Hidden Value In Telecom Italia

| About: Telecom Italia (TI)

Since its liberalization, the telecommunications sector has so far been a losing game for investors. Driven by the aim of governments to break up existing market structures, the former monopolists were treated unequally. The introduced regulatory framework worked perfectly in opening up the market to competition. But less so for the incumbents that had to carry the burden of constant investments into network infrastructure while seeing their customer base eroded. A simple fix to the incumbents' problem could be to separate the network activities from the service business. This would still guarantee the quality of these strategically important assets while allowing the former monopolist to compete on the same level as its rivals. Italy's former monopolist Telecom Italia (TI) is currently in the process of spinning-off its network activities which could trigger a huge re-rating of both parts of the business and become a blueprint for the sector.

TI is under attack. The confirmation came in form of a cryptic press release dated April 5, 2013. Apparently, pressured by the Consob, Italy's equivalent of the SEC in the US, TI's management confirmed that it had been approached by 3 Italia, Hutchinson Whampoa Ltd.'s Italian subsidiary. A later press release revealed that H3G's intention is to integrate its Italian operations into TI or merge the two entities, subject to being allowed to raise its stake to approximately 29.9%.

It's only fair to ask how TI could possibly get into this situation. Fierce competition and an unfavourable regulatory environment weighed on subscriber growth and profitability, leaving the former Italian telecommunication giant vulnerable to attacks from the outside. Since its year-2000 peak, TI lost nearly 87 per cent of its value. Its net financial debt of EUR 28.8 million as of the first quarter of this year is almost twice its market cap. Moody's just recently downgraded TI's senior unsecured debt and issuer rating to Baa3 from Baa2 on the basis of deteriorating revenues and EBITDA as well as for missing its 2012 net financial debt target. S&P followed in May and downgraded its TI rating to BBB-.

Since the liberalization of the sector in the '90s, incumbents have had a tough time. They had to digest radical technological changes as well as a transformation of their competitive landscape. Technological progress is an ongoing process. It is expensive but it is also the reason why investors are willing to bet on the sector. But the major problem faced by incumbents has been the change of the competitive landscape triggered by liberalizations. While the aim of liberalization is and was to create a plain level field for all telecom operators, it caused a major disruption to the incumbents' business model.

The Effects of Regulation

In order to attract new investments by foreign operators, a regulatory framework had to be established. Such framework had to guarantee fair network access and had to prevent former monopolists from squeezing the newcomers out by setting too low prices. In other words, all of a sudden, the incumbent lost control over its most valuable asset, leaving price the only variable determining market-share.

The effect was and still is devastating. Increased competition has brought prices down considerably. Currently, operators bundle flat tariffs including free unlimited fixed line calls and broadband access and offer them for prices as low as EUR 19 per month (TI's current offer). Although such tariffs are reserved for new clients only and only for the first twelve months - returning to the original EUR 37 per months thereafter - it is naive to think that consumers will simply accept the older higher price. Only a few months back, the best available offer was EUR 29 per month (Fastweb as well as Wind). Apparently, the former prevailing psychological barrier that discouraged consumers to quit the long lasting contract is removed. Consumers are informed and do act accordingly and they have numerous options to choose from. In fact, Wind and Vodafone (NASDAQ:VOD) offer similar bundles.

Due to the multitude of offers posted during the time by all the operators, it's impossible to have an accurate estimation of the average price point or trend line for telecommunication services. Flat fees for bundles of different services make the exercise even more difficult. An alternative is to look at the sub component of the Consumer Price Index (CPI), represented by the telecommunication services (see below).

CPI Telecommunication Sub Component (Italy, monthly)Click to enlarge

Under the current structure, the incumbent will keep losing customers and will be left, in the long run, solely operating the network. On top of this, the incumbents and owner of the networks have a legal duty to make sure the network is working, resulting in huge investment needs. In a research paper dated April 2012, PWC stated that global CAPEX levels have surged from US$ 50 billion to over US$ 325 billion in the last 30 years. Yet, according to the authors, these massive investments fail to generate the required returns. They claim that the average long-term return has been a mere 6 per cent or just 300 bps less than its cost of capital.

Average Returns on InvestmentsClick to enlarge

The Solution

Contrary to Fitch's opinion published on September 26, 2012 titled "Impact of Possible Tel Italia Network Spin-off Unclear" stating that controlling the access network is a major strategic advantage, in fact, regulation prevents exactly such a control. Access is open to everyone and prices are set by regulators. There is no advantage in owning the network.

As such, the network's value is hidden within the incumbents' corporate structure. This value could be raised by separating it and running it separately. One being run as an independent network company, selling its network capacity pro rata to users at an equal price, the other focused on reselling network capacity.

The idea is not new. BT Group (NYSE:BT), the UK telecom incumbent, set the precedent for network separation in Europe back in 2005, bundling its network activities in a separate division named Openreach. Three years later (2008), TI followed this lead and gathered its network management and development activities in a single entity named Open Access. Unfortunately, BT as well as TI have not been willing to risk the next step.

Back to TI

Apparently, triggered by Hutchinson Whampoa Ltd.'s attempt to take control of TI, network separation plans reemerged. Although it's questionable if the antitrust authorities would have allowed such a marriage, faced by the threat of losing its independence TI's Board of Directors suggested a more pragmatic solution: on May 30, 2013 it decided to spin off its domestic fixed-line access network and advised its management to pursue talks with the state-backed fund Cassa Depositi e Prestiti (CDP) for a possible sale of a stake in the network company. Apparently, this strategy has the blessing of Telco SpA, TI's controlling shareholder with roughly 22 per cent of the share capital. Telco SpA combines the interests of Telefonica SA (NYSE:TEF) and a group of Italian financial institutions.

According to Bloomberg information published on May 23, 2013, TI's network spin-off, Opac Spa, is projected to have EUR 4.6 billion sales this year and would be valued EUR 14 billion (US$ 18 billion). This landmark transformation would involve roughly 20,000 employees or around 25 per cent of its workforce. TI intends to sell up to 30% of Opac SpA. The proceeds would be used to reduce net financial debt. Under a clear regulatory regime the transfer of a considerable part of debt to Opac SpA could be an additional option.

TI is currently trading at 0.5 times its book value, reflecting a return on investment of close to 5% and a cost of capital of around 10%. There is no logic in allocating capital at this rate of return. On the other hand, a clear separation of the network activities forces regulators to rethink the allowed returns on the regulatory asset base.

To sum it up: since privatization, investing in TI and in the telecom sector in general has been a losing game. It's a capital intensive business with high operating costs and CAPEX needs, coupled with very insecure return prospects. The break-up of the incumbent's current structure will result in two investable business models and in more transparency. Investors will be given the choice of either investing in the stable utility-like network company or in the more volatile service business. The odds have considerably increased for TI investors. If this plan goes through it could become a lead for the sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.