This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here Dean Tenerelli, European ex UK Equity fund manager at T. Rowe Price, explains that he remains cautious about European telecoms stocks.
Media attention surrounding M&A activity among telecommunications firms, particularly Vodafone’s (VOD) sale of its stake in Verizon Wireless, has renewed investors’ interest in the sector. Developments surrounding the ownership of Telecom Italia (TIT) have also raised the possibility of market consolidation in Italy and, further afield, Brazil. These prospects of consolidation in certain markets along with the possibility of cash returns to shareholders have proven to be supportive for sentiment, allowing the sector to recover some of the underperformance it had experienced over the last two years relative the broader European market.
While I acknowledge the positive implications that some of these developments could mean for the sector, notably in terms of pricing power, I generally remain wary about the outlook for telecommunication companies and continue to underweight the sector in my fund.
My interest in telecom stocks has been limited mostly on account of the unfavourable industry features. Depressed economic growth in Europe has created a very challenging demand environment for this domestically-oriented industry, which, at the same time, has had to face an increasingly competitive landscape amid fixed-mobile-media convergence and a wave of new entries. This has resulted in a rapid of erosion of pricing power, which combined with rising capital expenditures requirements (fibre/LTE investments, spectrum auction costs) and structurally high fixed costs has led to significant pressures on cash flows and returns.
In light of these headwinds and structural issues, which I believe are not going away, careful stock selection is all the more important in this sector, as is my focus on quality and valuation.
During the third quarter of 2012, I initiated a position Iliad (ILD), a leading alternative broadband provider in France. At this point, the company was entering a market that had historically been very uncompetitive and where the combination of high pricing and low mobile termination rates provided a great opportunity for a new entrant. Iliad’s plan was to lever its low cost base to quickly gain customers through low pricing and to subsequently drive profitability as it rolled out its own network. Iliad’s aggressive strategy has caused massive market disruption in France and has proved highly successful as they managed to capture about 10% of the French mobile market in less than a year. I now anticipate these gains will spill over to the company's broadband business and help to boost margins. The firm’s compelling proposition of flexibility, high-quality services and attractive price points should continue to attract an increasing number of customers in a market where incumbent operators struggle to respond effectively, burdened by high-cost models.
The historically low valuations currently priced in certain parts of the sector have also provided some attractive value opportunities, notably in the periphery where macroeconomic conditions and market structure are stabilizing. In Spain, I own Telefónica (TDE), Europe's largest telecom operator by market capitalization. After 3 years of significant economic and competitive pressures in Spain, I think Telefónica is reaching an inflection point where cash flow generation appears more sustainable following an aggressive effort to reposition tariffs and cut costs. In the meantime, organic revenue growth in Latin America has remained strong while local competition has improved, supporting both market shares and pricing. The company is making good progress in shoring up its balance sheet post asset sales and dividend cut while easing sovereign risk concerns in Spain should help lower funding costs. As the company resumes revenue and cash flow growth, I believe the stock has the potential to re-rate and re-gain its historic premium valuation, justified, in my view, by the company’s shareholder-friendly management, good market positions and strong growth potential in Latin America.
The specific securities identified and described above do not represent all of the securities purchased, sold, or recommended for the European Equity Fund, and no assumptions should be made that the securities identified and discussed were or will be profitable.
.jpg)
