The telecommunication sector in Europe remains challenging for companies and investors. Cost pressures and stretched dividends are key concerns. Still, pressure on the industry should start to ease as inflation cools.
While the wider sector is undervalued, share prices shouldn’t be investors’ only considerations. We recommend they select firms with prudent dividend policies, good capital allocation and a cost-conscious mentality.
Key Telecom Stock Picks
• Deutsche Telekom (DTE)
• Tele2 (TEL2 B)
Telecom Stocks Are Undervalued
Telecommunications conglomerates such as Vodafone and Deutsche Telekom are trading at around 0.85 times price/fair value compared with streamlined firms such as Tele2 and BT.A, which are fairly valued at 0.97. Historically, conglomerates have more complicated corporate structures and lower cash flow visibility due to different market dynamics in each country and currency fluctuations.
Investors in conglomerates can get a higher return on investment but must be aware of these pitfalls. At similar valuations, we tend to prefer streamlined firms due to their more straightforward narratives and better cash flow visibility. Among conglomerates, Deutsche Telekom remains our favorite given 80% of revenue comes from US and Germany, two rational markets.
Key Telecoms Industry Issues:
• Pricing power remains low (apart from in the UK)
• Falling inflation will lower costs and increase margins
• Some dividends look vulnerable, such as Vodafone and Proximus
Only in select markets can price hikes be effective, as competitive environments often neutralise or reverse the benefits by driving customers to cheaper providers. In contrast, UK firms have managed to pass through inflation costs with minimal churn due to industrywide actions. However, in highly competitive markets like Italy and Spain, price increases are less effective.
With inflation cooling down, we see cost cuts as the most effective way to recover margins. With EU inflation dropping to 2.5% in June 2024, telecom firms can expect their costs to fall.
Many telecom firms keep absolute dividend policies despite deteriorating fundamentals, and they pose increased dividend risk. These firms maintain fixed dividend payments rather than payout ratio policies, often leading to unmaintainable dividends. This trend highlights the peril of firms delaying necessary dividend cuts until the last minute.
Top Stock Picks in the Telecommunications Sector
Deutsche Telekom
• Morningstar Rating: ★★★
• Fair Value Estimate: €25
• Morningstar Economic Moat: Narrow
• Forward Dividend Yield: 3.25%
Narrow-moat Deutsche Telekom offers investors exposure to two rational telecommunication markets, US, and Germany, and to a management team with an Exceptional Capital Allocation Rating. Deutsche Telekom shows the financial discipline and operational knowledge required to generate excess returns in the competitive telecom industry. In the US, Deutsche Telekom has executed a brilliant M&A strategy over the years, acquiring MetroPCS and Sprint and realizing ambitious cost synergies.
Since its merger with Sprint in 2020, DT has steadily been gaining share from Verizon and AT&T. In Germany, Deutsche Telekom leverages its better networks and knowledge of the market and executes gradual price increases that result in steady revenue and EBITDA growth. Investors in DTE can expect good organic execution, with growing shareholder distributions in the form of buybacks and dividends. Since 2019, DTE's dividend has grown from EUR 0.60 per share to EUR 0.77, and we see room for mid-single-digit dividend increases.
Tele2
• Morningstar Rating: ★★★
• Fair Value Estimate: SEK 100
• Morningstar Economic Moat: Narrow
• Forward Dividend Yield: 6.47%
Investors in Tele2 can expect nicely growing dividends going forward thanks to good management execution, a cost-conscious mentality, and exposure to stable or growing markets. In the past decade, dividends have grown at a 4.5% CAGR. We give Tele2 an exceptional Capital Allocation Rating. We expect revenue will grow at low single digits and EBITDA at mid-single digits thanks to cost controls in coming years.
In Sweden (80% of revenue) Tele2 outperforms Telia, stealing market share in both mobile and fixed thanks to more moderate prices. Tele2 has a cost-conscious mentality, paramount in the telecommunications industry, having reduced operating expenses meaningfully in the past decade. Some 20% of revenue comes from the Baltics, where Tele2 can keep growing at mid to high single digits in coming years. Tele2 properly understands that telecommunication companies tend to have stronger positions in their home market and weaker positions abroad, so it has narrowed its business, selling most operations abroad.
This article is an edited version of the Telecoms Europe: Q2 2024 industry report published on Morningstar Direct and written by Javier Correonero and Ben Slupecki.
