Digital Infra is Anything but Supercore

Digital infrastructure investing, like alternative asset investing generally, now has moved to embrace core plus concepts. The nomenclature comes from the traditional real estate investment concepts used by buyers of alternative assets. 

Some might say “core” assets are akin to Class A office buildings, which are the most prestigious in a city. Class B buildings might be those which offer fewer prestige value than class A, and might be located outside a downtown core area. Class C buildings will tend to be aimed at more industrial or service oriented businesses and smaller businesses. 

source: Bullpen

It might be more accurate to characterize the different classes of assets by risk and return profiles, as there is less the notion of “prestige” as in office space, and more the fact that digital infra is a newer class of alternative or real estate assets, albeit with generally higher exposure to economic cycles and less business moat protection. 

As the range of infrastructure assets has grown, some now see more gradations of risk, adding “supercore” as a category of regulated assets, to distinguish between other assets that are not formally rate or price regulated. 

By definition, digital infra assets would not be considered supercore, as data center, cell tower, fiber network and other “telecom” network assets are unregulated in terms of pricing and do not offer guaranteed rates of return. 

In a private equity or other institutional investment context, “core” infrastructure  has meant gas or electricity utilities that have business moats, offer predictive cash flow and are relatively resistant to economic fluctuations. These businesses also tend to be rate regulated, with low capital appreciation, longer asset holding cycles and lower yield. 

That profile fits requirements of large pension funds and other institutional investors including sovereign wealth funds, for example. 

“Core plus” adds new classes of assets such as airports, seaports, roads that have more exposure to economic cycles but higher capital gain potential, balanced by potentially less predictable cash flow. 

Data centers, specialized fiber networks, edge computing facilities, fiber-to-home networks, towers and hosting facilities are considered “value add” assets. Capital gain potential is higher, assets holding periods might be shorter and yield is expected to be  lower. 

“Opportunistic” assets might be digital infra in developing markets or  distressed assets. 

source: Mercer

Yet others will use a related taxonomy using “super core” (core); core (what others might call core plus) and core plus (what others might call value add). 

As always, people will disagree about the boundaries between asset classes or the placement of specific assets within a class. Some argue that “core” infrastructure includes assets which are primarily income-producing. That view groups toll roads, bridges and hospitals in the same grouping with gas and electrical utilities. 

Also, some now view “core infrastructure” as including mobile towers, cloud storage and data centers. In that typology, some would say core plus/value add is a different category. 

The classification scheme matters to the extent that it guides investment thinking about what is core and what is “core plus'' or “value add.” 

The obvious areas of disagreement are that some assets viewed as “core plus” by some will be considered “core” by others. In a digital infra context, that means deciding whether data centers, tower networks and fiber access networks are “core” or “core plus.” 

The same definitional issue is whether those sorts of assets are “core plus” or “value add.” Perhaps nobody is going to confuse those categories with “opportunistic” investments which involve some level of asset distress or uncertainty. 

Digital infra, as viewed by many, has become an “essential” sort of infrastructure akin to roads, airports, seaports, electricity and natural gas supply. If so, then cell towers, fiber networks and data centers are “core” assets. So “core plus” and “value add” are the adjacencies to be explored, aside from the occasional “opportunistic” play.  

As a practical matter, digital infra investors tend to view those assets as core. Historically, infrastructure investors have looked for investments that:

• are real, capex-intensive assets 

• are essential services 

• offer steady and stable returns

• Are economic cycle protected 

• provide cash yields

• have barriers to entry

• are typically within energy, telecom or transport.

Most observers would likely agree that “core plus” means any additional new asset classes or assets with less utility-like characteristics. That might mean assets with shorter-term contracts, no rate regulation and some exposure to economic cycles, though generally regarded as “essential” facilities and functions. 

With the emergence of “supercore” asset baskets that consist exclusively of assets with regulated pricing, it seems logical to include data centers, tower networks, edge computing facilities or fiber networks as “core.”

Will Telecom Italia's Fixed Network be Privatized?

Telecom Italia’s board of directions is said to be meeting Nov. 21, 2021 about a possible fixed network privatization effort by private equity fund KKR, which is already an investor in the Italian phone group's fixed network, Reuters reported. 

At first glance, the proposed deal looks like a standard private equity deal: buy an underperforming asset, make changes and then sell. But the deal might also reflect another private equity focus: buying infrastructure assets to hold longer term, as an alternative asset. 

Telecom Italia, for its part, also fits the scenario: it has high debt and shrinking recurring revenues and profits, arguably impairing its ability to invest in digital infrastructure including fiber to home facilities. 

At the same time, the access network scarcity moat is challenged by the building of a rival Open Fiber wholesale network owned and operated by electrical and gas provider Enel. 

KKR might or might not see value in merging merging TIM's access network merged with that of rival Open Fiber, which would then be able to run as a single national internet and communications access asset supplying retail services to other internet service providers and telcos.

Alternatively, the former Telecom Italia assets might have enough scale to operate independently of Open Fiber. In either case, the value KKR sees is linked to the scarcity value and regulated, stable cash flows the access network would generate.

As the access network is deemed to be a strategic asset by Italy’s government (as is the case in virtually every country), it presumably would benefit from investment to eliminate the digital divide. That changes the business model for FTTH as it introduces subsidies. 

Were the government to sanction a merger of Telecom Italia and Open Fiber assets, to create a single national wholesale provider, KKR’s investment would acquire a business moat. 

Future KKR options would then involve a sale of the assets to a third party or a longer-term holding as an alternative asset. 

Institutional and private equity investor interest in communications infrastructure waxes and wanes. Right now it is waxing, after a precipitous drop in interest in the wake of massive facilities overbuilding around the turn of the century. 

In large part, the interest is driven by returns on other assets, leading investors to desire some exposure to alternative assets, including infrastructure with some market moats, scarcity and dependable demand, plus free cash flow. 

That appetite is matched by connectivity provider capital investment issues, namely low returns on invested capital that have bedeviled connectivity providers in recent years. 

In many cases, service providers have trouble earning back their cost of capital, according to some analysts. 

source: Arthur D. Little

All of that creates a heightened private equity and institutional investor demand for investments in “digital infrastructure” that is similar to demand for the more-traditional interest in real estate and utility investments. 

But the strategies can vary. The easiest and arguably safest choices are core infrastructure operations where most of the return comes in the form of cash dividends. This is most often found in regulated segments of the industry, with low growth but consistent demand. Ownership of electrical utilities provides a good example of this type of asset. 

Most digital infrastructure assets do not offer predictability or moats as high as might be the case for electrical utilities or airports, but arguably is most true for mobile towers. 

In other cases, there are some specific drivers that shift a bit of the story to more growth, if some tweak to the business model is made. That seems to be the case for mass market telecom networks where the upside is the upgrade from copper internet access to fiber to home. 

In other markets, the same thinking underpins buying a regional airport with expectations of creating a higher-value super-regional hub. In the communications assets business, perhaps an example is the “roll up” strategy of amalgamating many diverse and smaller connectivity or data center assets to create scale. 

The point is that a confluence of connectivity provider need and investor want is fueling a resurgence of private equity and institutional investor interest in a growing range of digital infrastructure assets.

Perceptions of Network Asset Value are Evolving

As more private equity and institutional investment funds ponder taking stakes in digital infrastructure assets--including access networks, data centers and fiber backbone assets--we will have to see where the operator comfort level lies. Few have fundamental qualms about divesting tower assets. 

The issue is how much broader involvement in entire core or access assets could occur. Traditionally, private equity investments  have been concentrated elsewhere, especially in real estate, energy assets, business services and software. But telecom infrastructure investments have been growing. 

source: Toptal 

Telecom transactions accounted for 35 percent of total private equity infrastructure deal value in 2020, up from 15 percent a year earlier, Preqin data shows.

Telecom deals involving towers, fiber and data centers are now viewed as possible holdings in the alternative assets portfolio, which generally focuses on  transport, energy and utilities.

source: S&P Global, Prequin 

The trend has been in place and growing for some time, sometimes driven by the traditional “fix and sell” (leveraged buyout, consolidate assets, flip to strategic buyer) model, but with some increasing longer-term holding as well, where private equity might take a minority stake in an operating company without plans to flip the stake in less than six years.  

source: Columbia Business School 

Recently, some big divestitures of whole networks, accounts and infrastructure have occurred, primarily revolving around rural and less-dense fixed networks. Lumen Technologies recently divested about half its fixed network assets, for example. 

And increasing attention seems to be paid to operating assets more efficiently, a traditional driver of private equity investing strategy. 

source: S&P Global, Prequin 

Asset reshuffling tends to be rather common in the connectivity business, with occasional bouts of merger unwinding. Consider the proposed sale of Lumen fixed network assets to Apollo Global Management.   

Basically, the deal unwinds the merger of CenturyLink and Qwest fixed network assets (more an acquisition by CenturyLink of Qwest) in 2011. What remains for Lumen are the original Qwest local exchange operations, plus networks in Florida and Nevada that were not part of Qwest.

Perhaps more important is the Lumen retention of the former Level 3 Communications assets. The proposed deal still leaves Lumen a bit of a hybrid: operator of large tracts of rural fixed networks, plus a handful of tier-two cities, as well as a global enterprise services network. 

source: Lumen

The larger point is that different financing mechanisms for core telecom infrastructure might be entering a phase where there is more “burden sharing” than in the past with private investors. 

That might be far more successful than regulator-forced sharing.

Beyond Connectivity? Some Do Better than Others

Connectivity service providers might be said to suffer from envy about the valuations earned by application providers compared to mobile operator or telco valuations. After all, a public market valuation creates, or limits, currency that can be used to grow the business. 

On the other hand, firms in distinct industries have different valuation ranges, based in part on revenue growth prospects. And that is where practitioners simply must acknowledge that connectivity operations and asset valuations are closer to those of other capital-intensive, relatively slow-growing businesses including energy utilities, airports, seaports, toll roads, gas and oil pipelines. 

Provider	Expected Revenue Growth Rate	Expected Profit Margin
AT&T	1.5%	10%
Verizon	1.0%	12%
NTT	2.0%	11%
Telefonica	1.0%	9%
Orange	1.5%	10%
BT	1.0%	11%
Deutsche Telekom	1.5%	12%
Telecom Malaysia	2.0%	8%
Jio	3.0%	15%
Vodafone	2.0%	10%

For the better part of two decades, connectivity providers have struggled to recreate themselves as faster-moving entities with higher growth profiles, with mostly modest success. At the very least, firms have tried to position themselves as more-diversified entities with bigger roles in other parts on the internet ecosystem beyond connectivity. 

For the most part, investors harbor few illusions in that regard. Indeed, connectivity assets are valued precisely when they offer the expectation of steady cash flow and some scarcity value. That is the thinking behind private equity and institutional investor interest in “alternative assets” that are relatively uncorrelated with other traditional equity and bond assets. 

The logical implication, however, is that connectivity CxOs--and those who advise them-- probably should stop suggesting that connectivity roles and value are something they are not. 

Which is to say, high-growth vehicles. That does not mean connectivity providers cannot take on additional roles in the value chain: they can. It does mean that even when successful, those assets will likely earn a higher valuation when eventually separated from the connectivity assets. 

In other words, assets often are awarded higher valuations when separated from ownership by entities with lower valuation ratios. Pure plays often are rewarded by higher valuations, compared to the value they bring to owners who have other roles and valuations. 

That might have significant implications for business strategy. If and when connectivity providers move to take on different roles within the value chain, it might also be realistic to assume that, at some point, those assets bring the highest and best value to the owners when the assets can be spun out or sold. 

In other words, moves to create assets in other parts of the value chain should be viewed as assets in a portfolio that always are available for sale, at some point, and not a core operating holding. 

The clear exception is when the new operations are significant enough in magnitude to warrant becoming the foundation of the company’s long-term business. 

We rarely see this in the connectivity business, though. Typically, the newer lines of business are sold or spun out. A connectivity firm does not become a content provider; a retail data center business; an application provider; an entity that earns its core revenue from facilitating transactions, rather than selling connectivity services. 

Firms might change, over time, the services they sell, or the connectivity roles they play. But we have yet to see major evolution away from “connectivity services” to some other permanent role, as the primary revenue driver, for any tier-one telco. 

To be sure, lots of firms might boast significant revenue from services and products other than connectivity. But those always seem to be “nice to have” operations that complement the existing core business.

And even estimates of non-telco revenue can change quickly, as for example when AT&T divested its content, linear video and advertising operations. AT&T's latest quarterly report focuses strictly on connectivity service revenue and operations. In a short year or two period, AT&T can be said to have scaled its “non-telco” revenue back from 19 percent to near zero.  

Even the commonly-cited sources of such “non-telco” revenue are suspect. Jio, for example, is said to make such revenue from home broadband on a fixed network. That makes sense only if Jio is narrowly considered to be a “mobile services” provider, with “non-telco” revenue including any sources on a fixed network. 

That would not be the definition used for other “integrated” providers with both mobile and fixed operations. The same might hold for Telecom Malaysia, BT or KPN. In other cases, non-telco products might also count revenue earned by service provider internal operations that use e-commerce or mobile payment mechanisms. 

Were we to eliminate all other connectivity services, even firms with lots of initiatives in content, apps or devices might show significantly less revenue contribution from non-telco sources. 

Still, JioMart, an e-commerce platform, JioSaavn, the music streaming service and JioMoney could represent 11 percent or more of total non-telco Jio revenues. 

Company	Percentage of Non-Telco Revenue	Examples of Non-Telco Products
Vodafone	18%	Mobile payments, e-commerce, cloud computing, advertising
Jio	30%	Home broadband, DTH, fiber-to-the-home, smart home solutions
Telecom Malaysia	12%	Fixed-line broadband, data center services, cloud computing
Deutsche Telekom	15%	Mobile payments, e-commerce, cloud computing, advertising
BT	10%	Fixed-line broadband, data center services, cloud computing
Orange	14%	Mobile payments, e-commerce, cloud computing, advertising
KPN	11%	Fixed-line broadband, data center services, cloud computing
Telefonica	13%	Mobile payments, e-commerce, cloud computing, advertising
NTT	17%	Mobile payments, e-commerce, cloud computing, advertising
China Mobile	20%	Mobile payments, e-commerce, cloud computing, advertising
China Telecom	18%	Mobile payments, e-commerce, cloud computing, advertising
Verizon	16%	Mobile payments, e-commerce, cloud computing, advertising
AT&T	19%	Mobile payments, e-commerce, cloud computing, advertising

The point is that common citations of “non-telco” revenue tend to be inflated. Connectivity providers “are who they are.” Diversification moves beyond the connectivity function contribute a non-zero amount of revenue. But even that amount tends to be overstated.