Infrastructure Value Should Still Emerge in European Telcos

At the end of last year, we upgraded the European telecoms sector (see LINK), and let’s be honest, over the past month it hasn’t been a great trade, as the rest of the market has ripped up with the cyclical sectors performing well (and in fact, delivering one of the best Januarys for the stock market on record), and telecoms being left in the dust. So far, YTD the European telecoms sector is down 3%, with the vast majority of that driven by Vodafone’s weak performance alone. In the near-term, this clearly leaves us a bit disappointed (about our telco call that is, rather than the wider market performance), but not yet disheartened.

We are now around half-way through the European telecoms earnings season, and although the market in general has not warmed to the sector’s Q4 earnings season, we still strongly buy into our view that the risk profile around the European telecoms sector is lower than it has been in the past, and hence with more stable, and hopefully more predictable, cashflow trajectories, we believe investors over time should be willing to pay a higher multiple for these cashflow streams. While the large caps to report so far (KPN, BT and Vodafone) have all seen their shares trade down on results days, despite all reiterating their EBITDA and cashflow guidance, investors seem to currently perceive uncertainty ahead in the next few quarters. We have actually left our free-cashflow estimates unchanged, and for detailed write-ups on why we believe this should be achievable, see here: BTVodafoneKPN.

In a nutshell our thesis for the sector upgrade were ROCEs had fallen to historic lows, and that this led to various conclusions: i) earnings trends for the sector were stabilising; ii) regulators would become less intrusive into the sector and might even help to provide some support, and; iii) challengers would find it harder to undercut on price. Hence, we felt the telecoms sector should be perceived more like a utility, and valued on a higher multiple accordingly. With this in mind, we would therefore dwell on two other data points that have come out in January:

1) Our tariff tracking suggests a more benign outlook. We track all tariffs in Europe monthly (see HERE), and in January, we note that the average fixed-line price in Europe is up 5% YoY – the highest we have seen at any point over the past year. In fact, if we had been writing this comment a year ago, the figure at that time was fixed price declines of -2% YoY. Hence, we do believe we are entering into an environment where we should see less aggressive ARPU declines, and given that fixed ARPU increases are amongst the highest margin source of revenue growth, this should act as a support for EBITDA and cashflow over the months ahead.

2) A rumoured approach by Brookfield along with Dutch pension funds for KPN. We wrote a detailed write-up HERE. Although this is just a press story at the moment, we believe there is likely to be truth to it, and highlights the interest that is gaining more traction about the embedded value within the telecoms sector if the infrastructure part of the asset can be revalued upwards. We have already tried to factor this in with a lower cost-of-capital for the sector, but maybe there could be further upside? We saw ATC sell fibre assets last year at 24x terminal FCF, and if that multiple can be repeated for KPN, our fair value would increase from €3.5 to €3.9/ share, implying 50% upside from the undisturbed levels. This would put KPN on 9x EBITDA, or 23x FCF – that might sound high compared to EU telcos currently trading on 6x EBITDA, but let’s not forget that only a year ago, Macquarie launched a successful takeover for TDC at 8.7x EBITDA, or 24x FCF – and they aren’t even planning to spin off the infrastructure asset.

Similar interest is gaining traction in Italy, as Enel and TI have now finally sat down to talk together, and in the UK, with a new CEO, maybe we could see a change of strategy around Openreach independence, especially if the record fibre adds growth they have seen doesn’t get captured in the share price.

If investor interest wanes further, then there is a good chance more Brookfields will appear on the horizon. We think the asset class looks appealing, especially over the time horizon they would invest on.