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A stock that was out of flavor but is going to come roaring back is France Telecom (NYSE: ORAN).  Analysts loved France Telecom when it was a monopoly.

Then a company named Iliad SA entered the market and attempted to lure several of France Telecom’s customers away by offering products and services at a deep discount.

Add to that the irrational concerns associated with the never ending Eurozone crisis and you can understand why France Telecom’s share price plummeted.

But I feel that investors overreacted to all of the bad news surrounding Europe and France Telecom’s competitive environment.  After all, the crisis in Europe has been going on for several years, key bureaucrats have repeatedly promised to do everything possible to save the euro, and France Telecom is still as close to a monopoly as you can find in a country like France.

Reassurance from Leadership

The markets hate uncertainty – we all know that.  But the market appears to have unfounded concerns about France Telecom, namely its dividend policy, growth prospects, and leverage.

That is why France Telecom’s CEO and CFO have made a lot of positive statements regarding France Telecom’s dividend, growth strategy, and healthy balance sheet. 

France Telecom’s leadership has indicated (1) that they believe that the market is too pessimistic about France Telecom’s ability to generate cash flow from operations; (2) that France Telecom’s #1 priority is to ensure that they have a conservative level of debt (unlike many other telecom companies); and (3) that France Telecom will have a sustainable dividend of roughly 40 – 45% of operating cash flows.

In fact, France Telecom’s leadership has guaranteed its dividend for the next two years.  In a recent statement, France Telecom indicated that they would pay a dividend of at least 80 cents for each of the next two years.  That statement is in sharp contrast to many of France Telecom’s competitors that are focused on either investing in infrastructure or reducing debt.

Growth Catalysts

Based on a cursory read of France Telecom’s most recent financial report, I feel that France Telecom's leadership is making strategic decisions that will enable France Telecom to stabilize operations in the short term and then grow in emerging markets in the medium to long term.

France Telecom continues to examine opportunities for acquisitions and joint ventures.  Fairly recently France Telecom expressed an interest in both TeliaSonera’s Yoigo unit in Spain as well as Vivendi’s Maroc Telecom.  In addition, France Telecom has a partnership with Deutsche Telecom and at the beginning of 2013 announced a joint venture in the country of Qatar.

France Telecom has a sound strategy that should stabilize revenues and operating cash flow in France and Spain while at the same time grow profitably in Eastern Europe and the Rest of the World (Africa and the Middle East).  France Telecom could also significantly reduce its labor expenses by relying more on low cost labor in Africa and the Middle East.    

What are the Challenges?

There are three major challenges that France Telecom is currently facing.  Those include a more competitive operating environment, increased regulatory pressure, and a recent increase in the value added tax (VAT). 

First, France Telecom faces competition from Bouygues, Telecom Italia, and Vodafone Group in its domestic operations.  That competition has resulted in a loss of market share and has also affected France Telecom’s profitability. 

Second, the most notable impact of regulation is that a reduction in mobile termination rates in key markets such as the UK and Spain has had a material impact on revenues and earnings. 

Third, the French government increased value added tax (VAT) on triple-play services.  It is unclear whether or not France Telecom will attempt to pass these costs onto the consumer.  This will, however, have an impact on France Telecom’s profitability. 

How Does France Telecom Compare to AT&T and Verizon?

Instead of comparing France Telecom to its domestic competition, I am comparing to AT&T and Verizon because I feel that these three companies all have very strong brands, have a very similar competitive landscape and growth prospects, have comparable opportunities, and face similar short and long term challenges.  For a variety of reasons, I feel that France Telecom compares favorably to both AT&T (NYSE: T) and Verizon (NYSE: VZ)

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>France Telecom</p> </td> <td> <p>AT&T</p> </td> <td> <p>Verizon</p> </td> </tr> <tr> <td> <p>Price to Earnings</p> </td> <td> <p>6.5</p> </td> <td> <p>44.5</p> </td> <td> <p>40.1</p> </td> </tr> <tr> <td> <p>Dividend</p> </td> <td> <p>8 – 9%</p> </td> <td> <p>5.25%</p> </td> <td> <p>4.76%</p> </td> </tr> <tr> <td> <p>Net Profit Margin</p> </td> <td> <p>8.2%</p> </td> <td> <p>3.7%</p> </td> <td> <p>10.7%</p> </td> </tr> <tr> <td> <p>Leverage Ratio</p> </td> <td> <p>3.3</p> </td> <td> <p>2.6</p> </td> <td> <p>6.1</p> </td> </tr> <tr> <td> <p>Price to Cash Flow</p> </td> <td> <p>2.3</p> </td> <td> <p>8.5</p> </td> <td> <p>4.3</p> </td> </tr> <tr> <td> <p>Revenues</p> </td> <td> <p>$59 Billion</p> </td> <td> <p>$127 Billion</p> </td> <td> <p>$114 Billion</p> </td> </tr> <tr> <td> <p>Market Cap</p> </td> <td> <p>$31 Billion</p> </td> <td> <p>$195 Billion</p> </td> <td> <p>$124 Billion</p> </td> </tr> </tbody> </table>

Of these three companies, I feel that France Telecom has the most attractive valuation.  Compared to AT&T and Verizon, France Telecom has the best Price to Earnings Ratio and Price to Cash Flow Ratio, a Net Profit Margin and Leverage Ratio that is in between AT&T’s and Verizon’s, and a Market Cap that is well below what you would expect to see.  AT&T and Verizon, for example, both have a Market Cap that is more than the revenues that they generate in a year whereas France Telecom has a Market Cap that is roughly half of its yearly revenues. 

3 Reasons to Buy France Telecom

  1. France Telecom is committed to having a credible dividend policy.  Leadership has made it clear that France Telecom will continue to pay a dividend of at least 80 cents in 2013. 
  2. France Telecom has an attractive valuation.  France Telecom is a large and stable company that was unfairly lumped with other companies and is badly beaten down.      
  3. France Telecom is aggressively establishing footholds in emerging markets.  France Telecom is pursuing acquisitions, joint ventures, and partnerships, which should improve its scale, negotiating power, margins, and profitability.            

My Foolish Take

It appears as though France Telecom’s management is reducing uncertainty, mitigating risk, articulating a growth strategy – it is doing all of the things that investors want to see.   This company is attractively valued, has a strong brand, offers an attractive dividend, has plenty of room to either increase its leverage to pursue strategic objectives or to return more of its earnings to shareholders, and has a very attractive market cap, which is more evidence that the company is significantly undervalued.  For those reasons, I feel that this company offers a potential to return 25 – 30% or more over per year over the next few years assuming a purchase price of $12 or less.

RyanPeckyno is long France Telecom. The Motley Fool recommends France Telecom (ADR). The Motley Fool owns shares of France Telecom (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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