What to buy and sell if it all falls apart
We were worried about a recession at the beginning of the year, and published a report quantifying the exposure of our companies in the event of a recession. It was all for naught. The economy soldiered on, despite worries and warning signs. Well, we are still worried, and so we updated our recession exposure framework for the US and republished it this weekend (see report HERE). We summarize our findings on exposure in the US in this edition of the Global Weekly review. We also gathered thoughts from the team on what to buy and sell in Europe, Asia and Latin America. We are sorry to ruin your Sunday with gloomy thoughts, but we thought you should at least have our list of what to avoid if it all goes “pete-tong”, and our list of what to buy at the bottom.
Starting in the US…
We built a framework to compare the exposure of the stocks we cover to a downturn (Recession Special: HERE). We explored the impact of four different factors: business risk, refinancing risk, the impact of multiple compression, and the cushion from dividends, for those that pay them. We summed up the impacts, doing our best to account for areas where the four factors overlapped, to arrive at a rough view of potential exposure.
The first thing that jumped out at us was that there are no absolute winners (see Slide 8). The least exposed companies on our list face 20-25% risk to their stock prices (Verizon and the Towers). That may seem grim, but it is a lot better than the 70-75% risk faced by the most exposed (Sprint and DISH). The magnitude of risk we arrived at seemed implausible at first, but these same companies declined more in the last recession (see Slide 19).
The first factor is business risk. We built a framework for each of the six main products that our companies sell to determine revenue at risk from subscriber losses and pricing pressure (advertising and pay-tv are most at risk; wireless and broadband are least at risk). When combined with business mix, this gives us revenue at risk by company. The range is tight; all companies face revenue pressure of 3-5% (see Slide 12). The range of EBITDA at risk is much greater because different products have different incremental margins and different companies have very different starting margins (slide 14).
The second factor is refinancing risk, and there are two components to this: the risk posed to earnings and FCF from refinancing maturing debt at higher rates, and the risk to a company’s solvency if they can’t refinance maturing debt. Most companies face some risk to FCF from refinancing at higher rates; it’s modest for most, but quite significant for Sprint, DISH and Altice (slide 46). Only Sprint faces material risk of not being able to pay down maturing debt if credit markets seize up (Slide 45).
The third factor is multiple compression. Separate from the decline in EBITDA, all the companies and sectors we cover have experienced multiple compression in prior recessions. Multiples for our companies have fallen less than for the broader market, but they have fallen. The impact on equities depends on the magnitude of multiple compression, the starting multiple, and leverage. Towers face the most risk to their multiples, but with high starting multiples, the equity at risk from this factor is not much higher than most others, even with high leverage. Verizon and T-Mobile are least exposed to this factor, given modest risk to multiples and low leverage (slide 52).
Finally, we accounted for dividends since these offset some of the equity risk for the companies that pay them. Verizon and AT&T pay the largest dividends, but CCI, AMT and Comcast also benefit. Combining the impacts from the four factors gets us to the total exposure (slide 57). Verizon, the towers and T-Mobile are the best positioned, while Sprint and DISH face the greatest risk.
…and in Asia…
Shifting focus from the US to Asia, the Japanese & Indonesian telcos look best placed, and China worst to a recession. Japan because the country is defensive, valuations are low, buybacks are ongoing and revenues are almost entirely on a contract basis. We think Rakuten risk is manageable. In the event of revenue pressure, we see multiple levers which the companies can use to grow shareholder remuneration (see HERE), which we think is the key to the shares continuing to grind higher. Our preferred stock in the space is KDDI, but NTT is also highly defensive and would likely be resilient to recession.
Indonesia because although country risk is high, we think there is a strong underlying growth dynamic (data demand in a relatively stable pricing environment) which is likely to continue through a recession (HERE). In fact, if a recession made it harder for the smaller operators to finance themselves the pricing environment could even strengthen. Best recession-busting way to play this is Telekom Indonesia. On the towers side in Indonesia we would also be bullish through recession, as we also see an M&A angle likely to develop as Indonesian towers are likely to be taken off the Negative Investment List (HERE). Protelindo by virtue of lower leverage would be by far the best Indonesian tower play in a recession we think.
By contrast, Chinese telcos look most exposed to recession risk[fnote]Of course, relatively strong labor force and productivity growth are likely to preclude China and Indonesia from experiencing technical recessions, but their growth would slow and their financial markets would react.[/fnote] in our view, partly because of what is driving it: the trade war. However, our view is not to do with top line pressure, which we see as defensive. Rather, as we wrote (HERE) we see risk that the need to stimulate a slowing economy might cause the Chinese government to push the telcos into an accelerated 5G deployment. When the government did this after the crisis in 2008, telco capex rose by 69% over a three-year period. In particular, we think the smaller telcos are vulnerable to capex risk, despite recent talk of co-build. In this note (HERE) we increased our medium term capex forecasts for the smaller telcos by 10% and downgraded China Unicom to Neutral. The obvious way to play rising capex expectations in China is of course through China Tower, which we see as the best stock in the space.
…and then in Europe…
And then in Europe, we believe the whole sector should be highly defensive, as an ever increasing share of EU telecoms revenues have become fixed in nature, and there is now less scope for companies to cut price to defend market share given ROCE is now 10pp lower than at the time of the last economic downturn. However, if a recession is accompanied by further declines in interest rates, ironically this doesn’t seem to have been quite the support it could have been to the sector over the past year – as other European sectors with a higher duration seem to have fared better with lower discount rates.
Within the group, we would rank our preferences as follows:
Towers would probably be perceived to be the most defensive, but given that EU tower contracts are also linked to inflation (which would probably be lower in a recession), this offsets some of the nearer-term benefit of lower interest rates. However, Inwit would be our clear preferred play to own.
The challengers should also be well positioned. Although we don’t think consumers would drop telecoms services, they might shop around for cheaper services. Iliad, TalkTalk, and United Internet stand to benefit from increased share gains, but Iliad’s near-term ballooning costs in Italy are a potential cause for concern.
The telcos that are likely to do the worst would be those that are leveraged, exposed to higher retail prices and exposed to the Southern European markets that in the past have tended to fare worse in an economic downturn. This would put stocks like TI and Telefonica at particular risk, but other leveraged plays like Vodafone, Altice and Liberty Global might also be hit as tensions around balance sheet flexibility would rise.
…and finally, in Latin America
Across LatAm, we see Argentina in a technical recession while Mexico and Brazil skirt dangerously close to one; the rest of the region and the Caribbean are slowing but still registering healthy (low single digit growth). History teaches us to avoid leverage in LatAm (which typically comes with a hefty USD financing component) whilst the sector points us toward structural growth in cable and avoiding extensive pre-paid wireless exposure which in the recent past (Brazil’s 2016 recession for example) demonstrated a heavily cyclical component. As a general rule, it’s worth highlighting that across the region - and perhaps most significantly in Brazil - contracted revenues are a higher component versus pre-pay than historically (>50% for both Oi and TIM we estimate), suggesting that wireless more broadly will be more immune to economic pressure than previously was the case.
Pulling this together and the obvious stock to hold through a downturn is Megacable. Mexico is high-risk politically but Megacable has no leverage and close to 100% cable exposure. The stock isn’t too cheap on a EFCF yield basis but likely also has M&A support (see LINK for thoughts on Malone’s outlook on the region).
TEF and TIM Brasil both run very low debt but of the two, Telefonica Brasil will fare the better in the event that already strong economic headwinds accelerate: strong EFCF generation feeds into an attractive dividend – not the case at TIM. Should we see a further fall in rates in Brazil, its attractive dividend could see the valuation premium to TIM widen even more. We’d also highlight the structural support coming from the Telecoms Law finally passing (see LINK for comments on this); this has garnered most focus for Oi (given it’s almost essential for Oi’s survival) but also brings upside for Telefonica, both directly and as a by-product of in-market consolidation.
The other stock we’d flag is LiLAC. The leverage is a concern (at 4x prop) but it has the highest USD component of revenue of any of the stocks in the region and is exposed to a basket of markets where economic prospects avoid the region’s hotspots. Panama as a country is flying, the Caribbean is pretty robust. Plus there is a strong (40-45%) exposure to cable across the business which as of Q2 (see LINK) is progressing very nicely. The company is moving (finally) into positive EFCF (even with some hurricane costs in the Bahamas) while the weakened valuation of 5.5x 2020 EV/prop EBITDA implies some valuation support.
Our updated valuation comp sheets can be found HERE.
Full 12-month historical recommendation changes are available on request
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