It certainly fits a lot of American stereotypes about France to see the incumbent telecom operator (and leading wireless provider) France Telecom (NYSE: FTE) struggling with operating efficiencies and high employee costs. What may not be stereotypical, but is nevertheless true, is that brutal free capitalist-style competition is likewise putting a lot of pressure on the company's revenue generation in its home territory. Although arguably too cheap by several metrics, France Telecom has a worrisome capital and expense structure and relatively uninspiring growth potential.
Growth Is Getting Harder Every Day
There just aren't many telecom growth stories left anywhere in the world. While there are still countries (particularly in Africa) were penetration is below 80%, even most of these countries have two or three rivals to France Telecom's Orange brand.
What's more, competitors don't necessarily fight fair or for their own long-term best interests. In France, Iliad has definitely shaken up the market with cut-rate pricing and is now looking to start subsidizing handsets later this year. While France Telecom has fought back with services like quad-play bundling and the overall strength of its 4G network, this competition has made it harder to grow ARPU in the market that provides nearly 50% of the company's revenue. In the long term I think it will be hard for Iliad to price this way and still generate the capital it needs to upgrade its network, but they can create plenty of damage in the meantime.
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It also doesn't help that so much of France Telecom's business is tied to slower-growing regions. Another quarter or so of the company's revenue comes from Europe, with almost half of that coming from Spain and Poland. While the company has been able to compete pretty effectively with Telefonica (NYSE: TEF) with a low-priced service that has benefited from strapped customers trading down, that's not an encouraging model for the long term.
Expenses Are The Big Issue
The elephant in the room for France Telecom is its cost structure. Due in large part to its legacy as a state-owned business, France Telecom's employee roster is enormous when compared to the telecom operations of Vivendi (Nasdaq:VIVHY), Bouygues, and Iliad (alone or combined). To that end, employee costs in what is generally not thought of as a labor-intensive business are upwards of 20% of revenue.
Bullish analysts point to the fact that as many as one-third of the company's employees will reach retirement age over the next seven or eight years. That's all well and good, but let us remember that Wall Street struggles to think five days ahead, let alone seven years. What's more, who's to say that the government won't pressure France Telecom to hire replacements for a large percentage of those retiring workers? While it is true that new employees can be brought in at lower wages and benefits, it's going to be hard for France Telecom to meaningfully streamline or cut costs in the near term.
More Turbulence Is Almost A Guarantee
There's likely to be a steady drumbeat of concern around France Telecom for some time to come. For starters, the company has a huge amount of net debt on the balance sheet (over 30 billion euros) and nowhere near enough free cash flow to pay that off anytime soon. While there are assets that the company could sell, and companies like AT&T (NYSE:T) and Vodafone (NYSE:VOD) could be potential buyers, getting full and fair value will be challenging. Along similar lines, the market is also pricing in further dividend cuts, as the company will be under serious pressure to maintain payouts.
Last and not least, the company's CEO Stephane Richard is under formal investigation for alleged fraudulent activities committed while he was in France's Finance Ministry. There have been numerous claims that this investigation is politically motivated, but that doesn't change the fact that it is disruptive and likely compromises how aggressive the company can be with must-do items like cost cuts.
The Bottom Line
On a discounted cash flow basis, the company's huge debt load all but wipes out the fair value unless you believe the company can return to mid-to-high teens free cash flow margins – something that seems unlikely given the fierce competition in France and the growing competition in regions like Africa. On an EV/EBITDA basis, though, the stock looks significantly undervalued even when factoring in its unhealthy balance sheet, and the shares could be as much as 20% or 25% undervalued on that basis.
Much as I'm in favor of looking into beaten-down situations, it's hard for me to like France Telecom. I do believe the company's operations and assets are worth more than this, but the combination of unreasonable competition and unreasonable regulation are just too unappetizing for me. With many other telco providers looking underpriced and operating in better environments, I won't be adding France Telecom to my holdings.