France Telecom (FTE.PA) – Is It Time To Hang Up?

(This is the eleventh installment in my series of case studies on the shares that make up my portfolio. To see the other ten articles, on PetroNeft, Irish Continental Group, Independent News & Media, Total Produce, Abbey, Glanbia, Irish Life & Permanent, Datalex, Trinity Mirror and Datong, click on the company names)

 

When I first bought into France Telecom in May 2006, the attraction was its dividend. It was paying out €1.20 a share, and my €17.03 purchase price at the time made for a nice 7% annual yield. This gradually picked up to €1.40 a share in 2008, a payout level that was sustained up to the end of 2011. I (in hindsight, very foolishly!) topped up my FTE position in January 2011 at €16.02/share, but since then the shares have been a big disappointment, sliding to the current level of €11.73/share.

 

There have been a number of drivers of this decline. The Eurozone mess certainly hasn’t helped, and neither has the group’s chunky net debt, which stood at €37.1bn (on my definition, which includes the pension deficit but excludes a number of items that FTE puts into its stated net debt) at the end of 2011, or circa 2.5x EBITDA. I suspect France’s loss of its AAA rating has not helped matters on the balance sheet front. A number of other factors have also played a role. The extra costs associated with the hiring of 10,000 new employees in France has weighed on the outlook for earnings, which along with a very messy mobile price war has contributed to the group’s under-performance relative to peers such as Vodafone, Deutsche Telekom and Telefonica over the past year or so. Following Telefonica’s decision to cut its dividend before Christmas, it was no surprise to see France Telecom follow suit recently as dividends have eaten up 56% of net operating cashflows after investing activities over each of the past 2 years while net debt has remained relatively static.

 

Current sentiment towards the group doesn’t inspire confidence. Of the 33 analysts following the stock, 15 rate it ‘neutral’, while 8 rate it a ‘sell’ or ‘strong sell’. Fitch recently cut its outlook for the group to ‘negative’. Taking a longer-term view, the trajectory for telecom revenues in established markets is, in my view, downward, but France Telecom has taken action to mitigate against this, selling mature assets such as Orange Suisse and its stake in Orange Austria while looking to increase the group’s exposure to emerging markets. Reports that Deutsche Telekom is looking to sell its stake in its 50-50 Everything Everywhere jv with France Telecom in the UK are intriguing from a valuation perspective, and were France Telecom to offload its stake (which had a net book value of €6.7bn at end-2011), it would make a material impact on the group’s balance sheet. However, I’ve seen no indication of the group’s long-term views about its investment in Everything Everywhere.

 

From my perspective, I have to ask myself if the reasons why I bought into the stock are still valid. The company’s recent announcement that it is to cut its dividend has taken the gloss off what was my sole reason for buying the stock – given the muted growth outlook for the core business. I’m also nervous that this won’t be the last dividend cut. High capex requirements (the group has spent circa €6bn per annum on average over the past three years) and a still high payout ratio means, on my estimates, that net debt is unlikely to fall significantly over the coming years. Should the profits outlook worsen, France Telecom’s difficulties in taking costs out, especially in its home market, given that its biggest shareholder, the French government, is unlikely to welcome redundancies, means that dividends will likely be the first thing to be cut if the group needs to enhance cash generation.

 

I value France Telecom on a DCF basis, incorporating my usual 10% discount rate along with a -1% terminal growth rate (this is chosen to reflect FTE’s rising exposure to high-growth emerging markets versus its declining returns from more mature markets). This produces a price target of €11.79 / share, just 6c above where the shares closed at on Friday. My price target would put France Telecom on a 2012 P/B of 1.1x and EV/EBITDA of 5.6x, which is some way below the 6.5x EV/EBITDA multiple paid for Orange Suisse and the 7.0x EV/EBITDA multiple Espirito Santo reckons Everything Everywhere is worth. Perhaps that is too conservative, given the emerging markets exposure, but then again France Telecom has structural headwinds (inflexible cost base, a very aggressive low-price entrant in its domestic market) to contend with. Weighing everything up, my instinct is that I should look to exit this position. I will monitor the share price over the coming while and look for a suitable opportunity to hang up on the company.