Despite its low valuation, we steered clear of the European telecom sector for years. In 2007, it began recording a substantial decline in business activity due to the particularly hostile competitive and regulatory environment. The first signs of stabilisation would not be seen until mid-2013. It was during this period that we gradually reintroduced Telecom stocks to the METROPOLE Sélection portfolio. Since then, the sector has outperformed significantly and undergone a considerable revaluation. Until recently, that is. The series of merger plans that have fallen through in recent months has investors worried about whether the quiet on the competition front for the past two years can last. The underlying idea is that only the consolidation movement can explain the recent upturn in European telecom results. That’s not the real reason, though.
Over the past three years, a consolidation wave has swept the European telecom sector, altering the competitive landscape of several markets such as Austria, Ireland and Germany, with the number of operators reduced from 4 to 3. For the last few months, however, merger after merger has been halted in its tracks, leading the market to fear the end of the improved earnings cycle the sector has enjoyed these past two years. First of all, in September 2015, the second and third leading operators on the Danish market, Telenor and Telia, announced they were abandoning their merger. This was because of the large number of concessions demanded by the new European regulator, in an environment where the top two post-merger operators (Telenor/Telia and TDC) would have taken a near-80% slice of the pie.
Currently, the merger in the British market between O2 UK (Telefonica) and Three (Hutchinson) is apparently frowned-upon by both the local regulator (Ofcom) and the European Commission, and the concessions are dissuasive enough to put an end to the plan. Recently, in France, Bouygues and Orange failed to reach an agreement and had to scrap their merger as well. While as a general rule consolidation tends to be synonymous with less competitive tension, for the telecom market these deals are not the only source of the sector’s higher earnings.
Much like what happened in the United States, the true improvement in results came on the heels of investments in very high speed landline (fibre) and mobile (4G) networks. This new investment cycle, which in Europe really got off the ground in 2013, sparked an average 2-3 point increase in the investment over sales ratio of major operators, taking it to 15%-16%. The roll-out of new technologies took place in a pro-investment regulatory environment. After selecting price as the sole criteria for assessing intensity of competition, the regulators are now more focused on creating the right conditions for investment. The objective is twofold: to meet the exponential rise in traffic volumes and to promote network competition from a technological standpoint.
The new investment cycle has had a clear impact on operator revenues since the end of 2013 and is primarily responsible for the earnings turnaround. In the mobile segment, for example, there is a strong correlation between the increased penetration of very high speed networks in Europe and higher revenues earned by the main European operators. The roll-out of 4G networks is driving the growth of clients that use very high speed networks, which is in turn having an immediate impact on data usage.
The virtuous circle is clearly at work in countries with the highest very high speed penetration rates. In Nordic countries, for example, where 4G was launched earlier than in the rest of Europe, the penetration rate is already at 50%. Nordic operators have seen a dramatic rise in revenues, with Finland’s Elisa posting revenue growth of 5%-10% for the past several quarters, driven by growing demand for data. Other countries, such as Italy, are further behind. In the landline segment, the lack of competition (no cable operators) and Telecom Italia’s dominant position have put a damper on high speed investments. Italy has the lowest broadband penetration rate in all of Europe (60%), way behind the European average (83%). For the same reasons, Italy is also significantly lagging when it comes to very high speed fibre optics. From that standpoint, Enel’s recent announcement of its plan to build a fibre broadband network in Italy is not necessarily a bad thing. While it may initially upset the competitive balance for Telecom Italia and drive the group to ramp up investments, it will be offset by the higher penetration of broadband and very high speed technologies in particular, spurring greater earnings momentum. Finally, the recent succession of abandoned mergers in the Telecom sector should not be seen as the end of a brighter earnings period for operators in Europe. The positive effects of the very high speed investment cycle are yet to come. The sector’s revaluation potential is far from exhausted, which is more than ample reason to keep a large contingent of telecom names in our portfolios.