Conor White gives us an overview of the telecoms sector, which is better insulated than most against a worsening economy, and reports on some of the major players in the sector such as KPN.
The European telecom sector is down 36% so far this year despite robust earnings resilience (only -5% downgrade to FY08 consensus earnings) versus -42% for the market.
The first half of the year saw the sector under-perform due to:
1) a de-rating, as at the start of the year, the sector stood at a 25% premium to the market on a 2008E PE basis,
2) poor newsflow from the US, where both AT&T and Comcast commented about weakening economic conditions, driving an acceleration of fixed-line disconnects (the company has since indicated that this is getting worse),
3) M&A concerns. Deutsche Telecom’s acquisition of OTE (announced in March) followed by France Telecom’s interest in TeliaSonera (first mentioned in April) and;
4) uncertainty as to the EC’s treatment of termination rates in the EU, with the date of a final judgment continuously pushed out. As a result, the sector valuation has been brought down to a 10% premium to the broader market and, if one excludes financials, it would trade in line with the market.
Moreover, since June we have seen this trend of under-performance reverse somewhat, which has received an extra boost as we travelled through the reporting season — a trend we expect to continue.
The current rating ignores some attractive features of the sector. Earnings resilience and visibility will become increasingly important as we travel through the upcoming earnings recession. We could see a 20-30% downward revision to market earnings growth expectations for 2009 (currently at +10.5%).
Earnings for telecoms are not immune from the outside world, but are better insulated than most against a worsening economy. The dividend yield in the sector currently stands at 7.1% for 2008E, rising to 8.1% for 2009. Not only are telecoms one of the sectors yielding the highest dividend, they also offer good cover (ranging from 1.5x to 3.0x depending on the company).
Balance sheets are strong with the sector carrying a historically low level of debt (only 2x EBITDA) and only 23% due to be refinanced before 2011. To gain exposure to the sector, we would currently recommend KPN.
h4. KPN €10.52
KPN is the incumbent telecoms operator in the Netherlands, with the leading share in both fixed and mobile. The company also owns the third-largest mobile operator in Germany, E-Plus, and the number three mobile player in Belgium, BASE. The fixed market faces intense competition from cable, though KPN is fighting back through its own digital terrestrial offering (Digitenne).
The Netherlands accounts for 70% of revenue and 69% of EBITDA. KPN has 6.3 million fixed-line phone customers. However, KPN’s IP migration is at an advanced stage, the group has regulatory clarity on fibre and is well placed to take advantage of the resulting cost reduction opportunities.
Its mobile division is the market leader in Holland. The Dutch market has seen another leg of consolidation, leading to three players that should allow for rational competition.
In the recent Q3 results, Dutch EBITDA grew for the second quarter, 3.3% before additional one-offs, up from 2.1% in Q2. In fixed, the pace of line losses continues to moderate (30,000 lines lost in Q3 2008 versus 40,000 in Q2 2008 and 100,000 in Q3 2007).
Meanwhile, broadband share was sustained at 44%. KPN’s fibre roll-out will allow the company to compete more effectively with cable, potentially increasing market share of broadband from the current 44% to 50% long term.
New regulation in fixed line will be introduced on 1 January 2009, allowing KPN total flexibility to price products and therefore allowing different prices by region, depending on the competitive environment.
This new regulation opens the door for market share gains and perhaps price increases in certain areas. The company reiterated that the Netherlands EBITDA has now bottomed and can grow in 2009 and confirmed 2010 objectives as stated in its ‘Back to Growth’ strategy.
It is the number three in Germany via E Plus (20% revenue 22% EBITDA). E-Plus was a poor performing asset until 2007. Since then, it has seen steady growth in profitability despite a shrinking in the overall market. In the last quarter, E-Plus added 105k post-paid customers and increased service revenues by 6.4%. Margins came in 2% above expectations at 40%.
Overall, KPN reported a solid set of Q3 results with no obvious adverse signs from the dwindling economy. Management maintained its confident tone in terms of its expectations for delivering on its longer-term guidance, which is for sales of €15bn, EBITDA of over €5.5bn and free cash flow of €2.4bn by 2010, based on the turn around of the domestic business.
KPN was in transformational mode in 2006/07, starting migration to an all IP network and moving to a customer-centric structure. This process has laid the foundation for future earnings growth driven by three key pillars. The first is the turnaround of the domestic business (‘Back to Growth’ strategy). Fibre roll-out, ruthless cost cutting and mobile market repair will drive growth forward in the Netherlands.
The second is further value creation in Germany as E-Plus’s profitability increases, driven by market share gains and a larger mobile revenue pie in Germany.
The third is KPN’s unrivalled capital discipline. Shareholder returns are currently c.10% of 2009 market cap with upside for more. Strong management, assets with high strategic value and attractive shareholder returns provide good downside protection for the stock. KPN has an excellent long-term track record and the current share price provides a good entry point in what we consider a quality defensive story.
* Stock prices: Prices in share recommendations are quoted from the close of business on 18 November 2008.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed.
All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
About Gary Culliton
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