France Telecom Facing Significant Challenges

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We are upgrading our long-term recommendation on France Telecom (FTE) to Neutral from Underperform on its strong outlook. The company retains the Zacks # 3 (Hold) Rank for the short term (1–3 months).

We believe France Telecom remains significantly challenged by decelerating trends in its wireline voice business, which is shrinking at a greater pace than its major European peers, as recession-hit customers terminate landline phones. However, the company’s deleveraging balance sheet, healthy dividend payout and the combination of T-mobile and Orange’s network assets make the stock attractive for investment.

France Telecom strengthened its balance sheet by minimizing its debt position to €31.840 billion at the end of 2010 from €32.534 billion in 2009. The company generated organic cash flows of €8.11 billion, down from €8.218 billion in the prior year but above its 2010 target of €8 billion. For 2011, France Telecom expects to generate organic cash flows of €8 billion. The company targets an annual dividend of €1.40 per share for 2011 and 2012.

France Telecom reported strong fiscal 2010 earnings that were well above the Zacks Consensus Estimate and the year-ago earnings. The company achieved all its 2010 targets. Revenues improved slightly as the second half of the year was strong, particularly driven by growth in mobile services.

Moreover, France Telecom, the world’s largest telecommunications carrier, is expanding its coverage for both fixed and mobile networks, in both mature and emerging countries. The company continues to invest in the deployment of mobile broadband and fiber optic network in France and enhance 2G and 3G mobile networks in Africa and the Middle East. It will also invest in sub-marine cable programs, cloud computing as well as expansion in emerging markets.

While France Telecom’s wireless business remains on the growth track, we believe persistent fixed access line erosion coupled with increased domestic competition from Bouygues, Telecom Italia spA (NYSE:TI) and Vodafone Group Plc (NASDAQ:VOD), as well as unfavorable regulatory measures may continue to weigh on the top line.