One lesson observers might have learned from past investment bubbles in the computing and connectivity businesses is the importance of maintaining sanity when evaluating the prospects for sustainable financial returns.
Granted, many investments are either designed to be short term. The investors assume they can build an asset that is expected to be acquired by some larger entity before the issue of sustainability must be addressed.
In the software business, the example is a small start-up whose financial backers believe is destined to be acquired before it must actually scale up as a sustainable business.
Some observers might find it odd that private equity capital is being invested in fiber-to-home networks. Under present conditions, these investments have very-long payback cycles (10 years or more), which would seem unsuited to the private equity need to sell off assets within about a five-year horizon.
Still, as always, private equity investments are about growing asset values, not operating businesses long term. And that explains the investment thesis.
But the assumption seems to be that willing buyers can be found. Consider take rates and monthly revenue for Google Fiber, which targeted areas where it would be the first FTTH supplier in each city. Results suggest that Google Fiber is getting market share from customers who want faster speeds and are willing to pay for it, as its average monthly revenue is higher than incumbent ISPs (telcos and cable TV) generate.
Google Fiber prices range from $70 for gigabit service up to about $125 per month for 5 Gbps service. And speeds of up to 8 Gbps are being offered in several of the markets, for about $150 a month.
That suggests a calculation has been made that the assets can be created and then sold to other owners over a relatively short period, before full payback on the investment has occurred.
Consider the generic example of a PE firm buying an existing telco with little to no FTTH footprint, and then rebuilding using FTTH.
Assume the asset can be purchased for about $1,000 per home location, and then the owner can build a new FTTH network for about $1,000.
I am skeptical of the payback model for private equity funding of fiber to home (FTTH) networks, especially in cases where the PE firm has to buy an existing telco and then invest another $1000 per household to build the FTTH network.
Assume the firm can get 40 percent take rates, as it might already have about that level of customer penetration to begin with. Assume its home broadband revenue is about $90 a month.
So the key high-level assumptions include:
Upfront investment: $2000 per household ($1000 to buy the existing telco + $1000 to build the FTTH network)
Annual revenue per household: $90 x 12 = $1080
Operating expenses: Assume 50% of revenue, or $540 per household
Annual operating cash flow: $1080 - $540 = $540 per household
Assuming the PE-backed firm can achieve 40% market share, this means it will generate $540 x 40% = $216 in annual operating cash flow per household on average.
To reach operating cash flow breakeven, the PE-backed firm needs to generate enough operating cash flow to cover its upfront investment. This means it needs to generate $216 x 9.26 = $2000 in operating cash flow per household over 9.26 years.
Assuming a 10-percent required rate of return, the PE-backed firm needs to generate $2000 x 10% = $200 in annual profit per household, as well.
To earn a full recovery of invested capital, the PE-backed firm needs to generate $200 x 10 = $2000 in profit per household over 10 years, assuming the take rates are at 40 percent and customer revenue is $90 a month.
Of all the assumptions, the take rates at $90 per month, per account, are likely the most challenging.
Most incumbent ISPs selling FTTH have managed to get only about 40 percent take rates after several years, and at average selling prices closer to $50 a month.
So builders of new FTTH networks might do best when targeting more-affluent neighborhoods, rather than whole cities.
In this simplified model we do not include any inflation-related price increases, some amount of business customer revenue (for enterprise or cell tower backhaul, for example) or wholesale revenues from allowing competing ISPs to use the network.
The observation is simply that private equity firms historically want to sell assets after about five years (the range being three to seven years).
So such investments--always designed to be sold--will likely have been sold to other investors before full payback is reached.
On the other hand, at least at the moment, terminal values would seem to warrant the investment. In principle, investments of up to $2000 per home could reach $3000 per home in a sale, assuming present trends hold.
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