TEF - Telecom Italia: There Is Better Value Elsewhere

2023-05-12 04:44:39 ET

Summary

• Telecom Italia is a telecoms company with exposure to Italy and Brazil.
• Its operating performance has been weak in recent years and has high balance sheet leverage.
• Despite its weaker fundamentals compared to peers, its valuation is not cheap enough.

Telecom Italia ( OTCPK:TIIAY ) has weak fundamentals and needs to reduce debt, while its current discount to peers is not compelling enough to consider its shares.

Company Overview

Telecom Italia is a telecommunications company, being the incumbent operator in Italy and is the market leader in the country. Beyond its domestic market, Telecom Italia also has significant operations in Brazil, both in mobile and fixed-line. Its main shareholders are Vivendi ( OTCPK:VIVHY ) and the Italian state through Cassa di Depositi e Prestiti, with stakes of 23.75% and 9.8%, respectively. Given this shareholder structure, Telecom Italia is not likely to be a takeover target, as the company is perceived as a ‘strategic’ company in Italy. Its current market value is about $6.4 billion and trades in the U.S. on the over-the-counter market.

Its main competitive advantage is its strong position in the Italian telecoms market, holding a market share of about 42% in broadband and some 29% in mobile. This is a position that is not easy to challenge, as barriers to entry in the telecoms market are significant, even though competition in the market is fierce from other players, such as Vodafone ( VOD ) or Wind Tre. In Brazil, it’s the third largest mobile operator through TIM Brazil with a market share of about 20%, while the market leader is Vivo, which is owned by Telefonica ( TEF ).

During 2022, some 75% of its revenues were generated in its domestic market, while the rest was related to its Brazilian operations, a business profile that is not expected to change much in the near future. Due to higher profitability in the Brazilian market, some two thirds of its earnings are generated in Italy, with one third being generated in Brazil.

Restructuring Strategy

Telecom Italia has plans to reorganize its business and reduce complexity, while also monetizing its network assets. This strategy has been followed by other companies in the telecoms industry, allowing to reduce debt and monetize infrastructure assets, being a potential deal to unlock value in the group.

Telecom Italia’s plan is to explore the separation of its assets between a wholesale network company, and a retail service company, plus the merger with Open Fiber, an Italian telecoms company established in 2015 to build an independent fibre-based access network. This company is held by Macquarie and Cassa di Deposit e Prestiti, thus there is indirect government intervention in the management of this company.

While Telecom Italia and Open Fibre signed a memorandum of understanding in May 2022, and were supposed to sign a binding agreement until the end of 2022, they still have failed to reach a final agreement. According to some reports, Telecom Italia’s largest shareholder Vivendi is seeking a valuation of about €30 billion for the networks business, while CDP’s valuation is closer to €20 billion. Moreover, more recently KKR also made a bid for the phone monopoly’s grid, further complicating the matter.

Another issue is the capital structure of the wholesale company and the retail service company, as net debt which is now at Telecom Italia’s group would move to the new entity. According to initial plans, the wholesale company could have some €11 billion in net debt, while the retail company holding more than €5 billion, but this remains a key issue in discussions and a factor that could put the restructuring plan in jeopardy.

This plan is an important step for Telecom Italia to reduce its debt levels, which were about 4.7x net debt-to-EBITDA at the end of 2022, a much higher level than compared to its closest peers. Indeed, most European telecom companies have leverage ratios below 3x, showing that Telecom Italia’s debt position is quite excessive and clearly needs to be reduced, being a key factor why its credit rating is also lower than compared to its closest peers.

This makes Telecom Italia’s business profile somewhat riskier than other telecom companies, and the failure to execute on its deleveraging plan is also negative for its investment case, which is not unusual among Italian companies as the state intervention in corporate decisions usually leads to roadblocks that aren’t easy to change. This means that Telecom Italia’s delayering plan may not go ahead, as the company has recently said that it remains open to discussions with the Italian government and will continue to evaluate all strategic options, aiming to doing away with vertical integration and reducing debt at the group level.

Financial Performance

Regarding its financial performance, Telecom Italia has delivered relatively muted operating trends over the past few years, given that revenue and earnings have declined over the past five years, and Telecom Italia’s bottom-line has been volatile during this period, as shown in the next graph. This is justified by the company’s high operating leverage, fierce competition in its two markets, and high financial leverage.

In 2022 , the company’s operating momentum was not particularly impressive given that revenues and earnings continued a downward trend on an organic basis. However, due to the acquisition of Oi’s mobile assets in Brazil for about €1.3 billion during 2022, its reported revenues amounted to nearly €15.8 billion (+3.1% YoY), and EBITDA was up by 5.3% YoY to more than €5.3 billion.

On the other hand, on an organic basis, Telecom Italia’s revenue declined by 0.3% YoY and its EBITDA was down by 6.7% compared to the previous year, with this weak performance being mainly justified by the company’s domestic operations, while Brazil reported strong growth figures which were not enough to offset weakness in Italy. Its reported net loss for the year amounted to more than €2.6 billion, of which about €1.9 billion is justified by the write-off of deferred tax assets during the past year.

In the first quarter of 2023 , its operating performance improved slightly, with good performance in Brazil boosting the group’s results, while its domestic operations maintains a more challenging operating trend. Its quarterly revenues amounted to €3.8 billion (+4.3% YoY), even though service revenue in Italy declined 2.4% YoY to about €2.5 billion. Its EBITDA was €1.45 billion, an increase of 3.8% YoY, but its net loss in the period was €262 million. Its free cash flow in the quarter was negative by some 397 million and net debt (after leases) increased to €20.4 billion.

The company also updated its delayering plan, saying that it’s its main target for debt reduction, even though pricing is still one of the main hurdles to reach an agreement. Under the current timeline, Telecom Italia is still waiting for an improved offer from one of the bidders until next month (KKR or CDP), even though there is no guarantee and improved offer will be made.

This remains the company’s best option to reduce significantly its debt pile, one of its key fundamental issues. Indeed, at the end of last March, its net debt-to-EBITDA ratio was close to 5x (excluding leases), or about 3.4x with net debt adjusted for leases. This is a leverage position that is higher than compared to other European telecom companies, being a major reason why Telecom Italia trades at a discount to its closest peers.

Investors should note that Telecom Italia’s strategy plan for 2023-25 expects free cash flow to be slightly positive, which means that organically the company is not likely to reduce much its financial leverage, thus the sale of its landline network is the most viable option to cut debt in a meaningful way.

Regarding its liquidity, Telecom Italia returned to the debt market last January after a two-year hiatus and at the end of last quarter had more than €8 billion in cash, which is enough to cover its debt maturities until the end of 2024.

Therefore, there aren’t any prospects of liquidity issues in the short term, but Telecom Italia’s large debt pile is a major issue that needs to be fixed. Given this leveraged balance sheet, it’s no surprise that Telecom Italia currently does not pay dividends, even though according to analysts’ estimates , there is some potential of a dividend related to 2024 earnings. I think this may be too optimistic and is only possible if Telecom Italia reaches a deal to sell its landline network, something that is taking longer to execute than was expected some months ago.

Conclusion

Telecom Italia is a company with many fundamental issues, of which its high leverage is the weakest factor. The company acknowledges that it needs to reduce debt and has a plan to achieve it, but political interference in Italy is significant and a deal has been delayed in recent months. Not surprisingly, Telecom Italia is currently trading at cheap multiples, at some 6x EV/EBITDA, but the discount to its closest peers is not big enough (sector average 6.5x) in my opinion and there are better options in the sector, such as Vodafone or Orange ( ORAN ), as I’ve covered in previous articles here and here .

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