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Telecoms companies look superficially cheap when measured against the huge volumes of cash they are throwing off. But dig beneath the surface and a different picture emerges.
The telecoms sector has suffered a torrid couple of months on the stock market. But now some investors are wondering whether it isn't time to buy again.
The reason they are interested is that many traditional telecoms incumbents are trading on fat cashflow yields. That means the cashflow available to shareholders – what's left after interest, tax, capital expenditure and acquisitions, before dividends and buybacks – represents a relatively high proportion of the market capitalization.
Cashflow yields are essentially a proxy for dividend yields. They give an indication of how much cash underpins the payout. Investors look at them when they buy stocks on the assumption that dividends will flow in the years to come.
Using 2004 forecasts, in June France Télécom yielded 13%. Deutsche Telekom and Telecom Italia both yielded 10%. As large European stocks on average trade on cashflow yields of about 7%, these mega-yields are flashing a big "buy me" signal. But that doesn't mean investors should pile in.
Valuations based on cashflow yields flatter telecoms stocks. One reason they yield so much is that they are risky. Many are still stuck with big debts they took on a few years ago when they were on the acquisition trail. Even after a big debt-reduction effort, France Télécom had e44 billion of net debt left at the end of last year, poised on an equity base of only e12 billion.
On an unleveraged basis, telecoms stocks look less attractive. If one compares cashflows before interest with enterprise values, adding back the tax shield, France Télécom yields 8.6% and Deutsche Telekom 8.2%. Telecom Italia's yield drops to 7%. This is a bit more than the broader market measure, but the buy signal is flashing a good deal less urgently.
What's more, there's another big risk factor, namely that their core fixed-line businesses are in decline. And since these revenues carry a high profit margin, this is taking a big bite out of cashflow. The rate of decline varies from company to company dependent on the behaviour of the local regulator. Deutsche Telekom and Telecom Italia seem to have the most defensible franchises. But the overall trend is downwards.
Another problem is that there is no certainty investors will ever get their hands on the cashflow. There are plenty of other calls on the money apart from dividends. Telecoms companies are always keen to spend large amounts on their own businesses. And there is also the seductive appeal of acquisitions.
For instance, Deutsche Telekom bought $2.3 billion-worth of US network capacity last month. It splashed out even though it has not yet committed itself to resuming the dividend it cancelled during the last downturn.
Shedding stock
A last issue is that the cheapest stocks, Deutsche Telekom and France Télécom, both still have big overhangs. The share prices are suffering from speculation that the French and German governments are preparing to offload big blocks of stock. Whether or not they are willing sellers at current levels is debatable. But the governments could effectively cap any upside by selling stock every time the price reached a certain level.
So there you have it. On the surface, telecoms stocks yield an attractive amount of cash. But adjusting for debt tells a slightly different story. Until the companies can stabilize their fixed-line businesses, the cashflow is under threat. And the temptation to grow out of this problem – by throwing cash at acquisitions – remains.
Even with the risks factored in, a few stocks still look tempting. Deutsche Telekom, with its strong domestic franchise, is probably the most appealing. But cashflow yields are no reason for investors to pile indiscriminately into the sector.
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