Pacific Fibre II: Background and questions for new players
Kim Dotcom is the first, among many I believe, to try to resurrect the case for Pacific Fibre.
This has created a bit of a media kerfuffle, and so let’s get some background and questions for Kim and any other potential new players to answer.
I remain a very strong believer in the business case for a Trans Pacific cable from Australia, through NZ, to the USA. The basic business case that I mocked up on a spreadsheet after a chat to Rod Drury was improved countless times as we learned and even redone completely two or three times by others, but the drivers of value and the results for investors and customers never really changed.
There are three main activities to successfully complete to build a cable system – financing, operatons and sales to customers. Let’s look at each of them in turn and understand the key questions to answer in order to determine what new player have to do to be credible.
The company will need access to funds in the order of US$300m (NZ$400m) for an Australia-NZ-USA cable. This can be raised from a combination of debt or equity, but investors will demand substantial credibility to back up the proposition. The business case credibility seems obvious to me, but unfortunately people who run funds generally have very restrictive rules. Those rules can even make the investors appear to be illogical or unsophisticated, but rules are rules and when you are running huge funds managing the downside risk is everything. So sadly Pacific Fibre was unable to bridge the gap as investors demanded an out-sized book of signed pre-finance customers, along with known costs.
Pacific Fibre delivered on tight cost projections, but were unable to build a book that would justify the $300m raise. The potential investors collectively insisted on to many restrictive and overlapping covenants, including what I consider to be unrealistic customer signings given the market structure. Some major domestic potential funds essentially ignored the prospectus, and others were unable to understand the combination of cable system investing, investing in Australasia and the unique characteristics of the local submarine capacity market.
Finance Questions for new players:
- Can the new player secure US$300m of financing? Does the new player have the money really lined up, sitting in a bank account and releasable to the vendors?
- Is the new player credible to any other required investors?
- Does the new player have a track record of raising large sums for similar local ventures?
- Can the new player get financing without a full customer book?
The best answer is “yes – we have US$300m in cash ready to spend – let’s go”
Pacific Fibre shopped the prospectus to a large number of local and foreign investors. Some of those, perhaps government owned funds, may be regretting their decisions, but all will be far better informed for new player conversations. I believe those conversations need to be far deeper and collaborative – we are all in this together.
Getting a well scoped and priced contract to build takes time and credibility. The suppliers do not want to deal with fly-by-nighters, and it was to Pacific Fibre’s credit that they were able to run a very good tender process and eventually sign a compelling contract with TE Subcom. We had a world expert (really) on the team and learned a huge amount.
Beyond the master cable contract, the cable system needs to secure landing rights for each of the countries, and the authorities will look hard at the vendors, the technology, the company and the investors and owners. This makes it very problematic for certain vendors in certain regions, and for certain investor types as well. One obvious example was the recent damning (yet not substantiated) USHR report on Huawei land-based telecommunications equipment. The scrutiny for sub-sea equipment is even higher.
The cable landing requires fibre to be laid, landing stations and connection and colocations deals. All these take time, money and industry expertise.
Pacific Fibre learned a lot in the process, as did the vendors, and much of the operational risk for a new player who can learn from the experience is mitigated.
Operations Questions for new players:
- Can the new player convince TE Subcom and its peers to invest in responding to a tender?
- Can the new player and vendors secure landing rights in all countries of operation?
- Can the new player attract industry technical and legal veterans to deliver the goods?
- Can the new player get NZ, US and Australian Government support?
The best answer is “yes, we have a signed master contract with an approved vendor and landing rights and arrangements for all countries of operation.
For new players without financing building a customer book is the vital part of convincing investors that the project is credible. The business cases and modelling are simple and compelling to me, but players have to be able to bridge the credibility gap between the model and contracts. As inferred above truly sophisticated investors will see enough evidence in the model and small market validation, and a project that does not require up-front customer contracts makes higher returns due to less discounting.
If Pacific Fibre had had $300m in cash then signing customer contracts could have waited, but instead this was the main activity for much of the time. It took an extraordinary effort (on both sides) to contract with the large telcos who could take the volumes of capacity required to make the numbers work. From our perspective they absolutely validated the demand, but investors did not agree. There were a few smaller players to sign, but some who didn’t – Pacific Fibre, for example, didn’t even manage to sell to Government owned Orcon.
However the biggest issue, the elephant in the room that investors also struggled to deal with, is market structure. Telstra alone represents about 50% of the combined Australasia market for international capacity (before Telstra Clear was sold to Vodafone). They, along with giants Optus and Telecom and Australian ISP TPG, have ownership stakes in existing cables. It’s obviously not a very competitive market, and so those existing cable owners have every incentive to keep prices high by not helping out a potential new entrant with orders.
This is an extension of a well know game theory scenario from other cable markets, where typically incumbents drop prices just enough to discourage credible threats and then prices remain static and monopoly rent-taking ensues. Indeed the self-reported historical Southern Cross prices were amusingly static and then plummet arguably around about the same time as various credible threats turn up. Even given that I would argue that this market probably has less price drops reactions than others, simply because well over half of the capacity demand is withheld from new entrants. Withheld that is until after any new systems are financed or built, in which case it’s in the best interests of incumbents to diversify their own capacity demand, and they become buyers. It’s a well-worn road, but investors were never able to truly grok it, especially with their imposed investment rules.
For the (awesome) customers who did sign up with Pacific Fibre, the process generally took well over a year, and perhaps two or three.
Any new players that are telcos will bring their own demand, but they will also bring even more potential problems with finding customers before the cable is built. The normal approach is to join together with other telcos, but in this market the largest players already have cables in the water, mainly going to Australia. The giant Telstra, with the sale of Telstra Clear, now has very little incentive to go via New Zealand, and so the New Zealand market cannot rely on them being the next to build.
Customer Questions for new players:
- Is the new player credible enough to negotiate and sign individual contracts worth $10-100m before the cable is financed?
- Can the new player sign a critical mass of customer contracts to convince investors to invest?
- Will the largest industry customers ever buy from the new player?
Pacific Fibre warmed up the market somewhat, and there was a good learning curve for all parties. Any credible future players should find that sales conversations are easier, but will still need to invest serious time and legal expertise.
Lance Wiggs is an independent consultant providing management, strategy, growth and valuation consulting to industrial, media and internet based businesses. He was one of the four original and six public founders of Pacific Fibre, leaving the business in June 2011 when we handed over to a finance team. He blogs at Lancewiggs.com.