Are Telecoms poised for outperformance?
The European telecoms sector has been an unhappy hunting ground for investors for much of the past fifteen years.
Despite exponential growth in data consumption and a proliferation of connected devices, the trajectory of sector profitability has been relentlessly negative. Regulatory, competitive, technological and, ultimately, cyclical headwinds all contributed to a prolonged period of cumulative price deflation on fixed-line and mobile. Vast sums were spent by the operators to acquire 3G spectrum licences in the early 2000’s, which were not justified by the subsequent returns. Moreover, the starting point for valuations – from the peak of the TMT bubble in 2000 – was not at all conducive to sector out-performance in the years which followed. Looking ahead, however, there are many reasons for cheer. The prospect of a more disciplined pricing environment, underpinned by stronger regulatory protection for once in a generation fibre investments, will promote greater revenue stability at the operators which have prioritised reinvestment alongside cost-cutting in their response to the crisis of sector profitability. Even against a backdrop of heightened global macro-economic volatility, we see scope for selected European telecoms to re-establish their credentials as robust defensive growth investments.
Few would dispute that the earnings outlook for the sector has improved, but the magnitude and the duration of the recovery is easily under-estimated. Headwinds from declining profit centres such as voice calling, SMS and pan-European roaming charges are set to dissipate as these revenue streams have dwindled to insignificance. At the large incumbents which have invested in network upgrades, revenue growth will be supported by a combination of higher retail market share, pricing inflation from depressed levels as well as more favourable wholesale revenue trends. The move to “quad-play” selling, where mobile products are bundled alongside broadband and TV, has been shown materially to reduce the rate of customer attrition. As more customers migrate to quad-play, this will increase achievable profit margins. Over the medium-term, incumbent telcos which have rolled out optic-fibre will also begin to reap savings from shutting down parts of the redundant copper network.
Importantly for shareholders, at the telecoms furthest advanced in this process of investment self-help, the earnings inflection will be accompanied by a significant step down in capital expenditure. This will lead to meaningful expansion in the free cash flow available to repay debt and fund higher dividends. Stocks we like include KPN, NOS and Telefonica, which are on the cusp of multi-year earnings and free cash flow growth.
Having recently divested its standalone mobile operations in Germany and Belgium, we regard KPN’s retained Dutch business as one of the best positioned integrated telecoms operations in Europe. As a result of extensive investment in fibre, the company is competitive on both price and speed. We see scope to further increase the penetration of TV and multi-SIM mobile services to the broadband base, as well as migrate existing broadband customers to higher download speeds and price points.
Despite the subdued consumer environment in Portugal, NOS has been able to outperform its peers consistently by defending its Pay TV base and selling mobile products to its existing cable customers. NOS has also enjoyed significant success gaining share in the corporate market. The company is well invested, having rolled out nationwide 4G on mobile and fully upgraded the cable network to deliver ultra-fast broadband. There is potential for capital expenditure to reduce meaningfully from 2017 following the completion of the network extension plan.
Telefonica is pursuing an ambitious investment programme in Spain. It completed the acquisition of Digital+ in 2015, which provides the company with a rich portfolio of video content to drive pay TV penetration higher and support take-up of its ultra-fast broadband products. The more supportive economic climate in Spain has enabled the company to increase prices on its fixed-mobile bundles and we see scope for further increases. Significant cost savings are also achievable as services move from the copper network to fibre.
Niall Gallagher is investment director at GAM