KKPNY - Koninklijke KPN: A Quality Defensive Play

2023-07-27 03:32:41 ET

Summary

• KPN, a leading telecommunications and IT provider in the Netherlands, is our favorite idea in the telecommunication space.
• We are constructive on KPN's structural outlook due to its quality fixed digital infrastructure and competitive dynamics.
• We recommend building a long position on KPN shares and see 20%+ upside.

We present our thesis on Koninklijke KPN (KKPNF), a leading telecommunications and IT provider in the Netherlands. KPN provides fixed and mobile networks for telephony, broadband, and television, to both consumer and business customers. Our thesis on KPN revolves around its high-quality digital infrastructure, sound market fundamentals, its long-term growth, and its upcoming cash flow generation inflexion. In addition, we like the speculative appeal of KPN as it has been the subject of several takeover bids. Moreover, we believe KPN could be attractive for investors looking for steady, growing dividends and defensive sector exposure. In this note, we will provide a brief overview of the business, analyse key issues and drivers, and assess implications for investors.

Overview

KPN is a 100% Dutch pure play with a unique and strong network and high customer satisfaction. The company is headquartered in Amsterdam and listed in Euronext Amsterdam. It currently has a market capitalization of €13.3 billion. KPN consists of 4 divisions: Consumer, Business, Wholesale, and Network, Operations and IT, which respectively make up 53%, 34%, 13%, and 1% of FY 2022 revenue.

The Netherlands has a stable mobile telecommunications market with 3 main players: T-Mobile (#1, owned by Apax Partners and Warburg Pincus), KPN (#2), and VodafoneZiggo (#3, owned by Vodafone and Liberty Global 50/50). Mobile Virtual Network Operators (MVNOs) have approximately 20% market share. The Dutch competitive landscape is unique in Europe given the presence of 3 rather than 4 major players, which tends to be the norm. Mobile companies in the Netherlands enjoy a good degree of inflation protection, as they can implement tariff hikes without customers having the right to opt out of contracts.

The fixed market is almost duopolistic, with KPN (fibre and DSL) and VodafoneZiggo (cable) having a combined market share of over 85%. Both KPN and VodafoneZiggo own their infrastructure. KPN also wholesales its infrastructure, while VodafoneZiggo does not use an open access model.

Revenue Trends Inflexion And Cost Leadership

KPN faced low single-digit revenue declines for several years. The trend was reversed in 2020, and we believe the company is set for revenue growth of around 1% CAGR, due to price hikes in the consumer segment, good performance in the wholesale segment in part driven by fibre rollout, and supportive trends in the business segment.

Despite revenue pressures in the past, KPN has steadily managed to increase profitability thanks to cost base management. The company is well-known in the telco sector as an efficient operator with a prudent cost discipline, carrying out several cost cutting initiatives. KPN has high natural employee attrition of 500+ employees per year and has managed to significantly reduce its full-time employees number over the years. On its Capital Markets Day, KPN announced its target of reducing €250 million of adjusted net indirect operational expenses until 2023, a goal which may take slightly longer.

Fibre Deployment

KPN aims to cover 80% of the Netherlands with fibre by 2026, through a 50/50 Joint Venture with APG. The rollout of fibre will allow for upselling, drive average revenue per user (ARPU) higher, and reduce customer churn. However, this requires significant investments in the tune of €350-400 million of capex per year until 2026. We see little risk of overbuild as VodafoneZiggo has no plans to move from copper and is focused on its cable network which will be upgraded to the latest standard, and T-Mobile wholesales the fixed network from KPN. There are a couple of smaller alternative fixed infrastructure operators such as Open Dutch Fibre and Delta Fibre that are deploying a small footprint that could be sold to T-Mobile or KPN, in places where the latter will not be deploying. Building fibre is expensive. It has an average cost per household of around €800 and requires significant upfront investment. We believe this deters PE-owned competitors with more levered balance sheets from taking an aggressive competitive approach to fibre deployment. Moreover, we would like to point out the stable regulatory regime in the fixed market until 2030. KPN has pricing freedom for more than 85% of its fibre lines for the next 8 years.

We are very constructive on KPN’s structural outlook in the fixed market. As the FTTH rollout investment finishes, the capex to sales ratio which is in the mid to high teens should decline significantly and free cash flow generation as well as capital returns will increase, allowing shareholders to reap the benefits of the current phase.

Takeover Speculations

Over the last decade, KPN has been the target of many takeover bids. America Movil made a hostile bid offering ca. €7 billion for the company in 2013. The offer was rejected, due to the intervention of the KPN Foundation, and now America Movil has a 20% stake in KPN. KPN received two takeover bids in 2020, from EQT & Stonepeak and from KKR respectively. Both bids were rejected. KPN makes for a compelling leveraged buyout target as it is positioned in a robust market, has scope for growth, is medium-sized, and can be levered up to deliver attractive equity returns for private equity sponsors. Our view is that another bid is currently unlikely given rough financing conditions for sponsors, especially for deals this size. However, as interest rates decline and deal economics start to look attractive once again, we would not be surprised to see other bids emerge. It is important to note the complexities of the Dutch takeover law , especially involving foundations.

Valuation

We value KPN using an EV/EBITDA multiples approach which is common in the industry. Assuming 1% Sales growth in 2023, and 2% Sales growth in 2024, driven by factors mentioned previously in the note, we forecast €5.5 billion of revenue in FY 2024. We assume no margin expansion or contraction in FY 2023 and FY 2024, hence an EBITDA margin of 47% i.e., €2.6 billion of EBITDA. We would like to note that this margin assumption leans on the conservative side. We value the company at 9x forward EBITDA, half a turn to one turn higher than the sector median due to its earnings quality, arriving at an Enterprise Value of €23.4 billion, and an equity value of €17.7 billion. This implies 33% upside or a target price of €4.4 per share. Alternatively, we use an FCF yield approach. Forecasting €1.1 billion of FCF in FY 2024, and applying a target FCF yield of 5% we arrive at a share price of €4 per share, implying 22% upside. A blended valuation gives a share price of €4.2 or $4.7 / share.

Risks

Risks include but are not limited to higher than expected capex in the FTTH rollout and lower free cash flow generation, unfavourable changes in the Dutch regulatory framework, deteriorating macroeconomic conditions and weaker C2C & B2C trends, tougher than expected competitive landscape leading to a decline in market share and profitability, etc.

Conclusion

Given the strong fundamentals and appealing valuation, we recommend building a long position on KPN shares. It remains our favourite name in the European telco space.

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