M&A-related news and trading activity were the themes for much of last month, the most high-profile news concerning the pursuit of AT&T Wireless by both Cingular Wireless and Vodafone. Although most analysts reckoned that Cingular – the ultimate winner after lodging a whopping $41 billion cash bid – was in the driving seat, some analysts were surprised, even taken aback, by Vodafone’s aggressive pursuit of the US company.
This led to spreads on the British telecom’s bonds and CDSs to widen in the run-up to the outcome and soften back after the resolution. Nevertheless, rumours persist that Vodafone is still in the market for a tie-up, with Vivendi at the front of a line that also includes Verizon.
Not many other telecom corporates have escaped the rumour mill. Towards the end of February, press speculation combined the names of France Télécom and Royal KPN as being in talks for a possible merger, denied by both companies’ senior management.
Nevertheless, Royal KPN did announce it was interested in a merger with Europe’s sixth largest cellphone company, mmO2, although the British firm rejected the offer. Other business combinations that have been bandied about include TeliaSonera and TDC, and DT taking control of PTC, amongst a host of others.
Interestingly, this kind of talk was practically unheard of last year – the biggest merger concerned Olivetti and Telecom Italia – as firms were still in de-leveraging mode, trying to shore up their balance sheets in an effort to improve their credit quality. And many are well on the road to recovery, as proved by KPN and France Télécom. The latter was upgraded last month by S&P and Fitch to BBB+ on positive outlook. The market is still waiting for Moody’s to play catch-up and upgrade its Baa2 rating.
With improvements in credit fundamentals becoming the norm, bondholders need to determine the telecom firms’ next step. With the rise in corporate activity such as increases in capital expenditure, the search for top-line growth could tempt more firms down the M&A path.
But this is not the only concern that could affect investors, as event risk is a many-splintered thing. Regulation, competition and technology will all fuse together in 2004 to give firms food for thought in how they maintain the fine balance between appeasing shareholders and keeping bondholders happy.
In general, analysts view the lower-rated credits, those predominantly in the triple-B spectrum, as the names to focus on. These will provide investors with both spread and rating upside.
Improving credit fundamentals were the key driver for the telecom sector’s record outperformance in 2003. However the sector has traded sideways for 2004 to date as event risk has re-emerged to cloud the picture. Investors are now edgy about holding telco paper and some wonder if the sector is trading close to fair value.
After a year spent shedding assets, shoring up balance sheets and rebuilding financial flexibility, managers must decide how to provide value to shareholders without damaging credit quality and bondholder relations. Increased or reinstated dividends and share buybacks are the order of the day. Any material escalation of these policies could be as damaging as M&A activity.
Bond investors are not averse to modest share buybacks if credit profiles are maintained and no other use of cash is available. Equally, investors (both debt and equity) will not object to bolt-on acquisitions that make strategic sense and that provide returns in excess of the cost of capital. However it takes much longer to undo the effects of an ill-advised acquisition than it does to reduce a dividend or suspend a share buyback.
The investor community has not forgotten the track record of mega-deals that have not always enhanced earnings, but this has not stopped rumours of such combinations as KPN and mmO2, TeliaSonera and TDC, Vodafone and Verizon, or Vodafone and Vivendi/SFR. February brought a stark reminder, if one were needed, of the damage M&A can do to a credit profile. Cingular’s successful bid for AT&T Wireless triggered credit rating reviews for the group from all the rating agencies, while losing bidder Vodafone saw its shares rally 7.5% in a day and CDS levels tighten from 44bp to 36bp.
How should bondholders approach the sector given the return of event risk? Bonds with coupon step-ups continue to provide some compensation in the event of credit-negative corporate actions. However, coupon step features remain the exception rather than the rule in the market. For the most part investors must rely on management’s commitment to a stated strategy and credit rating. And hope that they have learned from the past.
Laura Winchester and Milena Ianeva
Telcos today have a problem, and it has nothing to do with debt. The problem is the lack of top-line growth rates as competition, regulation and substitution continue to bite. This makes M&A inevitable.
Where will the action take place? We expect little activity in fixed line beyond minority buyouts and investments in operators like Cesky. The TeliaSonera tie-up has been successful, but few other combinations would generate meaningful synergies or clear the cultural hurdles. While we may see a TKA/Swisscom deal (valuations seem to be the problem at the moment), the days of the proposed DT/TI or KPN/Telefónica deals have passed in our view.
In the internet space, operators will continue to look to fill their geographic footprints and build a broadband business. T-Online, Wanadoo and Terra Lycos all have cash and ambition.
The main action though will be in mobile. Whether Europe generates as much excitement as the US remains to be seen, but there is some potential. Speculation about TI or Telefónica buying out minorities in TIM and Telefónica Móviles will persist given the financial logic. Investment to increase stakes in Eastern European businesses is also likely for DT, Telia, TDC and Vodafone.
The UK, Netherlands, Denmark and Germany are all ripe for consolidation. MmO2 operates in two of these markets, making it a likely player if consolidation gets under way. KPN and TIM have made no secret of their mobile ambitions and Orange and T-Mobile are also likely to look for opportunities. Wind, Amena and Bouygues Telecom would all, in theory, make interesting additions to one of the leading operator’s footprints. And then there is Vodafone. The desire to take control in France could kick off the next round of European activity and is unlikely to be Vodafone’s last move.
Is all this necessarily bad news for bondholders? No. We believe management has learnt the lessons of the recent past and that future M&A will be financed in a way that preserves financial flexibility. Does this mean most deals will be equity funded? No. Telcos today are rapidly generating excess free cashflow and it will be either spent on acquisitions, invested for organic growth or returned to shareholders.
This does not mean there is no risk of downgrades for some of the higher-rated telcos. We are not complacent and will monitor both management behaviour and equity market sentiment and will certainly be more cautious about the trading levels of these names (witness the recent Vodafone widening).
We see telco event risk as likely to constrain the upside for the acquirer but unlikely to introduce real downside risk, possibly providing some positive news for those being acquired. Overall, we do not see M&A as undermining the bondholder story and remain modest overweight the sector driven by the large incumbents.
Overweight on lower-rated telecoms
We believe that ‘natural’ threats to the credit quality of European integrated telecom operators have greatly diminished and the companies are almost free to choose the ratings profile that suits their strategies. Therefore M&A-driven event risk, dormant for a while, is again becoming the main risk to telecom credits. However, we see many nuances that have been well illustrated by the story of the AT&T Wireless acquisition.
We notice that M&A risk perception is usually greater than reality (ie, DT was originally thrown into the hat and Vodafone was at some point thought to be a potential bidder for all of Verizon). Most management teams remain aware of the need to stick to financial discipline and not overspend on acquisitions. In support of this final point, M&A is not high on shareholders’ agendas for telecom companies and this should restraint acquisition appetite.
Acquisitions are unlikely to be materially credit dilutive, at least in the near term. Even Vodafone’s all-cash bid for AT&T would not have resulted in the loss of single-A ratings, according to management.
Nevertheless, M&A risk is greater for higher-rated companies (some of which are arguably under-leveraged already) whereas most triple-B telecom credits should remain more focused on operating improvements and balance sheet strengthening. This M&A risk is particularly high for telcos that struggle to produce sufficient top-line momentum and hence may be tempted to buy growth (eg, TeliaSonera). Event risk is greater in markets with a tough operating environment and in need of consolidation – generally, Europe is less exposed to these than the US, in our view.
To summarise, we have both bad and good news for telecom bondholders. The bad news is that M&A risk is on the rise and, in the context of tight credit spreads and limited upside, it is likely to be negative for spreads, even if perception of this risk may far exceed the reality.
The good news is that perception will probably exceed the reality. We see few obvious deals and even smaller scope for credit shocks in the near future, as managements retain memories of recent debt predicaments and shareholders remain sceptical of value creation through M&A. Still, we think the best hedge against M&A risk in the near term is overweight positions in a few triple-B rated names, whose financial discipline should remain more robust while the credit quality (and ratings) gap with their single-A peers continues to shrink.
Overweight in euros
How ironic that we are now faced with a debate on the level of event risk in a sector that only two years ago didn’t even have the time to worry about event risk – the telecoms sector was too busy dealing with the fallout from increased financial risk following a spate of acquisitions and UMTS auctions.
Event risk exists in many forms and guises but essentially in 2004 we identify acquisition, regulatory, technological and shareholder-related event risks as areas to watch. We believe the companies can withstand all of these, to the extent that we see them playing out, given the strong momentum currently maintained in cost cutting and cash generation.
Acquisition risk is pretty much limited to Vodafone, TDC and KPN with the US wireless experience kicking the show off. For Vodafone, France, Poland and potentially Russia are lurking in the background. For TDC we have the uncertainty of how the ‘we want to be a growth company again’ management team spends the Belgacom IPO proceeds. Finally for KPN, there is the potential mmO2 purchase, which leaves both companies actually looking stronger given the predominant stock contribution if a deal is done. None of these will damage credit in a material way but some could hurt sentiment following the honeymoon phase credit investors have experienced in recent times.
Regulatory risk would only approach event risk proportions if we had a paradigm shift in approach. We do not envisage this occurring this year as there are certain prescriptive measures already in place that are doing some damage to returns. Any shift in approach is more likely to be driven by the prospect of long-term supernormal return potential and this is clearly not a 2004 issue.
Looking at the return to a shareholder focus, we feel large-scale share buybacks can be described as event risk, particularly if not anticipated by the market. The biggest risk is an announcement of a large buyback from the likes of FT or DT. This would send shudders down the spines of credit investors if announced in the first half of 2004 but would probably be stubbornly accepted if done at the end of 2004, given the waterfall of cash pouring through the cashflow statement.
Technological event risk is again something for 2005 and beyond and we highlight VOIP (voice over internet protocol) and growing F2M (fixed to mobile) substitution as having the potential to reap havoc on the fixed-line business model. But for this year, we will likely see nothing more than tentative evidence of this and would not classify it as event risk, but rather a window to the future of operational risk.
No other new technology stands ready to blow apart the telecom business model and we therefore remain sanguine on this issue for telecom credit.
Wrapping it up then, we see event risk as manageable in 2004 and anticipate closing the year with improved credit fundamentals and only a few bruises and scratches picked up along the way.
Overweight, particularly triple-B credits
Once a telecom operator reaches its optimal capital structure, which we believe corresponds to a low single-A rating, an increasing portion of free cashflow is likely to be diverted into improving the return to shareholders or improving top-line growth through acquisitions.
Increasing appetite for acquisitions has clearly been demonstrated by failed bids by Vodafone for AT&T Wireless and KPN for mmO2. However, with only a few growth-enhancing or cost-effective targets available in western or eastern Europe, we regard the risk of a major shopping spree as limited in 2004, with the focus on buying out minorities, eg, FT offer for Wanadoo.
We argue that Telecom Italia’s acquisition of TIM is very likely to take place in the second half of this year or during next year. TIM’s status as a ‘debt-free’ company within a relatively leveraged group, and the significant dividends leaked to minorities (around e1bn per year) is a clear management concern. The inherent strategic and financial benefits of merging TI with TIM through a hybrid transaction involving both equity and debt are too great to ignore. Such a merger would have the potential to maximise cashflow utilisation, dividend capacity and reduce the risk premium, ultimately boosting debt and equity valuations.
Other likely acquisitions in 2004 are related to: (i) the consolidation of ISP minorities, eg, Telefónica acquiring the Terra Lycos minority and DT acquiring T-Online; or (ii) acquisitions of other subsidiaries, eg, Vivo (Telefónica and Portugal Telecom) buying out minorities, DT acquiring control of PTC (after failed attempt in 2003) or even Telefónica acquiring the Telefónica Moviles minority.
Short of a possible Swisscom acquisition of Telekom Austria, we are unlikely to see major integrated incumbents merging operations in 2004. We believe that despite press conjecture about a possible acquisition of TDC, it would make more sense for TeliaSonera to pursue consolidation in the Danish mobile market through the acquisition of Orange Denmark.
Although KPN remains keen on mmO2 and Vodafone is anxious to get Vivendi’s subsidiary SFR, the likelihood of the deals happening in 2004 is quite low in our opinion. However, with competition and capex in the wireless sector picking up, we expect local scale and international footprint to become increasingly important and drive wireless consolidation in the long term.
We do not expect major rating downgrades on the back of M&A activity in the European high-grade telecom sector in 2004. Although we see rating upside or spread upside for triple-B telecoms like DT, FT and TI, there is little rating upside for single-A operators. That is unless the industry’s top-line visibility improves (both fixed-line and 3G mobile revenues) or the rating agencies relax their debt coverage requirements – a highly unlikely scenario.
The valuations of single-A rated operators therefore look to be at fair value, and any further spread tightening could only come from supportive technical factors.
Michele de Souza
Event risk in telecoms in 2004 is on the increase. The prospect of consolidation in the US with AT&T Wireless on the auction block is likely to send waves through the sector. With healthier operator balance sheets and cashflow, credit investors have expected for some time to see increased shareholder demands for returns of cash (share buybacks/dividends) and growth.
Despite the flurry of M&A activity and potential domino effects, however, we still expect some measure of good sense to prevail among European operators and the lessons of the spending sprees of 2000 to hold.
In 2003, the focus of European operators was on cash generation, cost cutting and debt reduction. M&A focused mainly on fill-in acquisitions and house cleaning with a view to improved profitability. Changes in management at a number of large European carriers – DT, FT, BT and Vodafone – reinforced this trend towards extracting efficiencies and synergies from existing operations (though Vodafone will undoubtedly continue on the acquisition trail).
The prospect of further revenue declines in traditional voice services and competition in mobile with the launch of 3G will force telcos to make good on promises for growth from new services in broadband and wireless multimedia.
Event risk in our view remains low for the likes of integrated operators FT, DT and BT. FT reiterated its commitment to net debt reduction with any excess free cashflow going to shareholder distributions, capex and optimisation of its footprint, but no major acquisitions. DT has said it will not participate in the AT&T auction though Cingular has been eyeing T-Mobile USA should it lose out on AT&T. We expect BT to continue to target growth from existing businesses and TI to focus on net debt reduction and obtaining a higher credit rating (with any further corporate action within the TI structure on hold for another 12 to 18 months).
While Vodafone has the highest event risk, we would not expect it to go below single-A, even in the case of a successful outcome for AWE. We attach a higher probability of success to Cingular than to Vodafone, given the potentially large dilution for Vodafone shareholders, questionable benefits and the complexities of disentangling its 45% stake in Verizon Wireless. However acquiring the remainder of SFR in France, controlled by Vivendi Universal, would help fill the main gap in Vodafone’s European footprint.
Elsewhere, in the Nordic region there is room for consolidation with TeliaSonera having integrated their merger and now considering a “large acquisition”. Despite the company’s willingness to accept a lower rating medium term, event risk is relatively limited given its liquidity. Whether KPN will be tempted by mmO2 and a merger of their German assets is in our view a question of price.
While mobile will be the key arena for telecoms consolidation in Europe, event risk – although on the increase – should remain low in historic terms. Improved cashflow in the sector should help support the increases in shareholder distribution in 2004/05 (with some potential for further bond buybacks), and further pressure from shareholders should help keep operators’ acquisitive spirits in check.
Small overweight in euros and sterling
We have recently concluded a sector-wide examination of event risk. In this study we quantify the various types of event risk and adjust them based on the companies’ respective capacity to absorb them. We keep in mind that some event risk is under the control of management while other types of event risk are not.
Overall, ‘controlled’ event risk is increasing, in our view, but in most cases it does not appear to threaten bond valuations or credit ratings. While it is inherently difficult to predict or measure event risk in advance of any event, we continue to believe that those names with the highest risk have the greatest financial capacity to absorb these risks. We also continue to believe that most telecom operators are not willing to materially increase leverage and sacrifice ratings to achieve strategic goals.
The under-leveraged companies in the sector are looking for ways to increase equity value by using up some of their excess financial capacity. The over-leveraged operators still appear to be in risk-reducing mode.
From our analysis, TeliaSonera, Telekom Austria, OTE, Vodafone and TDC have the highest ‘negative’ event risk. Of these issuers, we only have concerns about Telekom Austria – but only within the context of our high triple-B rating and trading levels, not from the perspective of its Baa2/BBB ratings, which have a lot of headroom built in.
The only issuer to explicitly say it is willing to sacrifice ratings to achieve strategic goals is TeliaSonera. However we do not see this announcement affecting its bond valuations.
We continue to believe that Vodafone will use its financial strength to grow its mobile footprint, but we do not see the company abandoning its desire to keep its ratings and the resultant financial flexibility this affords the company. At the other end of the scale (that is, the better end from a bondholder perspective) we see companies like mmO2, BT Group, France Télécom and KPN as having small event risk – a net positive event risk in the case of BT and mmO2.
Overweight in euros and sterling
Our biggest concern is that shareholder value pressure will heighten event risk. In our view, companies will be focusing on growth internally and/or externally. Internally generated growth will be driven by higher investment and capital spending in existing businesses, which will not necessarily culminate in event risk. This process is already occurring, with capex/sales beginning to trend upwards again.
It is the external search for growth that worries us, as it leads to two forms of event risk: significant share buybacks and paying up for strategic acquisitions. Both are attractive options for shareholders. Neither would benefit credit spreads or, likely, credit quality.
So how should investors position themselves? We suggest concentrating on those European telecom incumbents that remain focused on balance sheet repair and de-leveraging. We continue to like TI, FT and DT. This is not to say that these names will not engage in acquisitions. We believe there is flexibility for add-on acquisitions that would not be detrimental to credit quality. However, we believe that senior management (and influential shareholders) will continue to focus on balance sheet repair in the medium term.
In contrast, we are concerned about those European telecom credits that have finished (or nearly finished) de-leveraging and are facing up to shareholder demands for returns and growth. Event risk within these companies is underestimated. For example, BT Group faces pressure from equity holders to boost the share price. Along with accelerating pressure on top-line performance, this could lead management to consider a sizable, one-off share buyback or more likely a large acquisition.
We believe that Royal KPN is facing similar pressures, combined with a large shareholder (the Dutch government retains a 19% stake) which has expressed the desire to sell. A share buyback or acquisition is not out of the question, but we believe it is not reflected in current spreads. Given that management has expressed its comfort with the high triple-B credit ratings, we believe the company has some degree of excess financial flexibility to use, should it choose to do so after S&P’s upgrade to A-.
This leads us to the most glaring example of event risk observed recently: Vodafone. Here is a credit with a great deal of excess financial flexibility, and which is under-levered for its existing ratings. The company also faces strategic and structural challenges in optimising its global mobile portfolio (ie, it does not own all the assets in all the markets that it desires). Finally, until recently, Vodafone credit spreads were pricing in significant financial prudence and stability.
In mid-December, we changed our recommendation on the telecoms sector from overweight to neutral on valuation grounds (single-A status almost fully priced in) and because we expect increased risks relating to M&A, shareholder-friendly policies and regulation/competition.
M&A is our main concern for 2004. We believe that the telecoms sector is reaching a turning point in three respects: the focus is moving away from the balance sheet to earnings growth; cashflow generation is being sustained; and management teams are looking for new strategic directions (becoming utilities, being global, cross-selling services etc).
We believe that M&A is a logical answer, potentially providing top-line growth and/or cost savings. We see the most likely consolidation taking place in mobile, justified by economies of scale, global consumer brands and purchasing power. In its full-year 2003 conference call, TIM, the mobile arm of Telecom Italia, stated that it expected to see industry rationalisation in 2004 and wanted a strong balance sheet to exploit M&A opportunities.
Although most companies are committed to ratings and debt target levels, the lack of available assets may force even the more prudent companies (DT, FT and TI) to enter the M&A race. But only if those relatively unleveraged companies (Telefonica, Swisscom, Vodafone, KPN, TeliaSonera, Telenor) or non-European companies (Hutchison Whampoa, NTT DoCoMo) start a consolidation wave in Europe.
We have identified some sizable independent targets that could be taken over (Amena in Spain, Wind in Italy, Bouygues Telecom in France, Cesky Telecom in the Czech Republic, UMC in Ukraine, MTS in Russia, all or part of mmO2). They would provide footprint enhancement in major countries and contribute to increased scale for European players.
Other event risks for 2004 relate to potential regulatory actions. The European Commission could surprise with a severe conclusion on mobile international roaming tariffs or a call for dominant mobile operators to open their networks to competition. In fixed telephony, closer scrutiny of the process for unbundling the local loop and offering wholesale DSL (digital subscriber lines) could lead to some incumbents resisting competition, possibly forcing them into greater transparency.
Our view is that telecoms remain a growth industry, and as such should be more competitive. The sector also constitutes a foundation for economic and social developments (broadband as a support to business and culture), and in that context is likely to attract the attention of national and supranational bodies.
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