The Stock

What to Buy: France Telecom (France: FTE, NYSE: FTE) < EUR16, USD23

Why Now: France Telecom (France: FTE, NYSE: FTE) is a dominant domestic telecom with a solid and growing presence in key emerging markets with low mobile telephone penetration rates. It’s trading at attractive valuations, including a 10 percent-plus yield on its New York Stock Exchange-listed, Level 3 sponsored American Depositary Receipt. Dividends are paid twice annually, with the “interim” payment likely to be declared next week.

This is an opportunity to lock in an attractive yield backed by a solid business with legitimate upside potential.

The Story

A wider-ranging discussion of France Telecom (France: FTE, NYSE: FTE) would certainlt reveal some pase difficulties in the context of a broader cultural story underscored by the rewriting of the French social contract.

The focus here, though, is on locking in a high, bankable yield while we wait for the company to get turned around from operational and other issues that have plagued it over the last half-decade and for the market to realize the potential of its emerging-market endeavors.

This eventuality–if we may call it that; like most of the prey we track in Big Yield Hunting there are plenty of risks involved with this stock–would likely produce a nice rally in the share price, back above USD24, perhaps, where it traded as recently as November 2010. Disposing of assets on favorable terms and eliminating even more debt are catalysts that could provide a short-term pop.

A high, bankable yield will provide solid compensation while we wait. Trading at attractive valuations of 3 times cash flow and 83 percent of sales, France Telecom–soon to be known around the world as “Orange”–is the type of speculative pick that could become a high-income cornerstone in a diversified portfolio if things shake out its way.

Roger: How about France Telecom (France: FTE, NYSE: FTE)?

David: Yiannis Mostrous recommend it in the latest issue of PF. While I was following up on Telstra Corp Ltd (Australia: TLS, OTC: TLSYY) a couple days ago–I was comparing the top 50 telecoms in the world–I noticed France Telecom’s yield. It was the third-highest in that group.

You know it actually prefers “France Telecom-Orange” now.

Roger: And soon it will beth simply “Orange.” This is part of a longer-term transition away from its state-owned, exclusively French identity.

David: And maybe the name change will help it get out from under the cloud of misery.

Roger: You’re fixating on entirely the wrong thing here.

David: I get it, and I know you’re right about leaving emotion behind when you make investment decisions. This seems a bit different. I sketched the story for Mrs. Dittman a couple days ago, and her only question was, “Why are you recommending that company?”

Roger: I don’t blame her a bit. I’ve tracked the stock in Utility Forecaster for years and have never been more than lukewarm on it. The main thing that’s always kept from being too negative is the fact that the French government seems to regard the company as some sort of national treasure. They’ve bailed it out time and again, no matter how stupidly management acted. And they seem to be blocking the European Union’s effort to open the local market as well. That’s not surprising, since the company employs more than 160,000 people. But at least up to now, management hasn’t really impressed me much.

One thing that has impressed me, however, is that save for a couple share-rights issues in lieu of cash and a switch from an annual to a semi-annual distribution format, the dividend this company pays has been remarkably stable. And that’s really the bottom line with all these trades, no? Did you mention that to her?

David: I didn’t. But the current EUR1.40 per share annualized payout, which makes for an indicated yield of 10.9 percent based on yesterday’s New York Stock Exchange (NYSE) closing price, is a nice number. And the history is clean, too. In 2006, it was one payment of EUR1, followed by a boost to EUR1.20 in 2007 and to EUR1.30 in 2008. In 2009 management switched to an “interim-final” calendar, with a first payment of EUR0.60 and a final payment of EUR0.80.

Management recently confirmed the EUR1.40 figure for the rest of 2011 and 2012.

Roger: Management has on two occasions paid the dividend in the form of a share-rights issue rather than cash, and the frequency shifted from annual to semi-annual. But it’s fair to say France Telecom hasn’t cut its dividend over the past 10 years, and that’s covering some pretty tough territory.

And you probably failed to note that management plans to raise cash by selling assets, and that it will use at least half of the proceeds to buy back shares.

David: The conversation didn’t have a chance to get that far, but I’m aware of the company’s intention to get rid of things it doesn’t own most of.

It’s a complex organization. And it’s in the midst of a complicated transition. The hope is that it can evolve from an ossified, state-sanctioned monopoly into a nimble, global provider of mobile-focused telecom services.

You could also describe it as an indirect bet on the Middle East and Africa, with an impressive yield attached.

Roger: Good luck on the transformation of the company. You might as well ask all of France to turn itself upside down. The timing for dramatic transformations isn’t too good either, with the economy there not exactly steaming ahead. But we really don’t need that to happen to be winners here.

Look, this is no Telefonica SA (Spain: TEF, NYSE: TEF), which I hold in the Utility Forecaster Growth Portfolio, not even close. But if management continues to reduce debt, things go well with asset sales and tensions in its growth markets don’t pull the MENA region into total chaos, this stock has good upside from these levels. And again, the dividend is about as solid as you’ll find from something yielding more than 10 percent.

David: Here’s the lay of the European telecom service provider land: Revenue growth is forecast at 1 percent to 1.5 percent for calendar 2011, which reflects continued economic weakness in core markets on the Continent. Wireline has been in decline for years. Wireless data will drive growth, with demand driven by rapid smartphone and tablet penetration. The 4G rollout should provide enough momentum in developed markets to keep revenue trends positive in the near term.

The big telcos are arguing that European rules right now inhibit scale-building consolidation and even network-sharing arrangements that would bring down costs and enable the faster build-out of high-speed broadband across the Continent.

Of course they want things to be easier. But the same rules didn’t prevent France Telecom from getting together with Deutsche Telekom (Germany: DT, OTC: DTEGY) on a deal to jointly purchase network equipment, which will lower costs.

And they didn’t prevent a meeting of executives from France Telecom, Deutsche Telekom, Telefonica, UK-based Vodafone Group Plc (London:VOD , NYSE: VOD) and Telecom Italia (Italy: TIT , NYSE: TI)–Europe’s five largest mobile operators–in Paris last year to discuss mobile operating systems, surging quantities of data traffic on wireless networks and other topics related to dealing with rapid technological change.

Four of those companies, including France Telecom, used to be national monopolies, so you could say they’re used to having their way.

Roger: The reality is that European regulators have instituted measures to increase wireless competition, including a mandate to reduce interconnect fees, which is what carriers charge to complete calls started on other networks. A fourth network provider is being ushered into France next year, too.

But this isn’t New Zealand. In fact, the French government is supportive of this company, no matter who’s in charge. And that type of cooperation is a positive from our perspective: What investor wouldn’t want the companies that he or she owns to explore every option to reduce costs and increase efficiency, especially in a constrained market with rapidly evolving infrastructure requirements?

Why such the long face?

David: Do you remember the episode of “Taxi” where Alex’s dog died? I was thinking about that for a second. Anyhow, now I’m re-focusing on your initial point, which is that emotion is the investor’s enemy. Here are recent numbers.

First-quarter (ended Mar. 31) operating and financial numbers were decent considering increased competition in France and what’s happening in some of its key growth markets, including Egypt. Overall customers rose 7 percent year over year to 215.9 million, led by 25 percent mobile growth in Africa and the Middle East. Revenue was up 0.4 percent to EUR11.228 billion, excluding the impact of regulatory measures. Results for mobile services in France (up 5.9 percent), Spain (up 7 percent) and Poland (up 4.5 percent) were solid, driven by the success of smartphones and segmented offers.

Sales in its smaller European markets rose 1.2 percent in the first quarter, compared with a 5.8 percent rise in Africa and the Middle East excluding Egypt.

EBITDA (earnings before interest, tax, depreciation and amortization) was EUR3.734 billion, while EBITDA margin was 33.3 percent, down 1.3 percentage points versus the first quarter of 2010. That was due mainly to the impact of the partial pass-through of a value-added tax (VAT) increase that started Jan. 1, 2011, in France. CAPEX–EUR1.081 billion–was equal to 9.6 percent of revenues, which management describes as “in line” with its target rate of about 13 percent for the year.

From 2006 to 2008 the company–under the “NeXT” slogan–cut costs, streamlined operations to eliminate redundancies among its many businesses in different locations, and tried to establish a single brand, Orange, for most of its operating portfolio. In real world terms this means a lot of brands were eliminated and a lot of people were fired.

Now it’s on to “conquests 2015,” which is the plan that includes the potential asset dispositions you referred to earlier. Management has said it could see about USD1.5 billion from disposing its minority stakes in businesses in Austria, Belgium and Romania, which will be used on a combination of debt reduction, share buybacks and other growth-oriented efforts.

We certainly hope management “wins over the men and women that form the heart of the company” and creates “a beneficial working environment” based on “a new vision of human resources, a new management style and shared values.”

Roger:  I would credit a lot of what you call good news to the fact that global demand for connectivity is exploding. And as long as regulators are supportive, even the slowest moving company will profit.

I really hope management can improve employee morale. I think it will be a major boost to their effort to build and maintain a reliable network, which is really the key to their success–and ours from buying the stock.

David: That’s No. 2 on the priority list: “The conquest of networks.” Functionally this means increasing coverage and bandwidth for fixed and mobile networks, in its developed and its developing markets. It’s fair to say, too, that establishing a better reputation among its customers is a worthy and necessary goal; this seems to be a particularly acute problem in mature markets such as the UK.

Roger: As I’ve written for readers in Utility Forecaster, a lot of that boils down to having the funds to make the needed capital expenditures. And there are few companies anywhere in the world with the financial power of this company, which certainly dwarfs that of any local competitor. Am I correct in that the meat of the matter in the long run for the company’s growth is “Orange’s” success in Africa?

David: That’s true. That’s where the growth is. Take the latest negotiation, in the Democratic Republic of Congo (DRC). Orange is looking to buy Congo China Telecom, the country’s fourth-largest mobile provider. It’s negotiating with China’s ZTE Corp (Hong Kong: 763, OTC: ZTCOF) to buy 51 percent, then will attempt to buy the other 49 percent from the Congolese government. The combined transactions will likely approach EUR300 million.

The DRC–one of Africa’s biggest but most under-developed countries, now emerging from nearly a half-century of civil war–is home to 65 million inhabitants. The mobile penetration rate is just 17 percent. The big-picture plan is to double emerging-market sales over the next five years, and by 2015 Orange plans to grow from 215 million customers right now to 300 million across its entire footprint.

Roger: And the wireless sector in emerging markets has relatively low average revenue per user (ARPU) and relatively high penetration of prepaid customers. The opportunity is to convert these folks into higher-ARPU, postpaid subscribers. Smart phones may be a bit out of reach for most users, but if they can add customers they’ll add revenue.

David: The major risk is political, and that goes for domestic operations as well as its foreign ambitions. France Telecom operates in 16 Middle East and African countries, including Egypt, Tunisia, Morocco, Senegal, the Ivory Coast and Jordan. It recently acquired a stake in Iraq’s third-largest mobile operator. It employs some 16,700 workers in these countries and hopes to double annual sales from them to EUR7 billion by 2015.

But, as the FT put it this week, these are “some of the hottest spots in the Arab spring.”

Roger: Another concern is leverage, as the debt-to-assets is high among its peers at 40.6 percent. That’s always been a problem at this company. In fact, the government had to bail them out of a huge mess created by acquisition-related debt some years ago. The current level looks manageable, and there are no major maturities remaining in 2011–which would insulate the company against tightening credit conditions. But I’d be a bit more concerned if management tried to lever up again on an acquisition.

The other number that needs to be pointed out here is the payout ratio for 2010, which was 97.3 percent. I fully look for that to come down, based partly on management’s forecasts, but also on what seem to be stabilizing conditions in Europe. Importantly, cash flow covered the dividend by 1.03 times, which is probably a better indicator of dividend safety given these companies’ ability to minimize taxable earnings per share.

David: From what you’re saying, it’s unlikely we’ll see dividend growth in the near term, but it’s just as unlikely we’ll see a dividend cut. The bet here is that the market recognizes a successful orientation of its business toward high-growth African markets while strengthening its domestic position.

Roger: That about sums it up. By the way, the variation in pricing between the Paris Euronext-listed share and the New York Stock Exchange-listed share is entirely a function of the changing relationship between the euro and the dollar. What trades in Paris is the same as what trades in New York.

David: This is starting to sound a lot more like Telstra to me: Dominant domestic telecom with burgeoning foreign operations, underpriced because of overdone concerns about debt and regulatory burdens.

Roger: Be careful, now; we booked a 32 percent gain on Telstra. I think at least some of that was due to pretty good market conditions for super-high-yielding stocks. Also, the favorable outcome of the National Broadband Network negotiation seems to have given the stock bit more of a boost. It’s possible that there’s a similar cash infusion on the horizon for France Telecom, but the regulatory trends are a bit more ominous.

Telstra’s foreign exposure isn’t as potentially volatile as France Telecom’s, but let’s bear in mind some other facts: France Telecom is the No. 10 telecom in the world in terms of market capitalization, at USD54.35 billion. The French state and a state-sponsored sovereign wealth fund (SWF) own a combined 26.4 percent of the company. Institutions own 43 percent of outstanding shares.

If you trade the New York Stock Exchange-listed share you’re buying actual stock issued by France Telecom for the express purpose of raising capital in the US market. Its American Depositary Receipt (ADR) is of the “Level 3” variety, the most thorough sponsorship available to foreign companies. It basically means France Telecom follows roughly the same type of reporting requirements that US companies do under Securities and Exchange Commission rules and regulations.

Each company-sponsored, company-issued ADR represents one regular share of France Telecom equivalent to the Paris-listed share.

David: Its dividend is “qualified” for US tax purposes, taxable at a withholding rate of 15 percent.

Roger: Buy France Telecom up to USD23 in the US or EUR16 on its home exchange.

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• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL