Jun 29, 2015

Sea of Change in Euro Telecom

Changes in the European telecom industry has benefited the big players, turning them from purported losers into clear winners - and McLean & Partners' International Strategy holds two of the biggest beneficiaries of this transformation.

A sea change in the European telecom industry is turning the big players from purported losers into clear winners - and CWB McLean & Partners’ International Strategy includes two of the biggest beneficiaries of this transformation.

Roughly 30 months ago, CWB McLean & Partners bought into two of the major players in the European telecom space — Orange Telecom of France and Telecom Italia. During this time, both of these companies experienced stocks that had been beaten down, well below their intrinsic values. Changing regulations had forced big telecoms to share their vast copper-wire and cellular networks with new, smaller competitors who, in turn, collected market share and revenues from the majors. Being a small and nimble telecom was cool, and North Americans travelling in Europe gaped in envy at the ability of Berliners and Londoners to call home from Rome or Paris without fear of being pillaged by their cellular-service providers. Liberalized regulation induced hyper-intensive competition, and service rates plummeted just as the big telecoms were making massive investments in Fibre-to–theHome (FTTH) networks and 4-G technologies to accommodate the latest mobile devices, highdefinition TV and cloud computing.

Now, however, technological transformation and a regulatory reversal are eliciting the perfect conditions that would, once again, raise the status of the big telecom companies. The majors are rolling out highspeed, high-definition services through fibre-optic networks and regulators are ruling that, this time, those high-cost networks won’t have to be shared with upstart competitors. Smaller companies will be forced to build their own fibre-optic systems or be left behind in the transition to new technologies. Meanwhile, the big players who’ve made the necessary investments in technologies, including Orange and Telecom Italia, are seeing their business fundamentals take an upward turn.

Orange has seen its share price double, from €7 when we acquired it to around €14 today, and Telecom Italia has risen from €0.54 to €1.19. Still, we believe this fundamental market shift is not yet broadly understood or adequately valued by investors and there is substantial room for continued share price appreciation by these two market leaders, especially as an ongoing round of consolidation continues to unfold.

In the early 1990s, governments across Europe were strongly supportive of their flagship telecom providers and the copper-wire networks they built — largely at government expense — as the telecom revolution first took hold. But, by the first decade of the 21st century, the public necessitated an increase in diversity among telecom firms and regulators ordered open access to those government-funded networks at wholesale - some claimed, firesale-prices.

Competitors with miniscule infrastructure costs flooded most European markets, ushering in severe price deflation. Consumers enjoyed bargain-basement rates while major telecom companies struggled to earn their cost of capital and the continent slipped behind North America in the move to expensive 4-G and fibre-optic technologies. By some estimates, Europe’s rates of telecom investment were less than two-thirds of U.S. rates and less than half those in Australia. On the ground, this meant that in early 2012 only three per cent of the world’s 4-G LTE subscriptions were in Europe. Simply put, European operators were hesitant to invest in new technologies without some certainty that they would be permitted to recoup their costs and earn a reasonable return on their invested capital.

At this point, Orange and Telecom Italia shares were essentially priced for permanent capital destruction, even though their existing networks formed the backbone for indispensable communications services in France and Italy. We saw this situation as strategically and commercially unsustainable and, in addition, believed aggressive European Central Bank monetary policy would prove to be very beneficial. We could also see that there would be failures in a super-competitive European market, precipitating both consolidation and a rebalancing of the regulatory environment.

Therefore, we see Orange and Telecom Italia as very compelling opportunities and check all the boxes of the CWB McLean & Partners’ investment process. These include:

  • equity valuations below our estimates of intrinsic value;
  • sustainable competitive advantages, potentially including significant barriers to entry into 4-G and fibre-optics markets for competitors;
  • stable or growing returns on investment and returns on capital exceeding their costs of equity;
  • free cash flows that are expected to grow over the medium term;
  • balance sheets which are more appropriate to the business model; and,
  • proven management teams.

Over the past 24 months, in order to encourage needed additional expenditures of at least €200 billion for FTTH and another €50 billion for 4-G LTE coverage, regulators across Europe have consistently upheld the rights of fibre-optic investors to control the new networks they’re building, as well as to increase user rates. And this comes at a time when the demand for 4-G services is growing by as much as 100 per cent per year in the United States. U.S. consumers are willing to pay more for a richer mobile experience and HDTV, while businesses want more and better data services. A similar response is anticipated in Europe and that phenomenon is already beginning to transform the outlook for the owners of 4-G networks.

Big companies with wider coverage, more bandwidth and greater reliability can be expected to exert increasing market power and we see user rates for 4-G and FTTH services rising in the months ahead. Moreover, the cost of debt is declining, giving big companies the ability to borrow and refinance at reduced costs. In fact, we have already witnessed increases in return on equity and stronger balance sheets, with the prospect of increased dividends as revenues continue to grow.

At the same time, various upstart competitors have become victims of their own aggressive pricing tactics and a wave of telecom consolidations are beginning to sweep Europe. Much of this activity will undoubtedly see mergers among struggling smaller companies, as they attempt to build critical mass. However, it will provide opportunities for the big players to acquire market share at distressed prices.

We expect telecom rationalization to continue in Europe over the coming months and years, with increasing upside for flagship companies. We see Orange and Telecom Italia as two of the leading competitors, with excellent prospects for share-price appreciation and dividend growth as Europe makes up lost ground in the telecom space. In this new environment, the companies that once had the most to lose now have the most to gain.