Investing in Fiber to the X
How last-mile telecom can revolutionize the way we communicate.
Similar to how eCommerce and logistics companies are reinventing the last-mile delivery process for customers, the telecommunication industry has been doing the same — except with fiber. For decades, fiber is how the world communicates, hence being the ‘backbone of the internet’. This is why sending and receiving information from around the world happens in split seconds. But what is evolving is how end-users send and receive data in the ‘last mile’; that is, enabling high bandwidth for users throughout the infrastructure to mitigate latency. This is called Fiber-to-the-X.
Fiber Technology
To really make a justifiable investment thesis for the fiber optics and telecom industry, it’s essential that we first understand how the technology works on a high level by digging in deep — no pun intended. Let’s break the technology part down into 3 parts:
- Understanding Fiber
- Understanding Fiber-to-the-X
- Fiber-to-the-X Architecture
After, we’ll take off our engineering hats and then leap into the key drivers of the fiber infrastructure industry as well as identifying the attractiveness of the industry by private equity.
Understanding Fiber
Unlike older generation systems (Dial-In, Digital Subscriber Line (DSL), and Cables), fiber cables facilitate the high-speed transmission of data. This is possible because fiber does not transfer electricity like copper cables, but rather light. And the speed of light, as you know, is extremely fast.
When you send information, your data goes through a hair-thin piece of fiber protected by a considerable amount of coating. The light (your data) is carried in a thin piece of glass over long distances and supported by multiple amplifiers to help maintain momentum for the light to push through to its destination.
Let’s look at some of the benefits of fiber:
- Superior transmission for broadband data (1 Gbps)
- Scalable
- Durable
- Cost-effective in the long-run (not short-run)
Cable, on the other hand, is designed using coaxial cables which are made of copper that conducts electricity. Here are some of the problems associated with it:
- Signals degrade over long distances due to electricity
- Electricity is prone to natural environmental conditions
- Interference as a result of electrical signals
- Copper may corrode and result in high maintenance costs
Fiber-to-the-X
Now that we better understand the underlying fundamentals of fiber, let’s move onto the Fiber-to-the-X infrastructure. “X” is just a substitute for destinations, including
- Fiber-to-the-home (FTTH) / Fiber-to-the-premise (FTTP)
- Fiber-to-the-building (FTTB)
- Fiber-to-the-curb (FTTC)
- Fiber-to-the-neighborhood (FTTN)
- and many more…
You can think of Fiber-to-the-home as the “last mile” of fiber directly connecting to a living space. Since this would entail no use of copper cables throughout this infrastructure, the end-user would be provided with significantly higher data rates and bandwidth compared to its coaxial cable peers. Other deployments like FTTC (Fiber-to-the-curb) are not as strong as FTTH, primarily because the fiber cables don’t reach the end-user directly, but rather a nearby cabinet, which is then connected to copper coaxial cables to the house, thereby losing bandwidth during delivery.
Fiber-to-the-home enables consumers and businesses with higher demands to have greater bandwidth needed to stream video, internet, and voice services. Current cable and DSL providers face challenges trying to squeeze out as much bandwidth from the existing infrastructure, while fiber optics are continuously being improved, providing significantly more economic value to both the consumers and the providers.
FTTX Architectures - Centralized vs. Cascaded
Although the distribution of fiber networks from the central office to the customer premise may seem trivial at first glance, the structural design impacts operational costs and efficiencies.
In a centralized model, a single fiber is directed to each dedicated subscriber where the central office has direct control of the deployment.
Because there are no network interface points in between, all maintenance is done within the central office, therefore reducing operating expenses.
In a cascaded architecture, you may notice a seemingly more complex-looking distribution system — and even though it is, this architecture turns out to have lower capital expenditures.
The difference between the capex between both architectures depends on the demography and densities of the area. For sparse locations, a cascaded system may be a viable option, unlike crowded and dense urban areas. Despite a rigid cascaded system that uses less fiber, fewer ducts, and less digging, a centralized system may be easier to maintain in the long term when, for instance, there needs to be an upgrade to the network.
Alright, now let’s leave the rest to the engineers and dive into the industry landscape.
Strong Data Growth Drives Fiber Demand across Industries of all sizes
The global fiber optics market size is anticipated to reach $9.73B by 2027, which yields a 10.3% CAGR from the $4.48B in 2019. Where technology companies try to add value is optimizing the real estate and costs towards the optical distribution network, which is basically the source of data (central office) all the way to the end-user (living space) connected via fiber and/or any other means of transmission.
Despite fiber being the fastest internet option, the availability is dispersed, since the cost of replacing the existing infrastructure connected to homes and businesses that are currently made up of copper cables is relatively expensive. According to BroadbandNow, fiber-friendly cities are those “where 90% or more of residents have access to at least one fiber broadband provider.” Below is a small sample of 13 major cities in relation to fiber availability.
Cities like San Diego, Chicago, and Miami, among others, are predominantly served by cable. The reason for this is a result of short-term costs — switching to a fiber infrastructure that is directly connected to homes and buildings is very expensive, despite the long-term “future-proofing” of fiber and the other advantages it brings.
The Rise in Global IP Traffic
COVID-19 has enabled a more distributed world, where people across industries are accessing the internet from anywhere, whether it be their kitchen, backyard, or even in the car. The demand for fast and high-quality data at any given location has reached an unprecedented peak. Annual IP traffic in the United States is anticipated to reach 977 exabytes in 2021, up from 376 exabytes in 2016, a stunning 21% CAGR. Over the past few years, there has been an extraordinary volume of global IP traffic and is even projected to grow as the world adapts to new software that solves problems and makes life easier and efficient for both consumers and enterprises.
From $5.3B in 2019, the global video conferencing market is expected to grow at a 9.7% CAGR to nearly $11B by 2027. As a result of the distributed world we live in where high-speed internet is in high demand to facilitate advanced video communications, fiber is an essential facet of infrastructure needed to meet those expectations whether it be in the enterprise, SMB, or even consumer segments.
Cloud vs. On-Prem Deployment
Some on-premise applications don’t require internet primarily because the software is installed directly to an organization’s assets. However, many applications are utilizing a cloud-based infrastructure to conduct operations that require high-speed internet to work in real-time anywhere at any time. The enterprise software market is mainly driven by the demand for cloud-based software that has a CAGR of 16.2%, while on-premise software is growing only at a 1.9% CAGR. Medium and large-sized enterprises make up the majority of the on-premise software segment because of long-term contracts as well as the conservatism in transitioning into modern tools on the cloud, whether it be data security conflicts or significant friction that causes impediments in the workflow. With the growing cloud market and the need to connect with end-users directly, the opportunity for further penetration of fiber, as well as the “last mile”, still remain largely untapped.
Fiber-to-the-Tower Growth & 5G Development
Let’s not forget about cell towers — Fiber-to-the-Tower (FTTT) deployments rely on fiber growth, especially for 5G capabilities. With mobile phone applications being used worldwide for a large number of data-intensive applications, including high-quality video, music streaming, and a number of interactive applications, the need for infrastructure that will accommodate for the increase in global traffic is imperative. Well, how can we support the need for this unprecedented growth in data? Cell towers may seem like an obvious answer, but they’re expensive and take up too much real estate, especially in high-density areas. The solution is small cells that are much more cost-effective and provide signals to a small group of subscribers. Because they use low power, they tend to interfere with each other much less frequently.
Small cells — which are attached to street lights, utility poles, or nearby buildings — must be low-cost to maintain higher margins, since each cell provides data for just a few subscribers. When a user needs to send data, radio waves are being sent to the small cell, which is then transmitted through fiber optic cables to support increased speeds, long-distance, unlimited bandwidth, and low interference. And this makes sense — small cells cannot communicate to each other around the world just by wireless transmission, thus making fiber the backbone of the internet. Without deep fiber deployments, mobile carriers won’t be able to support the anticipated data traffic in the near future. According to Deloitte, the analysis estimates “that the United States requires an investment of $130-$150 billion in fiber infrastructure over the next 5–7 years to adequately support broadband competition, rural coverage, and wireless densification.” Despite there being a motivation to develop infrastructure of this nature, policymakers and legislative bodies do control a substantial amount of regulation and procedures that may likely stunt the growth of fiber development.
Fiber Industry in the Eyes of Private Equity
- Attractive entry-point for participation in growing global IP traffic and bandwidth.
- A high-quality network that enables high-speed data across attractive established and growing markets.
- High margins particularly due to initial high fixed costs and low distribution costs for end-users.
- High Capex as a result of deploying and maintaining high-quality physical assets, but creates stronger barriers to entry.
- Long-term contracts that enable recurring revenue along with cheap debt capital create a safe cushion for debt repayment.
- Fiber/Telecom sectors are favored by debt investors because of high risk-aversion.
- The horizontal nature of fiber infrastructure allows for a number of industries to be impacted, thereby supporting cross-border investments if desired.
- Ability to achieve economies of scale — infrastructure that is deployed in a high-density area can promote a higher return on an investment (low marginal costs) relative to the high fixed costs.
- Low churn
- A rapidly growing industry with increasing EBITDA multiples
- Significant dependencies on regulatory bodies can either allow for opportunity or impede growth in new or existing markets.
Fiber M&A Activity
In 2019 alone, there were 35 Pan-American fiber M&A transactions, totaling over $30B, according to TMT Finance. Strategic buyers are seeking opportunities in acquisitions for geographic expansion where there is potential to enter or expand into new markets. Past transactions often had post-synergy multiples that were much lower than the unadjusted valuations (TEV/EBITDA), suggesting net positive synergies. In addition to operational synergies, the cost of cheap debt capital enables fiber companies to increase their leverage that can ultimately accelerate M&A activities.
Large enterprises are more attracted to a single provider that offer a range of services. Fiber providers who can increase their scale can improve their competitive positioning, including a wider geographic reach or a larger breadth of services.
According to EY’s 2021 M&A report, cross-border M&A remains more attractive than during the start of COVID-19. This is especially true for fiber network providers who are looking to gain access to new and emerging markets around the world that show potential for opportunity to deploy fiber infrastructure, all the while taking into account government regulations as well as the existing digital infrastructure.
Notable Transactions
Here are just a few of many transactions in the fiber network provider space within the past few years that are worth mentioning:
Mid 2019 — Voneus, a European provider of broadband networks particularly in rural areas, was acquired by Macquarie Asset Management to support growth in UK’s fiber rollout.
Mid 2019 — Deep Blue Communications, a high-speed wireless internet provider, was acquired by Comcast to combine forces of Comcast’s scalability and global reach with Deep Blue’s cutting-edge solutions.
Early 2020 — Zayo (ZAYO) was previously a public company turned private by Digital Colony and EQT in order to accelerate growth in the North American and European markets.
Publicly Traded Fiber Companies
A sample of fiber and broadband companies based in the United States is trading at 12.3x LTM EBITDA multiple.
Looking at the past decade of fiber companies’ valuations, it’s fair to say there is an upward trend with a decent amount of volatility. With COVID-19 accelerating the high demand for faster and higher quality internet speeds from the comfort at home to higher adoption of technologies like IoT and 5G, it’s safe to say that valuation multiples are likely to be growing in the future.
