France Telecom – The Thrill Is Gone

By Stephen D. Simpson, CFA | March 06, 2012 AAA

Continuing a theme that not all great-looking dividends are suitable for income-oriented investors, France Telecom (NYSE:FTE) is having serious struggles in the market these days. Price-based competition is still a very real threat to France Telecom in Europe, while Africa is simply too small relative to Western Europe to make a substantial difference. That said, the lousy market performance of this stock seems to have washed out a lot of pessimism.

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Dreary Results, as Expected
Little was expected of France Telecom for end-of-year results, and that's pretty much what the company offered. Fourth quarter revenues dropped about 3%, with a 4% drop in revenue from France (which is about 50% of the total). There weren't any real surprises in the "why" - France Telecom is under considerable pressure on price and customer retention. To that point, churn rose again - up 70 basis points from the third quarter and almost three points from the year-ago period.

To management's credit, they are compensating for revenue weakness with reasonable expense control. EBITDA for the period dropped about 4%, and EBITDA margin fell about a third of a point. For related reading, see A Clear Look At EBITDA.

Down Goes the Dividend
Although France Telecom's dividend yield pops out, the sustainability has been an issue. Now France Telecom has brought that home to roost, announcing that dividends will be supported by 40 to 45% of operating cash flow. That suggests a potential cut of around 10% for the next year.

Even with that cut, though, France Telecom's dividend yield will be quite competitive with Vodafone (Nasdaq:VOD) and at least in the ballpark with Deutsche Telekom (OTCBB:DTEGY) and Telefonica (NYSE:TEF). Moreover, it's hard to see that the high dividend yields at Telefonica and DT are all that much more sustainable, though at least Telefonica has a substantial Latin American business to prop up results.

Is Growth Even an Option?
One of the biggest issues for France Telecom and its Orange brand is the limited growth opportunities for the company. Europe is brutally competitive and markets like Poland, Turkey and Russia doesn't offer much upside. While Africa offers some reasonable long-term potential, it's just too small relative to France and Spain at this point to really make a huge difference.

Nevertheless, there is ample concern in the market that France Telecom is going to waste money on more M&A. There are certainly plenty of potential targets (especially in emerging markets), but Wall Street basically sees every mobile market as an eventual market in decline.

Perhaps the best that France Telecom can shoot for is a sort of sustainable level of competition in its core markets. Capital expenditure costs real money and the transition to 4G should create some opportunities for the company relative to bargain-priced providers who will continue to stay a generation or two behind and use that to offer value-oriented services. Among the bigger players, though, nobody has much vested interest in killing prices and creating a nobody-wins marketplace.

The Bottom Line
If the sell side is right, investing in France Telecom is mostly about betting that the story is going to get less-bad than most believe. Certainly there are rather modest expectations built into today's stock price. More to the point, the company can see free cash flow erode at an ongoing rate in the mid-single digits and the stock is still arguably underpriced. For related reading, see Free Cash Flow. Free, But Not Always Easy.

Eventually, France Telecom will settle down and be more or less an income conduit as a telecom utility. That doesn't leave huge potential in the shares, but it does seem as though the worst is in the past. While investors need to keep conservative expectations in mind here, snuffing out the last of the optimism may have actually made this a safer stock going forward.

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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