BCE buyout: On hold

If the BCE deal goes through, can George Cope fix Bell?

The world’s biggest leveraged buyout deal, whether it closes or collapses, will also rank as among the most tumultuous. From that spring day in 2007 when the Ontario Teachers’ Pension Plan signalled it would attempt a hostile takeover of Bell Canada Enterprises, nothing has gone smoothly in the $51.7-billion privatization of BCE (TSX: BCE). The subsequent auction extracted from the Teachers’-led consortium a price of $42.75 a share for the venerable Canadian telecom icon, but it was a controversial and unruly process that had the board, private equity funds, investment bankers and corporate lawyers in knots for weeks. BCE director Paul Tellier described the auction as “messy.”

As it turned out, that was just the beginning. Sure, shareholders voted 97% in favour of the deal last September, and both the CRTC and Industry Canada eventually gave their approval this spring. But as of early June — almost a year after the BCE board of directors signed off on the offer — it was still far from a done deal.

At press time, a confluence of events threatened to torpedo the privatization. First, the Quebec Court of Appeal gave a lawsuit by bondholders new life when it ruled BCE didn’t fully consider the hit its bondholders would take; the case will go before the Supreme Court of Canada. Second, the tightening credit markets are giving the bankers behind the deal second thoughts, and they are aggressively seeking new terms. The situation may lead one or more of the victorious consortium’s U.S.-based private equity partners — Providence Equity, Madison Dearborn and Merrill Lynch Global Private Equity — to throw in the towel. Under the terms of the deal, they could walk away as of June 30 without paying the $1-billion break fee.

Shareholders and bondholders alike have a lot of money on the line. But also at stake are the reputation of Teachers’ CEO Jim Leech and the legacy of BCE CEO Michael Sabia, who is set to step down when, or if, the deal finally goes through. Yet for all the unanswered questions about BCE’s ownership and the final financial structuring of the company, there is still a telecommunications business to run — and it’s a business that will continue to face competitive challenges and difficult decisions even after those questions are answered.

It will fall on George Cope, Bell Canada’s current president and chief operating officer, and Sabia’s announced successor, to grapple with the thorny issue of how to guide the 128-year-old company into a future burdened either by billions in debt or a host of frustrated shareholders. It’s new territory for the 48-year-old, a wireless wunderkind who grew mobile network operator Clearnet Communications for 13 years. When it was acquired by Telus Corp. in 2000 for $6.6 billion, Cope took the helm of the western telco’s wireless division, the source of much of its growth. In 2005, he jumped ship to Telus’s larger eastern rival, Bell Canada.

At the time, cable telephony was just starting, but the threat was already clear. As Cope joined Bell in January 2006, Vidéotron was trumpeting its 163,000 telephony customers in Quebec after nearly a year in service. Meanwhile, in Ontario, Rogers Communications (also owner of Canadian Business) could claim 48,000 subscribers, although it launched cable telephony only six months earlier. At BCE, a net loss of 324,000 residential, business and wholesale landline connections, or 2.5% of total landline business, heralded an acceleration of its shrinking base.

Since then, the situation has worsened. As of March 31, Bell (not including Bell Aliant lines) now counts 15.9% fewer landline connections since the end of 2005, although the migration has eased since August, when the CRTC lifted its price regulation of 90% of Bell Canada’s residential market. Of course, Bell is more than just a local phone service. But landline is its core business, and its former monopoly, so those customers who do switch from the tried-and-true Ma Bell phone service aren’t likely to buy mobile telephony, Internet or satellite television services either. Sabia spent his tenure restructuring BCE as a holding company, divesting significant stakes in CTV Globemedia, IT services firm CGI, and satellite operator Telesat; devising a complex arrangement to spin some rural lines into Bell Aliant, which then floated a majority stake of the company as an income trust; announcing a trust conversion in the fall of 2006 only to retract the plan when Finance Minister Jim Flaherty changed the rules governing that corporate structure; and, now, stickhandling the privatization scheme. During all of this upheaval, the taproot of Bell’s business has been withering in the changing market environment. As of the end of 2007, revenue from its local phone business was down 10.4% over two years, and long distance was down 21.2%. Internet services (which Bell reports as “Data”) have grown just 1.7%, and now represent more than a third of all Bell non-wireless revenue — the largest slice. Digital television’s revenue is a bright spot, up 35% over two years. But it’s not enough to counteract the larger trend: wireline operating revenue has declined 3.8% over two years, and operating income is down 32.6%. The fact that Bell Canada’s total operating revenues have increased at all — although just 1.9% over two years, to $14.7 billion — is wholly due to its wireless division, where revenue is up 20.5% since the end of 2005. Yet even a nearly 50% improvement in operating income at Bell Mobility hasn’t fully backstopped that accounting measure, which slid 9.6% over two years for all of Bell Canada.

Of course, the company isn’t exactly wallowing in red ink: it had $2.6 billion in operating income in 2007. And BCE as a whole raked in $4.1 billion in net earnings, or $4.88 earnings per share on the year. The problem is growth — as in, lack thereof. Landline phone services and long distance, once the cash cow of Bell, have been commoditized. The growth areas are wireless and broadband Internet. In both areas, Bell is disadvantaged. The best example of the challenge Bell faces is in Quebec, where Vidéotron, Quebecor’s cable division, has tested 100-megabit-per-second service over coaxial lines, and has begun rolling out service packages at 30 Mbps and 50 Mbps. Bell continues to operate on an aging DSL network, which tops out at 16 Mbps. The company is slowly deploying optical fibre-to-the-node (FTTN) technology, which will boost speeds as high as 26 Mbps. As it stands, the plan is to use additional techniques that will increase bandwidth to 40 Mbps — eventually. But even that looks like a relative trickle compared to Vidéotron’s broadband firehose. Moreover, it won’t take much for Vidéotron to boost speeds even further. “This doesn’t take a forklift upgrade for Vidéotron,” says Iain Grant, managing director of telecom consultancy the Seaboard Group. “They just shove a little box in the central office, and voila! — the entire network is streaming forward at three times the speed. Just turn the crank, and it’s 100 Mbps. Turn the crank again and it’s 200 Mbps, without really having to invest much.”

Bell, on the other hand, would have to spend between $700 and $1,500 per household, according to Grant — upwards of $6 billion for its entire territory — to run optic fibre to the home (FTTH). That move, which could deliver up to 100 Mbps to the home, is at the core of U.S. carrier Verizon’s strategy to combat the threat from cable operators. Fortunately for Bell, Rogers, its main competitor in Ontario, has not upgraded its broadband offerings as aggressively as Vidéotron has, but Grant figures it’s only a matter of time. “We think Rogers is holding one hand behind its back,” says Grant. “Vidéotron is the one Bell competitor that has steadfastly said its ambition is to replace Bell in every household in Quebec. Rogers seems much more content with a saw-off.” But Grant adds that he’s heard from Rogers officials that 30 Mbps and 50 Mbps packages could be available in some cities by the end of 2008.

So Bell’s cautious build-out of its FTTN network may not be enough to remain competitive. “I don’t know if Bell is going to have any customers left by the time that is complete,” says Grant. “There is an opportunity here for Bell to turn up its migration plan, to start spending some proper money to make the fundamental changes necessary, rather than just trying to patch the stuff.” A new wrinkle might lie in the growing debate on net neutrality. Bell’s highly public defence of its right (it would say requirement) to employ technologies that throttle, or “shape,” certain kinds of Internet traffic during peak times has put it in the spotlight for a practice that some observers think goes against the principles of the Internet. A Quebec consumer group has launched a class-action lawsuit. The CRTC is weighing the throttling issue this summer, and a private member’s bill has been tabled on Parliament Hill. Regardless of how those developments play out, though, Bell ends up looking like it has a network that can’t hack it. The bigger worry for George Cope may not be the pipes in the ground, but the signals whizzing through the air. Lawrence Surtees, IDC Canada’s lead analyst for Canadian telecom, points out that in the $37-billion annual telecommunications market, the combined revenues of all services that run over wires in the ground has been flat for the past three years. “Growth, at the macro level, would appear to be entirely due to wireless,” says Surtees.

Wireless is certainly the dynamic at Bell — but it’s still not growing as quickly as its competitors. Between the end of 2005 and the first quarter of 2008, wireless subscribers climbed 25% and 20% at Telus and Rogers, respectively. At Bell, subscribers rose 15%. Considering Bell rolls in subscribers of Virgin Mobile (which operates on its network, and has 580,000 customers), that picture is even more disconcerting. Telus, in third place, pulls more of its revenue from wireless — 47% versus 28% at Bell, in the first quarter of 2008. At Rogers, wireless’s share was 55%. Surtees says that in several quarters in the past two years, Bell Mobility had flat or negative subscriber growth. “Most of us would be hard pressed to find such a situation with any other wireless company in the developed world,” he says. “If I were to pick one thing about BCE that would scare the living hell out of me, it’s that.”

One issue is its wireless network. While CDMA (for Code Division Multiple Access) operates effectively, and Bell has been upgrading to the complementary higher-speed EVDO (Evolution-Data Optimized) for mobile data, neither are the now preferred technology for the trendiest wireless device manufacturers. A case in point: the wildly popular iPhone, which Apple launched last year to much fanfare on AT&T Wireless’s GSM (Global System for Mobile communications) network, and which will come to Canada on Rogers’ GSM network later this year. Another example is Research In Motion’s latest BlackBerry, which will be available first on GSM.

It all feeds into the consumer market perception that Bell just isn’t hip. Rogers and Telus have successfully targeted the youth demographic in their marketing, playing up social networking and music capabilities; Bell seems a step out of it. “Rogers is really walking away with the market” is Grant’s frank assessment. The competition is not going to get any easier. Industry Canada’s auction for Advanced Wireless Services got under way in late May, with 40 MHz of a total 105 Mhz set aside for new entrants. In the early rounds of bidding, it was clear Vidéotron, Shaw and two foreign-backed entrants, Globalive Communications (seller of Yak long-distance services) and Data & Audio-Visual Enterprises Wireless, were among the most aggressive. According to a report by the Seaboard Group, those new entrants might need to invest as little as $500 million to launch in the top 15 cities across the country — even less, if they made regional plays of the type Shaw and Vidéotron appear to be pursuing. The new entrants almost certainly won’t deploy CDMA-based technology, and will likely leapfrog to a 3G or 4G GSM technology like HSDPA (High-Speed Downlink Packet Access) or LTE (Long Term Evolution). If that’s the case, Bell’s wireless network quickly starts to look even more antiquated. So what does Bell do? In the short-term, it could bolster its wireless offering with an unlimited data plan for mobile phones, which Rogers will likely unveil as part of the iPhone. “They need to aggressively position something in advance of a new entrant, or they’ll be in a much more reactive mode,” says Surtees. “Bell has been terrifically distracted by the Teachers’ deal. It’s at the mid-management level, where they are running groups with an eye to strategy, that just so much is on hold.” And longer term, the stakes only get higher. “Somebody’s got to make some tough decisions here,” says Grant. Bell could invest heavily in a next-generation wireless technology, like LTE, but for an incumbent carrier that would involve more than 15 cities and could cost between $1 billion and $3 billion. And there could be added costs associated with financing existing customers to upgrade. Even that might not be enough to hold off the competition. Bell has recently introduced the Better Home bundle as a defensive tactic against the cable companies. But it might not work for long. “No matter how smart your bundle is, it’s only as strong as its weakest link, and right now, it’s weakest link is DSL,” says Grant. “I don’t think Bell’s bundle will stand the test of focused advertising by a really hungry competitor.” In particular, Vidéotron, with the likelihood of attaining its own wireless service, will have a much more compelling proposition. Grant argues Bell has to get aggressive, and fast, with multibillion-dollar deployments of better broadband service and a better wireless network. And if it can’t afford to do both, it should consider radical surgery: either sell off the wireless business and invest in broadband, or sell off its wireline divisions and focus on wireless. “Those are the types of things owners have to think about, and those are the types of things that management can’t do by itself,” says Grant. “This isn’t like opening another phone store. This is a fundamental rethink of what it means to be Bell.” And so it comes back to the privatization deal: Who will be Bell’s owners? What do they want the company to become? And, most importantly, how much financial flexibility will they have? Should Teachers’ complete the deal without alterations, it will load $44 billion of debt onto Bell’s books. Finding ways to pay that down debt as well as invest in future operations will require some considerable financial engineering. Perhaps the new Bell sells and leases back its land lines, or its wireless towers, to free up cash. Or perhaps it sells the wireless business, and during the agreed-upon period of non-competition builds a new, better network. Or maybe it decides to become all-things wireless — after all, in three years, the best mobile networks might be transmitting at 40 or 50 Mbps. “The board has the same problem as a mother bird with a nest of young ‘uns — those mouths are all open and they’re all saying, ‘Give me money,'” says Grant. “And there isn’t enough of it to go around. The privatization actually compounds the problem. If Sabia had had the stones to borrow $20 billion [in the first place], he’d have fixed both of the problems and had half the amount to pay back that Teachers’ will [have to pay].” The Ontario Teachers’ Pension Plan didn’t launch this takeover more than a year ago to keep Bell’s business the same — that much is certain. But it’s much less clear how it will actually change Bell for the better. If, that is, it ever gets the chance to try.