European telecoms set to regain ground

European telecom stocks, one of the laggards in the market rally, deserve investors' favour for their attractive dividends and strong growth opportunities in emerging markets.

Companies in the sector, once dogged by heavy debt, have cut costs, produce substantial free cash flow and give much of it back to shareholders, analysts and fund managers said.

Deutsche Telekom (DTEGn.DE: Quote, Profile, Research), Telefonica (TEF.MC: Quote, Profile, Research) and Vodafone (VOD.L: Quote, Profile, Research) are among the top picks for most analysts, and fund managers see attractive valuations across the sector.

"These companies are cash-generative businesses. The amount of cash flow these companies are now throwing off is prodigious, enabling them to pay down debt aggressively or pay dividends. This will be a key driver of returns going forward," said Andrew Goodwin, fund manager of the SVG European Focus fund.

Telecom dividend yields are higher than in most sectors, offering yields of up to nearly 9 percent. The banking sector , for example, offers no more than 5 percent.

"A 9 percent dividend yield in a big, low risk stock is incredibly attractive compared to what investors can get in cash and bonds today," Goodwin said.

"This is an area in the market place that will attract new investors. If you look at the yields you can get from other asset classes, telecoms really do stand out."

Investors are starting to see the lure of telecoms. In the second quarter, the DJ Stoxx Telecom index was in the bottom two performers, but no longer, and is up 9.5 percent so far this quarter.

On a forward price-to-earnings basis, telecommunication stocks are among the cheapest, trading at a multiple of 10.97, with only the insurance sector being cheaper.

High Free Cash Flows

The sector has the highest free cash flow yield of all sectors, at 11.1 percent on 2010 earnings, a long way clear of the next best sector, healthcare, at 8.9 percent.

"Some of these companies have 13-14 percent free cash flow yield and a lot of flexibility in terms of capex. Now the question is what they are going to do with it," said James Gautrey, telecommunications analyst at Schroders.

"There is room for M&A activity, and careful consolidation in the industry could ease the competitive nature of the market."

Restructuring and talk of consolidation has been paying off for companies. Deutsche Telekom has struggled with its UK arm, T-Mobile, which took an impairment writedown of 1.8 billion euros (1.6 billion pounds) in the first quarter, while the U.S. business has shown a faster decline than expected.

In the first quarter the stock fell 13 percent, and in the second it was down 10.2 percent. But sources close to Deutsche Telekom have said it will part company with the UK business if one of a range of possible bidders make a good offer.

"Deutsche Telekom has big cost restructuring potential. Besides, there is meaningful upside if they manage to exit the UK market at a reasonable price and solve their strategic problems in the U.S., where they currently don't have a compelling offering," Clemens Aichholzer, lead manager for Lombard Odier's flagship Europe Fund said.

In August, the company reported second-quarter core profit in line with expectations and reiterated its outlook for the full year. The stock is now up about 9.6 percent so far this quarter and has been outperforming the sector.

Emerging Markets Growth

Investors may have avoided European telcos as Europe is a saturated market, and recession has hit mobile phone sales. But JPMorgan said mobile revenues closely tracked GDP trends and as economies were beginning to recover, this boded well for telcos reporting in the next few quarters.

Both France and Germany emerged from recession in the April-June period.

Operators have also been expanding in emerging markets, where there is higher scope for growth.

Mobile operators in India, the world's second-largest wireless market, have been adding more than 10 million subscribers a month.

Telefonica has been performing well on the back of emerging markets growth and is up 10.9 percent so far this year after a fall of 28.7 percent last year.

In July, it beat analysts' expectations with a 0.7 percent rise in first-half profit to 3.62 billion euros, driven by strength in Latin America and cost-cutting measures.

Vodafone in July reported quarterly revenues that largely mirrored wider economic developments, with strength in India and South Africa compensating for weakness in Europe.

The stock is up around 12.9 percent this quarter, compared with 4.5 percent in the second quarter.

Source: Reuters, 2nd September 2009

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