Telcos have experienced a disconnect between revenue and profit growth, leading to depressed valuations over the past decade. 

Several factors drove this underperformance, including excessive competition and price erosion, high capital expenditure (capex) requirements, and a failure to keep pace with explosive demand for data. As a result, revenue growth has lagged increases in global gross domestic product, highlighting the sector's diminished importance.

Telcos have faced various challenges in converting growing demand into improved revenues. These challenges include regulators' focus on price competition, an inability by telephone companies (telcos) to resist market pressure, the inability to think long-term, and unsuccessful innovation. Our latest report, "The Ideal Telco," offers a roadmap for telcos to improve valuations and rerate into the range of nine to 11 times EV/EBITDA, depending on region and market conditions.

Key opportunities ahead for telcos to rerate

Several dynamics will shape market opportunities, including the heightened importance of telco networks in economic and national security, the realization by regulators that current market structures are not yielding the desired level of investment and quality in a national asset, and the likelihood that technology upgrades will be incremental.

Additionally, subsets of the telco value chain have been rerated and priced at higher multiples. Operators in mature markets are slowly realizing that growing the market is a superior value-creating strategy compared with growing market share.

These factors create an environment where telcos can produce growth by increasing topline permission in concert with strong cash conversion efficiency. Topline permission refers to actions telcos can undertake to advance longer-term market structure improvements and capture value. Cash conversion efficiency involves actions that develop cost and investment efficiencies, so that top-line improvements are turned into cash.

Topline permission in telcos — enhancing growth and optimizing operations

An ideal market structure enables production of efficient and low-cost telco services and encourages a digital infrastructure that fosters economic opportunity and national security. Getting there requires a shared vision between market players and policymakers, rational market dynamics, sustainable premium versus low-cost separation, structuring the market to increase loyalty, and lower churn.

Companies can also create greater value across a few key dimensions:

• A well-defined multibrand and commercial strategy. Maximizing value in each market segment requires clear brand and portfolio differentiation. Consumers must easily recognize that the premium brand provides features and benefits that are absent in the low-cost offerings. Maintaining this differentiation is vital to prevent the premium brand from being diluted by downmarket movements.
• Growing the customer base. Using artificial intelligence (AI) to target marketing and exploit operator apps provides new cross-, deep-, and upsell opportunities. Telcos need to evolve from a basic next best offer (NBO) capability to full core and non-core next best action (NBA) and even fully contextualized next best experience (NBX).
• Growth beyond the core. Success factors include maximizing use of the telco assets without being incumbered by large-scale telco process and IT, commercial bundling and integration with core services, and independent service profitability.
• Optimal B2B setup. Providing integrated connectivity, communication, and security services to small and medium enterprises (SMEs) could open new growth opportunities.

Cash conversion efficiency — improving cash flow in telcos

Cash conversion efficiency means improving the ability to convert revenue into steadily growing free-cash flow. Most large European telcos have been focused on cost efficiency for several years. Much of that work has gone into operational simplification, digitalization of back- and front-end processes and interactions, and top-down headcount reduction programs.

There is room for further improvement in cash-conversion effectiveness, driven by two macro trends:

• Technology creating deflationary effects on costs. Fiber and 5G are more efficient to maintain and operate than previous technologies. Software-defined networks make it easier to run telco systems, align elements, and use inexpensive, less bespoke equipment. Cloud-based architectures are simpler, more flexible, faster to market, and command lower licensing fees and operating costs. AI will also enable telcos to accelerate innovation. AI should allow for automation in network engineering, operation, and maintenance; front- and back-office customer processes; and operating and maintaining platforms.
• Sector evolving toward simplification. Telcos should avoid adding complexity to the core business when they venture into new consumer market growth areas. Separating core businesses, which yield maximum free-cash flow and growth area investments, and running them independently may make sense for some operators. For capex management, a telco must balance investment against other cashflow commitments. A characteristic of the telco industry is the need to invest resources in infrastructure maintenance and improvement, including major technology upgrade cycles almost every decade. For that, telcos must balance capex investment against all the other cashflow commitments, firstly by investing only in those capabilities that sustain a competitive differentiation and by investing smartly to reduce total cash cost.

These are some guiding principles for capex and balance-sheet management: maximize asset sharing that does not drive competitive differentiation, avoid overengineering the network, find other owners for essential assets that can use the infrastructure more effectively, and control the urge to capitalize internal labor costs.

Telcos big opportunity to drive growth

Telcos have an opportunity to take advantage of structural changes in their markets. But telcos will need support on behalf of these shifts. While these changes may not be dependent on individual telcos, they nonetheless require a long-term commitment from all actors. Developing an optimal market structure is a goal shared by both telcos and policymakers, and one that can be achieved by companies through continuous commitment to healthier market dynamics and prioritizing the long-term perspective over short-term gain.

By coupling this long-term commitment with actions under their own control, telcos can deliver significant upside value. An improvement from six to seven times EV/EBITDA to nine to 11 times EV/EBITDA has the potential to triple the equity value of a telco and guarantee years of reinvigorated investment in technology, national digital ecosystems, and innovation.