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AT&T Inc. (T), Telefonica S.A. (ADR) (TEF): Hunting for Acquisitions in the European Telecom Market

Recently, there has been much speculation running around the market as AT&T Inc. (NYSE:T) snoops around in Europe. The company’s Chief Executive, Randall Stephenson, has been flying in and out of Europe talking to governments, regulators and CEOs for the past few months in a bid to get a feel for the market and the opportunities that AT&T Inc. (NYSE:T) may or may not have available to it.

AT&T Inc.

However, Europe is not the best place to do business right now. The continent is buckling under pressure from an ongoing recession/depression, forcing consumers to cut expenditure, and regulators are cracking down hard on excess fees and anti-competitive practices.

That said, it is not all bad news. Smartphone penetration in Europe is growing and with it the need for super-fast networks such as LTE and 4G – two areas where AT&T Inc. (NYSE:T) has a wealth of experience. Furthermore, there are still some signs of growth on the continent, for example, the telecom markets in Switzerland, Germany, the Netherlands, Sweden and the UK all remain robust. Additionally, no single telecom company is overweight in one country.

Unfortunately, even though some markets remain robust, increasing competition, regulation and price wars are taking their toll on telecom company revenues throughout the continent. Having said that, companies are not standing idle; indeed, telecom companies throughout Europe are slashing costs and dividends in an attempt to restore investors’ faith in the stocks.

This is not a short-term play, and investors who got in too soon have not been rewarded. Telefonica S.A. (ADR) (NYSE:TEF), one of Europe’s largest telecom companies, has seen its share price fall 52% in the last two years alone, and Deutsche Telekom, with operations in the relatively stable markets of the UK and Germany, has seen its stock price fall 22% in two years.

Do any companies look appealing?

There are opportunities in the market. Carlos Slim, until very recently the richest man in the world, made his first tentative steps into the European telecom market earlier this year when he acquired stakes in KPN in the Netherlands and Telekom Austria. Although both stakes have recently fallen, Slim knows what he is doing, and the longer term outlook is actually positive.

One of the best opportunities, it would appear, is in France through France Telecom SA (ADR) (NYSE:FTE), a company that has been hit hard with a double whammy of bad news recently: first the deteriorating European telecom sector and second bribery allegations against its CEO.

That said, fundamentally France Telecom SA (ADR) (NYSE:FTE) is not as distressed as it would appear. The company currently offers a 10.5% dividend yield that is well covered with cash flow:

Metric Dec 2012
Total cash from operations E10,016
Cash required for investing -E4,710
Cash available for financing E5,306
Dividends paid E3,632
Cover 1.5

Figures in euro millions

France Telecom did post a loss during the second half of last year but this was down to higher SG&A and unusual costs, which totaled E1.6 billion as the company re-structured and cut costs. Apart from this loss, the company appears to be in robust financial health; it has an E8 billion cash position, and a net debt position of E30 billion – a debt to equity level of 1.25. (A lower amount of receivables at the end of 2012 lowered the value of the company’s assets; without this adjustment debt would be 1x equity, a relatively low level for the sector.)

The other company that looks appealing is previously discussed Telefonica S.A. (ADR) (NYSE:TEF). Telefonica’s main market is within Spain, which has the highest level of smartphone penetration in Europe, higher than the UK with over 60% of the Spanish population using smartphones, indicating a strong market for data fees.

Overall, Telefonica S.A. (ADR) (NYSE:TEF) is in a good position and, unlike many telecom companies in Europe, is still profitable. During 2012, the company had a net income of E5.6 billion and EPS of 87 cents per share, after extraordinary items.

Telefonica S.A. (ADR) (NYSE:TEF)’s position as one of the only profitable telecoms companies in mainland Europe, as well as being the largest by market capitalization, is the reason for increasing speculation that the company will become prey to AT&T Inc. (NYSE:T), but how much would this takeover cost and how much would investors benefit?

Unfortunately, Telefonica S.A. (ADR) (NYSE:TEF) is burdened with debt, nearly three times EBITDA but this could make a deal easier for AT&T Inc. (NYSE:T). AT&T Inc. (NYSE:T) could offer Telefonica’s investors a 40% premium over its current share price, but the value of debt would mean that AT&T would only have to pay a premium of 20% for the company, or about $155 billion. If AT&T proposed a 50/50 cash share merger, AT&T would only have to raise $43 billion in new debt, taking its net debt to EBITDA ratio to 3.6x only slight higher than Telefonica’s current ratio.

Of course, AT&T could acquire France Telecom. At one third the size of Telefonica, France Telecom would be a cheaper target, although France is becoming an increasingly hard market to do business in and smartphone data usage is not as high as Spain.

Foolish summary

Overall, there are opportunities in the European telecom market, but the risks are high. AT&T may be looking in the wrong region for acquisitions, as although companies currently appear cheap, regulation is increasing and the consumer environment is hostile. That said, Telefonica and France Telecom both offer an opportunity for investors who are willing to take on a little risk.

The article Hunting for Acquisitions in the European Telecom Market originally appeared on Fool.com and is written by Rupert Hargreaves .

Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool recommends France Telecom (ADR). The Motley Fool owns shares of France Telecom (ADR). Rupert is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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