A Consideration Of Orange As A Bond Proxy In A Strategic Context
Summary
- Along with its nearly 10% dividend, some investors have argued Orange serves as an effective bond proxy.
- I consider this argument in the context of the firm’s Engage 2025 strategy model, recent Q3 FY ’21 performance, FY '21 forecast.
- A valuation model, using Orange’s strategic growth algorithm as an input, supports the idea that current share prices have "meat on the bone".
- I conclude that Orange, with shares near their 52-week low, is likely to preserve investor capital as it throws off enough cash to support and grow the dividend.
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Bond Proxy or Best Avoided
French telecommunications giant Orange S.A. (NYSE:ORAN), with more than €42B in sales and nearly 260 million customers around the world in FY ’20, has been batted around as something of a bond proxy; a, perhaps, very attractive bond proxy given its ~10% dividend yield as I write this.
Figure 1: Orange and Selected Competitor Statistical Data
Data Source: Yahoo Finance
Table Source: Yves Sukhu
Notes:
- Data as of market close November 30, 2021.
On its own, the dividend yield might entice some investors to allocate a few bucks toward the company. But, of course, it does not tell the whole story. ORAN’s most recent Q3 FY ’21 results for the quarter ended September 30, 2021 were acceptable; and seem to generally reinforce the firm’s long-term objectives. ORAN has placed its strategic bet – generally speaking – on the fast-growing telecommunications, particularly mobile, market in Africa, enterprise IT services, and consumer-oriented value-added services – namely mobile banking via Orange Money and Orange Bank. Will these bets, along with the company’s transformation of its core telecommunications business to fiber, propel it toward sustainable long-term growth? Moreover, can investors be reasonably confident that the business will continue to throw off enough cash to support the dividend? As ORAN has just set a new 52-week low, this report considers the preceding questions to determine if the firm is an overlooked opportunity, or best avoided – particularly in consideration of Chairman and CEO Stéphane Richard’s resignation on November 24 after a Paris appeals court convicted him of misuse of public funds.
Slicing Up Orange
To be clear and as a reference for the remainder of the article, ORAN’s operating structure is composed of 5 operating segments that are largely geographic based.
Figure 2: Orange Operating Segments and Corresponding FY ’20 Revenue
Data Source: ORAN Annual Report FY ‘20
Graphic Source: Yves Sukhu
Notes:
- FY ’20 revenue data listed for each operating segment excludes (€1,861) of inter-group eliminations.
Figure 3: Orange Operating Segment Revenues FY ’19 and FY ‘20
Source: Orange FY ’20 Databook KPIs
Excluding France, the Europe and Africa & Middle East operating segments compose the results of 25 individual country operations (i.e. 26 countries in total minus France), with 7 countries falling under the Europe reporting segment and 18 countries under Africa & Middle East.
Figure 4: Orange Geographic Composition
Source: ORAN Annual Report FY ‘20
As seen in Figures 2 and 3 – and as expected – France generates a significant proportion of overall revenues; roughly €18.5B in FY ‘20, or more than 40% of total revenues. Europe is the second largest operating segment generating in excess of €10B, with Spain accounting for nearly half of all Europe segment sales.
European Telecoms Have Not Exactly Been Screaming Buys for Long Investors
Before jumping into the main analysis, there is an additional point to keep in mind along with ORAN’s operating structure: the last 5 years have not been so kind to a good number of European telecommunications companies from a performance perspective, including ORAN.
Figure 5: Selected European Telecommunications Firm Performance
Data Source: Yahoo Finance
Table Source: Yves Sukhu
Notes:
• Data as of market close November 30, 2021.
As seen in Figure 5 above, only Deutsche Telekom (OTCQX:DTEGY) produced a positive return over the last 5 years, while Vodafone (VOD) and Telefónica, S.A. (TEF) performance has been even worse than ORAN. Further, the STOXX Europe 600 Telecommunications Index (SXKP) has significantly lagged its Nasdaq peer (IXTC) and the S&P 500.
Figure 6: Telecommunications Index Performance vs. S&P 500
Data Source: Yahoo Finance, Nasdaq.com, Investing.com
Chart Source: Yves Sukhu
Notes:
• S&P 500 historical data plotted on left vertical axis; IXTC and SXKP historical data plotted on right vertical axis.
• Data as of market close November 26, 2021.
On a historical performance basis alone, and in the context of the historical performance of the broader European telecommunications market, a long investment in ORAN would seem to be a great way to lose a good amount of capital.
Looking Beyond Performance: An Evolving Telecommunications Giant
Were we only to consider ORAN’s past performance, our analysis would largely be complete. Of course, however, there is more to discuss. ORAN has been working to enhance its legacy telecommunications business and, as also mentioned in the introduction, pushing into higher-value services and offerings for both its retail and enterprise customers. The latest iteration of the company’s strategy is its Engage 2025 plan, as introduced back in 2019. The plan, as outlined in the preceding link, is built upon five initiatives:
- Enhanced connectivity (i.e. transformation from copper to fiber).
- Continued infrastructure development/modernization (data centers, mobile networks, terrestrial networks, submarine cables) in key geographies.
- Domination of fast-growing Africa and Middle East telecommunication markets.
- Increased growth and revenue contribution from enterprise IT services, particularly cybersecurity services.
- Expansion of financial services/banking offerings.
Interestingly, ORAN defines its core business activities – of which there are also 5 – slightly differently, as seen in the center ring of the following diagram:
Figure 7: Orange Core Business Activities
Source: ORAN Annual Report FY ‘20
Arguably, the major difference between ORAN’s definition of its strategic initiatives and its business activities is that wholesales services, centered on infrastructure development and encompassing the firm’s B2B engagement with other network operators, are specifically identified as a core business activity. Accordingly, when thinking about the infrastructure component of the company’s strategic initiatives, it is worthwhile to remember those activities are inclusive of ORAN’s wholesale services business.
ORAN’s management has attached 3 growth objectives to its strategic initiatives:
- Growth of EBITDAaL between 2% and 3% per year on average for the 2021-2023 period.
- Increasing organic cash flow for telecommunications activities between 2020 and 2023 with a target of between €3.5 and €4 billion in 2023 (versus over €2 billion in 2019).
- A net debt/EBITDAaL ratio for telecommunications activities of ~2x in the medium term.
In an effort to “organize” the major elements of the plan, I constructed the following diagram to provide a simplified mapping of the company’s operating segments versus its strategic initiatives and growth algorithm.
Figure 8: Overview of Orange’s Strategic Model
Source: Yves Sukhu
Notes:
- FY ’20 revenue data listed for each operating segment excludes (€1,861) of inter-group eliminations.
Naturally, the model above must beg the question if the growth algorithm, as illustrated in the top, blue rectangle, is supported by recent performance, thereby providing evidence that the firm’s strategy is working.
A Strategic View of Q3 FY ’21 Results, Questions About Cash Flow, and Fate of the Dividend
With the strategic model of the previous section in mind, we can turn our attention to ORAN’s financial performance. To begin, ORAN’s Q3 FY ’21 was reasonable insofar as business performance was relatively flat quarter-over-quarter (“QoQ”). Key highlights included:
- Slight decline of (0.7%) in QoQ sales of €10,508M. On a comparable basis, sales declined by (0.4%).
- Slight decline of (1.0%) in QoQ EBITDAaL of €3,550M. On a comparable basis, EBITDAaL declined by (0.7%) and grew by 4.5% excluding co-financing.
- European segment growth, excluding Spain, of 2.0% on a comparable basis. Growth in Europe included 5.7% growth in retail services.
- Strong comparable basis growth in Africa & Middle East of 12.0%. Revenues for the segment reached €1,652M in the quarter.
- Strong comparable basis growth in the International Carrier and Shared Services operating segment of 10.8%.
- Increase of 25.5% in Fiber-to-the-Home (“FTTH”) customer base. FTTH growth was driven primarily by France and Poland.
The results above were offset by:
- Comparable basis revenue declines of (4.1%) and (4.4%) in France and Spain respectively. As Orange’s two largest countries in terms of revenue contribution, operations in France recorded €4,483M in Q3 FY ’21 sales versus €4,676M in Q3 FY ’20 on a comparable basis; while Q3 FY ’21 sales in Spain stood at €1,176M versus €1,231M in Q3 FY ‘20 on a comparable basis.
- Slight enterprise operating segment comparable basis decline of (1.4%). Enterprise operating segment performance was primarily impacted by a decrease in fixed services revenue of (5.2%), but still enjoyed success in key growth areas including cybersecurity services which increased 14% QoQ.
For the 9 months ended September 30, 2021, total revenue was €31,374M – a virtually flat performance on a historical YoY basis – while EBITDAaL declined (1.2%) to €9,387M, similarly on a historical basis.
All in all, Q3 results were strong enough for ORAN management to maintain their FY ’21 objectives, including:
- Stable EBITDAaL, implying full-year EBITDAaL in the neighborhood of FY ‘20’s result of €12,680.
- Organic cash flow from telecoms activities of €2.2B.
Curiously, however, management failed to reiterate their confidence in their strategic model as they did in their Q2 FY ’21 earnings release. Following Q2 results, management stated:
In line with our Engage 2025 strategic plan, the Group’s vision remains firmly focused on creating long-term value for all of our stakeholders. Our growth engines – Africa and the Middle East, Europe, the B2B market, [cybersecurity], banking and our infrastructure – all have good momentum and we’re beginning to gather the fruits of our investments. This allows us to reiterate with confidence our objectives for 2023.
With the absence of a similar declaration in the Q3 FY ’21 release, there could be cause for concern. Are ORAN’s strategic goals at risk? For one thing, organic cash flow from telecommunications activities is headed in the wrong direction.
Figure 9: Orange Organic Cash Flow from Telecommunications Activities
Source: Orange Annual Report FY ’19, Orange Annual Report FY ’20, Q3 FY ’21 Earnings Release
Before reading too much into the preceding data, we should recall that Orange benefitted from the COVID-19 pandemic in FY ’20 with a significant increase in the use of traditional voice services and data. As the world returns somewhat to “normal” in FY ’21, ORAN’s core business has been under pressure. The expectation, however, is that the overall situation will improve through 2023 via a return to growth in France/Spain, a planned eCAPEX reduction in 2022, and realized benefits from the company’s cost reduction program. These ideas are discussed more fully in short order.
With management confirming its outlook for the remainder of the fiscal year, perhaps it is reasonable to assume the company’s growth algorithm is still valid. If so, a simple linear extrapolation of organic cash flow from telecommunications activities produces the following data using the low-end of the targeted range:
Figure 10: Orange Extrapolated Organic Cash Flow from Telecommunications Activities
Source: Yves Sukhu
It would seem, superficially, that cash flow projections would permit ORAN to maintain the proposed FY ’21 dividend of €1/share through the 2022 and 2023 fiscal years, if perhaps even to increase it. Although, with the dividend fluctuating over the last several years, nothing is guaranteed of course.
Figure 11: Orange Dividend 2009 - 2021
Source: Orange
Despite the generally “flattish” performance expected through the remainder of FY ’21 and management’s apparent “caginess” toward discussion of its Engage2025 goals in its Q3 FY ’21 earnings release, I think it would be premature to think that the plan is in jeopardy. We should remember the strategy was devised pre-pandemic and the company did, in fact, produce some good results relative to the 5 initiatives that it is tracking. Perhaps, then, a cautiously optimistic investor attitude is warranted. But, if the growth algorithm holds, where is the share price itself headed?
Valuation Model
I built a simple valuation model using the growth algorithm as an input. As I always advise, valuation models like this one should be viewed cautiously and with a critical eye. Investors/readers should always do their own due diligence when forecasting.
The model utilizes the first component of ORAN’s growth algorithm, namely growth of EBITDAaL (Earnings Before Interest, Taxes, Depreciation, Amortization and Special Losses) between 2% and 3% per year on average between 2021 and 2023. I make two additional assumptions to allow me to forecast EBITDAaL through 2025:
- EBITDAaL will decline ~(1.0%) in FY ’21 versus €12,680 recorded in FY ’20, consistent with management’s expectation that the FY ’21 result will be essentially flat, but still negative for the current fiscal period.
- The EBITDAaL growth rate will carry through 2025.
Using the lower-end of the EBITDAaL growth rate range of 2%, and the preceding 2 assumptions, a somewhat conservative EBITDAaL forecast is as follows:
Figure 12: Conservative Model EBITDAaL Forecast 2021 - 2025
Source: Yves Sukhu
Carrying the current (FY ’21) outstanding share count over all forecasted periods, it is trivial to estimate EBITDAaL/share values:
Figure 13: Conservative Model EBITDAaL/Share Forecast 2021 - 2025
Source: Yves Sukhu
To derive a share valuation from this forecasted data, I took a step back to the period 2017 – 2020. Specifically, I considered the EBITDAaL/share values, as well as the average share price, during each fiscal period. I subsequently calculated a share price/EBITDAaL ratio for each year:
Figure 14: Share Price/EBITDAaL Ratio Data 2017 - 2020
Source: Yves Sukhu
We can easily see that the price/EBITDAaL ratio has a range between ~2.5 to ~3.5 over this period. A selection of a ratio value allows us to then return to the forecasted periods and calculate average share price values for each forecasted year by multiplying each EBITDAaL/share value by the chosen ratio. For example, if we choose a lower ratio value of 2.5, a completed conservative model is as follows:
Figure 15: Completed Conservative Valuation Model
Source: Yves Sukhu
Notes:
- Assumptions: EBITDAaL growth rate of 2% and share price/EBITDAaL ratio of 2.5.
A move aggressive approach using an EBITDAaL growth rate of 3% and a price/EBITDAaL ratio of 3.5 generates the following model:
Figure 16: Completed Aggressive Valuation Model
Source: Yves Sukhu
Notes:
- Assumptions: EBITDAaL growth rate of 3% and share price/EBITDAaL ratio of 3.5.
Interpreting the models is a bit tricky since, of course, they are basically just mathematical “guesses”. Interestingly, ORAN’s average share price through November 30 was $11.77, not far from the average FY ’21 share price estimated by the conservative model. If we assume that model is a better predictor of the future, we will note that it forecasts a tepid ~2% annual share price growth rate through 2025. On the other hand, the average FY ’21 share price estimated by the aggressive model, $16.45, is so unlikely as to be effectively impossible. Yet, if we stick with an average FY ’21 share price of ~$11.75, and the rest of the share price predictions from the aggressive model prove accurate, it predicts ~58% upside by 2025 with an implied ~12% annual share price growth rate.
With such a wide divergence in outcomes, choosing between these models (i.e. one over the other) does not seem particularly useful to me since we can simply push the numbers around as we wish. However, we might at least be able to construct some arguments to point us in a general direction – i.e. more conservative or more aggressive.
Arguing for Optimism
Personally, when considering where ORAN’s share price is headed, and more generally where the business is headed, I think there are more reasons to be optimistic than pessimistic:
- Spain is likely to remain a challenging market, but ORAN may have already “turned the corner”. While ORAN managed to limit the “bleeding” in its Spanish operations in Q3 FY ’21, the company noted in its Q2 FY ’21 earnings release that “...the overall context [in Spain] has worsened obliging us to book a significant impairment to the value of our assets.” However, management stressed in the same release that they “...expect a return to growth in EBITDAaL in 2023 and in organic cash flow starting in 2022.”
- Results in France should improve moving forward as momentum in fiber and retail services continues to build. In Q3, Orange increased its fiber customer base to 5.6 million customers in France, an increase of 36% YoY. Further, retail services increased 1.2% in the quarter. “However, as yet [ORAN’s] accounts reflect little of this promising trend owing to the decline in co-financing received from other operators on [ORAN’s] fiber network in 2021 compared to 2020.” Excluding co-financing, France segment revenues were virtually flat in Q3. Thus, as fiber adoption continues in parallel with retail growth, and as co-financing contributions improve, France segment performance is likely to return to positive growth.
- The European telecommunications market is highly competitive and fragmented, but remains a key growth area. As investors know, Europe’s telecommunications market is highly fragmented, inclusive of a large number of smaller telecom players, versus the market in the United States, for example, that is essentially an oligopoly. Accordingly, ORAN – like its peers – will continue to battle the competitive pressures in each of its 7 markets under its Europe operating segment. Moreover, investors may see increased deal-making and consolidation in Europe as regulators within the European Union appear to be warming to the idea of “...[letting] carriers combine within nation states.” This is both an opportunity and risk for ORAN. As the “...kingpins of private equity... driven by low interest rates and drawn by digital infrastructure’s stable, long-term returns” push more deals onto the table, as KKR has done with its recent bid for Telecom Italia SpA, such activity is certain to pressure operators as private buyers seek to cut costs and exploit pricing advantages in the marketplace. At the same time, “...the [new] mood music in Brussels” permits players like ORAN to ratchet up their own deal-making activity in key areas, with the recent acquisition of TKR in Romania as one example. Importantly, ORAN’s better debt profile relative to its peers (see Figure 1), also supports its deal-making capability. In this context, and with the exception of Spain, management’s goal of “...a compound annual EBITDAaL growth rate of around 5%...in the other six countries in the region” appears reasonable.
- While far from a “lay-up”, Africa & Middle East is a significant growth opportunity, not only in terms of core telecommunication services, but in consumer services as well. Africa & Middle East operations remain the fastest growing of ORAN’s operating segments. This is unsurprising as a Mordor Intelligence report notes “[the] Africa entertainment and telecommunication market is expected to register a CAGR of 11.2% during the forecast period [of 2021 – 2016 and]... the region’s digital consumption growth is among the highest in the world.” Further, sub-Saharan Africa – where ORAN has its strongest presence – has some of the lowest Internet penetration rates on the continent implying a strong opportunity for growth in the region.
Figure 17: African Internet Penetration Rates 2020
Source: Mordor Intelligence
Indeed, ORAN noted in its Q3 FY ’21 earnings release that “[each of its Africa operating segment] countries recorded growth in the third quarter, ten of which delivered double-digit growth.” Beyond telecommunication services, “[in] sub-Saharan Africa, only 37% of women and 48% of men have a bank account” according to the firm. Yet, at the end of Q3 FY ’21, the number of customers using Orange’s banking products in Africa stood at a mere 0.6M. Given that the population of the African continent is anticipated to exceed 2B people as early as 2040 driven by a youthful, tech-savvy demographic, ORAN appears to be well-positioned to capitalize on rapid growth within the financial services sector. Although, it should be noted that ORAN’s financial services operations are presently operating at a loss with the expectation to reach breakeven by 2024. Overall, “[in] the Africa & Middle East segment, Orange [anticipates] a compound annual revenue growth rate of around 6% [through] 2023, with double-digit EBITDAaL growth and organic cash flow growth that will be faster than that of EBITDAaL.”
- Expansion into IT services should help offset deterioration in core telecommunications operations. To be clear, ORAN expects continued growth “across the board” from its telecommunications operations, particularly as it continues its transition to fiber and positions itself as a convergent solutions provider of fixed-line, mobile, and digital services in each of its key markets. Nonetheless, the company’s push into the lucrative IT services market not only serves to develop an additional lever of growth, but also (obviously) establishes a hedge against unexpected downturns in the core business. To that end, and despite an overall decline in the Enterprise business, IT & integration services grew by 2.1% on a comparable basis, led by 14% growth in cybersecurity services at the end of Q3 FY ’21. Management expects the Enterprise segment, impacted by the COVID-19 pandemic, “...will return to sustainable revenue growth and the Group anticipates [a] compound annual growth rate of around 2% in 2022 and 2023, as well as a return to growth in EBITDAaL in 2022 and an acceleration in 2023. [From the standpoint of cybersecurity services], the Group is aiming for market-beating double-digit revenue growth.” A top line growth rate of 2% may feel somewhat lukewarm. However, ORAN should be able to accelerate growth as it drives an increasing contribution from IT services which presently stands around 40% of total Enterprise segment sales, versus conventional (B2B) telephony services. Recent Enterprise wins, such as that with Safran Aircraft Engines, exemplify the segment’s “...transformation into a ‘network native digital services company.’”
- Ongoing reductions in operational expense and eCAPEX will support the company’s growth algorithm in terms of EBITDAaL growth and organic cash flow targets. With ORAN often touting its early recognition of optical transmission as the medium to support long-term business growth, much of ORAN’s eCAPEX in recent years has fueled its transition to fiber. Accordingly, “[their] lead in fiber allows [them] to confirm [a] commitment to reducing eCAPEX from 2022 and achieving an eCAPEX to consolidated revenue ratio of around 15% by the end of 2023.” Further, the firm has re-affirmed its guidance to eliminate €1B in indirect costs, including labor, by 2023.
Figure 18: Orange Indirect Cost Reduction Program
Source: Orange Annual Report FY ’20 Presentation
In tandem, the eCAPEX and savings efforts will (obviously) help the firm track against the EBITDAaL and cash flow components of its growth algorithm.
Overall then, and based on the preceding reasoning, I tend to lean in the direction of the aggressive valuation model. While I remain hesitant to place too much faith in the specific share price values, and hence upside, predicted by it, I think the general idea that current share prices offer some “meat on the bone” is reasonable, particularly given that shares are trading just a hair above the 52-week low.
Conclusion
Perhaps a reasonable “30,000-foot” view of ORAN might be that of a company that is largely betting itself on Africa as it stabilizes and returns to low-growth in Europe. Of course, such a description is not entirely fair, but it at least captures the notion of Africa as the “...#1 engine of growth for the group.” I fully expect that ORAN’s road ahead will be filled with bumps and potholes due to the complexity of its business and its markets; a complexity made more so as the firm expands into tangential areas. Indeed, a number of analysts may hold a similar opinion.
Figure 19: Orange Analyst Ratings
Source: MarketBeat
Nonetheless, just as it was noted that private equity is “...drawn by digital infrastructure’s stable, long-term returns”, I suggest in this article that ORAN, over the long-term and based on where shares are presently trading, is likely to preserve investor capital as it continues to throw off sufficient cash to support and grow the dividend. That is to say, I am not so sure new investors will see a “home-run” return in terms of share appreciation, but I do think the stock could indeed function very well as a bond proxy in consideration of the dividend and – to beat the point home – based on where shares are presently trading.
Finally, it is not entirely clear to me what exactly occurred in regard to the recent Paris court conviction of Chairman and CEO Stéphane Richard. Whatever really happened, I obviously hope his successor can continue building upon the foundation that has been laid.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of ORAN either through stock ownership, options, or other derivatives. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (20)
To my knowledge Wolf Report didn't recommend it before April 2021, so anything prior to that is immaterial to judging his recommendation. Also, you don't need much growth with a 9% dividend to get a decent total return (yes, I understand the tax withholding situation). The idea is that you get paid to wait until it reverts to it's mean historical valuation, at which point I will sell.It seems many telecoms, including high quality ones such as VZ are out of favor now (VZ down almost 20%) I am buying the discounts and enjoying the dividends while I wait until they are back in favor, or at least back to neutral.
Hmmmmmm, does the rich divvy really make much difference?A current 8.7% dividend scarcely makes up for a one year SP drop of 17.87%Nope, I'll take corporate or T bonds, I think..........................
Using all 3 as Bond proxies, however with all 3 companies being near multi year
lows, I feel all 3 realistically have about 20+% upside over the next 18 months.
I’ve written 20% +/- out of the money covered calls on VOD and T to increase Yield. Strikes are written at my approx target prices over the next 12 months.
Overall, I feel all 3 of these Telco’s offer limited downside in the current hazardous market environment. I believe ORAN goes ex dividend ( semi annual) in about 2 weeks. Good luck all.
Long ORAN, VOD, T