DTEGY - Deutsche Telekom: Valuation Matters Smashes Q1 2023

2023-05-20 22:53:23 ET

Summary

• I still have a considerable position in Deutsche Telekom, one of my communication stocks that has performed very well.
• However, the time has come to revisit the thesis and consider what sort of upside still remains in Deutsche Telekom. As an example, I sold 60% of my stake.
• I sold at a high of €21-22 on average, and I am looking to see how high things can go before I trim the rest to redeploy the capital.

Author's Note: This article was published on iREIT on Alpha in May of 2022.

Dear readers/followers

Deutsche Telekom ( OTCQX:DTEGY ) (DTEGF) has been a good investment for me. I have outperformed the market, and been able to earn a respectable yield and safety by investing in one of the largest telecommunication businesses around. Some investors would tell you that the company is actually still worth investing in here at this point.

While I see a potential upside if growth rates remain good, I also see the potential for a valuation decline if historical patterns keep up. Furthermore, with relatively high uncertainty on the forecast side, and one of the highest leverages in the telecommunications industry, I do see Deutsche Telekom as coming into a more "fair valued" position at this time.

In this article, I will justify to you why that is.

Deutsche Telekom - Updating the thesis

When I last clarified my thesis on Deutsche Telekom stock, we were back in June of 2022. That makes it almost a year old at this point. Of course, since that particular time, the company has outperformed not only other telco stocks, but it has handily outperformed the S&P500 as well, confirming my long-term appeal in this business.

Some of you might say that I'm "leaving" too early. I say to you that the fundamentals and the future are changed enough to where I see better alternatives out there, and while I trim some, I'm not leaving it all behind here.

To put it simply, Deutsche Telekom at these valuations, or at the valuations where I sold the stock, went from a double-digit conservative upside to a single-digit conservative upside - but more on that in valuation.

DT is a tale of two worlds - and this makes it appealing.

It's the European operations, which for the time being, are the ones responsible for rewarding shareholders with dividends, and which depend on many legacy markets with superb market positioning.

But it's also the US segment, which is characterized by more of a "growth" story with the expectation for an eventual dividend that, of course, will flow to DTEGY as well.

At least, this makes it attractive as long as growth and fundamentals continue on point. And for the time being, even with the latest quarter in the bag, this seems to be somewhat the case. On a GM and RoE basis, the company remains an above-average-telco with good profitability. In other profit KPIs, it's somewhat average or below average. What I want to draw your attention to though in this article because it's relevant due to interest rates, is debt. The company is one of the higher-leveraged telcos out there, with a cash-to-debt of 0.04x, debt-to-equity of 3.04%, and an LT debt/cap of over 62%. Interest coverage is no more than 1.67x. Even for a Telco, which can handle higher amounts of leverage, I consider this to be high. And this is reflected by a BBB rating, which typically for larger telcos would be higher.

Local margins are good - Germany remains at that 40%, which is just like Orange ( ORAN ) in its relative home markets. The key difference between Deutsche Telekom and other more local and international telcos is that DTEGY is actually a bit of a growth story, as opposed to a zero-growth story like most telcos are, and this remains part of the focus here.

The story for T-Mobile is still part of the thesis - by which I mean that once TMUS starts paying its dividend, we're likely looking at 5%. The problem is, I don't have an issue finding a higher-rated telco dividend at that level or above elsewhere - and at a better valuation than this one.

Comparative margins for Deutsche Telekom are a mixed bag. In some and metrics, the company's margins are superb - like net and Gross - but in some, they're below average, such as an operating margin of around 8.5%. This means the company has both efficiencies and inefficiencies to consider, but on a high level, we can agree that the company's profitability over time has actually markedly improved.

The company's heaviest issues from a margin/operational perspective lie in the relatively high amount of OpEx, which is why we get such a below-average Operating income margin. Anyway, we have 1Q23, so let's look at that.

Remember, I am an active manager of my investments. This means I both add and trim stakes - I don't hold forever, and I often measure my potential returns in one investment on a conservative basis relative to the conservative potential in another investment.

I fully expected DTEGY to outperform 1Q, and they did. For a telco, organic growth of 2.6% for a company this size is nothing to really ignore or explain away, and the adjusted EBITDA increases of almost 4.5% are excellent as well. With TMUSA raising guidance, the DTEGY "sphere" is doing very well, and DTEGY now has a majority stake in the US arm, at 50.2%, achieved in March of 2023.

The company also recently closed on its tower deal, receiving over €10B worth of cash, and reducing company leverage down below 3x.

This is excellent.

Take a look at the organics for the quarter.

This mix and this appeal are really second to very few telcos out there. The only sub-par variables we can mention at this point, aside from pointing out that the valuation is no longer dirt-cheap, is that the company's yield is still significantly lower than on-sale telcos out there.

However, quality matters - and DT is definitely quality.

The company is pushing the envelope both on the Network side, a leader in 5G in most of its markets, and customers are mostly growing - some churn on the US postpaid, but growth in broadband adds. The company also moved forward and notched up its climate/ESG ambitions - but you all know, if you know my work, that I put this fairly low on the priority list when looking at a company.

The company even ratcheted up its guidance somewhat, now expecting nearly €41B in adjusted EBITDA, and slight improvements across the board with EPS down (but up on net of non-recurring).

Much of the positive stance I held on Deutsche Telekom at this time is starting to materialize. Several things I forecasted have come to pass, and the resulting gains in share price mean following me has had the potential to outperform the market by a fair amount here.

With reduced churn and the 21st consecutive quarter of EU organic EBITDA growth, the risks or concerns to Deutsche Telekom should be considered to be extremely limited in scope. Net debt excluding leases is now down below €100B, which marks the first time in some time that it has managed this - and as a comparison, the company's leverage was at 3.07x at the end of 2022 - so Deutsche is progressing rapidly in carving away at its mountain of debt (that most telcos do have).

1Q23 was an excellent start to a good year. I've been in contact with DT IR, and the breach above €20/share was a big deal both on the corporate side and on the investor side. It proved that things are moving the right way.

In fact, at one point it went so well that the company reached my first "trim" level once it broached €22.2/share back in April. I sold a small amount of my large, 4.2% stake at the time, and I'm hoping to reinvest once things cool off a bit. With the journey we've seen from €17.5 back in September to over €22/around €21 native here, the company has been on an absolute run.

Let's look at what valuation dictates us doing from here on out.

Deutsche Telekom Valuation - lower upside, but still good

So, the reason I sold at €22.5/share is very simple (and by selling, I mean trimming around 1%). At that point, my conservatively adjusted upside on a 2025-2027E basis fell below 10% per year, even including a normalized, conservative dividend.

When this happens, I act for the sake of capital diversification, and preservation, and in this case, because the market offered substantial discounts in finance, real estate, and other companies. Had those discounts and the market not been in turmoil, I probably would have let my full position "ride".

So does this mean you need to sell Deutsche Telekom?

No, I would say that would be a bit of an exaggeration.

What I will say, however , is that Deutsche Telekom has gone from being significantly undervalued relative to its earnings potential and the expected returns we as investors could realistically calculate, to being "average" in terms of upside.

2023E is, as clarified above, expected to be a year that's negative for EPS. IFRS doesn't take into account the non-recurring nature of portions of its earnings. So, Deutsche Telekom is likely, as I see it, to see some near-term pressure due to the YoY nature of its earnings. Beyond 2024-2025, I see EPS growth potential in the high single digits and, if the company continues to outperform, low double digits as some of the puzzle pieces with TMUSA fall into place.

However, this dictates a barely double-digit rate of RoR even at €21.66/share. One look at the FactSet/F.A.S.T graphs forecasts here...

And please bear in mind that these forecasts are more positive than my own. Adjusted for my forecasts, we're looking at an annualized RoR of around 9.87% here. Again, this is still market-beating and in no way bad - but it's also not close to any of the superb potential we have in other communications stocks or other sectors out there today.

Many investors are comfortable letting their winners "breathe" or "ride". Provided I see further upside, I don't have an issue with this. That is why I only trimmed 1% at the onset of this climb to €22/share. However, I do think it important to point out that there are a number of factors that could , if you were minded in such a way, point to the company starting to become overvalued here.

These include:

• A relatively high, 62%+ Lt/debt Cap
• Close to a 5-year P/E premium
• An imperfect, 25% negative miss forecast accuracy ratio (Source: FactSet)
• The low growth rates are characteristic of Telcos.

As investors, as with anyone, with can never rest on our laurels. DT was a great investment - and may still be. But as anyone who has been any sort of manager in any organization will tell you - when everyone is happy and everything is going swimmingly, and your department heads are not reporting any issues whatsoever, that's the time to be on your game.

So as companies become better - I become more alert.

As I am now. Simple DCFs that account for a sector-relevant growth rate of 2-4% put the company at a long-term current FV of €24-€25/share. Accounted for sector-specific valuation pressures which are not part of such a model, anything above €21-23/share for this company is starting to be a price where the real upside is lower than it once was.

I think this is a good time to point out what sort of returns you may be sitting on with DTEGY, if you followed my stance.

Specifically, I wrote the following:

So, a few things.

I believe, at that point, that DTE will rise significantly in valuation.

I also believe that DTE is probably the most qualitative Telco in Europe at this time. Note that I did not say cheapest. I believe that to be Orange, and as you know, I'm deeply invested in Orange.

(Source: Deutsche Telekom Article )

This brings me to my updated thesis for Deutsche Telekom, which currently is as follows.

Thesis

• Deutsche Telekom is one of the more qualitative and price/mix-appealing telco businesses on earth. While it does have somewhat higher leverage and lower credit rating and yield than some of its peers, it makes up for this with a potential longer-term upside and growth that is outside the 1-2% norm found in the sector.
• I believe Deutsche Telekom can be bought with ease and as a "STRONG BUY" at anything involving a €1X native share price.
• When the native share price reaches above €21/share, things look somewhat different. It's still a "BUY", and I put the PT around €24.5/share, but at over €21/share, your returns are looking likely to include single-digit RoR.
• I'm still at a "BUY" for the company, but I'm more careful here, and I have trimmed.

Remember, I'm all about : 1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them ( italicized ).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

Deutsche Telekom is no longer cheap - but it's decent enough with a good upside, and I maintain my "BUY" here.

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