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For income investors the telecommunications sector is a popular choice, given that is usually considered defensive because it is resilient to economic cycles, it's very profitable, has a strong cash flow generation capacity, and pay high dividends to shareholders. However, in Europe this sector hasn't been performing as expected over the past few years, with many investors being attracted by high-yields but suffered from widespread dividend cuts. Large telecom companies like Telefonica (TEF) or Orange (ORAN) canceled or cut their dividends, proving that their double-digit yields were not sustainable. On average, the European telecom sector still offers an attractive dividend yield of 4.1%, with Orange offering the highest-yield within the largest operators at close to 8%.

CompanyORANTEFTLSNYTELNYVODDTEGYPTBTTIKKPNY
Div. Yield (%)8.06.05.84.74.54.13.72.81.20.4

In 2013, the sector has rebounded due to a better economic environment in Europe and several mergers and acquisitions [M&A] transactions. The largest announced transaction was the divestiture by Vodafone (VOD) of its 45% stake in Verizon Wireless (VZ) for $130 billion. Other transactions include the Portugal Telecom (PT)/ Oi merger and Telefonica's agreements to sell its operations in Ireland and Czech Republic, beyond others. For 2014, M&A activity should remain a theme supporting the sector valuation and the share prices of the companies which will most likely be involved in M&A, like Vodafone, Telefonica and Telecom Italia (TI).

For 2014, the modest improvement in the economic environment along with easing regulatory pressures should provide some support for the telecoms sector. Although still facing challenges, many of the more difficult markets in Europe are starting to see signs of a better economic environment, especially in Southern Europe. On the regulatory front, after years of significant mobile termination rate [MTR] cuts, MTRs should begin to stabilize in 2014. MTR cuts have been one of the key drivers of revenue and EBITDA declines over the past few years across many telecom operators. With MTRs now generally set to stabilize, this will provide another source of improved operational performance for telecoms.

However, competitive conditions are likely to remain challenging, especially in mobile, where pricing pressure should continue to be present. Increasing competitive dynamics was a key theme in many markets during 2013. This was especially true in mobile, where markets such as Italy and France saw mobile operators under significant pressure with price being the most important factor in costumers' purchasing decisions. Competition should remain fierce in 2014, impacting many of the leading telecom operators in its domestics markets, including incumbent operators such as Telefonica, Orange, and Telecom Italia. Mobile data revenue should continue to grow and will offset some of this pressure, but overall mobile revenue is expected to remain under pressure. This issue is especially true in France, where Iliad should continue pressuring its larger competitors Orange and SFR from Vivendi (OTCPK:VIVHY) to further its market share gains.

In an effort to increase differentiation versus competition, telecoms will continue to focus on investment in next generation technology, across fixed and wireless networks. In mobile, investment in 4G LTE technology should provide a basis for differentiation especially versus smaller operators. Operators should have some ability to command premium pricing based on superior network quality and coverage, but consumer confidence will need to improve for this to be a significant support for the companies' revenue growth. Vodafone has been very active on this differentiation effort, given that over the past few months announced a fiber co-build strategy with Orange in Spain while also laying fiber in markets such as Portugal and acquiring cable operator Kabel Deutschland in Germany. In mobile it is expanding its 4G LTE network coverage, which should help to stabilize its revenues.

Generally speaking, 2014 should be another year of revenue declines for incumbent operators, although the rate of decline should improve compared to 2013. According to analysts' estimates, Telecom Italia should report the worst performance with a 10% revenue decline, while Telenor (OTCPK:TELNY) is expected to increase its revenues by 4.5% in 2014 being the highest growth forecasted among the largest European telecom operators. EBITDA will also remain under pressure but to a lesser extent thanks to widespread ongoing cost saving initiatives. With revenues and profitability under pressure, telecom operators expect operating free cash flow to remain steady or slightly improve. This means capital expenditures are expected to be flat or decline a little, even considering the investments in next generation networks.

After significantly cutting dividends in recent years, this relatively stable cash flow profile and lower indebtedness across the sector should generally sustain dividends at current levels, barring some exceptions. Portugal Telecom and Orange have the worst outlook regarding shareholder remuneration, given that Portugal Telecom's dividend is expected to fall by 23% and Orange is expected to cut its dividend by 10%. On the other hand, BT Group (BT) and Telenor are expected to increase its dividend in 2014 by 15% and 13.4%, respectively.

Conclusion

For income investors the European telecoms sector still offers some value, but as shown over the past couple of years high-dividend yields may be traps as the sector continues to face several headwinds that will continue to pressure the companies' revenue growth, profitability, and cash flow generation leading to risky dividends. Therefore, operators with good geographical diversification and exposure to emerging-markets should be preferred. I think Vodafone and Telenor are currently the best investments in Europe due to its strong business fundamentals and sustainable dividends. For more in-depth analysis, consider my previous articles on Vodafone and Telenor.

Source: A Review Of European Telecom Yields And Outlook