March 22, 2018

European Telecoms are racing to invest in 5G

by Tajinder Dhillon

Earlier this week, the UK opened up bidding for the latest chunk of airwaves that will host the next generation of wireless technology – 5G. There has been much anticipation of 5G and how it will revolutionize society by offering a network that will be 10x faster and provide more consistent coverage compared to 4G (where speeds may decline outside major metropolitan areas). By providing a network capable of handling our ever-growing data consumption habits, 5G will look to deliver on the promise of the Internet of Things (IOT) –autonomous driving, wearable technology, virtual reality, smart homes, buildings, factories, and cities.

Whilst 5G has been a space in development for a number of years, it is anticipated that the US and Asia will be the first adopters of the technology and provide commercial solutions by early 2019, while Europe will look to be ready by 2020. UK’s telecom regulator Ofcom initiated the bidding process for the latest 5G airwave, which will see the major telecom players enter a multi-week auction process. Vodafone (VOD.L), BT (BT.L), (owner of EE), O2 (TEF.MC), and ThreeUK which is owned by CK Hutchison (0001.HK), will compete for a total of 190 MHz which will be split between 40 MHz of 4G airwaves and 150 MHz of 5G airwaves (Note: BT will be limited as to how much it can purchase due to its dominant position as it owns almost half of the UK airwaves today).

5G may be the savior for the industry, as European telecoms have had their struggles over the last year, as seen in Exhibit 1. The MSCI Europe Telecommunications sector has declined 11.3% over the last year alongside double-digit declines in BT and Telefonica.

Exhibit 1: Price performance of major European Telecom companies

Watch debt levels

The telecom industry will want to avoid the same mistake made almost two decades ago when they notoriously overpaid billions of dollars for 3G wireless technology, which perhaps did not live up to its hype. This is of particular importance as the majority of telecom players have poor credit scores according to our StarMine Credit Risk models. In particular, Vodafone, BT, and Telefonica all score in the bottom quartile of the StarMine Smart Ratios model, which provides a view of a firm’s credit condition and financial health by analyzing a wide array of accounting ratios that are predictive of credit risk.

We can see in Exhibit 2 that the majority peer group suffers from high degrees of leverage and low liquidity. Among these three, VOD.L has the lowest debt/equity ratio and Telefonica the highest. In addition to debt, BT also has a large underfunded pension liability. High leverage and low liquidity might be a dangerous combination that will become more difficult to manage as interest rates are likely to rise in 2018 as indicated by the Bank of England.

All three companies have fairly high interest coverage ratios – giving them some cushion, providing they don’t overpay for spectrum (i.e. airwaves) and greatly increase their debt levels. It might also be worth noting that our StarMine Implied Rating for BT.L, VOD.L, and TEF.MC are all lower than agency ratings which could be a predictive indicator of a future downward rating revision. We have found that when the Model Implied Rating differs from the Agency Credit Rating, the agencies are four to five times more likely to revise in the direction of the Implied Rating than in the opposite direction.

Exhibit 2: StarMine Smart Ratio Model Scores

‘Value trap’ or genuine value?

As the sector has had poor stock price performance in recent months, it has made valuations look attractive across the board. As indicated by the StarMine Relative Valuation model in Exhibit 3, BT, Vodafone, and Telefonica all score in the top decile when looking at companies in developed Europe. With percentile scores of 100, 88, and 97, it is undervalued vs. region, sector, and industry when looking at six valuation ratios including P/E, P/B, P/CF, EV/EBITDA, EV/Sales, and Dividend Yield. While some may conclude that these companies are “value traps,” all three companies are expected to experience EPS growth over the next year of 2.5%, 8.4%, and 14.2%, respectively. An alternative explanation for their market underperformance may just be that high dividend yield stocks have fallen from favor in an environment where short term debt is becoming a stronger competitor.

Exhibit 3: StarMine Relative Valuation Model Scores

Remember the equipment makers

Whilst most of the discussion has been about the telecommunications carriers that will offer new products and services utilizing 5G, it is important not to forget about the overall supply chain. The equipment manufacturers of 5G technology will ultimately be doing the heavy lifting.

Two of the biggest players in Europe include Ericsson (ERICb.ST) and Nokia (NOKIA.HE), which will certainly benefit once network rollouts occur over the coming years. Ericsson and Nokia will be competing with each other (amongst other players in the US and Asia) to win contracts with telecom service providers to build the required infrastructure for 5G. This will be a catalyst for growth and it can’t come soon enough.

Borje Ekholm, chief executive of Ericsson equipment, echoed worries that Europe is becoming a laggard in implementing 5G, compared to the United States and China. “We have to be honest. We don’t have a good investment environment,” he said. “It is a concern for me as a European. One hundred years ago we built roads and railways and in the future we need digital highways. This is critical national infrastructure. Unless we create an investment framework, how as a continent are we going to compete?”

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