This week marked a significant change in view for us, as we upgraded the European telecoms sector, having generally been negatively disposed towards the sector for many years. For full details of our change of view, see here: LINK
Generally poor trends in the European telecoms sector for many years have left many browbeaten, especially after the sector’s underperformance vs. the market by 20% since its 2015 peak. We believe the combination of the underperformance and poor operating trends has led to many investors not even being willing to look at the European telecoms sector. As for many, put simply, the trend is your friend – why will be 3 year trend in stock market underperformance, or a 7 year trend in earnings downgrades come to an end?
However, we now strongly believe the sector now deserves a fresh look, as the historic trends are no longer indicative of future trends. We will repeat that as we think it is really important – we think historic trends (in particular regulatory drag) are no longer indicative of future trends.
We believe the sector regulatory and competitive risk profile is better than in the past. There is a commonly held view that regulators only do negative things to the sector. However, with telecoms ROCE approaching WACC, we believe regulators are more likely be there to support existing profitability (as we recently saw in the UK business review (LINK), the Belgian cable costing analysis (LINK), or the T-Mobile/ Tele2 deal - LINK).
Whilst returns in European telecoms were excessive, regulators were just doing their job and protecting consumers from over-earning telecoms companies. The telecoms companies always protested that negative regulation would curtail investment. However, investment levels in the sector actually were never really negatively affected by regulatory intervention – because the operators were still able to make very attractive returns from their investments. However, with ROCE now closer to WACC, operators are much more sceptical about making big investment commitments (precisely why DT, BT and TI are dragging their heels on FTTH deployment). In fact we think regulators are now fully aware of this and are doing more to ensure they do actively encourage investment, such as the creation of monopoly FTTH rollout with essentially guaranteed returns as we are seeing in France (LINK), or formal introduction of the fair bet around FTTH returns in the UK, or some regulators offering discounts on mobile licences to ensure better coverage. The French example is particularly interesting, as longer-term infrastructure investors have been willing to put FCF multiples of over 20x on this asset, given the longer-term visibility of returns. Maybe we could see the same in Italy if TI, Enel OpenFiber and the Government can all reach a sensible agreement.
Monopoly infrastructure need not be anti-competitive, especially when the costs of network replication are so high. We have only one gas network, one electricity network, one water network – why therefore the historic fascination with multiple telecoms networks?
So with returns closer to WACC, and regulators are having to change their tune to more proactively encourage investment, and we believe the telecoms sector can look more like the utilities sector. For many CEOs, this might seem like the ultimate capitulation – “what, we aren’t as appealing as a high-growth tech stock?” , or “But hang on, I wanted to be valued as a media company” – but if investors are willing to accept the fact that telecoms can become a quasi-utility, it can have 2 benefits: i) we think there should be a re-rating in the telecoms sector multiple, reflecting a lower risk profile, and ii) investors should be less afraid of leverage in the sector. In fact, we believe investors should start to push telecoms operators to consider leveraging up in order to boost equity returns, similar to the approach investors have often taken with US cable names where higher leverage is rewarded.
So, European telecoms, a dumb pipe? Maybe yes. But dumb valuations? Maybe yes too. Time for a fresh look.
Large cap buys: Vodafone (fresh upgrade), Telefonica (recent upgrade), KPN, Proximus, Telecom Italia, Liberty Global – full details in our note HERE.
For the full weekly review and updated comp sheets, see HERE.