Digging for Pay Dirt in European Markets: France Telecom

By Daniel Ferry - July 13, 2012 | Tickers: T, FTE, TEF, VZ, VOD | 0 Comments

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Last weekend, customers of the largest telecommunications provider in France endured a nine-hour blackout of phone and Internet service. Customers were furious, and the company will have to pay compensation, estimated to cost “several dozen million euros.”

Yet shares of the firm barely budged. Why? Perhaps because the company, after being battered by the recession and the ongoing financial turmoil in Europe, simply doesn't have much further to fall. Recently I've been looking for diamonds in the rough in Europe: critical infrastructure providers like Veolia Environnment who, despite ongoing trouble in their core markets, have long-term competitive strengths and are selling at rock-bottom prices. As the dominant telecom provider in Europe—with the incumbent advantage in most of its markets, a highly favorable regulatory atmosphere, and a price valued at only seven times forward earnings—France Telecom (NYSE: FTE) fits the bill.

Telecoms generally are well-positioned to take advantage of consumers' increasingly insatiable appetites for more data as smart devices replace feature phones. This trend isn't going away -- even as incomes stagnated or shrank in Europe, smartphone adoption increased from 31% to 44% from 2010 to 2011. Big telecom providers benefit tremendously from their installed customer base upgrading to higher-value data plans, providing steady revenue, which many telecoms pay out as attractive dividends. These secular trends are making many major telecoms attractive, especially to income investors. France Telecom, however, is more profitable, pays a higher dividend, and is selling at a steeper discount than any of its peers:

Verizon (NYSE: VZ) and AT&T (NYSE: T), the largest American telecoms, have mature turnkey operations that generate plenty of cash flow. However, while the firms face fewer risks than France Telecom, because the American operators are more fairly valued, their dividend yields are much lower than France Telecom's whopping 13%. Moreover, with few real growth prospects and no expectation of valuation multiple expansion, neither firm has much to offer in terms of capital appreciation. France Telecom, on the other hand, has been investing steadily in high-growth markets in Africa and the Middle East, and a return to a fair valuation would generously reward buyers at today's price.

Vodafone (NASDAQ: VOD) and Telefonica (NYSE: TEF) are both, like France Telecom, carriers with strong cash flow from European operations that are expanding aggressively in emerging markets. Telefonica, native to Spain, has excellent growth prospects in Latin America, but recently the company has suffered margin compression under competition from America Movil in Latin America and from France Telecom's own low-end Orange service in its home market of Spain. The UK's Vodafone has a truly global operation, with particular focus in India and Turkey. Vodafone also owns 45% of American provider Verizon Wireless, which contributes about 40% of operating profit. This asset, together with its global reach and focus on wireless operations, rather than the eroding fixed-line business, has kept Vodafone somewhat shielded from the European malaise. Both Telefonica and Vodafone are stable dividend payers with strong emerging market growth prospects, and Telefonica in particular also looks like a potential buy at current prices, but neither offers the high dividend or potential for multiple expansion to match France Telecom.

Much of France Telecom's appeal ultimately comes down to the deep discount on its shares. There are a few reasons for this sale price. The company has significant operations in the Middle East and old colonial French Africa, and revenue tumbled last year due to the political upheaval of the Arab Spring and other armed insurrections. Management announced early this year that they were considering cutting the company's dividend. A low-cost mobile competitor, Iliad, entered the European market this year with a splash, threatening to undercut France Telecom in its most mature market.

Yet all of these problems, with solutions in sight, look more like catalysts than obstacles. Revolutionary zeal across the Middle East and Africa appears to be giving way to the pragmatic need to rebuild troubled economies. The dividend looks safer than ever after a June 8 vote in which shareholders overwhelmingly voted to sustain it, and with a 78% payout ratio the yield is expensive, but manageable. And Iliad, after launching with a bang and taking over 600,000 customers from France Telecom, appears to be slowing down. Iliad's entrance to the French market will erode pricing power for France Telecom, but the worst damage appears to have been dealt and priced in. Further, after last weekend's blackout, France's new Socialist government—a minority owner of France Telecom—announced it would embark on a period of heavier regulation to concentrate more on network quality and job security than price competition. This should benefit established providers like France Telecom over disruptive entrants like Iliad, and may eventually restore some pricing power to the firm.

Moreover, all of these drags on the stock price are relatively recent, but France Telecom had already lost nearly half its peak value by 2010. At least a portion of the overhang on valuation appears to be due to nothing more than capital flight from the Euro area as investors exit the broader market due to uncertainty. Recession or not, and whether customers are paying in euros, francs, or pesetas, France Telecom's subscribers will continue to rely on its services. Eventually, the company's steady income and excellent profitability metrics will overcome skepticism about Europe writ large, and multiples will expand closer to industry averages, yielding a 50 – 100% upside. Until that day, investors can sit back, relax, and enjoy an unbelievable—and sustainable—dividend yield.

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