator Matav (25%), the U.K.-based media group Pearson (20%), and the Hungarian bank Unicbank Raiffeisen (6%). RTL Klub offers entertainment programming, such as celebrity shows, chat shows, and recently won the rights to broadcast Formula 1 racing.
Hungary’s television broadcasting also features many commercial channels that are accessible via cable or satellite, as well as a number of local stations that cater to the local information need of their audiences. Multichannel penetration in Hungary is one of the highest in Central and Eastern Europe, with 48.1% of TV households subscribing to cable by the end of 2003. MTV’s prolonged monopoly in the national terrestrial space contributed to the popularity of cable and satellite channels; however, the demand for multichannel television has been growing steadily even since the launch of private terrestrial channels in 1997. Exhibit 23.3 provides an overview of Hungary’s major television channels.
EXHIBIT 23.3 HUNGARIAN TERRESTRIAL AND NON-TERRESTRIAL TELEVISION CHANNELS
CABLE TV INDUSTRY
Cable is the dominant multichannel platform in Hungary because it offers greater availability and attractive pricing when compared with satellite and digital TV. The Hungarian cable industry is highly fragmented, although it has begun consolidating in the past several years. During the socialist regime, the cable TV industry was money losing and virtually non-existent.
The first basic cable networks were laid in the late 1980s and early 1990s by local municipalities and owners of apartment blocks. Capital expenditure was generally subsidized by the government, allowing municipalities to keep the prices at a level that was sufficient to cover operating costs. During the early 1990s, average revenue per user (ARPU) was very low and ranged from USD1 to USD3. The technical capacity of cable networks was rather limited: the narrowband nature of networks restricted the number of television channels available, thereby allowing the provider to offer only one basic package for all. Moreover, the networks were built as a local loop, which made it difficult for providers to enforce subscription payments as pirated connections could not be cut.1 The technical inadequacy of the networks restricted the services that could be provided and, as a result, the fees that could be charged. The cable TV market grew mostly in local clusters during the 1990s and still remains highly fragmented, with more than 400 operators in 2003.
The consolidation of the Hungarian cable industry was initiated in the late 1990s by the three largest players: UPC Hungary, MatávkábelTV, and FiberNet. All three operators employed similar strategies: (1) acquire local loop networks; (2) upgrade networks from loop to star in order to combat piracy and offer more services, such as broadband internet;2 (3) increase prices as much as possible without breaching regulations; (4) improve the content and continue increasing ARPU. Although such a strategy resulted in some customer churn, the operators were broadly successful in raising prices, often in conjunction with network upgrades and improved content offerings. By 2003, ARPU from cable services reached between USD7 and USD10 and was broadly in line with the average figure for other Eastern European countries. Moreover, most cable providers began offering a broadband internet srvice, with ARPU ranging from USD35 to USD39 in 2003.
However, price hikes in the cable TV industry did not go unnoticed by the regulators: Hungary’s Competition Office performed an ex-post price review based on customer complaints, but so far has accepted most of price increases in the market. The National Communications Authority is another regulatory body that, since January 2004, is entitled to review the level of market dominance by individual operators. Moreover, Hungary’s recent membership in the EU implies that its regulatory environment may become tighter because its regulatory regime is expected to come in line with EU requirements. As a result, it was unclear how further price increases in the cable industry would be received by the regulators.
The evolution of the Hungarian cable industry implies that operators behave like local monopolies virtually everywhere, apart from the capital city of Budapest, where there are parallel cable networks. All cable operators have access to the same content at broadly comparable prices, as they are supplied through a Hungarian cable association that negotiates with content providers on their behalf. Since content providers are significantly larger in size than the largest operators, only the three large players could go directly to the major content suppliers to negotiate specific subscriber volume-based discounts that amount to approximately 10% to 30%. Although there are no regulatory barriers to entry, the emergence of new players is unlikely because of very high capital expenditure requirements. The new entrant will inevitably be confronted by price competition from the incumbent and most likely will find it virtually impossible to earn an adequate return on capital investment. The cable industry in Hungary faces little threat from substitute offerings, such as satellite or digital TV. Although satellite TV has better content, it is significantly more expensive than cable TV and is popular among high-income families or people living in rural areas. Digital TV is unlikely to grow significantly over the next few years given the investment required by broadcasters as well as consumers.
Since the cable industry in Hungary enjoyed heavy state subsidies in the 1980s and later experienced explosive growth driven by the three large operators, the country is characterized by a relatively high cable TV penetration when compared with other Eastern European markets. In 2003, 57% of all households had access to cable TV,3 and 76% of these households actually had a subscription to the cable service. Cable networks can be further extended to cover more households in additional residential areas, although this effort may not be economically viable for most established operators. Further growth in the industry is expected to come from developers of apartment complexes, as the government continues subsidizing capital requirements for installation of cable networks in the new apartment blocs. Exhibit 23.4 provides key historical data and projections for the Hungarian cable TV market. Exhibit 23.5 provides comparative statistics for Hungary and other European markets.
EXHIBIT 23.4 KEY STATISTICS FOR HUNGARIAN CABLE TV MARKET, ACTUAL AND PROJECTED
FIBERNET’S KEY COMPETITORS
Although the cable TV market in Hungary is very fragmented, it is dominated by a handful of operators, with the Top-3 players accounting for 66% of the market (Exhibit 23.6). FiberNet is the third largest player, behind UPC Hungary and MatákábelTV.
EXHIBIT 23.6 MARKET SHARES BY NUMBER OF SUBSCRIBERS OF KEY CABLE OPERATORS, 2002–2003
UPC HUNGARY
The operator entered the Hungarian cable market in 1993. Netherlands-based UPC is the largest cable operator in Hungary: as of September 2002 it passed 952,800 households and attracted 674,100 subscribers, which was equivalent to a 71% connection rate. UPC Hungary operates in the cities of Budapest, Miskolc, Debrecen, and Pécs. The operator recently made significant investments for network upgrades in order to allow full two-way interaction. The connection fee for reception of analog TV service is about HUF25,500, although discounts are frequently available. Exhibit 23.7 shows the cable TV packages offered by UPC Hungary.
EXHIBIT 23.7 UPC HUNGARY ANALOGUE PACKAGES, BUDAPEST TYPICAL
UPC Hungary launched a broadband internet service in November 2000 in Budapest, just 2months after the telecommunications provider Matá launched the country’s first high-speed internet service via ADSL transmission. Such timing ensured that no one standard became dominant in Hungary during the early adoption of a broadband internet service. By September 2002 UPC Hungary extended its services to other cities, passing 482,000 homes with subscriptions amounting to HUF20,000, which was equivalent to a 4% connection rate. The operator offered only one high-speed internet package (see Exhibit 23.8).
EXHIBIT 23.8 UPC HUNGARY HIGH-SPEED INTERNET PRICE PROFILE
MATáKáBELTV
Telecommunication operator Matá provides cable services through its subsidiary MatákábelTV, which was formed in 1998. Since then Matá has sold 25% of its equity and 75% of its shareholder voting rights to insurance company Hungaria Biztosito in order to comply with stricter regulations relating to the cross-ownership of cable and telecommunication interests. MatákábelTV offers cable services mainly in Budapest and some rural areas. As of September 2002, the operator passed approximately 360,000 households and attracted 325,989 subsribers, which was equivalent to a 90% connection rate. Like UPC, MatákábelTV recently upgraded its networks in order to improve its offering to customers. The connection fee for reception of analogue TV services is about HUF25,000 for a residential subscriber, or HUF40,000 for a business subsriber. The operator offers the cable packages shown in Exhibit 23.9.
EXHIBIT 23.9 MATÁVKÁBELTV ANALOGUE PACKAGES, BUDAPEST TYPICAL
MatákábelTV offers a broadband internet service in Budapest and three other cities: as of the beginning of 2002, the operator passed about 70,000 homes and attracted about 1,900 subscribers, which was equivalent to a connection rate of approximately 3%. The operator provided two offerings: Otthon, a basic package, and Profi, a package that allows up to five concurrent users (see Exhibit 23.10).
EXHIBIT 23.10 MATÁVKÁBELTV HIGH-SPEED INTERNET PRICE PROFILE
THE FIBERNET OPPORTUNITY
Company
FiberNet entered the Hungarian cable industry only in 1999 and, as a result, was in a weaker position than its rivals UPC Hungary and MatákábelTV. FiberNet provides services to small towns and operates in only one of Hungary’s Top-12 cities, compared with 11 cities served by UPC and 9 cities served by MatákábelTV. The operator’s strategy to date has been to focus on acquisitions and upgrades of small cable TV players in the regions. Going forward, the company hopes to combine organic growth with further acquisitions.
More than 90% of FiberNet’s networks are not overlapped by other cable networks (Exhibit 23.11), thereby allowing the operator to experience substantial growth. As of early 2004, the company passed about 330,000 homes and attracted about 210,000 subscribers, which was equivalent to a connection rate of 64%. FiberNet recently undertook a series of technical upgrades, with a superior star/broadband network representing over 70% of all networks by subscribers in 2004. Most remaining networks are scheduled for an upgrade over the next 2 years. The content provided by FiberNet is broadly comparable with rival offerings (see Exhibit 23.12).
EXHIBIT 23.11 GEOGRAPHICAL COVERAGE OF KEY CABLE OPERATORS IN HUNGARY
EXHIBIT 23.12 FIBERNET ANALOGUE PACKAGES
FiberNet recently entered the broadband market, passed about 97,500 homes, and was able to attract approximately 6,150 customers as of the beginning of 2004, which was equivalent to a connection rate of about 6%. The operator offers multiple broadband internet packages (see Exhibit 23.13).
EXHIBIT 23.13 FIBERNET HIGH-SPEED INTERNET PRICE PROFILE
The more expensive Otthon package offers additional email addresses, while Otthon Plusz provides 5, MB of web space.
Management
FiberNet’s management team was quite good, although some team members were stronger than others (the organizational chart is shown in Exhibit 23.14). The operator’s CEO, Jozsef Szepesi, has been with the company since 1999. During his tenure at FiberNet, Szepesi built a loyal team around him and overall demonstrated a solid track record as a business builder. Szepesi had a superb knowledge of the cable industry in Hungary and had a clear vision about how to aggressively grow FiberNet in the future. FiberNet’s CFO, Istvan Magyar, had a very good understanding not only of business, economics, and financials, but also operational specifics of the cable industry. Even though he was younger than other members of the team, he proved himself to be highly reliable, intelligent, and resourceful.
EXHIBIT 23.14 FIBERNET’S ORGANIZATIONAL CHART
Certain other members of the management team were less impressive and were likely to be replaced. Moreover, the positions of COO Laszlo Mokos and Marketing Director Zoltan Kemeny were likely to be reviewed, as their roles in the organization were not clearly defined. Apart from reviewing the roles of certain team members, FiberNet needed to hire a business development director to support the CEO and COO and focus on identifying suitable acquisition targets.
Overall, the management team at FiberNet was functional yet incomplete. It was clear that it would be challenging to continue business as usual while replacing key executives at the same time. In addition, it would be difficult to find high-quality Hungarian managers who possessed deep market knowledge and were able to execute FiberNet’s ongoing strategy.
Financials
During the past 2 years, FiberNet has enjoyed explosive revenue growth averaging 47% per annum, with an EBITDA margin averaging 42%. Management’s projections (shown in Exhibit 23.15) assumed that revenue growth would slow in the future to approximately 10%. Future growth was assumed to come from both increased cable TV prices and a greater number of subscribers. In addition, management assumed improvements in EBITDA margins, as they hoped that the price increases would not require significant content enhancements, thereby keeping costs at approximately the same level. Moreover, FiberNet’s executives expected capital expenditure to decrease, as most of the networks had already been upgraded.
EXHIBIT 23.15 MANAGEMENT PROJECTIONS FOR FIBERNET, FEBRUARY 2004
Exhibit 23.16 provides information about private cable transactions that took place in 2002 and 2003, whereas Exhibit 23.17 provides information on the yield curve in Hungary. As Kovacs researched the opportunity of investing in FiberNet, he wondered whether Warburg Pincus should go ahead at all with the transaction. He was worried about the risks that the Hungarian deal posed and did not know how he would resolve the potential conflict of interest when friendship and business had to be mixed.
EXHIBIT 23.16 CABLE TRANSACTIONS 2002–2003
EXHIBIT 23.17 INTEREST RATES AND FORWARD YIELD CURVE IN HUNGARY
a The case was prepared by Tamara Sakovska (LBS MBA 2004) under the supervision of Eli Talmor.
1 1. A loop network is built as a ring connecting multiple subscribers via one cable.
2 A star network links individual subscribers via a direct connection that can be easily cut in case of piracy.
3 According to industry convention, this metric is labeled as percent of “households with cable passing”.