European Telecom - A Hit Or A Miss?

Includes: ORAN, PT
by: ValueMax

Despite the turmoil in global markets, countries cannot function without telecommunications. Regardless, whether it is landlines, cellular phones, or voice over internet, people need to communicate across long distances. Economic turmoil in Europe continues and is likely do so for sometime, however, the European Telecom sector may provide excellent dividend yields at very attractive valuations. Below, I will explore three of Europe's largest and best known telecommunications businesses, Portugal Telecom (NYSE:PT), Deutsche Telekom (OTCQX:DTEGY), and France Telecom (FTE), and perform detailed analysis on each to determine whether or not they present investment opportunities. I picked these three telecom companies, because I believe they will provide the best insight into European Telecom sector at this time.

Portugal Telecom provides telecommunications services in Portugal, Brazil and Sub-Saharan Africa. International expansion has been primarily into Portuguese speaking regions where Portugal Telecom has a competitive advantage over other internationally focused telecoms. The economic struggles in Portugal have not left Portugal Telecom unscathed, as its credit rating has been downgraded to junk status by both Moody's and Standard & Poor's. These downgrades will impact Portugal Telecom's cost to borrow, but are not likely to impact its ability to borrow. Portugal Telecom continues to look toward international expansion to ease its reliance on Portugal's fragile economy. In 2011, it acquired a 25.3% stake in Oi, a Brazilian telecommunications company. For the 9 months ended September 30, 2011, the company reported revenues of €4,416 million ($5,811 million), a 58.1% increase over the same period in 2010. Excluding the effect of acquisitions, revenue would have been €2,558 million ($3,366 million), a decrease of 8.4% from the previous period. The decline in organic growth can be attributed to weakness in its Portugal business. EBITDA for the period was up 46.5% to €1,654 million ($2,176 million). The current dividend yield is near 6.9%, and the company's American Depository Shares [ADR] has a 52 week range of $4.95-$12.69, and the current share price is trading close to the bottom of the range. Equity investors should be wary of Portugal Telecom until the issues surrounding Greece's debt restructuring have become clear. A Greek debt restructuring deal will likely serve as a model for a potential debt restructure by Ireland and Portugal in the second half of 2012.

Deutsche Telekom (OTCQX:DTEGY) is a global player in the telecommunications industry, and is known in the US for its ownership of the T-Mobile brand. Although its deal to sell T-Mobile to AT&T is likely dead, Deutsche will pocket $3 billion in cash break up fees. For the three quarters ending September 30, 2011, revenue totaled €43,742 million ($57,564 million), down 6.8% from the same period in 2010. Deutsche Telekom has over time broadened its focus from strictly Germany with the breakdown of revenue from operations now roughly 60% from Germany, 38% from other European countries and 2% from non-European countries (including North America). Year to date operating profits at September 30, 2011 were €5,619 million ($7,394 million) down 1.1% from 2010. EBITDA was €12,757 million ($16,788 million) down 8.4%. Assuming Deutsche is able to execute on its plan to improve margins through cost reductions over the next two years, the current share price looks to be underpriced, trading at close to $11.68, with a dividend yield above 5.7%. Equity investors would need to be willing to accept currency risk as the ADR trades in dollars; however, this should not stop investors from taking a closer look at Deutsche Telekom as a potential long term equity purchase.

France Telecom was privatized in the 1990s, and has since become one of the world's largest telecommunications companies. It currently has more than 221 million customers. France Telecom's primary markets are in France, Spain, Poland and emerging markets such as Egypt. For the three quarters ending September 30, 2011, France Telecom reported revenues of €33,848 million ($44,543 million), which was down from the same period in 2011 by 1.6%. Operating cash flows (reported as EBITDA - Capital Expenditures) was €7,880 million ($10,370 million), down 10.5% from the same period in 2010, however better than expected. France Telecom expects 2011 operating cash flows to be €9,000 million ($11,844 million).

Similar to the other European Telecom companies, France Telecom views the emerging market as a key driver of future growth, with a focus on Africa and the Middle East. A primary assumption underlying the view that the share price is currently under-valued is the company's ability to generate growth over the long-term. Achieving growth will require the company to use free cash flow generated in mature markets to fund acquisitions, and organic growth in the emerging market. This assumption appears sound, as the management team continues to work to reduce costs and fund acquisitions that will generate faster growth. United States equity investors should be concerned about potential weakness in the Euro, which would reduce the value of the ADR. As with all European equity, investors need to be aware of potential sovereign risk. The fiscal position of France is stronger than the current situation in Portugal, but is definitely weaker than the German fiscal position. The risk of contagion is real, but difficult to currently quantify. For long-term investors, France Telecom may offer above market returns, with a current dividend yield close to 9.1% and a share price trading near the bottom of its 52 week range of $14.50 to $23.70, but reaching them may be require some short term downside risk in the equity price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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