Crushing Costs and Debt Force Euro Wireless Alliances
By VITO J. RACANELLI
JANUARY 29, 2001
Barron's
Faced with the enormous expense of building third-generation wireless networks across
Europe and hobbled by debt-laden balance sheets, competing European wireless firms
are now beginning to share 3G infrastructure costs. There's a good chance this trend will
intensify, and that's not likely to be kind to the stock prices of
telecommunications-equipment providers. And it might even jump-start a rally in the
depressed telecom-operator shares.
Last week saw several seemingly unrelated announcements that suggest the 3G
landscape will change in ways that could have critical ramifications for both operators
and suppliers. Tuesday, Europolitan, majority-owned by Vodafone Group, and Hi3G,
owned by Investor AB and Hutchison Whampoa of Hong Kong, said they would jointly
build and maintain up to 70% of the 3G infrastructure required in Sweden, where each
was awarded a separate license. Hi3G planned to sink about $3.5 billion and Europolitan
$2.7billion in their networks, so the deal should cut out a big chunk of outlays.
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On Wednesday, Spain's Telefonica and Portugal Telecom announced they would merge
their Brazilian mobile phone subsidiaries into one entity. The same day, Telefonica
dropped out of France's 3G contest, leaving three firms bidding for four licenses.
These moves differ, but the pattern is plain: The number of distinctly competing wireless
operators -- customers for vendors -- is shrinking, largely because of the
balance-sheet-busting costs involved.
Jean Marc Fraysse, a money manager at Cazenove, expects this spending consolidation
to continue. Given the uncertainties surrounding the operator profitability of the "fairly
unproven" 3G venture, "it's one of the only ways to cut down [significantly] on costs," he
says. There are some restrictions about "how far you can go with this," says Jeff
Currington, head of European equity investment at Morley Fund Management. "But it's a
clear negative for the overall size of the market for the companies who supply the
infrastructure."
Europolitan CEO Jon Risfelt says Sweden's large land mass and low population density
make it a special case, but "clearly this is a concept that could work elsewhere,
particularly in rural areas. I'm pretty sure many will follow how successful we are."
For those new to the game, 3G -- often referred to as the universal mobile
telecommunications system -- promises to transform the cell-phone experience. UMTS
operators can deliver music and video downloading over the wireless handset -- as well
as location-based services, mobile commerce like banking and shopping and much
faster data transmission than the current system. Many believe it could boost sagging
telecom growth in average revenues per user by 25% within five years. Indeed, the major
European wireless firms are all betting the house on it.
This specter of dwindling customers is one more concern for 3G infrastructure providers
like Ericsson, Nokia, Nortel Networks, Motorola, Siemens, Lucent Technologies and
Alcatel, among others. Granted, their stocks are down sharply from their highs, thanks to
growing uncertainty about operator 3G profitability, heavy pressure for vendor financing
and likely delays in the general availability of service.
Lars Godell, a European telecom analyst for Forrester Research, says sales
expectations for these vendors in general were infused with "too much hoopla," with
some believing that vendors "would be selling [a 3G network to] each one of the
operators" in each country.
In all, there are more than 85 3G country licenses being handed out across Europe, with
infrastructure costs alone estimated at about $5 billion and more per network in the
largest countries. But Per Lindberg, a Dresdner Kleinwort Wasserstein analyst, sees just
25 operators or "constellations of operators" by 2005. "By pooling resources, there will
be an elimination of networks," he points out. He sees a $150 billion industry opportunity
over seven years versus market expectations that he puts at $200 billion.
Even if touchy European political pressures have so far stymied the ability of the national
telecom incumbents to merge, this is "back-door consolidation," avers Lindberg and
others. A consolidating group of buyers will have stronger bargaining power and will
exploit vendor price differences around the globe, he says.
Additionally, predicts Morley's Currington, this trend could favor the older, established
players in the game, mainly Ericsson, since in cost sharing there will be two systems
riding partly on one infrastructure. It's particularly bad news for the newer entrants to the
infrastructure business, he adds, because two operators who must agree on one system
will want less risk.
Nor do investors realize the sales cannibalization involved in switching to 3G from the
current so-called 2G network. As strapped operators buy 3G equipment, they'll pull
money away from the older 2G system spending, Lindberg points out. Yet 2G margins
are fatter because they are at the end of the product cycle.
Down the road, if the costs are divvied up, it will make it much more likely that these
networks are eventually rolled out, says Lindberg. However, in the here and now, "from a
stock-market perspective, the price of a share is a function of expectations and
expectations are still too high." And if they aren't met, stock prices of Nokia, Ericsson and
others, several of which still trade at relatively high price-to-earnings levels, could suffer.
Longer term, Lindberg also believes Ericsson, the infrastructure industry leader in
Europe, is in a better position to reap the rewards of 3G. Friday, Ericsson released
fourth-quarter results and announced it would outsource its troubled handset business,
something Barron's suggested might happen ("Mixed Signals," November 27).
Even so, the Dresdner analyst puts fair value of Ericsson ADRs at about $9.50 per share.
He notes fourth-quarter infrastructure operating-profit margins of about 15% are below
16.7% in the third quarter, 18% a year ago and general market expectations of 20%.
Revenue growth slowed as well. Friday, Ericsson closed at 11 1/4, down 1 3/4.
At first glance, the Swedish firm's handset woes would seem to be Nokia's boon, since
the Finnish giant gets about 70% of its revenues and 85% of profits from handsets.
Lindberg, however, points out that the Ericsson move is more evidence that handsets are
rapidly becoming a commodity and should be treated as such. Average handset selling
prices are falling, and Nokia gets a relatively small amount of revenues from 3G
infrastructure, which it's quickly trying to bulk up. The analyst puts Nokia fair value at
$22-$23 per share with the Nasdaq at current levels. Friday, Nokia finished at 37 1/4. As
for the operators, whose shares are down anywhere from 40% to 80% from highs, this
trend could be the start of something good for their shareholders.
Granted this sector suffers from high debt loads, notes John Boselli, an analyst at Putnam
Investments and longtime skeptic of the sector. But if further joint-venture transactions
such as the one between Portugal Telecom and Telefonica occur within Europe, it could
prove a catalyst for sector outperformance, he adds.
Boselli says such deals tend to minimize competitive threats, save on capital expenses,
allow the leverage of sales, general and administrative expenses against a wider base,
and can lead to preferential roaming treatment of each other's customers in territories
where the two don't compete.
Indeed, other observers have noted that with many funds underweight in telecom, a
simple move to neutral weighting could give the downtrodden operator stocks a nice lift,
particularly since falling interest rates will help them on the debt side.
Shares in France Telecom's wireless subsidiary Orange will soon be floated (See
Offerings in the Offing), and it will likely set the tone for a host of similar offerings planned
for the rest of the year.
In the hot debate over whether the faster growing Orange should be valued at a premium
to Vodafone, the industry leader, investors might be forgetting to take a closer look at
MobilCom, a wireless firm with a 3G German license, in which Orange holds a 28.5%
stake. Since it's a minority position, MobilCom's results aren't consolidated into Orange
in the prospectus, but investors should make the calculation themselves, avers Caspar
Rock, a fund manager at Framlington Investment Management.
For strategic reasons Orange at some point will want to control a 3G license in Germany,
he says. The prospectus notes Orange has a call to buy another 33% in MobilCom,
exercisable in 2003-2006, and MobilCom's founder, Gerhard Schmid, has a comparable
put option against Orange exercisable in limited circumstances.
The specifics of how the put and call are activated are complicated, but suffice it to say
that the likelihood of Orange gaining control of MobilCom -- and thus being required to
consolidate results -- is strong. If Orange exercises its option, it will gain control and if it
decides to buy another company with a German 3G license, it appears that could trigger
the put, the result being control of MobilCom as well. In any event, if Orange doesn't
control a German 3G license, it doesn't have a pan-European story and the premium
valuation that comes with it, opines Rock.
He estimates that once you consolidate MobilCom's roughly 12 billion euros in debt, 3G
license and infrastructure costs, and losses going forward, then the 2004 multiple of
Orange's enterprise value (market capitalization plus debt less cash) to earnings before
interest, taxes and depreciation and amortization jumps to 13.2 times from 9.9 times.
That's a 27% premium to Vodafone's 10.4 times four years out, he says.
Rock's conclusion: Once you include MobilCom, even at the bottom of the offering range,
11.5 euros per share, Orange stock "looks pretty expensive."
Last week, the Dow Jones Stoxx pan-European index finished at 361.36, up about 1%. |
