"The three most important words in any investment process are" Margin of Safety ", ie, the difference between an asset’s intrinsic value and the price at which we buy. When pessimism settles, in the economy, at a sector or concerning the performance of a particular company, it is natural for prices to fall and sometimes cheap stocks get even cheaper. The risk-averse investor acknowledges that the greater the difference between price and value, the greater the margin of safety on the investment and the better the rate of return.
Because the telecommunications business is not a business without risk, in particular regulatory risk and the constant need for major investments, before considering any investment in this sector, we should require a large safety margin.
France Telecom (FTE) is an example of an asset that at the current price, allows us to invest with a very comfortable margin of safety.
1. The business of France Telecom
It is the largest telecommunications operator in France, a business that accounts for about half of its turnover. The company's business is divided into: mobile services (41%), fixed-line services (29%) and other telecommunications services (30%). France Telecom has a presence in Spain (8.8%), Poland (7.39%), and rest of the world (18.1%) which includes a joint venture with Deutsche Telekom in the UK, and several operations in North Africa and the Middle East. The business unit represents 15.3% of sales. In 2012 the company presented a free cash flow of 8 billion euros.
Last year, a new mobile operator entered the French telecommunications market, Iliad. In the first three quarters, thanks to an aggressive strategy of low prices, Iliad won 6 million customers. The three incumbents felt increased competition and France Telecom was no exception. The company lowered prices to adapt to the market and the result was a recovery in the number of customers.
European mobile operators have had difficulty increasing their revenues. One important reason has been the trend at European level to impose limits on the "termination rates" - the rates that operators pay to your competitors so that customers can make calls to other networks. France is, indeed, the most advanced country in this requirement, having cut these rates to 0.008 cents since January 1, 2013. The European average is 3-4 times higher. This means that France Telecom will not be much affected by future reductions in comparison with their counterparts European.
In addition to the mobile market, France Telecom has heavily invested in marketing of its broadband solution, with good results.
On television, it is seeing significant growth: the television business has already 4.9 million subscribers, roughly the same as the largest French operator of cable television, Numericable.
The French state has a 26.94% stake in France Telecom. Two thirds of the company's employees are qualified as public officials. However, at least 30% of these workers will reach retirement over the next eight years which will enable a very significant cost reduction.
France Telecom has been focusing on significant growth geographic areas, particularly Africa and the Middle East, where the telecommunications market has the greatest potential. The company aims to double its presence in emerging markets by 2015.
2. Debt levels and results
The high indebtedness of most European telecoms sector stems from the fact that the telecommunications companies generate stable results, which support a high debt service, and the fact that large sums of capital are required to support the large investments that characterize this activity.
The telecommunications sector faces remarkable challenges. Need to adapt to the competitive environment, technological change and regulation. For the future, maintaining a sustainable competitive position will require companies to have financial strength and flexibility to explore new markets and opportunities. France Telecom will be able to stabilize its business and prepare for future growth. The company expects to achieve a free cash flow of 7 billion euros in 2013 and initiate a recovery in 2014, supported by significant operational improvements.
The current economic crisis and increased competitive and regulatory pressures forced companies to rethink their leverage ratios and limit dividends distributed to shareholders. KPN, the largest Dutch operator, was recently forced to make a capital increase and cut its dividend. France Telecom is one of the least indebted European operators (see table), with the objective of maintaining a ratio of net debt to EBITDA (earnings before interest, taxes, depreciation and amortization) of less than 2.
Business Net Debt / EBITDA
France Telecom: 2.23
Telecom Italy: 2.76 5.19
Deutsche Telekom: 2.11
Portugal Telecom: 3.49
Verizon (USA): 1.63
PER Est Current Year
France Telecom: 7.34
Telecom Italy: 5.25
Deutsche Telekom: 12.31
Portugal Telecom: 10.45
Verizon (USA): 17.74
To achieve this, it has decided to reduce its high dividend, bringing it to more reasonable levels and in accordance with the current level of business income.
3. What does France Telecom produces in earnings and dividends for its shareholders?
Over the past five years, the company produced an average EPS of € 1.61. For the next year the expected EPS is, on average, 1.12 euros, a figure quite conservative compared to the past. That is, if an investor were to buy a stock at current prices, € 7.84, you get an annual return on investment (earnings per share / price of investment) of about 14.29%, assuming that the results remain constant.
The company will not distribute all of its profits to shareholders. Management's objective is to continue to invest and reduce debt, which will increase the company's value. However, the administration has already committed itself to the payment of a dividend of € 0.80 for the next two years. This amount, for current stock price, represents a dividend of 10%.
4. Investment in FTE shares versus bond investments
Investing is abdicating to consume today in order to be able to consume more in the future. Therefore, when we invest, we must assess the likelihood - a reasonable probability – of an investment to cause the owner a loss of purchasing power in the future. Contrary to what many think, the assets can vary greatly in price and not be risky, if there is a reasonable certainty that, for the period we expect to be invested, they will allow us to increase our purchasing power.
Similarly, deposits, money market funds, bonds and other fixed income instruments, are viewed by investors as “safe”, but are in essence very risky assets. Over the last century, these investments have destroyed the purchasing power of many investors in many countries, although these investors received their payments of interest and coupons on the agreed dates, and the value initially invested.
France Telecom recently issued a bond due in 2023. This obligation pays an annual coupon of 2.5% for the next 10 years. Those who invested in this bond will certainly receive year after year the respective coupon and, at maturity, will be refunded for the capital invested. However, those who invest today in the company’s shares are entitled to a dividend, also paid annually, of 10%. Better yet, if we ensure that we are buying a cheap stock, we will also have significant capital gains in the future.
Trading for 7 times their expected EPS, it’s a very cheap asset with immense value. Today, we would be buying from pessimists. In the future when there is a general consensus on the merits of this investment in the market, it will have risen very significantly already.