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France Telecommunications SA (FTE), a France-based multinational telecommunication corporation, is among the largest telecom operators in the world. The telecom giant was incorporated in 1988 when the French government privatized its telecommunication agency. Currently, France Telecom operates in several countries in Europe, providing telecommunication services, internet access, and mobile operations. Most of its services are offered under the 'Orange' brand name. The company employs more than 180,000 employees and the services are offered to around 224 million customers.

Industry Background:

Europe has been experiencing a sluggish economy for a while. High uncertainty about the government spending cuts and increases in the tax rates have added to the low-growth economy. Many of the member states experienced negative growth. European Central Bank's efforts to boost the economy have resulted in a very low-yield fixed income securities.

Given the near-zero interest rates, telecom sector became highly popular among investors who are looking for the high-yield investment. Since a drop in the share price automatically translates into a higher dividend yield, should we consider them as great buys? Definitely not! Many companies which used to pay high dividend yields had to cut their dividends due to the global economic challenges, intense competition, and huge debt burdens.

The performance of France Telecom over the past few years has been well. The ongoing turmoil and overall weakness in the Europe have caused the shares of France Telecommunication to fall to the lowest level in the last decade. Taxes, regulatory measures in Europe, and increased competition also contributed to the company's negative performance. Low-cost mobile carrier, Iliad, also has brought a major challenge to the Europe's mobile industry.

France Telecom's net profit for 2012 dropped by 79%, primarily due to the writedown on operations in Romania, Egypt, and Poland. The company is facing serious trouble in cutting down the cost and maintaining a stable operating cash flow. Gervais Pellissier, Chief Financial Officer, said;

The pressure on prices will be worse in 2013 than we thought, But we still aim for a slight improvement to operating free cash flow next year (2014), and since prices may not stabilize in France, we will work more on our cost structure to get there.

Domestic Competition:

France Telecom is largely dependent on its domestic market. Half of its 2012 sales are generated within the country. It faces a fierce competition since Iliad's entry in the market. The arrival of Iliad's Free Mobile low-cost and no-contract offers have drastically changed the telecom industry in France. Iliad has led to a price war which resulted in lower profits for the existing companies. A 10% fall has been observed in the average revenue per mobile user [ARPU] as compared to the last year. Free Mobiles by Iliad have captured 6.4% of the market share since their launch in January 2012. Due to the intense competition, France Telecom and many other domestic telecom companies had to cut down their prices on most of the products they offer. These companies also have to offer competitive packages and discounts to be competitive in the market.

Dividend Thesis:

Since the company has announced a major cut in the dividend in October 2012, it has observed a great fall in its share price. The company also announced a dividend cut for year 2013 and 2014, from $1.75 per share to $ 1.04 per share minimum. The planned deduction in the dividend cut is due to a drop in the forecasted cash flow over the next two years. Following its U.S. peers, such as Frontier (NASDAQ:FTR) and CenturyLink (NYSE:CTL), France Telecommunications also wants to divert its resources to pay down debt and reduce interest costs.

The current share price of $10.06 has observed a constant fluctuation since October 2012. The major decline in the share price is the result of last two dividend announcements. Both of these last two dividends observed a decline from the previous paid dividend. A cut in the dividend resulted in capital losses.

Below is the historical dividend per share of France Telecom. France Telecom has paid a semi-annual dividend for last 4 years. The annual dividend of €1.40 ($1.83) per share remained unchanged from 2008 to 2011. A stable dividend payment for more than four years made the stock a trustworthy and attractive to the investors. Even after the dividend cut, FTE offers one of the highest dividend yields in the European telecom industry.

Source: France Telecom website

2012 brought many challenges to the company. Most of all was the fierce competition brought by Iliad's low cost mobiles. As a result, the company not only had to cut the prices but it also cut its dividend in 2012. France Telecom announced a dividend cut for 2013 and 2014 to the minimum of an annual €0.80/share. Further dividend cuts are also possible in the future due to the company's domestic competition and the weak European economy. Still, the dividend yield of the company remains above 5%.

Industry Comparison

FTE

Industry

P/E [ttm]:

25.09

21.4

PEG (5 yr expected):

-1.11

4.08

P/S [ttm]:

0.47

2.68

P/CF [ttm]

6.7

9.9

Source: Yahoo finance

The negative earnings growth of France Telecom is much lower than the industry's earnings growth. On the positive side, price to sale, and price to cash flow ratios are also lower than the industry averages, which indicates that the stock is undervalued based on these metrics

Conclusion:

Decrease in the revenue, weak European economic outlook, fierce competition, and price wars should make 2013 another tough year for the company. Planned dividend cuts are the result of the company's efforts to reduce its debt burden, improve the cost structure and operating cash flows. As the company is still observing one of the highest dividend yields among European Telecom stocks, it can provide a good cushion against further decline in the stock. After the dividend cut, the management seems to be committed to offer the same dividend for the next 2 years. However, a further decline in the share price along with a dividend cut may not be attractive to the investors. It may take several years for the company to reverse the trend in dividends. Until then, I suggest a neutral stand in the company at the moment.

Source: France Telecom: A Buy After Dividend Cut?