Plugdin: Broadband Headwinds: The altnet challenge and the likelihood of Government intervention

Recent press coverage has suggested that the Government and Ofcom are preparing contingency plans to deal with the potential failure of a number of alternative broadband network providers (known as the altnets) due to the well documented macro-economic headwinds. These headwinds are understandably beginning to impact new and existing investor sentiment in the sector. Government/ Regulator operated schemes such as those in the energy market have been mooted but does the Broadband/ FTTP market need such interference? Would there be any benefits of such a scheme, or should the operation of the free market be allowed to rule if, as seems increasingly inevitable, some of the smaller altnets begin to face insurmountable financial challenges?

The altnet challenge

Altnets face an array of increasing challenges fuelled by economic headwinds:

• Inflationary pressures mean that infrastructure and installation costs have escalated since business plans were written and initial funds raised. Return on investment dynamics have changed and will need reassessment
• The low-cost finance environment of the past 10 years has changed. Interest rates have risen. Investors have already and will increasingly become more cautious
• Overbuild (whereby a number of competing providers build networks in an area) has long been a consideration but is also increasing. It may be possible for an altnet to gain a first mover advantage, but in towns and cities in particular it is ever more unlikely that they will be the only fibre to the property (FTTP) provider
• Converting homes passed by their fibre networks into paying subscribers remains a challenge. This is particularly the case where altnets do not have a geographical advantage and are required to go head-to-head with one or both of BT and Virgin Media O2 (VMO2). Customer penetration rates have remained low, and while the benchmark seems to be 30% or more, all too many altnets have achieved 5% or less
• Positive EBITDA remains elusive for all but a few of the largest altnets as building continues. For those needing funding in the next 12 – 18 months, they may find that new and existing investors require more stringent plans demonstrating a resilient path towards profitability/cash break even before they are willing to commit funds.

Government investment - Project Gigabit

The Government launched Project Gigabit in March 2021. £5 billion was earmarked to upgrade the current broadband infrastructure as part of the levelling up and infrastructure investment strategy. To August 2022, however, only £690m of Project Gigabit procurements had been launched (covering harder to reach geographic areas). This spend includes a number of areas where there was no take up from broadband providers.

"As of August 2022 c. 40% of UK households have full fibre broadband, while a little over 70% of households are considered to have a gigabit capable broadband connection (the difference being made up by homes passed by the VMO2 Docsis 3.1 network)."

Despite these improving figures, the law of diminishing returns has a major impact on the economic viability of harder to reach homes and we expect to see further awards of Project Gigabit funds as overbuild makes urban and suburban areas less attractive and the altnets look to expand into more rural areas to grow their subscriber/customer base.

Government intervention in the energy market and sector differences

Two key processes underpinning the energy market intervention regime are worth testing against the dynamics for altnets:

• Supplier of Last Resort (“SoLR”) - whereby OFGEM directs an existing energy supply company (“ESC”) to take on the customers of a failed ESC
• Special Administration Regime (“SAR”) - this is a backstop where a SoLR cannot be appointed because to do so, would potentially precipitate their failure due to the size and number of customers being transferred

There are a number of key differences between the energy and broadband sectors:

• There has been no “shock” in the broadband supply chain, at least not to the extent that there has been in the energy market. Whilst the economic headwinds mean there are inflationary pressures on installation and operating costs, these are not at the levels seen in the energy sector. Altnets are able to manage these through their T&Cs which generally provide a right to increase prices annually in line with inflation
• Gigabit broadband is important to many households (including for their livelihood in many cases) but is generally not a matter of ‘essential’ in the same sense as energy. Substantially all of the population have access to either alternative broadband providers or the 4G/5G networks, which could be used whilst they transition to a new supplier
• While there is some infrastructure sharing (e.g. Local Loop Unbundling), in the case of full fibre it tends not to be shared (as is the case with Energy). It can therefore be more complicated to immediately transition customers to a new supplier without impacting the rights of secured creditors (who will typically have rights over the infrastructure)
• Altnet infrastructure costs are sunk costs. The price of acquiring infrastructure out of an insolvency process would certainly be lower than the costs of installing the infrastructure in the first place. This makes distressed acquisition appealing, subject to manageable complexities and costs of integration. The operation of capital market principles would therefore, in most cases, resolve the situation
• Customers in the energy sector generally have built up a pre-paid surplus (depending on the timing and basis of payment) which would be lost but for the SoLR process (which requires a new supplier to honour a customer’s account balance). Such a situation doesn’t exist in the broadband market, where customers generally pay monthly in arrears and equipment is loaned/leased to the customer. Protecting customer’s payment balances is not therefore an imperative in the same way it may be considered to be with an ESC.
   

Despite these differences, there may still be specific situations where the free operation of the markets does not lead to the achievement of wider Government objectives. As such, Government may wish to intervene, for example where a rural area has a single broadband supplier that enters insolvency, or where the infrastructure is partially constructed in an area where there is no/limited alternative and where, in both scenarios, the failure of the broadband supplier would be detrimental to the local economy and wellbeing of its population.

What happens if an altnet becomes Insolvent

There are likely to be situations over the coming months where some less well funded altnets are unable to obtain additional investment or debt funding and run out of cash. Where they are geographically distinct from other altnets, it is expected that they will remain attractive to being acquired (most likely solvently) by some of their better funded competitors, as part of the widely anticipated consolidation in the sector.

There are limited examples of an altnet becoming insolvent as historically most have been acquired by a competitor before that point is reached. People’s Fibre entered administration in August 2021 and was sold to Swish for £2.8m (presumably representing value ascribed to the network build as revenue was minimal). In most cases, one would expect there to be an accelerated M&A process, with a transaction occurring immediately on or shortly after the appointment of an Administrator. Alternatively, if a purchaser cannot be found and the altnet ceases to operate, customers would be notified, and they would be free to subscribe to an alternative provider (to the extent one exists). Whilst this may create an “internet down” period and may necessitate reversion to a lower speed alternative broadband provider, this would be a viable option for all but a relatively small proportion of the rural population.

Conclusion

Whilst we support the Government’s contingency planning efforts for what is sometimes referred to as the ‘fourth utility’, there appear to be a limited number of situations where Government intervention in the broadband market would be required, absent the failure of one of the bigger market participants.

On the flip side, the challenge for the altnets remains to connect customers at a pace sufficient to achieve profitability as they continue to build out their networks and to repay the significant investments made across the sector. The potential (and increasingly likely) reduction in investor appetite, the absence of meaningful progress with customer acquisition and the overbuild risk, mean some of the altnets are likely to find themselves facing challenging times ahead.

How we can help

Key to achieving the best outcome is to tackle these challenges head on at an early stage. At BDO our multi-disciplinary Advisory teams are available to support you at every stage. We have individuals with deep sector expertise in the telecoms sector and can bring to bear years of situational expertise to find the right solution for the challenge being faced. We can support on Strategy, M&A Advisory, Due Diligence (Commercial, Financial, Technical, Tax, Integrity, etc), Restructuring, Fundraising and Debt Advisory and Growth Acquisition.