Ringing the changes

IT was the 1970s before the first telephone was installed into south Kerry’s Black Valley.

It arrived on the same day as electricity. A local man, recently interviewed on radio, spoke of the miracle of standing in his own kitchen in a remote valley on that first day and speaking to his two brothers in America.

It's hard to appreciate now so many years later how momentous that first call was, or how different it all was back then.

What's happened in the past 30 years that's changed that picture so fundamentally? In that time a vast State-provided service (with social, rather than profit motive) has ended up as a E3 billion British shelf company. A lot of things have wrought that change. There has been the revolution in technology; there has been the emergence of competition in the market, and there has been the old reality of the chance of making a quick buck.

For Eircom is about to yield a E1.5 billion-plus profit for a small consortium of venture capitalists (VCs), including the likes of Tony O'Reilly and George Soros. The most astounding thing behind the story is that they took over the company a little over two years ago. Their own investment then was less than E1bn. And, as they prime it for flotation later this year, they have made most of their investment back already.

When the initial Eircom flotation occurred back in 1999, the hype was of zeppelin proportions. In that buoyant market, the share price set by then Minister for Public Enterprise Mary O'Rourke was high. The State benefited to the tune of E6 billion, now sitting in the National Pension Reserve Fund. For the 400,000 people who bought shares in the company, the story was not so rosy. After an early spike in share prices, they went on a downward slide that saw them plummet to half their value in the space of two years.

This is how one experienced financial analyst describes what happened: "Eircom was floated when the market was at its most optimistic. That meant it came at a huge price multiple. In other words, it was priced according to how they projected it would perform over a period of 20 years or so. It was also priced against other telecom companies.

"But the problem was that they were all overpriced and the projections were completely unrealistic."

Eircom's potential for growth was severely limited. It had sold off its mobile arm, Eircell, to Vodafone, and with new technologies and emerging competition in the fixed-line market, it was looking at a scenario where its revenues would fall. In addition, its investment programmes were eating into its profits. It was beginning to look like a dinosaur.

With Eircom fortunes at a low ebb in 2001, the company needed to find a buyer. During 2001, two of Ireland's biggest hitters in the business world, Denis O'Brien and Tony O'Reilly, both cast themselves in the guise of knights in shining armour. Mr O'Brien's eisland consortium pitted itself against Valentia, a consortium which included a number of American venture capitalists and the renowned George Soros. Mr O'Reilly, who headed Valentia, had a 5% stake. For several months, they both increased their offers, hoping to get 80% of the shareholders to accept their bids. In the end, it was the shares of Eircom Employees (ESOP) which proved crucial. Owning 15% of the company, they were ultimately swayed by the Valentia offer, which would give them an impressive 29.9% stake in the company, then worth E3bn, after the deal.

"These were financial buyers. Typically, they would have a three-year to five-year outlook for their investment. Their attitude would be that you cannot get in unless you can get out.

"One big advantage a telco would have for a prospective financial buyer is that there is a lot of cash flow. Eircom had a big customer base and had the monopoly on fixed lines. The income also goes up at a pretty steady rate."

According to another analyst, the timing and nature of the Valentia investment made it a textbook example of VC strategy. There had been over-investment prior to their arrival, but that cycle had come to an end. The consortium also knew that it could cut costs in the telco. In a classic VC move, the consortium's purchase of Eircom was highly leveraged. Of the E3bn asking price, they committed E900,000 of their own money, and raised the rest by borrowing. It helped that the interest rates for borrowing had fallen to their lowest levels in decades. "There is always a risk involved. But looking at it in hindsight, the VCs timed their investment in Eircom perfectly," he says.

But has the success story for the VCs meant a commensurate success story for the country's consumers? The one neon-like story that has emerged out of Eircom in the past two years has been its decision to jack up the prices of fixed-line rentals to the country's 1.6 million telephone subscribers by 25% in the past year. One estimate is that those increases are worth E90m per year to Eircom.

In an exhaustively long Oireachtas Committee hearing last Wednesday, we were afforded insight into how this increase came to pass. Eircom had always made a loss on its fixed-line rental (i.e. the process of putting a phone line into every home and business in the country) but balanced that loss with profit made from phone charges. Eircom, which owns the network, has a monopoly on fixed-lines and emerging competitors competed solely on phone call costs. Consumers switching from Eircom then received two bills, one from Eircom for line rental and one from a competitor for usage.

However, a key and controversial decision by telecoms regulator ComReg changed that situation radically. Instead of putting caps on all individual elements of a phone bill, Comreg issued a directive in February 2003 that there would be only one cap covering the entire basket of services. The rule was that the overall increases in a telephone bill would not exceed inflation. That allowed Eircom to substantially increase the line rental while reducing the cost of calls to balance out the overall bill.

It, and indeed ComReg, argue that that was allowable, because the charge for line rental must reflect its costs. But it means that residential line rental in Ireland is now almost twice the European average E24.30 per month compared to an average of E14.20.

In the hearing last Wednesday, Eircom stoutly defended its charges on the basis of Ireland's low population density, low urbanisation and burgeoning population. The expense of providing lines to one-off houses was also a factor, it argued.

But its competitors say that the high line rental has tilted the balance too much in favour of Eircom. It now has a steady income on line rental coupled with the ability to undercut its rivals on phone charges. ComReg balked at the initial request for an increase last year. Knowing that the rise would hit those with low usage (i.e. the poor and the elderly) hardest, it obliged Eircom to introduce a vulnerable user's scheme offering discounts. Disgracefully, Eircom publicised it so wanly that the uptake as of last week amounted to a paltry 300 to 400 consumers out of a possible 60,000 vulnerable users.

Eircom has impressive operating profits of E551 million up to March 2003, a huge turnaround within two years. Eircom's own presentation to the committee showed how it increased profits when revenue fell. A reduction in costs and staff numbers, allied to a reduction in investment added to the bottom line. Dr Nolan explained that the decrease in investment could be attributed to the sale of Eircell and the conclusion of major projects. He utterly rejected the charge that the VCs were "sweating the assets."

But the VCs and ESOP (which owns 30%) have already had two lucrative paydays. They were paid dividends of E192 million from the sale of Golden Pages and a further E512m in dividends when the company took out bond refinancing of 1 billion in July last year. But what now? Dr Nolan said on Wednesday that an IPO would be in the long-term interests of the company, allowing it to invest in broadband and re-enter the mobile market, long-term projects not in the interests of VCs. If it refloats at E4bn, it will mean the VCs will be looking at a profit of a cool E1.5bn to E2bn in the space of two-and-a-half years. That's a universe removed from the spirit that guided the first phone call in the Black Valley.