France Telecom

France Telecom Inc (FTE)
16 Nov 2011

• The investment thesis is we buy France Telecom (FTE) for the dividend yield.

Company Overview
• Revenue Trends

Revenues - FTE’s revenue for first 9 months of 2011 was €33,848m, down 1.6% compared to comparable 2010 figures. EBITDA was €11,611m for the three quarters of 2011, down 5.4% from 2010.

Margins – FTE’s EBITDA margins were 34.3%, down 1.4 points from previous year.

Cashflows - FTE confirms their full year guidance. They expect their operating cash flow to be slightly above €9b for 2011.
• France Telecom’s Operating Segments
France


France is FTE’s largest operating region by revenue. FTE took new steps in offers segmentation implemented in France driving successful momentum share of broadband net adds. That is the reason naked ADSL customers increased 31.2%. Revenue fell 3.1%. ARPU for Personal Communication Services (Mobile Phones) fell 2.6%.


Market share for Orange is stabilizing.



Excluding regulation, ARPU grew 1.6%. With regulatory restrictions, ARPU fell 2.4%.



Churn rates have been brought down and stabilized at 14% to 15%. Strong net contract adds of 229,000 new subscribers.
Overall, the picture looks bleak. But the good thing is the metrics (Market share, churn, ARPU) have stabilized.
The remaining segments are small compared to France. The various key metrics are in the following tables:














Note that Everything Everywhere is FTE’s Joint Venture with Deutsche Telecom in the UK. FTE merged Orange UK with Deutsche’s T-Mobile. FTE owns 50% of the resulting JV.
• Capital Expenditure
CAPEX was equal to 11.0% of revenues, representing 3.731 billion euros of investment in the first nine months of 2011, a 7.5% increase on a comparable basis on the previous year. FTE confirms their guidance that CapEx will reach 13% of revenue for the full year. I estimate that to be 5,868m for the full year.

• France Telecom Debt Profile


The above table is accurate as of 30 June 2011. No table was given in 3Q 11. FTE’s debt maturity profile is quite benign for 2012, given that only 2.7b in debt is coming due. That is only 8.15% of total debt on 30 Jun 2011. Even if the new debt is refinanced at a much higher rate, the overall average interest expense will not increase significantly because the amount of debt to be refinanced is not a large part of the total.

FTE’s total debt as of 30 Jun 2011 is €33,137m and €660m in financial lease liabilities. Bonds and perpetual bonds (TDIRA) make up €29,830m of the debt. Total Gross financial liabilities is €36,902m. The difference is made up of commitments to purchase shares, derivatives and other financial liabilities.

At an average interest rate of 5.5%, FTE will have a 10% head room to meet dividend payments. At 6.6%, FTE will just be able to cover all dividend payments.

Company Positives
• Dividend yield is 11.25% at a €12.445 share price.

• Business is stabilizing – ARPU, market share and churn - are all stabilizing.

• Debt maturity profile over 2012 is benign.

• Cash flow coverage of the dividend is adequate. There is approximately 10% headroom in terms of dividend cover.

Company Negatives/Risks

• If the European Sovereign crisis were to spread to France, and FTE is not able to re-finance or has to re-finance at punitive rates, then the company will miss its dividend payout.

• FTE cuts their div. While this is unlikely in 2011, given the fluidity of the situation in Europe, this remains a possibility.
• Key drivers of a div cut is a fall in revenue, increase in operating costs or a sudden increase in capex.
• Of the 3, I believe that a fall in revenue is the most probable threat because of the bad economic situation in France. It is hard to model how bad this could get. The reason is a lot of this is driven by the macro-economic situation. So if we buy this stock, a critical signal for us to sell would be consecutive quarters of revenue/ ARPU drops.
- Consequences of a div cut would be a drastic drop in price. Again here, it depends on how bad the div cut is. If they do cut, I suspect that it will be to make the div yield fall to ~5% - 6% or Eur 0.70 (div now is Eur 1.40). The reason is the US telcos are yielding around ~5%. I'd be ok with a 5% div yield, esp if we buy the US ADR. They are unlikely to cut to 0 because the French gov is a large shareholder of the company (~25%) and the French gov needs all the cash they can get their hands on.

Conclusion & Recommendation

• I would buy the stock at ~€12.00 or alternatively buy the US ADR at around ~$16.00. There’s no need to chase the stock.

Value Pharma: Amgen (AMGN)

I've been rooting around the pharma sector due to the uncertainty in the area caused by Obama Care. I think I've found a great business.

It's called Amgen (AMGN). Market Cap 56.8B. PE around 11.7 times 2009 est earnings. For the first 3Q of 2009, they made $3.58 diluted. So I'm estimating $4.80 for the full year. Around 14 times 2008 earnings. The company estimates $4.90 to $5.05.

Business
Amgen manufactures a special category of pharmaceutical drug called biologics. Basically, they are large molecules like monoclonal antibodies, growth hormones or some receptor blocker protein. This differs from your average pharma company 'coz the average pharma company makes drugs with a small molecule active ingredient.

Competition
The reason all the above stuff is important is the biggest fear for all pharma drugs - Generics. The Food and Drug Administration approval process for generic biologic drugs called biosimilars is a lot more complex and time consuming than for your average generic. This leads to a huge increase in the cost of the biosimilar. In fact, biosimilars take about 8 to 10 years to come to develop and around $100M to $200M (refer to FTC report on biologics). Due to the large cost of development, the biosimilar costs just 10% to 30% less than the brand name drug. So the difference is not really huge. And there aren't that many of biosimilars 'coz of the large upfront cost of the approval process. This builds a large moat around the business above and beyond the original patent.

Furthermore, the biologic drug companies just won a concession for a 12 year exclusivity for the brand name biologics.

I think this company should be trading at a premium to the market instead of a discount. The average PE for the S&P 500 is around 18 to 20 times right now. I am not comparing it to the pharma sector PE because the entire pharma/ healthcare sector is depressed due to the uncertainty of the new laws so the PEs are all depressed.

Full Disclosure: I am long AMGN

Kraft: The Saga

I'm sure you guys have heard about Kraft (KFT) attempted takeover of Cadbury. If you haven't, I'll give you the skinny.

In Sept 2009, Kraft proposes to buyout Cadbury for a total of USD 16.7B, in a mixture of cash and KFT's shares. Cadbury flatly refuses the offer, saying that it is way too cheap. The figure Cadbury has in mind is somewhere around USD 21B. So instantly, the takeover becomes hostile.

Let's examine Cadbury a little more. Cadbury is an iconic British confectioner, with extensive global reach. They manufacture chocolates, gum and candy. Being a British firm, they have 30% of the chocolate market share in the UK and 42% of the market share in Ireland. They have a large presence in France with 43% of the gum and 17% of the candy market. The key part of their business is their presence in Asia. They have very strong brand recognition in India, Thailand and Malaysia. In India, they are the leading chocolate manufacturer. Their presence in China is also growing. The reason Asia is so important is that Asia is the next growth frontier. India and China are where confectioners want to be. In 2008, they made an operating profit of GBP 370M, approximately USD 592M.

Let's look at valuation of Cadbury. What sort of discount rate would give us a USD 16.7B? A discount rate of approximately 3.53%. To put that in context, the US 10 Year Treasury bill is yielding 3.8% right now. That would imply that Cadbury should have a Treasury Bill like income, meaning stable, certain and extremely predictable. If you were to look at the Cadbury's last 5 years of income, you'd see that it's anything but predictable or stable.

Op Profit (In GBP, in Millions)
2008 - 370
2007 - 149
2006 - 176
2005 - 347
2004 - 198

As you can see, it's all over the place. Not a good sign. Esp if KFT were to pay USD16.7B for the company.

Furthermore, KFT is using its own undervalued shares (at $27 per share) to pay for Cadbury. Just an example of how undervalued KFT's shares are. KFT IPOed in 2001 at $31 per share. It's now trading at $28 per share. Meanwhile, KFT has bought back USD 5B worth of shares at an average price of $33 per share. So in effect KFT is buying high ($33) and selling low ($27). Buffett pointed this out in a statement released 5 Jan 2010.

I'm going to continue this saga at a later date. Things sure are interesting. And potentially profitable if you are long KFT. I'm not sure about shorting Cadbury. It is possible that Cadbury's price may not fall after the takeover. Witness Comcast failed takeover of Disney.

Disclosure: I am long KFT.

Seth Klarman on Gold Part 2

So what then would be a good hedge against inflation if Gold isn't quite doing the trick?

The second part of Mr Klarman's answer as to that question is real assets.

Let's examine what real assets are: Investopedia defines real assets as "Physical or identifiable assets such as land, equipment, patents, etc."

The only way one can gain ownership of many of these assets is through ownership of REITs or companies that use patents or manufacture equipment.

I submit to you that ownership of companies that own real assets is one way of combating the bit of inflation on your assets. This means not every company is going to benefit from inflation. Only the ones with real assets that can raise prices when inflation comes around.

The problem with most companies is that in an inflationary period, they raise their prices but they also suffer from increased costs. So at best, they can pass on their increased costs to their customers. Or they might not be able to pass on the full cost increase to their customers and it'll start to eat into their profit margin. That would really be bad. There's a good piece by Buffett on this issue.

So you're look for companies that really have pricing power, you'd be looking at monopolies, at companies selling commodities and at real estate related companies. Finally, inflation protected securities or inverse treasury ETFs.

The last two are a bit iffy. Simply 'coz Treasury Inflation Protected Securities (TIPS)'s yield is linked to the CPI index. The CPI index is a poor tracker of inflation because it doesn't have the price of oil in the index. Inverse Treasury ETFs are also difficult because the yields might not exactly match inflation.

So the time is now for us to starting hunting. I've defined the areas so we need to do our digging in those areas.

Seth Klarman on Gold

My buddy goes to MIT's Sloan Business school to do his MBA. Somehow he is doing a class at Harvard and his professor got Seth Klarman to come in and talk to the class! That's awesome! I managed to ask my buddy to ask Mr Klarman a question.

Simply put:
Does he believe that Gold, even at today's high price, is a good hedge against inflation? If not, what would be a good hedge against inflation?

This is his reply: Mr Klarman said he does think is gold overvalued. He said the best long-run hedge against inflation is real assets.

I agree. I have a lot of difficulty valuing Gold. There's no long term predictable cash flow. There's no business prospects to evaluate. So how can I as an analyst figure out the long term price of gold?

What's the difference between gold and collecting art or wine then? One of the reasons why value investors don't buy art or wine is 'coz they don't have long term predictable streams of cash flow. Hence they can't be considered an investment.

There are 3 main uses of gold - jewelry, manufacturing and financial. The first 2 uses have seen dramatic drops in demand and they normally account for 2/3 of the total gold demand. Currently, what is driving the gold price is mainly financial. Financials can only sustain the gold price for so long. Once markets get back to normal, pp are going to want to go back into other assets, like stocks as their price goes up. That will probably lead to a decrease in the gold price. So the pp who bought it as a retention of real value, just found themselves buying gold at its peak, only to put their capital at risk of permanent loss.

The other thing is I don't quite like buying stuff when everyone else is buying it. Esp if I'm buying the stuff at a multi-year high. Call me a contrarian. But Gold is trading at a multi-year high. I'm not hot on following the crowd. 'coz you never know when the crowd will turn and leave you holding the ball.