Hop, skip, jump....the triple jump to value creation
It's the World Athletics Championships at the moment so a few shameless athletics metaphors. Watching the telecoms sector in Europe over the past 20 years has been similar to watching the flight of the javelin....soaring returns from 1998-2008, followed by a steady crash back to earth in the following 10 years from 2008-2018. However, with the sector now trying to haul itself out of the proverbial sandpit, we see three easy steps for the sector to start to regain its past glories and head to the top step on the medal podium. We wrote an updated view on our optimism on the European telecoms sector this week (see HERE), and see three easy steps for the sector to offer really attractive returns for investors and be positioned to outperform.
Read on to follow our European triple jump to gold.
Step 1 – The Hop: Stop declining. The first thing that the European telecoms sector needs to prove to investors is that it is no longer prone to the banana skins of the past, and to prove that the earnings downgrades and YoY declines are no longer going to be a negative shock to investors. With returns now effectively at the cost of capital, we think we are pretty much there on this front. OK, we have seen some slight downgrades from Telecom Italia and BT this year, but excluding this, sector estimate revisions have been broadly stable, the first time we have seen this since 2010. Given the ongoing trend of negative earnings revisions in the past 8 years, we find most investors have become jaded as a result of this trend, and just assume it will continue. For the early investors though, we now see a real opportunity to capitalise on this improving trend.
We are currently fielding questions from investors as to whether there are still potential areas for a red flag jump – such as rising 5G capex, or 5G offering a threat through fixed-wireless broadband. As we address in the sector note we published this week, we believe that with mid-band spectrum offering the potential in Europe to increase capacity by c.10x – and critically from existing cell sites given the higher existing tenant density in Europe, we believe the near-term risk of site densification in Europe is low. If anything, given the RAN sharing agreements being announced in Europe – and we also saw another one of these announced this week between Masmovil and Orange (see HERE for our Masmovil target price upgrade on the back of this), we think if anything there is the chance that mobile capex estimates in Europe could fall.
While we continue to monitor the secondary threat of 5G fixed-wireless broadband (see HERE for deep-dive on this topic), we believe the ever rising demands on fixed usage in particular from the shift from linear TV to OTT streaming limits the potential market share threat from this.
Step 2 – The Skip: Deliver the growth. So if we’ve landed the hop, can we nail the skip, and finally get the sector actually back to growth? Here is the amazing statistic – we believe the European telecoms sector is on track to deliver its first year of domestic OpFCF growth since 2009. And we actually believe that the growth can continue. Over the past year, the European telecoms sector has delivered 5% EFCF CAGR – better than the market at flat earnings – and this in part helps to explain the telecoms sector outperformance over the past year. In fact, the sector has been the 3rd best performing sector over the past year in Europe as a sign that momentum for the group is really starting to return.
Looking forward, we still think the sector will struggle for domestic revenue growth. But let’s build up the puzzle. We model in flat domestic revenue growth, but cost efficiencies mean we get 1% domestic EBITDA CAGR. Then add in the international exposure and this rises to 2% CAGR. Layer on the slight capex declines as we go through peak FTTH spending in most markets (ex-UK and Germany) and we should see OpFCF CAGR of 5%. Finally, with the sector then delevering from 2.3x, this all falls through to 8% EFCF CAGR – bang in line with what the market earnings forecast is likely to be according to Bloomberg. However, the extra lift here is that the sector trades at a 10% discount to the market for similar growth, and if we enter a period of economic uncertainty, then we would see the telecoms earnings trend are more robust and less cyclical than the wider market.
Step 3 – The Jump: M&A as the final flourish. Steps 1 and 2 can take time though to feed into share prices. There is nothing like M&A to help really crystallise this value case, and while we feel the in-market M&A story in Europe has largely played out and we see limited appetite yet for cross-border consolidation, we believe financially driven M&A is likely to rise. Remember TDC? It has already been taken out by infrastructure funds at nearly 9x EBITDA – but the sector still trades on only 6.3x EBITDA. Tower deals have clearly been all the craze this year and Vodafone has shown value can be unlocked as the utility nature of the sector is made more visible. We believe Orange could offer the most upside from a similar tower deal (see HERE for more details).
However, we believe the real value could come from fixed-line/ fibre spin-outs. We have already seen this done in France by Altice and Iliad, but last week we put out a report posing the question of whether an Openreach spinout could happen at BT (see HERE for all the details). We believe it can, and our detailed work with a UK pensions specialise shows that the often-cited pension deficit should be manageable. Openreach represents 40% of BT’s EBITDA, while Vodafone’s tower portfolio was only 6%. BT’s management aren’t keen to spin off the asset at the moment, but Vodafone’s management team weren’t keen to spin out their tower asset a couple of years ago. If BT’s share price still languishes, we believe more direct action should be taken to unlock the value that we believe is hidden within – and this could well have sector-wide implications.
We think the outperformance seen in the European telecoms over the past 12 months looks set to continue and for those that have made it this far, what is a further link between the triple jump and telecoms? Well, 17.92 won the triple jump gold in Doha last week – and 1792 was year in which telecoms systems were first claimed to be invented (LINK). Bet you didn’t know that before….amazing what one can learn on the Internet nowadays. Have a happy weekend one and all.
Full 12-month historical recommendation changes are available on request
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