It’s a sector whose long-term fundamentals are rather dismal, to say the least, and for many investors, European telecom is looking less and less attractive despite low valuations because so many companies, faced with a serious cash crunch, are slashing dividend payments in order to cope with the financial strain.
However, for investors focusing on quick and easy value creation, even slashed dividends can compare favorably with low valuations and make for continued opportunities in the European telecom space.
“Telecom companies tend to be valued on their ability to pay dividends to shareholders, but although we are forecasting a 50% dividend cut for European telecom companies, when we look at that in the context of valuations and where they are currently, we come out with a figure that’s still attractive and in certain cases, makes for a good investment for us,” said Bryce Fegley, portfolio manager of Saturna Capital’s Global High Income Fund. Through the sovereign crisis, Fegley has invested in several European telecom companies including Spain’s Telefonica and France Telecom, which has paid him back 10% on his initial investment, he said.
France Telecom, like all other European telecom operators (Telecom Italia is the latest to join the list) has had to cut dividend payments in order to control debt and cope with increasing competition, but in the context of current valuations, which in Fegley’s opinion are still cheap, it and other telco stocks in Europe are still worth it.
“If you use a simple dividend discount model, you’d see that the cumulative value of many European telecom stocks is significantly higher than where the companies are now trading, so as pessimistic as we may be on the longer-term outlook of the sector, the valuations are just too attractive to pass on,” Fegley said. “We get companies that yield double digits based on their last dividend, and even when we model a significant cut to the dividend followed by terminal revenue decline, we still find that the market price is too pessimistic, and that works well for us.”
When European telecom companies lower their dividend payments, many investors actually become more enthused because they believe that in the current economic context, this contributes to the companies’ longevity, according to John Buckingham, Chief Investment Officer at Al Frank Asset Management. The ensuing rise in stock prices bodes well for value investors like himself, up to a point, of course.
A company such as Portugal Telecom (PT), for example, passed Buckingham’s value test from a technical perspective, but it is also, he says, a company that is well positioned for the near term because of a number of other positive attributes.
When PT slashed its dividends, the stock rallied but “this is also a misunderstood company that suffered from being located in Portugal, even though it generates half of its revenue outside Europe, in Brazil, Africa and Southeast Asia. Many investors headed for the hills because of the Portugal connection, but there was great value in the company, which is profitable and had sound financials that have become sounder because it has been able to roll over debt and is fully financed until 2016,” Buckingham said.
What’s more, Portugal Telecom had invested large amounts of Capex toward expanding and enhancing its network in Portugal, which means it isn’t facing the kind of expenditures that other companies might be facing, and now can actually “start to reap the benefits of this expansion,” Buckingham said.
With most European stocks, telecom included, are still trading relatively cheap, stories like Portugal Telecom’s are attractive, and worth taking advantage of in the near-term. In fact, Buckingham said that the PT value proposition may not last too much longer, since more and more investors who had steered clear away from Europe are now looking with greater scrutiny across the region and scouting out opportunities in various sectors, thereby causing stock prices in general to rise.
In the longer-term, of course, few feel that the European telecom industry is the place to be and neither Buckingham nor Fegley would commit to it for the long haul.
Falling revenues, higher costs, deregulation and increased competition, issues that have worsened as a result of general macroeconomic troubles and that are only going to worsen going forward, are going to continue to plague this space, Fegley says. Companies are having a tough time coping with the costs of providing high bandwidth for Internet usage, and cannot pass those along to the consumer.
“Right now, the sector has value but the fundamentals will take between three and five years to get sorted out,” said Fegley.