Positively becalmed: Checking the pulse on European Telecoms

In December last year, we upgraded the European telecoms sector (LINK) to a more positive stance and four months on we revisit that call. While the market has been on fire since – up 16% largely backed by a change of view at the Federal Reserve helping reverse cyclicals’ underperformance in Q4 – the European telecoms sector is only up 1%. So, although the sector hasn’t done as well as the wider market in the last four months, let’s be grateful for small mercies – at least the European telecoms sector isn’t down – having seen declines of 12%, 4% and 8% in 2016, 2017 and 2018 respectively. We might be only 4 months into the year, but we already see this as a reversal of a historic trend.

Can the European telecoms sector deliver a positive return from here? We absolutely think so. What is lacking at the moment though seems to be a “story” to bring investors to the table in the near-term. Newsflow in the European telecoms sector has been relatively thin this year, but we see that as positive, especially as so much of the past sector newsflow, in particular on the regulatory front has been negative. A major part of our upgrade thesis was that the European telecoms sector was beginning to look more like a utility – and with a utility-style business we are looking for more predictability and stability, rather than any undue volatility. Interestingly, this is partly reflected in the volatility of the SXKP index being close to a 5 year low. Newsflow might be thin, and there don’t seem to be obvious shocks on the horizon. We believe this should imply the sector is due a lower cost-of-capital, yet this isn’t yet feeding through into sector valuations.

Whilst a big-picture story might be lacking at the moment (come on Brookfield – when are you going to bid for KPN?), we have seen a plethora of smaller bits of newsflow that we believe support our broader view that a) the sector is beginning to look more like an infrastructure sector, but isn’t valued as such, b) the regulatory environment for the sector is becoming more supportive as ROCE is closer to WACC, and c) with less excess profit in the sector, the life for challengers is becoming harder.

Since December, we have seen infrastructure funds buy out 2 mid-cap UK telcos (Manx Telecom at 11x EBITDA and KCOM at 11x EBITDA), and market rumours of a far larger bid by Brookfield for KPN. On the regulatory front, we have seen BNetZA suggest a 10% increase in ULL fees, and a positive shift in Ofcom’s FTTP stance allowing for potential future price rises to support infrastructure costs. On the competitive front, we have seen Iliad suggest that their current prices in Italy are untenable and they will have to lift prices in future (if so, Italy could really be the market to deliver an upside surprise in H2 19); we have seen Belgium effectively reject the idea of a 4th mobile licence – lack of interest is likely to have been a driving factor; and Hutch UK as a challenger delivered no revenue growth for the first time ever in H2 18.

In addition our sector estimates since the beginning of the year are actually up 4% - largely due to us delaying the risk of DT being sucked into a value-destructive FTTP project. Remove this, and our sector estimates YTD are broadly flat – helping to explain sector volatility being at such low levels.

We might not be used to such becalmed waters in European telecoms. But we don’t think this is the calm before a storm, and we believe a quiet outlook should be rewarded with a quite handsome return over time. Our favoured ways to play this would be through Vodafone, BT, Telefonica, Proximus, Liberty Global and KPN.

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