Less than one year after going public Telefonica Deutschland announced the acquisition of its German rival E-Plus from KPN. One year later, after clearance from the EU commission and a highly dilutive rights issue the deal has closed for thirty days now. As a consequence, the competitive German wireless market has been consolidated from four network operators to three. Management expects the deal to bring substantial operating and capital expenditure savings as the combined entity will spread procurement, customer service, network expansion and maintenance costs over a much larger customer base. The clearance of the merger might signal a first step towards more deregulation giving the wireless operators incentives to make larger investments in their network infrastructure. The purpose of this write up is to prepare a valuation for the combined entity.
As announced in one of my last posts, for the portfolio I have established a 3% position in Telefonica Deutschland (TEF) shares for a VWAP of EUR 3.54 on October 16th 2014. I use this price as a reference point for the valuation throughout the analysis.
Overview of the German wireless market and the regulatory environment
The graph below shows the sales trend for the different segments of the German telecommunications industry (click on the picture to enlarge):
Source: Dialog Consult
Revenues of the German wireless market remained stable over the last years at roughly EUR 25 bn (postpaid: EUR 19 bn, prepaid: EUR 6 bn). There are roughly 117 m distributed SIM cards (postpaid+prepaid) which corresponds to a penetration rate of 144%. However, a large portion of prepaid SIM cards is not active.
TEF (incl E-Plus) controls 39% of distributed SIM cards, followed by Deutsche Telekom with 34% and Vodafone with 27%. However, TEF’s market share in the important postpaid segment is much smaller with 32% slightly ahead of Vodafone and far behind Deutsche Telekom with a 37% market share. TEF has a strong position in the consumer client segment, but falls behind Deutsche Telekom and Vodafone in the business client segment. The companies’ respective market shares include mobile virtual network operator (MVNO) related customers. In Germany the largest MVNOs are United Internet and Drillisch, but there is a large number of other players. These wholesalers acquire mobile data and minutes from the network operators at regulated mobile termination rates (MTR, Mobile Terminierungsentgelte). If separated from the three operators MVNOs have a combined market share of roughly 15%.
Although the total number of SIM cards has been stable since 2011, there has been growth in the number of postpaid subscriber contracts. The major reason for that is the rise of the smartphone. The number of smartphones in use increased to 40 m at an annual CAGR growth rate of 47.7% from 2009 until 2013. Smartphones can handle the increasing usage of data. Mobile data usage measured in million gigabyte increased at an annual CAGR growth rate of 68.6% from 2009 to 2013. I expect this trend to continue due to the ongoing smartphone and tablet penetration. Smartphones are relatively expensive. Within a contract customers do not have to pay for a new smartphone upfront and they can sign for a flat-tariff which appears to be cheaper than buying data and voice on a prepaid basis. As a consequence, there is an ongoing prepaid-postpaid substitution in the German market.
Average revenue per user (ARPU) is four times higher for postpaid customers than for prepaid (incl inactive prepaid cards). Nevertheless, the increasing number of postpaid contracts has not let to increasing mobile service revenues for the whole market. To the contrary, between the first quarter of 2012 and the second quarter of 2014, mobile service revenues declined slightly by 3.7% to EUR 4.7 bn. Reasons for that are regulatory price cuts (especially roaming), fast substitution of SMS-messaging through online messages services like WhatsApp and a high degree of price competition among the service providers incl the migration to lower priced bundled tariffs.
From the first quarter of 2012 until the second quarter of 2014 the number of postpaid customers grew at a quarterly cumulative average growth rate (CAGR) of 1.6% from 52.1 m to 60.2 m. However, monthly ARPU declined at a quarterly CAGR of 2.0% from EUR 31.2 to EUR 26.1.
The regulatory impact on the industry plays a major role. In Germany there is the national regulator (Bundesnetzagentur) and on the European level there are the EU regulator and EU antitrust authorities.
National regulators (there are 28 in Europe) have often come to different conclusions how to interpret pan-European legislation/recommendation due to differing goals and most of the time detrimental to the industry’s interests. In addition, so far the EU antitrust commission tried to prevent industry consolidation to protect consumers from price increases.
In July 2014, Germany was the first large EU country where a consolidation from four to three wireless operators was allowed (so far consolidation was also allowed in Austria and Ireland). The question is, whether the approval of the consolidation in Germany marks a turning point in terms of regulation meaning that regulators will allow wireless operators to earn a higher return on capital to be able to finance the required investments in network infrastructure.
So far, the consumer friendly regulation led to declining returns on capital for the operators. Returns might have reached a level where the heavy expenditure for spectrum licenses and new state of the art networks is no longer justifiable from an economic perspective. While regulation has benefited customers in terms of pricing, this might come at the cost of low network quality. The large EU operators are currently focusing their lobbying on the EU falling behind the US in terms of quality of telecom services provided.
Indeed, while telecom revenues have been flat or declining across the big EU telcos, they have been investing little while paying high dividends to their owners. At the same time most operators are carrying high net debt on their balance sheet. I believe that regulators are beginning to consider a less restrictive stance towards the operators, which should give the industry the opportunity to stop the shareholder value destruction which took place over the last years.
First key parameter: number of mobile subscribers
In the market environment described above, TEF increased the number of users from 18.6 m (postpaid 9.5 m, prepaid 9.1 m) in the first quarter of 2012 to 19.6 m (10.6 m, 9.0 m) in the third quarter of 2014 at a quarterly CAGR of 0.6% (1.2%,-0.2%). From Q1 2012 until Q2 2014 TEF’s market share in terms of postpaid customers declined from 18.2% to 17.5%.
E-Plus increased the number of users from 23.1 m (postpaid 7.6 m, prepaid 15.5 m) from the first quarter of 2012 to 25.8 m (8.9 m, 16.9 m) until the second quarter of 2014 at a quarterly CAGR of 1.2% (1.8%,1.0%). During this period the E-Plus market share in terms of postpaid customers increased slightly from 14.6% to 14.7%.
In my scenario, the detailed forecast period runs from Q3 2014 until Q4 2019 (under consideration of the TEF stand-alone numbers for Q3 2014 which were released on November 10th 2014). In this period, I expect the German postpaid market to grow to a client base of 72 m at half the rate the market grew from the beginning of 2012 until mid-2014. This equals a quarterly CAGR of 0.8% (3.3% annualized). Afterwards, contract customer net additions should be much lower. For a country with 81 m inhabitants this appears to be a high penetration rate. However, current smart phone penetration (roughly 50%) is relatively low compared to other countries. In addition, the share of prepaid customers is still relatively high. As a consequence, the shift from prepaid to postpaid should continue for some years. Apart from that, the number of users continuously rises who have access to several SIM cards because they are using different end devices like private phone, business phone and tablet. Moreover, machine to machine (M2M) SIM penetration is growing rapidly. M2M refers to technologies that allow both mobile and wired systems to communicate with other devices of the same ability. Currently, this market segment is estimated to present roughly 6% of all SIM cards in use, and is expected to grow revenues by 17% per annum until 2017. If this scenario plays out, postpaid contracts might increase even more rapidly.
How does this translate to the TEF and E-Plus customer base? On a standalone basis, I assume that both companies will grow their postpaid customer base in line with the market at a quarterly CAGR of +0.8% defending their market share. I expect the number of prepaid clients to decline by 1% per annum mainly due to prepaid-postpaid substitution. However, given that E-Plus and TEF have a relatively large prepaid customer base where they can source postpaid clients from, an above market growth in the postpaid segment might also be a possible scenario.
Regarding E-Plus, KPN started to increase costs at E-Plus in 2013 to regain market share momentum. This extra EUR 350 m of operating expenditure (incl handset subsidies) has led to accelerated growth in net additions of customers in 2013/2014. Going forward I assume that this expansion programme is being stopped as much of this would be duplicative to TEF’s operation, but that it will have a remaining positive impact on E-Plus customers in 2015 (net additions 3.8% postpaid, 1% prepaid).
Second key parameter: average revenue per user (ARPU)
From Q1 2012 to Q3 2014 TEF’s monthly ARPU decreased from EUR 13.5 (EUR 21.4, EUR 5.3) to EUR 12.7 (EUR 19.1, EUR 5.3) at a quarterly CAGR of -0.6% (-1.1%,0.0%).
From Q1 2012 to Q2 2014 the monthly ARPU at E-Plus decreased from EUR 11 (EUR 21, EUR 6) to EUR 10 (EUR 19, EUR 5) at a quarterly CAGR of -1.1% (-1.1%,-2.0%).
I expect 2017 to be an inflection point, when ARPU should increase for the first time after several years of decline.
In 2017, non-SMS over data revenues of TEF and E-Plus should have reached more than 90%. Increase in mobile data usage should continue to more than compensate for the negative effect of falling text messaging use and stagnating voice connections. For the whole industry text messaging revenue declined from EUR 2.7 bn in 2009 to an expected EUR 1.3 bn in 2014. During the same period revenue from mobile internet access increased from EUR 2.8 bn to EUR 8.2 bn. Roughly 45% of data usage is currently routed through the 4G (LTE) network. For TEF and E-Plus this ratio should be lower as they are behind T-Mobile and Vodafone in terms of network expansion. According to TEF, data consumption for an LTE client is three times larger than for a conventional client and ARPU is roughly 30% higher. As a result, with the ongoing network expansion and additions of LTE customers revenues from mobile internet data should continue to grow between 20% and 30% per annum until 2019.
As already mentioned, TEF and E-Plus include mobile virtual network operator (MVNO) related customers in their statistics. These wholesalers acquire mobile data and minutes from network operators (Deutsche Telekom, Vodafone, Telefonica Deutschland and E-Plus) at regulated mobile termination rates (MTR, Mobile Terminierungsentgelte). Regulators have pushed for an increasing cost-based orientation in setting MTRs. The German regulator Bundesnetzagentur has continuously decreased MTRs from 8.80 cents per minute in 2009 to 1.79 cents in 2013.
This explains part of the difference between market ARPUs (EUR 26.1) and ARPUs of TEF (EUR 19.1) and E-Plus (EUR 19), as revenues generated with wholesale accesses are substantially below direct client revenues. Another reason is that premium customers are willing to pay higher prices for access to the D-network (D- Netz) from Deutsche Telekom and Vodafone. 3G coverage of E-Plus and TEFD still lags the big two operators and both competitors are ahead with the building of the LTE network. While this gap might exist for the long term, the merger between TEF and E-Plus will bring the new TEF in a better position to compete in terms of network quality.
There are two major regulatory factors affecting ARPU to look at:
First, MRTs have already been reduced substantially, but the European commission has repeatedly criticised Berlin for the rate mobile operators are allowed to charge rivals to connect calls in Germany, which are among the highest in Europe. So there is a risk that rates will be further reduced below 1.0 cents per minute in November 2014. This would then be at the lower range of the European peer group. Hence, I do not assume that after this reduction there will be large additional cuts in the future.
The second factor is roaming rates. The European Parliament approved a new roaming regulation in June 2012 that set new caps for roaming charges. The last cut took place in July 2014. This means that both the retail price that users pay for making and receiving calls while abroad, and the wholesale rates that network operators charge each other for providing roaming services have decreased since 2011 from 70 cents to 20 cents per MB, from 11 cents to 6 cents per SMS from 35 cents to 19 cents per call out minute and from 11 cents to 5 cents per call in minute. However, despite these reductions these rates are still much higher than average national tariffs compared to relative costs.
In addition to that, in April 2014 the European parliament voted to end roaming fees within the European Union from December 2015. According to the proposed regulation, any service offered by a mobile operator must not cost more when roaming inside the EU than on the mobile operator’s own network (“roam like at home”). However, considerable delays in the process of agreeing the legislation and resistance to a number of its elements can be expected as the proposal implies some severe consequences. For instance, a customer could just switch to a lower-cost operator outside of his home nation and then use his phone to make and receive calls anywhere in Europe, without ever incurring roaming charges. At the same time the operator would not have to invest in any network. Obviously, regulators are aware of these issues and it is unlikely that this scenario becomes reality. Nevertheless, the new rule should tailor a single EU market for mobile services favouring pan-European operators like Telefonica Deutschland which is actually a listed affiliate of Spanish big telco Telefónica. In addition, the decrease in roaming tariffs could be partially made up for by additional usage due to lower prices. Apart from that, thanks to growing global usage of non-EU roaming tariffs, which are not regulated, could also make up for part of the income decrease. However, ultimately it should be expected that Telefonica Deutschland will completely lose a very profitable revenue stream either in 2016 or at a later point in time.
How does this translate to the TEF and E-Plus ARPU? I estimate that postpaid ARPU will decrease by 2% in 2015, will be flat in 2016 and will then increase by 2.5% per annum until 2019 based on the assumption that the increase in data usage and reduced price pressure will gradually outweigh the short term regulatory impact and the migration from SMS/voice usage to data usage. Apart from that, I expect that after the merger the quality of TEF’s network will improve and will come closer to the network quality of Deutsche Telekom and Vodafone, enabling TEF to reduce the premium paid by customers for the D-Netz. In terms of prepaid ARPU I assume that it will decrease at an annual rate of 1% in 2015 and 2016 and will then be stable until 2019 reflecting a lower usage of data services than in the postpaid segment.
Arising uncertainty from the agreement with German MVNO Drillisch
To receive clearance from the European Commission for the acquisition of E-Plus, TEF agreed to sell upfront 20 % of its combined mobile network capacity to Drillisch (measured with mobile data usage) using a Mobile Bitstream Access model, with the opportunity to extend up to an additional 10%.
There is only limited information available about the details of the agreement. It will become effective in January 2015 and will give Drillisch the opportunity to gradually increase capacity used to 20% until 2019. In addition, the agremment provides Drillisch with two extension options for additional five years. Drillisch can take over up to 600 stores from E-Plus and TEF. Drillisch will be the only MVNO having exclusive access to TEF’s LTE network for a 12 month period. As far as I understand, Drillisch will also contribute to the extension of TEF’s network. They will make an upfront payment of EUR 150 m to TEF in 2015.
For a small company like Drillisch with revenues of roughly EUR 300 m this deal provides a great opportunity. However, it also comes with tremendous risk, as they have to pay upfront for the use of capacity and have to substantially increase their cost base to deliver sufficient customers.
What are the consequences of this deal to TEF? As I do not know the purchase conditions for the mobile data under the agreement, it is difficult to come up with an estimate of the effect on the income statement. TEF’s management is eager to emphasise that the conditions were negotiated on commercial terms. In terms of capacity TEF plans to reduce network sites by 14,000 units during the integration of E-Plus. So I assume that there will be enough capacity for TEF’s and Drillisch’s combined expansion plans. Overall, I think it is conservative to assume that network revenues from Drillisch equal expenses. Hence, I expect that the Drillisch contract is neutral on EBITDA and EBIT in the P&L. As a consequence, I ignore the revenue contribution from Drillisch. To be consistent with this approach I do also exclude the EUR 150 m upfront payment from Drillisch to TEF in my scenario.
Apart from the main revenue component mobile services which I described above, I assume that handset revenue after reaching its peak in 2013 is slightly declining due to lower growth rates in net additions to postpaid subscribers and falling prices for smartphones.
TEF is also operating a wireline business offering fixed telephony and internet (narrowband/broadband) accesses to direct clients and wholesalers. In this segment the company has been steadily losing DSL customers. There is growing competition from cable operators due to rising demand for broadband speeds faster than DSL and attractive offers of triple play bundles of TV, Internet and wireline voice. Cable operators also have a competitive advantage as wholesale fibre pricing is deregulated. With fibre pricing deregulated, cable operators can charge high prices from wireless operators to prevent them from entering the market. At the same time, they have access to subsidized mobile phone service which they can include in their offerings to attract new customers.
Apart from that, the resale of TEF’s ULL (Unconditioned Local Loop) is expected to be discontinued in 2017, as resellers are increasingly migrating to other operators. TEF is now in the process of using the fast VDSL network from Deutsche Telekom for resale to its clients. While this might stabilize the company’s client base over the long run, I expect the current trend to continue with revenues declining annually by 5% until 2017 and by 2.5% in 2018 and 2019.
Putting this all together, I come up with the following projection of combined revenues for TEF and E-Plus over a five year detailed planning phase (click on the picture to enlarge):
On February 11th, 2014, the company held an extraordinary meeting to vote on the proposed acquisition of E-Plus. Attached to the report of the executive board was a valuation report of PriceWaterhouseCoopers (PWC report) analysing the merger of the two companies. The assumption made in the PWC report are mostly based on management’s business plan for the next five years. This report is quite helpful, as I can use it as a sanity check and source of information for my analysis. PWC’s revenue estimates are quite similar to the revenue projection presented above.
Projection of merger synergies, expenses and operating lease payments
As a consequence of the E-Plus acquisition, TEF expects to unlock significant value with synergies reaching EUR 800 m pa after a five year integration period. Within the PWC report there is a detailed forecast of the synergies to be generated from the merger between TEF and E-Plus. I am using these assumptions with the exception that the deal will be cash flow accretive only from 2016 on and not 2015 as PWC and the management is projecting:
PWC (and TEF’s management) argues that the net present value (NPV) of synergies is roughly EUR 5.5 bn. However, it is noteworthy that this projection is based on a discount rate (cost of equity) of 6.6%. Hence, the NPV of net savings might be exaggerated. Using a more realistic discount rate (8%) and the same cash flow stream as in the PWC report incl a 0.5% terminal growth rate, the NPV declines to roughly EUR 4.2 bn.
Both companies TEF and E-Plus have substantial operating lease liabilities with regard to the sales network (i.e. shops), antenna sites and network equipment. For my DCF model I am using free-cash-flow-to-the-firm (which is before interest payments). Therefore, I need to add all liabilities to the enterprise value computation incl off-balance sheet items like operating leases. However, as operating lease payments are treated as operating expenses in the income statement, I need to make an adjustment to the income statement. This includes the conversion of the operating lease payments into a depreciation component and an interest component. In other words, I am converting the operating lease liabilities into finance lease liabilities. As a result, I exclude the operating lease payment from operating expenditures (positive effect on EBITDA and EBIT). At the same time I am adding the depreciation component to D&A and the interest component to interest expenses. Hence, EBITDA and EBIT will increase due to the adjustment, while simultaneously the enterprise value incl operating lease liabilities reflects the true picture of the company’s amount of debt.
Regarding operating expenses and depreciation/capex I am taking the lead from the PWC report. I have made adjustments where PWC’s estimates for 2014 differ from the extrapolated second/third quarter 2014 numbers, but these adjustments are minor. Overall a slight decrease of operating expenditures over the detailed planning period is supported by a reduction in personnel/supplies expenses at E-Plus based on the assumption that the company will reduce its large investments in customer acquisitions and a decline in material costs for both companies due to reduced interconnection prices/MTRs and declining prices for smartphones. In terms of capital expenditures, I have adopted PWC’s projection of a gradual increase until the end of the detailed planning period. I am also following PWC’s approach to include payments for upcoming auctions for spectrum in the capex computation of the terminal value. However, it is important to emphasize that they do not include potential savings from future spectrum auctions as bidding tension might be lower as a consequence of the merger between TEF and E-Plus. Savings for the operators might be substantial going forward.
Valuation – DCF approach
Based on the assumptions described above, I have computed the following forecast for a five year period reflecting the integration of E-Plus and a normative estimate for the calculation of the terminal value:
Both companies have substantial tax assets. On a stand-alone basis, PWC assumes that E-Plus will start paying taxes in 2015 gradually increasing to 31.3% until 2017. TEF is expected to pay taxes starting from 2017. For the terminal value calculation they use a 17.3% tax rate. Synergies are assumed to be taxed with 30.6%. I have used the blended tax rate from these three components, although there might be additional tax synergies to be generated.
The following graph presents the drivers of EBITDA from 2014 until 2019:
As a result, this financial scenario leads to a value per share of EUR 4.46. This represents a price-to-value ratio of 0.79x at the time of investment:
For the discount rate, I use the weighted average cost of capital (WACC). At the beginning of 2014, the company issued a seven year bond with an effective interest rate of roughly 2.5%. I add 50 bps and make the assumption that the company’s cost of debt before tax is 3.0%. My estimation of the cost of equity is 8.0% based on a risk free rate of 2.0%, a beta of 1.0 and a market risk premium of 6.0%. In my scenario, I assume that the terminal growth rate is 0.5% slightly lower than long term GDP growth. Below you can find a sensitivity analysis of the price-to-value ratio in relation to the cost of equity component of the WACC and the terminal growth rate:
As mentioned above, for the revenue forecast I assume that net postpaid subscriber growth equals 3.3% per annum during the detailed planning period. At the same time, I expect postpaid ARPU to rise by 2.5% per annum from 2017 until 2019. The following table provides a sensitivity analysis of the price-to-value ratio in relation to annual net postpaid subscriber growth and postpaid ARPU (while keeping expenses stable):
Valuation – peer group analysis
The table below provides some key figures and ratios for companies of the telecommunication industry as of YE 2013:
From my perspective, there are three key takeaways in comparing TEF to its other industry members. First, the market seems not to give any credit for TEF’s relatively low debt level. Second, I believe that the market has yet to ascribe any value to the potential rise in profitability due to the generation of synergies from the E-Plus acquisition. In addition, the current EV/EBITDA multiple is also modest when considering the company’s substantial tax assets, which will lead to a reduced tax rate for a number of years.
In this analysis, I value a business of average quality that is part of an industry which is currently under severe regulatory pressure. While I incorporate substantial net savings from the merger with E-Plus there is still significant potential for value enhancement coming from a more deregulated market in the future which I do not include in my valuation. Apart from that, TEF seems to be a platform for Spanish Telefonica to create a German telecommunications business not only restricted to the wireless segment. For instance, a merger with a cable operator might be an option in some years from now (see the acquisition of Kabel Deutschland by Vodafone).
I use the discounted cash flow approach to model the integration and transformation of the two entities over the next five years. The goal of this exercise is to come up with a conservative appraisal that can stand up most scenarios. While I think that considerable synergies will be achieved, I exclude potential savings from spectrum auctions and assume that the acquisition of E-Plus will be cash flow accretive not until the third year of the merger. I also take a conservative approach on the agreement with Drillisch.
I assume that the company’s cost of capital is 6.3%. The after tax cost of debt component of 2.2% reflects the current low interest environment and more importantly the company’s access to debt capital at more attractive terms than its peer group. An 8% cost of equity component might appear low, but it is still 200 bps above the discount rate PWC used in its valuation of TEF and E-Plus.
After year five I assume little growth at a rate of 0.5% for the calculation of the terminal value. Hence, I make the assumption that TEF will grow at a lower rate than GDP. As a result, I come to the conclusion that TEF’s share price is trading with a discount to its intrinsic value. This absolute perspective is supported by a peer group analysis showing that TEF’s low financial leverage and potential net savings from the E-Plus acquisition have not been reflected in the share price yet.
I used the following sources for my analysis:
- Annual report Telefonica Deutschland
- Annual report KPN
- Prospectus for capital increase financing the acquisition of E-Plus
- PWC valuation of TEF and E-Plus
- IPO prospectus TEF
- Bundesnetzagentur Report 2012/2013
- Bundesnetzagentur Annual Report 2013
- Mobile service users in Germany
- Market report from Dialog Consult
- Market report from smartweb
- Development of machine-to-machine segment (M2M)
- EU regulation documents
- German telecommunication law
- WSJ: EU approves E-Plus takeover
- TEF: EU lagging the US in terms of infrastructure
- WSJ: Interview with Deutsche Telekom CEO
- Deloitte paper on consequences of roaming regulation for operators
- The risk from carrier agnostic SIMs
- Sell side study about Drillisch
- Development of MTRs
- Comparison of European MTRs
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!