European telcos long for tie-ups

There's already support from some politicians, who increasingly see them as providing the nuts and bolts of the digital economy, rather than just a source of tax revenues. For instance, German chancellor Angela Merkel recently argued for an easing of restrictions on industry consolidation, as a balance of market power and competition is needed to ensure European telcos can compete with US, Chinese and Latin American rivals. Others believe overzealous regulation has stifled innovation and network investment.

Other legislators, however, are less keen. Regulators continue to enforce cuts to roaming and connection fees, which have eaten into telecom revenues. Mobile contract prices have been slashed by 30 per cent on average, says Orange (ORA) chief Stéphane Richard, which, he argues, is not sustainable for some operators. And Europe's competition regulator, Joaquín Almunia, describes calls for reform as "misguided", and claims they would transfer costs to customers. Rather, he argues that national governments' tight-fisted grips on domestic telecom regulations - along with their penchant for lucrative spectrum auctions - has hampered European telcos.

And their woes may worsen soon. European parliament recently voted to scrap mobile roaming fees in Europe by 2016, and to enforce 'net neutrality', barring telcos from charging enterprise customers for faster Internet speeds - a potentially lucrative business.

The middle ground may be to have conditions attached. For example, Austria moved from having four telecom operators to three, on the proviso that spectrum was set aside for a fourth competitor, and new virtual operators could enter the market.

Nonetheless, recent mergers such as Numericable's tie-up with SFR - Vivendi's telecoms arm - may herald further industry consolidation. So could the success of deals currently awaiting approval, including the takeover of Dutch cable operator Ziggo by America's Liberty Global, which already owns the Netherlands' largest operator, UPC. Other deals on the table include Telefónica's (TEF) purchase of E-Plus from Netherlands' KPN (KPN), and Hutchison’s Three's proposed takeover of Telefónica's O2 operations in Ireland.

The Ziggo deal could be a thorn in the side of KPN - it's likely to increase domestic competition and raise spectrum prices. It's already suffering from service revenue declines in its consumer mobile business, and cash profits from its business segment fell 22 per cent year on year last quarter. And its shares look expensive, trading on 19 times broker Espirito Santo's forecast earnings for 2015.

The Numericable-SFR deal has already piled on the pressure for spurned suitor Bouygues (Fr: EN), which is reportedly in talks to merge or partner with Orange in response. In fact, cooperating and resource-sharing is a popular alternative to merging. For instance, Virgin Media recently signed a deal with BSkyB (BSY) to license five HD channels for its TV, online and mobile packages. And Sky, TalkTalk (TALK) and CityFibre are building a high-speed broadband network in York, which could threaten BT Group's (BT.A) dominance of broadband infrastructure in the UK.

Similar trends can be seen over the pond. Four mobile operators dominate the US - AT&T, Verizon, Sprint and T-Mobile. The last two are the smallest and quite keen to merge, but that could prove problematic. Four-fifths of Sprint is owned by Japanese telecom giant SoftBank, while over two-thirds of T-Mobile is owned by Deutsche Telekom (DTE). Their clamouring is likely to rise following the news that AT&T wants to buy satellite-TV provider DirecTV for $48.5bn (£28.8bn). Regulators aren't enthusiastic about the prospect of having only three major US mobile operators, but Sprint and T-Mobile argue they need the scale to compete with the other two, which control more than three-quarters of the US wireless market.

Overseas events can seem far removed from Europe's issues, but they do have consequences. For example, AT&T's (US: T) latest deal reduces the chances of it buying Vodafone (VOD), which it was rumoured to be interested in.

Vodafone continues to have its share of issues, but it won't be dying for a deal. True, regulator-driven cuts to mobile termination rates (MTR) - the charges that carriers pay Vodafone to deliver a call using its network - and a depressed European economy sent its sales in Spain and Italy down 14 and 17 per cent, respectively, last quarter.

But the company has also broadened its business, buying both Kabel Deutschland and Ono - Spain's second-largest broadband, pay-TV and fixed-line service provider - recently. That should help it compete with rival Telefónica's 'fusion strategy' of offering bundled TV, phone and broadband services, giving customers the convenience of a sole provider.

But investors may want to hold off - Vodafone shares trade on 15 times broker JPMorgan Cazenove's earnings estimates, a 40 per cent premium to Orange and Telefonica. Similarly, TalkTalk has amassed over 1m customers for its new TV service in 18 months, but its shares trade at a lofty 22 times earnings estimates.

IC VIEW:

It's a mixed picture for Europe's telecom companies. BT, BSkyB and Telefónica have reacted well to fixed-line declines by expanding into new businesses, while companies such as Colt have been mired in restructuring. With few exceptions, their stocks have climbed in the past year - with stand-out performances from KPN, Orange and Daisy - and offer both attractive ratings and decent yields. Consolidation - at the right price - is certainly in the interest of both companies and investors, as it should allow greater technology and network investments. We're bullish on prospects for the sector, and believe investors should be, too.

FAVOURITES:

Telecom-titan BT has had little choice but to diversify its legacy business. Sales at its global services, wholesale, business and Openreach divisions fell last quarter, and cash profits rose in only two of the units. Government control of the price of fibre broadband also caused a £150m to £200m fall in profit last year.

But BT has made bold moves to combat those issues. It spent over £2bn on developing and securing top-flight football content for its new BT Sport TV channel, now shown in 5m UK homes. It's also acted as a gateway drug. BT signed up 170,000 retail broadband customers last quarter - over three-quarters of the market’s total additions - up from about half before BT Sport's launch. Admittedly, hefty investments in TV and network-building hit divisional profits last year, but momentum is building and BT shares trade on just 13 times forecast earnings, a discount to Vodafone and BSkyB on multiples of 17 and 14, respectively.

OUTSIDERS:

Colt Group (COLT) has tried to simplify its business, but has been hindered by regulator-driven price cuts and adverse currency movements. Moreover, falling gross profit in its voice and data division meant its cash profits slumped 4 per cent last year. And although sales at its managed networking services business rose a tenth to €218m (£177m), that was offset by flagging demand for its older, low-bandwidth products as customers embraced faster Ethernet options.

Last quarter, it announced a withdrawal from about 85 per cent of its carrier voice trading contracts in the coming months, aimed at liberating 5bn minutes a year of voice network capacity to pursue more profitable enterprise voice business. That will lead to a loss €175m in annualised revenue (last year Carrier voice revenue was €350m), with half the reduction evident in fiscal 2014. It expects cash profits to be 5-10 per cent below consensus estimates of €325m, and to incur restructuring charges of €30m in the second half of 2014.

Colt's shares are up about 8 per cent since we said sell in February, but our negative view remains unchanged.

THE BROKER'S VIEW:

Europe's telecom industry is regulated incorrectly, based on a framework designed almost two decades ago. The result is that telecom services are cheaper than in other developed countries, but outside of Scandinavia and increasingly the UK, they are much poorer.

We see a rising probability of larger, pan-European telecom companies, and believe that would encourage infrastructure investment - greater scale should mean competition moves towards network quality and away from price. The alternative is dwindling infrastructure and a cherry picking by overseas companies of Europe's best telecoms assets. We expect both the Irish (Three/O2) and German (Telefónica/E-Plus) deals to go through, which will be a step in the right direction and signal political support for consolidation.

We believe investors should own incumbents with a good recovery story based on fibre deregulation and cost-cutting. Examples include KPN, Telefónica and Deutsche Telekom, where we see substantial upside. KPN's domestic recovery is progressing well as past investments begin to pay off, and the successful sale of its E-Plus business to Telefónica in tandem with other catalysts could push its value up to €4. Moreover, we expect KPN to be an attractive takeover target in Europe's eventual consolidation.

As for Telefónica, it is doing the right strategic things in depressed markets such as Spain and Brazil. Specifically, it's reforming its balance sheet and refocusing its portfolio into dominant positions in major markets. That makes an it interesting investment for investors with a longer timeframe.

Meanwhile, Deutsche Telekom continues to outperform peers in a tough wireless market - it added over half a million contract customers last quarter, and now boasts 3.5m high-speed mobile data customers.

We have an outperform rating on all three stocks. Our target price is €14 for both Deutsche Telekom and Telefónica and €3.40 for KPN.

Robin Bienenstock is senior research analyst at Bernstein Research