DTEGY - Deutsche Telekom: Perfect Opportunity To Ride Out Economic Storm

Summary

• Deutsche Telecom posted strong Q2 results in a volatile economic environment.
• Deutsche Telecom has a good dividend policy that will grow over time as the company grows its EPS.
• The company has been actively managing inflation headwinds and operates in a recession-resistant industry.
• Valuation model shows that the stock is vastly undervalued by the market.

Thesis

We recommend investors buy Deutsche Telekom AG ( DTEGY ) for its strong financials and dividend growth opportunities. The company has had an outstanding Q2 on the back of strong growth in T-Mobile US (TMUS), and has raised guidance for this year. In addition, the company provides good yields and has a dividend policy that will likely grow over time. We believe that the stock is perfect for investors who would like a defensive stock to provide stable income and growth in their portfolio.

Company Overview

Deutsche Telekom AG is a German telecommunications conglomerate, with 248 million mobile subscribers around the globe. The company provides fixed-network/broadband services, mobile communications services, Internet services, IPTV products, and more. In addition, Deutsche Telekom has a large stake in T-Mobile US, and as of this writing, owns nearly half of T-Mobile. Year-to-date, Deutsche Telekom has had a positive return of 2.63%, which far outperformed the MSCI Germany ETF ( EWG )'s return of -33.37% in the same time frame.

Strong All-Around Growth

Deutsche Telekom AG's 2Q 2022 results were all-around strong, with solid financial and subscriber growth year-over-year. The company reported an organic revenue growth of 6.2% for T-Mobile US as well as huge postpaid net additions. For the non-US division, results were still solid, with 1.8% YoY growth in service revenues and a higher FCF generation. We believe that the 1.8% YoY growth is great given the economic circumstances in Europe, driven by high inflation and economic pressures from higher interest rates. In Germany, the company reported an EBITDA margin of ~40%, which is an industry leading margin. Combining all regions, the company has seen an aggregate revenue growth of 5.9% YoY this quarter. Furthermore, T-Mobile U.S. has been a bright spot for the business, as the company continued to grow and take market share from competitors. Management reported that the previous Q2 was the best ever quarter of account additions for postpaid subscribers in Q2, and that the churn rate is one of the lowest in the industry at 0.8%. We believe that strong growth in the U.S. and the solid financial performance in Europe show the company's financial resiliency.

Inflation Protection

As a telecommunications company, Deutsche Telekom AG can provide ample protection against the inflationary environment. Management has been proactive in anticipating inflationary cost pressures and preparing for any impact on the bottom line. Some key takeaways for investors are that there are hedges to offset any rise in energy costs (important for investors given the energy crisis in Europe) and that the majority of the debt are fixed-rate instruments, with long-term tenor. The fact that 100% of its U.S. debt is fixed and that the average tenor is 10 years give us confidence on the limited impact of interest rate hikes in the near future. In addition, the telecom industry tends to fare relatively well during inflationary periods due to its pricing power and fixed cost structures.

Dividend Growth Opportunity

Currently, the company pays out $0.17 in quarterly dividend per share, which presents a dividend yield of 3.69% at current price levels. The yield is more than twice the S&P 500 yield of 1.69%. Management also projects that the dividend payouts will increase over the next few years, as the company projects a payout ratio between 40% to 60% on a guided EPS of >1.75 euros per share in 2024. Based on management's estimates, that means that within the next couple of years, the company will pay around ~0.7 to 1.05 euros per share. Compared to the 0.64 euros per share paid out in fiscal year 2021, the guidance projects a 9% to 64% dividend growth in the span of a few years. Taking the midpoint of this estimation range, we see Deutsche Telekom paying 0.875 euros per share which translates to roughly ~$0.87 per share, representing a two-year CAGR of ~13.1%. This is solid dividend growth that investors can reasonably expect in the short-term.

Valuation

We used the Gordon Growth Model to value the stock based on its dividend and future dividend growth rate. We use the annualized dividend of $0.68 and assume an annualized dividend growth of 3.5%, which is far below the 13.1% dividend CAGR expected in the next couple of years. We used 3.5% annual growth based on the assumption that the company will perform in line with or slightly better than medium-term inflation expectations, as benchmarked by the 10-year and 30-year treasury yields which are trading between 3.0% to 3.5%. We then used a required rate of return of 6.20% by using a telecommunications industry discount rate from a cost of capital study . Based on these assumptions, we see that the stock should be valued at $26.07 per share, which presents a 38.5% upside from current levels.

Risk to Thesis

The main risk to the thesis is the failed execution of the T-Mobile US business strategy. Deutsche Telecom has invested heavily in T-Mobile US to provide additional levers of growth outside Europe. The company plans on becoming a majority owner of the business, and management has stated the strategic importance of the success of the T-Mobile acquisition. Already, T-Mobile's U.S. business amounts to more than two-third s of Deutsche Telekom's net revenue. Nevertheless, we believe the U.S. fundamentals should provide enough support to help grow T-Mobile. First and foremost, the U.S. economy is still very strong and the unemployment rate is still at historical lows. Second, T-Mobile continues to post better results than AT&T (T) and Verizon (VZ) in net subscriber adds, adding 1.7 million subscribers over AT&T's 1.06 million and Verizon's 12,000 net additions. Lastly, T-Mobile operates in an industry that is less cyclical than most other industries. According to a McKinsey study , telecommunications bill payments were paid in full at the highest rate, coming in higher than even rent and mortgage payments. We believe that these factors make us confident that T-Mobile's business operations will continue to do well and provide ample free cash flow to Deutsche Telekom.

Conclusion

We believe Deutsche Telekom AG is a great telecommunications stock for investors who are looking for regional diversification as well as dividend income and capital appreciation opportunity. The company has had solid results in both the U.S. and Europe, and has a clear plan to raise EPS and dividends over the next few years. Based on our valuation model, we believe the stock is vastly undervalued, and we recommend investors to buy the stock for dividend income growth.

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