Telecoms companies have spent the past few years furiously cutting their debt. But now they are starting to pile it on again.
Telecom Italia has taken on €14.5 billion of new debt to finance a merger with its mobile subsidiary TIM. Spain’s Telefónica has submitted a preliminary offer for Cesky Telekom, which it would probably finance with €5 billion of debt. And BT, the UK ex-monopolist, recently said that it was reviewing its debt target.
This revival of interest in borrowing is striking. It is only a few years since debt almost brought the sector to its knees. Having borrowed far too much to finance acquisitions in the late 1990s, companies spent the next three years paying for it.
Now they are back in the habit. Is this an extraordinary lapse, or have the markets been through their cleansing process incredibly fast?
Incentives to borrow
Happily, the latter seems closer to the truth. After the bubble, telecoms companies diverted their prodigious cashflows to cutting debt as quickly as possible. Most have got their net debts below the two times ebitda mark considered a prudent level of leverage. And France Telecom has almost made it. The outlier now is TI, whose leverage has increased to 2.7 times after acquiring TIM. But TI is an exception: its owners are reluctant to issue shares in case they are diluted to the point where they risk losing control.
Others may even have cut more debt than needed to keep their balance sheets efficient. Telefónica’s leverage is close to one times. BT’s and that of KPN of the Netherlands are closer to 1.5 times.
Companies with the capacity to take on more debt have a powerful incentive to do so. Debt is currently very cheap, owing to very low interest rates and tight credit spreads. Meanwhile, telecoms companies are finding equity relatively expensive to finance. That’s because they are paying big dividends to shareholders – to make up for wasting cash during the bubble.
Look how this adds up. The average cost of debt for European telecoms companies is only 3%, after factoring in the tax shield, according to Merrill Lynch. But the average dividend yield of these companies is 4.2%. By taking out debt, buying back shares and cancelling them, they can reduce their financing costs. This way of juicing up earnings is particularly attractive for companies in low-growth industries, such as telecoms.
Of course, there are caveats. Share buybacks will destroy value if the shares being bought and retired are overvalued to begin with. Bad deals destroy value, however financed.
That said, telecoms stocks don’t look wildly overpriced, trading on cashflow multiples close to or below the broader market’s. And TI’s deal isn’t very risky as it is only a minority buyout. If there is a niggling doubt, it is over Telefónica’s interest in Cesky. After all, the Spanish group would be taking on €5 billion of fresh debt to buy an underlying earnings stream of only e1 billion – located in the distant Czech Republic.
Releveraging isn’t an unalloyed benefit for investors. Shareholders might like it but it makes a company’s debts riskier. That’s bad for bondholders.
But bondholders had their day in the sun during the deleveraging phase. Now shareholders deserve their turn. Provided managers keep their heads and don’t go crazy with acquisitions, this is as it should be.
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