SECTOR ANALYSIS: TELECOMMUNICATIONS

0 Agosto 2015

SECTOR ANALYSIS:US TELECOMMUNICATIONS

1

Table of Contents

US Telecommunications Sector.................................................................. 3 Individual Company Analises................................................................ 10-13 AT &T............................................................................................... 10 Verizon............................................................................................. 11 Sprint…………................................................................................... 12 T-Mobile ......................................................................................... 13 Conclusion................................................................................................. 14

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Principal Tendencies The purpose of this document is to analyze the current environment of the United States telecommunications sector, the valuation of which is markedly lower than that of the S&P 500 index. The sector can be broken down into two businesses: wireline and wireless. Wireline provides internet connectivity through DSL and high-speed connections, television services through IPTV, video conferencing, high bandwidth dedicated lines, and secured communication setups to large customers. While residential customers are increasingly moving away from wireline and toward wireless, businesses continue to purchase wireline services in order to get highcapacity broadband and advanced communication services, providing telecom companies with a stable revenue stream. The wireless segment makes money by selling voice and data plans as well as the phones and tablets through which these services are provided. Companies attempt to provide faster and more reliable service by purchasing and employing large portions of the finite radio spectrum, the sector´s most important commodity. US telecom is defined by a variety of themes that have resulted in drastic changes in the sector over the last few years. Industry consolidation is largely complete, leaving four major industry players: AT&T (T), Verizon (VZ), T-Mobile (TMUS), and Sprint (S), which together control 97% of wireless subscribers, the result of which has been intense competition for wireless customers. Because US telecom has a market penetration of over 100%, companies engage in ongoing price wars as an attempt to poach subscribers from the competition. Because of this market penetration, companies focus on increased efficiency.

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Spectrum: A valuable commodity Spectrum is the whole range of electromagnetic radiation that exists in the air with respect to its wavelength or frequency. Spectrum is the most valuable commodity for telecom carriers because it enables the individual carriers to transmit data to their respective receivers. Telecom carriers may obtain these radio waves through auctions held by the government. Since the last auction Sprint remains the leader in overall spectrum holding, though a pending M&A of T-Mobile and Dish could give the carrier the second leading position in the industry with 152.2MHz in spectrum.

Source: Bloomberg

High Operating Leverage: As a result of high fixed cost, the sector is marked by high operating leverage. Telecommunications is a capital intensive industry. Companies must constantly improve their networks to woo subscribers away from competitors. Wireless companies have more recurring capital investments, such as spectrum purchases, physical stores, and infrastructure expenditures, than wireline companies.

Source: Bloomberg

4

Net debt/EBITDA has generally increased over the past five years. AT&T, Verizon, and T-Mobile have debt/EBITDA of around 3x, suggesting a relatively normal financial state, though it is higher than the S&P 500 Telecoms Index debt/EBITDA of 2.34x. Frontier Communications has a significantly higher debt/EBITDA of 4.68x, though this could be a result of its recent purchase of Verizon wireline operations in Californa, Florida, and Texas. Sprint is the outlier with a very high debt/EBITDA of 8.59x, likely because of its high churn rate (Sprint has been losing subscribers to its competitors very quickly) and price cuts meant to lure in new customers. Price has been stable over the last two years, while P/BV has increased. Price has remained stable and book value has decreased. S&P 500 vs S&P Telecom 160 140 120 100 80 60 40 20 0 jan-07

jan-08

jan-09

jan-10

jan-11

SPX

jan-12

jan-13

jan-14

jan-15

SP Telecom

Source: Bloomberg; Research BiG

P/BV S&P 500 vs SP Telecom 4 3,5 3

2,5 2

1,5 1

0,5 0 jan-07

jan-08

jan-09

jan-10

jan-11 SPX Index

jan-12

jan-13

jan-14

jan-15

SP Telecom

Source: Bloomberg; Research BiG

The enterprise multiple of the telecom sector is historically lower than that of the S&P 500. This is because the sector has for several years experienced slow growth as a result of intensifying price wars, market consolidation, and high market penetration.

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EV/EBITDA S&P 500 vs SP Telecom 16 14 12 10 8 6 4 2 0 jan-07

jan-08

jan-09

jan-10

jan-11 SPX Index

jan-12

jan-13

jan-14

jan-15

SP Telecom

Source: Bloomberg; Research BiG

In March of 2013 T-Mobile announced its ”Uncarrier” program, which essentially ended two year contracts, formerly the only method for subscribers to pay for phones and the accompanying services. Other carriers followed suit by offering their own financing plans, driving prices and subsequently revenues lower across the industry. Before these new plans, purchasing a new phone at a reasonable price required consumers to sign expensive annual service contracts, and they could not upgrade until the contract ran out. High early termination fees dissuaded customers from switching carriers. Now, customers can pay for phones and services separately. They can pay in small, interest-free monthly installments, and when the phone is paid off, the monthly payment decreases. They can also upgrade as desired and use their own unlocked phones. P/E for S&P 500 Telecom dropped below P/E for the S&P 500 in March 2013, suggesting unenthusiastic growth expectations for a sector with historically low valuation levels. P/E SP 500 vs SP Telecom 30 25

20 15 10 5 0 jan-07

jan-08

jan-09

jan-10

jan-11

SPX Index

jan-12

jan-13

jan-14

jan-15

SP Telecom

Source: Bloomberg; Research BiG

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Regulations: As the sector is regulated by a variety of government agencies, it is important to consider the decisions of regulators. For example, the two industry giants AT&T and Verizon own massive amounts of the radio spectrum available to the industry, and they have the capital to dominate the Federal Communication Commission´s periodic spectrum auctions. As a result, the FCC is considering capping bidding discounts that smaller firms can receive for the auctions. In 2014 the FCC voted to restrict the participation of Verizon and AT&T in the 2016 auction (expected to be the largest and most complex to date) by reserving a piece of each market’s airwaves for non-dominant carriers. The 2016 auction will be the first chance since 2008 for carriers to purchase low-frequency airwaves, which carry heavy data over long distances and through obstacles such as buildings.

While consolidation is largely complete within the industry, some players are acquiring businesses from other sectors in an attempt to increase profitability in the face of lackluster subscriber growth. On July 25th AT&T acquired DirecTV for $48.5 billion, putting the country’s second largest mobile carrier together with country’s largest pay-TV company. Verizon purchased AOL for $4.4 billion in an attempt to boost its video advertising capabilities. Mobile data traffic projected to increase exponentially: The importance of AT&T and Verizon’s acquisitions is underscored by the growth of mobile video services, expected to grow at an average annual rate of 66% from 2014 to 2019. The expected total growth from mobile video traffic until 2019 is the area of 800-900%. In addition, the industry’s top two carriers, Verizon and AT&T, plan to launch multicast video, which by definition would allow consumers to broadcast video and audio simultaneously to several receivers. Multicast video will likely lead to an inflection in mobile data traffic. Wireless video streaming requires high data usage relative to internet surfing and music streaming. Because data usage is the most expensive part of carrier plans, increased video streaming could increase revenue over the next several years. As Verizon and AT&T begin create and license video content through their acquisitions, and as they offer advertising through that content, we could see telecom matching or even exceeding the S&P 500.

Source: Bloomberg

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Declining Dividend Yields: Among the top 20 yielding stocks in the S&P 500, AT&T was near the top with a 5.2% dividend yield. The S&P 500 had a yield of 2.1%, which was 140bps lower than the telecom industry’s yield of 3.5%. Though this may be attractive to investors, when looking at the empirical data we see the SP telecom yield has been declining since the beginning of 2013.

Dividend Yield S&P 500 vs Telecom Carriers 8 7 6 5 4 3 2

1 0 jan-07

jan-08

jan-09

jan-10

jan-11

SPX Index

jan-12

jan-13

jan-14

jan-15

US Telecom Carriers

Source: Bloomberg; Research BiG

Industry group leaders, AT&T and Verizon, have contributed to this trend largely by decreasing dividends paid to investors. This decrease in dividends paid to investors further shows how there is declining growth within the telecom carriers industry. Other group leaders, T-Mobile and Sprint, have not paid out any dividends due to weak performance, and in Sprint’s case, negative earnings. Dividend Yield Verizon vs AT&T 12

10 8 6 4 2 0 jan-07

jan-08

jan-09

jan-10

jan-11

Verizon

jan-12

jan-13

jan-14

jan-15

AT&T

Source: Bloomberg; Research BiG

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Revenue Growth S&P 500 vs SP Telecom 160 150 140 130 120 110 100 90 80

70 60 jan-07

jan-08

jan-09

jan-10

jan-11

SPX Index

jan-12

jan-13

jan-14

jan-15

SP Telecom

Source: Bloomberg; Research BiG

Capex S&P 500 vs SP Telecom 140 130 120 110 100 90 80 70

jan-15

abr-15

jul-14

out-14

jan-14

abr-14

jul-13

out-13

jan-13

abr-13

jul-12

out-12

jan-12

abr-12

jul-11

SPX Index

out-11

jan-11

abr-11

jul-10

out-10

jan-10

abr-10

jul-09

out-09

jan-09

abr-09

jul-08

out-08

jan-08

abr-08

60

SP Telecom

Source: Bloomberg; Research BiG

Sector Framework – Principal Tendencies

P/E 2015E P/E 2016E AT&T INC 13,45 12,98 VERIZON COMMUNIC 11,97 11,67 T-MOBILE US INC 46,05 21,25 SPRINT CORP N/A N/A Average 23,82 15,30

P/BV 2,07 16,70 2,12 0,65 5,38

YTD % Dividend Yield 3,19 5,40 0,41 4,69 55,20 N/A -14,58 N/A 11,05 5,05

ROE ROA 5,90 1,70 75,35 4,26 1,81 0,56 -14,39 -4,09 17,17 0,61

D/E EBITDA Margin EV/EBITDA 2014 95,02 0,23 9,25 921,05 0,28 8,34 156,30 0,20 9,24 155,83 0,10 14,46 332,05 0,20 10,32

Source: Bloomberg; Research BiG

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AT&T Description: AT&T is the second largest telecommunications company in the US by market capitalization. It provides wireless services to over 120 million customers and wireline services to nearly all of the Fortune 1000 companies as well as neighborhood businesses country-wide. AT&T also provides IP-based and satellite television, security services, telecommunications equipment, and

Price and Performance P rice

34,66

52 Week M ax

36,45

52 Week M in

32,07

YTD (%)

3,19

A verage Daily Vo lume (millio ns) M arket Capitalizatio n (millio ns) B eta

29.810.440 213.074 0,778

Dividends P er Share

1,85

EP S

1,19

directory advertising and publishing.

Financial Information Sales (millio ns)

132447,00

EB ITDA (millio ns)

30019,00

Emplo yees

243620,00

ROA (%)

1,70

ROE (%)

5,90

D/E

0,53

DY (%)

5.43

Source: Bloomberg

Results: AT&T posted Q1 earnings of 63 cents per share, beating analysts’ 62-cent estimates. Revenue, however, fell short of expectations, increasing 0.3% to $32.6 billion versus an estimated $32.8 billion. With free tablet offers and data rollover plans, AT&T managed to add 441,000 monthly wireless subscribers. AT&T is up 3% for the year.

Fundamental Analysis: The stock is trading at a discount, with P/E 2015E of 13.45x, P/E 2016E of 12.98x, and P/BV of 2.07x, compared to peer averages P/E 2015E of 23.82s, P/E 2016E of 15.30x, and P/BV of 5.38x. AT&T has a lower ROE and a higher ROA, at 6.52% and 1.70%, respectively, than the average of its competitors at 17.17% and 0.61%. D/E is also relatively low at 95.02% compared to a peer average of 332.05%. This could be attributed to decreases in capital expenditures, which could increase over the next several years if AT&T wants to continue competing with other telecom and cable companies to provide faster broadband speeds. Comparative Performance: AT&T is up 3.19% YTD, likely due to positive investor sentiment regarding plans to expand into Latin America and the acquisition of DirecTV. AT&T acquired Grupo Iusacell and Nextel Mexico for $4.4 billion this year and plans to invest another $3 billion by 2018 to provide high-speed mobile internet for up to 100 million people in Mexico. This investment could be the key to increased growth in a relatively stagnant industry. AT&T has also expressed interest in acquiring Brazil’s Oi or TIM Participacões. Since the start of the year AT&T has decreased capital spending by $18 billion, which is a 14.3% decline. With the $48.5 billion DirecTV deal completed, AT&T intends to deliver programming and TV services across a wide range of devices including tablets and smartphones. This could increase subscriber growth for the carrier by 40-50 million by 2018. EBITDA and EBITDA Margin 60000

Price and P/E Ratio 40 35

50000

30 40000

25

30000

20

20000 10000 0

EBITDA

EBITDA Margin

35

16

30

14

25

12

10

20

8

15

15

10

10

4

5

5

2

0

0

0

6

PX_LAST

PE_RATIO (dta)

10

Source: Bloomberg: Research BiG

Verizon Price and Performance P rice

46,97

52 Week M ax

51,73

52 Week M in

45.09

YTD (%)

0,41

A verage Daily Vo lume (millio ns) M arket Capitalizatio n (millio ns)

15.402.639 190.966

B eta

0,892

Dividends P er Share

2,16

EP S

2,42

Financial Information Sales (millio ns)

128.986

EB ITDA (millio ns)

36.132

Emplo yees

Description: Verizon is the largest telecommunications company in the US by market capitalization. It offers residential and business wireline services, wireless services, internet services, and network services to the federal government. Results: Like AT&T, Verizon also gave away tablets in Q1, earning $1.02 per share compared to a forecast of 95-cents. Verizon attracted 565,000 subscribers, more than AT&T. The stock price has not performed well, down 0.40% for the year.

177.300

Fundamental Analysis: From the P/E ratio, we see ROE (%) 75,35 the stock is trading at a discount in relation to its D/E 0,60 peers with P/E 2015E and P/E 2016E at 11.97x and DY (%) 4.70 11.67x, respectively, compared to averages of 23.82x Source: Bloomberg and 15.30x. Verizon’s P/BV, however, is 16.70x, much higher than the industry average of 5.38x. ROE (75.35%) and ROA (4.26%) are also much higher than the peer averages of 17.17% and 0.61%, respectively. It is worth noting that Verizon has a very high D/E of 921%. This is the result of its February 2014 acquisition of Vodafone’s 45% interest in Cellco Partnerships for an aggregate consideration of $130 billion. Verizon has a low net-debt/EBITDA of 2.8x, suggesting that it should have little trouble repaying its debt. ROA (%)

4,26

Comparative Performance: Despite strong subscriber growth in Q1, the stock price has declined about 0.41% for the year. On June 23, 2015, Verizon completed the acquisition of AOL at a cost of about $4.4 billion. The purchase brings Verizon programmatic advertising technology, the automatic buying and selling of ads online. Estimated annual video traffic growth of 66% presents big opportunities for Verizon and other carriers. Because AOL does not own many internet video properties, Verizon seems more interested in generating revenue through advertisements rather than charging for access to content. As part of the AOL acquisition, Verizon also acquired Huffington Post, which plans to have 50% of its content in video form by mid-2016, as well as TechCrunch and Engadget. Net Income vs EBITDA Margin 14000

Price and P/E Ratio 45 40 35 30 25 20 15 10 5 0

12000 10000 8000 6000 4000 2000 0

NET_INCOME

EBITDA Margin

50 45 40 35 30 25 20 15 10 5 0

18 16 14 12 10 8 6 4 2 0

PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

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Sprint Corporation Price and Performance P rice

3,55

52 Week M ax

7,37

52 Week M in

3,10

YTD (%)

-14,58

A verage Daily Vo lume (millio ns) M arket Capitalizatio n (millio ns) B eta

17.215.368 14.064 1,263

Dividends P er Share EP S

N/A -0,85

Financial Information Sales (millio ns)

34.532

EB ITDA (millio ns) Emplo yees

3.454

Description: Sprint Corporation, through its subsidiaries, provides various wireless and wireline communications products and services to consumers, businesses, government subscribers, and resellers in the United States, Puerto Rico, and the U.S. Virgin Islands. Sprint Corporation offers its services under the Sprint, Boost Mobile, Virgin Mobile, and Assurance Wireless brands. Currently, Sprint has a market capitalization of $14.06 billion, making it one of biggest players in telecommunications industry. However, Sprint faces some major challenges, one being negative subscriber growth for the past 7 years.

N/A

Results: Sprint Corp.’s earnings topped analysts’ estimates as promotions helped extend a streak in D/E 2,43 subscriber gains for a third quarter. Ebitda was $2.08 DY (%) N/A billion in the fiscal first quarter ended in June, Overland Source: Bloomberg Park, Kansas-based Sprint said Tuesday. That topped the $1.8 billion average of estimates compiled by Bloomberg. Sprint added 675,000 subscribers, helped by tablet sales. Sprint also managed to reduce losses in the more lucrative postpaid segment for the fifth consecutive quarter -- a decline of 12,000. For the first time in almost two years, Sprint recorded monthly postpaid phone net additions in May and June. Total users of 57.7 million fell short of TMobile’s 58.9 million. ROA (%)

-4,09

ROE (%)

-14,39

Analysis: In fundamental terms, Sprint has experienced quarterly negative net income since Sept. 30, 2014. As a result, a P/E is not applicable for this company. The reported P/BV is 0.65x vs the 5.38x industry group average. Also, EV/EBITDA is 14.46x vs the 10.32x industry group average, suggesting Sprint is overvalued when compared to its competitors. Sprint has a negative ROA and ROE. EBITDA margin runs low at 10% compared to the sector average of 20% Comparative Performance: Since the beginning of the year, stock prices have depreciated 14.58 signaling that investors continue to lose confidence in Sprint’s claims to become the industry leader. In spite of Sprint’s recent gains in monthly subscribers, we believe that a future appreciation would not be supported by the analysis obtained. 6,5

Price

6 5,5 5 4,5

4 3,5 3 Dec-14

Mar-15

Jun-15

Source: Bloomberg: Research BiG

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T-Mobile US Inc. Price and Performance P rice

41,81

52 Week M ax

41,82

52 Week M in

24,26

YTD (%)

55,20

A verage Daily Vo lume (millio ns)

4.216.518

M arket Capitalizatio n (millio ns)

34.070

B eta

1,006

Dividends P er Share

0

EP S

0,91

Financial Information Sales (millio ns)

29.564

EB ITDA (millio ns)

Description: T-Mobile US, Inc. provides mobile communications services in the United States, Puerto Rico, and the U.S. Virgin Islands. The company offers voice, messaging, and data services in the postpaid, prepaid, and wholesale markets. The company provides its services under the T-Mobile and MetroPCS brands. T-Mobile has a market capitalization of $34.07billion making it one biggest players in telecommunications industry. In 2013 T-Mobile became a wholly-owned subsidiary of Deutsch Telekom.

5.828

Results: T-Mobile US Inc.’s data giveaways, rollover ROA (%) 0,56 offers and price cuts fuel subscriber growth last ROE (%) 1,81 quarter, prompting the mobile carrier to raise its D/E 0,73 annual forecast. In the second quarter of 2015, TDY (%) N/A Mobile added 2.1 million customers, bringing its total Source: Bloomberg customer base to 58.9 million across postpaid, prepaid and wholesale. Total net customer additions were up 41% year-over-year and 14% sequentially. On June 9th T-Mobile announced free talk, text, and data to and from the US, Canada, and Mexico. Emplo yees

45.000

Analysis: From the key metrics of evaluation, we see that the stock is negotiated at a premium with a P/E 2015E of 46.05x compared its industry group average of 23.82x. However, T-Mobile P/E 2016E is at a discount of 15.03x compared to the sector average of 21.25x. T-Mobile P/BV is 2.12x which is lower than the sector average of 5.38x. Comparative Performance: There has been an appreciation of 55.20% in price since the beginning of the year, which is the highest among its peers. T-Mobile hopes to continue this growth by extending promotions such as free calling in new markets like Canada and Mexico. In addition, T-Mobile is discussing a possible a merger with Dish Network, a TV service company with a market capitalization of $33B. As of right now, the talks are in a “formative stage” according to the Wall Street Journal. There is every chance that a deal might not happen. Price and P/E Ratio

EBITDA and EBITDA Margin 7000

35

40

6000

30

35

5000

25

4000

20

3000

15

15

2000

10

10

1000

5

5

0

0

0

EBITDA

Margem EBITDA

180 160 140 120 100 80 60 40 20 0

30 25

20

PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

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Conclusion: Over the last several years, the US telecommunications sector has been defined by decreasing earnings as a result of lackluster subscriber growth and intense price wars. Only now are some companies beginning to explore foreign markets. T-Mobile recently announced its “Mobile Without Borders” plan, allowing its customers to make calls between Canada, Mexico, and the US at no extra cost. AT&T will soon expand into Mexico through a variety of mergers. Both strategies seem poised to increase subscriber growth. The sector is also beginning to diversify its revenue streams. Verizon’s recent purchase of AOL, and its programmatic ad technology, will allow for direct competition with companies such as Google and Facebook. AT&T’s purchase of DirecTV brings in large amounts of video content, such as NFL Sunday ticket, through which the company can raise advertising revenue. T-Mobile has been in talks with Dish Network about a possible acquisition. FCC regulations could limit the spectrum purchases of AT&T and Verizon, creating possibilities for T-Mobile and Sprint to increase coverage and low-rated network performance. This may help to offset shrinking margins due to large price cuts, and, in the case of T-Mobile, elimination of roaming charges throughout North America. In an industry that has long been the subject of slow growth, there seems to be a lot of potential. Opportunities: Geographical expansion: AT&T looks to profit from its expansion into Mexico. T-Mobile stands to benefit from its no extra cost roaming in Canada, Mexico, and the US. Diversified revenue streams: AT&T´s acquisition of DirecTV will bring in video content and advertising potential. Verizon´s acquisition of AOL brings the company programmatic ad technology. FCC Regulation: Sprint and T-Mobile stand to benefit from spectrum reserved for smaller firms. Risks: Ongoing price wars: High market penetration and low subscriber growth, resulting in intense price wars, continue to limit growth possibilities. FCC Regulation: New restrictions on spectrum purchases could hurt Verizon and AT&T network expansion. Alternative Calling and Messaging: Various Internet-driven modes of communication, such as Facebook, Viber, WhatsApp, Skype, and iMessage increasingly allow customers to bypass carrier fees.

Buy AT&T

Hold Verizon T-Mobile

Sell Sprint

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SECTOR ANALYSIS:EUROPE TELECOMMUNICATIONS

15

Table of Contents

Principal Tendencies.................................................................................. 17 Individual Company Analises.................................................................22-27 Deutsche Telekon............................................................................ 22 Telefonica........................................................................................ 23 Telecom Italia.................................................................................. 24 Orange............................................................................................ 25 Vodafone........................................................................................ 26 KPN................................................................................................. 27 Conclusion................................................................................................ 28

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Principal Tendencies Regulations: Historically, European telecom regulation has focused on encouraging sector competition by implementing strict consolidation rules and awarding spectrum to smaller, less profitable companies. Beginning in 2012, regulatory agencies started to recognize the advantage of more open policies and began to ease some regulations accordingly. Nevertheless, regulations need a major overhaul before carriers feel comfortable enough to accelerate cross-border expansion. The European commission is currently drafting resolutions to create a single European telecommunications market, which could provide a major boon to consolidation. The first proposals for a single European telecommunications market were made in 2013 but failed to come to fruition. A new set of proposals is set to be released in 2016. Different regulations from one country to the next impede consolidation. Consistent policies for spectrum purchases and infrastructure investment are essential going forward. Swift enactment of reforms could spur consolidation, while disagreement on national regulatory powers could delay it. In April 2014 the European Commission voted to eliminate roaming charges in Europe. Fees will slowly be reduced, with a planned decrease of 75% by April 2016, before being eliminated entirely. Roaming fee reductions have already cut into KPN and Proximus mobile revenue by 1.6%. Mobile revenue for the whole industry is expected to be cut by 2% between 2016 and 2017.

Industry Consolidation: France and Italy have major potential for acquisitions. Iliad is set for a possible acquisition of Orange. In May 2015 the European Commission approved Orange’s acquisition of the Spanish Jazztel. After concluding the purchase of PT Portugal SGPS in June 2015, Altice now has its eyes on Bouygues Telecom. In Italy the possible acquisition of Wind Telecomunicazione by Hutchinson Whampoa would create a formidable competitor to Vodafone and Telecom Italia. Telefonica’s acquisition of E-Plus made it the largest telecom carrier in Germany. Vodafone, Deutsche Telekom, Orange, Hutchinson, Liberty Global, and Altice are likely to be leaders in pan-European consolidation and expansion. Carriers that operate in a single country or mostly in one country, such as KPN, Telecom Italia, and NOS, are the likely acquisition targets for larger companies.

Greek Debt Crisis: The Greek debt crisis could adversely affect some carriers. 70% of all mobile subscriptions in Greece are pre-paid, so capital controls will likely decrease average revenue per user immediately. With a 40% stake in Hellenic Telecom, Deutsche Telekom has some of the most exposure. Greek business also accounted for 2.1% of Vodafone’s revenues in 1H2015. Vodafone has a 72.7% stake in the wireline operator Hellas Online. 17

Outperformance in First Half 2015 In the first half of 2015 the Stoxx 600 Telecom Index outperformed the wider index by 4.25% on a total return basis, the sector’s best performance since 1999. Deutsche Telekom, Telefonica, Vodafone, and BT accounted for about 65% of this surge. Altice’s surge of 89% over the first half also contributed to the sector’s outperformance.

Stoxx 600 vs Stoxx 600 Telecom 120 115 110 105 100

95 90 Jan-15

Feb-15

Mar-15

Apr-15

Stoxx 600

May-15

Jun-15

Jul-15

Stoxx 600 Telecom

Source: Bloomberg; Research BiG

In the first quarter of 2015 the forward P/E ratio of the Stoxx 600 Telecom Index reached its highest level relative to the wider index since 2007, due to customers’ increasing adoption of 4G and fiber, industry consolidation, and the possibility of relaxed regulation. Telecom has the second highest P/E ratio of any sector after health care.

Price to Earnings 25 20 15 10 5 0 2007

2008

2009

2010 Stoxx 600

2011

2012

2013

2014

2015

Stoxx 600 Telecom

Source: Bloomberg; Research BiG

Of the sectors included in the Stoxx 600, European telecom has the second lowest ratio of buy recommendations to sell recommendations after Oil and Gas, despite the sector’s outperformance of the index over 1H2015. Excluding FY 2013, the sector has experienced higher revenue growth than the Stoxx 600 since 2007. Deutsche Telekom, BT, and TalkTalk have the highest percentages of buy ratings among their peers.

18

Revenue 130

120 110

100 90

80 2007

2008

2009

2010

2011

Stoxx 600

2012

2013

2014

2015

Stoxx 600 Telecom

Source: Bloomberg; Research BiG

Higher revenue growth of the telecom sector relative to the Stoxx 600 is due in part to the historically high levels of capital expenditure. High capex is the norm for telecom, as carriers must consistently update infrastructure to woo customers in a hyper-competitive market. We expect continued capex growth in the near future. Recently, telecoms have been investing in expanding the 4G network, which now covers 70% of the population of Western Europe, compared to 50% during the same period last year. The faster speeds provided by 4G, relative to 2G or 3G, encourage customers to increase data usage. Decreasing Average Revenue per User

Wireless ARPU (€) 25 20 15 10 5 0 2008

2009

2010

2011 Total

2012

2013 Voice

2014

2015

2016

2017

Data

Source: Bloomberg; Research BiG

Mobile average revenue per user (ARPU) has decreased steadily since 2008, due in large part to the rapid decrease in voice ARPU. On the other hand, data ARPU has increased steadily since 2008. People are calling less but spending more on larger data plans (the most expensive part of a cellular plan that includes voice, text, and data). Voice ARPU is expected to increase between 2016 and 2017, while data ARPU is expected to decrease over the same period. Data ARPU is expected to increase in Western Europe and decrease in Eastern Europe between 2016 and 2017. Revenue continues to grow as the subscriber base increases. The total number of wireless subscribers has grown by 43% over the last three years. 19

Expansion of 4G

Source: Online Marketing Trends

The importance of 4G is apparent in its ability to drive data consumption. 4G smartphones typically experience 3x data traffic compared to 3G smartphones. In Q1 2015, 4G networks covered about 70% of the population of Western Europe compared with less than 50% one year earlier. The example of South Korea justifies the expansion of 4G in Europe. South Korea is the only country that has achieved 100% 4G coverage. Because of the quality and speed of 4G, South Korean 4G users often choose stay on 4G even when Wi-Fi is available.

Increasing Capital Expenditures

EV/EBITDA 12 10 8 6 4 2 0 2007

2008

2009

2010 Stoxx 600

2011

2012

2013

2014

2015

Stoxx 600 Telecom

Source: Bloomberg; Research BiG

The enterprise multiple of the telecom sector is historically lower than that of the Stoxx 600 because the sector has for several years experienced slow growth as a result of intensifying price wars, high investment costs, and market consolidation.

20

Capital Expenditures (billions €) 40 35 30 25 20 15 10 5 0 2007

2008

2009

2010

2011

Stoxx 600

2012

2013

2014

2015

Stoxx 600 Telecom

Source: Bloomberg; Research BiG

Since 2007, CapEx has increased significantly to support investments such as expanding 4G, installing NGN networks, and improving cloud computing capabilities. We can expect continued increases in CapEx for the foreseeable future.

Dividend Yield 10 8

6 4

2 0 2007

2008

2009

2010

2011

Stoxx 600

2012

2013

2014

2015

Stoxx 600 Telecom

Source: Bloomberg; Research BiG

Telecoms have historically outperformed the Stoxx 600 in dividend yields. Between 2009 and mid-2012 that gap increased significantly. After this period, the dividend yield of Stoxx 600 Telecom rapidly approached that of the greater index. Despite this dramatic decline, the sector continues to demonstrate a significantly higher average dividend yield than the Stoxx 600.

Sector Framework – Relative Valuation TELEFONICA ORANGE DEUTSCHE TELEKOM VODAFONE GROUP KPN (KONIN) NV TELECOM ITALIA S Average

P/E 2015E 17,89 16,32 22,73 46,38 76,87 20,36 24,73

P/E 2016E 16,83 15,13 19,58 39,54 48,17 18,20 21,86

P/BV 2,86 1,32 2,69 0,97 3,05 1,27 2,03

YTD % 18,12 5,90 23,85 8,24 37,14 36,05 21,55

Dividend Yield 5,25 4,00 3,05 5,17 2,88 N/A 4,07

ROE 20,88 4,30 7,19 8,41 3,65 6,78 8,53

ROA 3,86 1,45 1,49 4,71 0,90 1,69 2,35

D/E EBITDA Margin EV/EBITDA 2014 283,13 0,31 8,47 116,29 0,27 6,18 217,11 0,28 7,64 53,00 0,30 6,61 228,32 0,38 7,67 190,67 0,41 6,24 181,42 0,33 7,14

Source: Bloomberg: Research BiG Note: P/E 2015E and P/E 2016E averages exclude KPN values

21

Deutsche Telekom Price and Performance P rice

16,40

52 Week M ax

17,63

52 Week M in

10,07

YTD (%)

23,77

A verage Daily Vo lume (millio ns)

12.209.990

M arket Capitilizatio n (millo ns)

75.549

B eta

0,988

Dividend

0,5

EP S

0,65

Financial Information Sales (millio ns)

Description: With a market cap of 78 billion euros and 151 million wireless subscribers, Deutsche Telekom is Europe´s largest carrier. It offers wireless and wireline services for residential customers as well as information technology and communication services for business customers. In addition to Europe, Deutsche Telekom’s geographical footprint extends across North America, South America, Asia, and Africa. T-Mobile is a wholly owned subsidiary of Deutsche Telekom.

62.658

Results: In Q1 of 2015 sales increased by 13% and Emplo yees 227.811 earnings jumped by 11% to 16.84 and 4.57 billion ROA (%) 1,49 euros, respectively, beating estimates. The CEO ROE (%) 7,19 announced an increase in dividends for the year. The D/E 0,76 company forecasts 18.3 billion euros in EBITDA and 4.3 DY 1,26 billion euros for FY 2015. This forecast relies on the Source: Bloomberg continued performance of T-Mobile, which could drive earnings even higher because of the dollar’s strength. The stock is up about 24% YTD, due in large part to T-Mobile’s stock performance, up about 40% YTD. EB ITDA (millio ns)

17.821

Fundamental Analysis: Deutsche Telekom has lower than average P/E 15E of 22.73x and P/E 16E of 19.58x, compared to averages of 24.73x and 21.86x, respectively. P/BV is above average at 2.69x, compared to 2.03x. ROE and ROA are below average at 7.19% (vs 8.53%) and 1.49% (vs 2.35%). ROE is above average (6.07%) if Telefonica is not included in the calculation. D/E is above average at 217.11% compared to 181.42%. EBITDA margin is relatively low at 28%. Comparative Performance: With a YTD gain of 23.77%, Deutsche Telekom is the third biggest winner among its peers, after KPN and Telecom Italia. It is the only European Telecom company with a major subsidiary in the US. A strong dollar versus the euro could continue to bolster revenue from T-Mobile. Deutsche Telekom invests heavily in T-Mobile; 43% of its 2014 CapEx went toward the American unit. Deutsche Telekom recently agreed to acquire 7,700 towers from Telefonica Deutschland. EBITDA and EBITDA Margin 25000

Price and P/E Ratio 40 35

20000

30 25

15000

20 10000 5000 0

EBITDA

EBITDA Margin

14

100 90 80 70 60 50 40 30 20 10 0

12

10 8

15

6

10

4

5

2

0

0

PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

22

Telefonica Price and Performance P rice

13,87

52 Week M ax

14,12

52 Week M in

10,64

YTD (%)

17,69

A verage Daily Vo lume (millio ns)

36.620.520

M arket Capitilizatio n (millo ns)

68.496

B eta

0,951

Dividend

0,3954692

EP S

0,64

Financial Information Sales (millio ns)

Description: With a market capitalization of 69 billion euros, Telefonica is Europe´s second largest carrier, offering wireline and wireless calling, Internet, and data transmission services to both residential and corporate customers. The Spanish-based company has the second largest subscriber base in the UK and, after its acquisition of E-Plus, is also the largest wireless operator in Germany. More than half of the company´s revenue comes from Latin America, where its largest operations are in Mexico and Brazil.

50.377

Results: In Q2 2015 sales increased 3.3% to 11.88 billion euros, beating analysts’ estimates by 0.18 Emplo yees 123.700 billion. With Spanish economic growth expected to be ROA (%) 3,86 ROE (%) 20,88 double that of the European Union’s this year, D/E 0,91 Telefonica plans to ramp up domestic expansion. DY 0,93 Revenue from Spain fell 1.1% in Q2, compared to -3.8% Source: Bloomberg in Q1. Spain’s recovery helped to increase demand for broadband, television, and phone services. In May and June Telefonica reached revenue stabilization for the first time since December 2009. EB ITDA (millio ns)

15.515

Fundamental Analysis: With regard to P/E ratio Telefonica is trading at a discount. Estimated P/E for 2015 is 17.89x, compared to a peer average of 24.73 and estimated P/E for 2016 is 16.83x, compared to an average of 21.86x. On the other hand, P/BV is 2.86x, compared to a peer average of 2.03x. ROE and ROA are above average at 20.88% and 3.86% compared to averages of 8.53% (6.07% when Telefonica is excluded) and 2.35%. Telefonica has an EBITDA margin of 31%, below the peer average of 33%. Comparative Performance: Telefonica’s is up about 18% YTD. In 2010, Telefonica completed the acquisition of Portugal Telecom’s stake in Vivo for $9.75 billion, which required the company to assume a large debt load. In 2012 Telefonica reduced its dividend to zero, sold part of its German and Central American operations, and sold its Irish and Czech businesses to help pay down its debt. Now, Telefonica has one of the highest dividends in the sector, 5.3%. Price and P/E Ratio

EBITDA and EBITDA Margin 25000

50 45 40 35 30 25 20 15 10 5 0

20000

15000 10000 5000 0

EBITDA

EBITDA Margin

16

20 18 16 14 12 10 8 6 4 2 0

14

12 10 8 6 4

2 0

PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

23

Telecom Italia Price and Performance P rice

1,21

52 Week M ax

1,28

52 Week M in

0,74

YTD (%)

36,62

A verage Daily Vo lume (millio ns)

112.048.600

M arket Capitilizatio n (millo ns)

21.906

B eta

0,997

Dividend

0

EP S

0,07

Financial Information Sales (millio ns)

21.573

EB ITDA (millio ns)

8.786

Emplo yees

82.445

ROA (%)

1,69

ROE (%)

6,78

D/E

1,72

DY

n.a

Source: Bloomberg

Description: Telecom Italia offers wireline and wireless services, including local and long-distance telephone, satellite communications, Internet access, and teleconferencing services. It has a market capitalization of 22.6 billion euros and operates in Italy and abroad. Earlier this year Vivendi acquired a 14.9% stake in Telecom Italia, replacing Telefonica as the largest shareholder. Telecom Italia owns 70% of TIM Participacões, the second largest wireless carrier in Brazil. Results: Telecom Italia reported Q1 results that were mostly in line with analysts’ estimates. Q1 sales were 5.05 billion euros versus an estimated 5.04 billion euros. TIM Brazil reported sales of 4.55 billion reais (1.31 billion euros). Actual and estimated EBITDA were both 2.03 billion euros. Net debt increased by 779 million euros.

Fundamental Analysis: Looking at some of the fundamental metrics, we see that Telecom Italia is trading at a discount relative to its peers. P/E 15E is 20.36x, P/E 16E is 18.20x, and P/BV is 1.27x, compared to peer averages of 24.73x, 21.86x, and 2.03x, respectively. ROE and ROA are slightly below average at 6.78%, versus 8.53%, (It is above average when Telefonica is excluded) and 1.69%, versus 2.35%. Telecom Italia has one of the lowest EV/EBITDA ratios of its peers at 6.24x and the highest EBITDA margin of its peers at 41%. Comparative Performance: Telecom Italia’s stock is one of the sector’s biggest winners with a YTD gain of 36.62%. The company plans to improve growth by increasing capex over the next two years. It is going to invest 14.5 billion euros between 2015 and 2016 with the goal of achieving EBITDA growth by 2017. A large portion of this investment will go towards fixed next generation network (NGN) technology, which allows all services (voice, data, and video) to travel through one network. Telecom Italia seems poised to take advantage of an unsaturated Italian market. On 21 July 2015, the company announced a partnership with Akamai Technologies, Inc. to offer content delivery and web optimization solutions. Telecom Italia is also in talks with Netflix to bring the video streaming service to Italy, though a timetable has yet to be released. The company values its wireless tower unit, Inwit, at 2.4 billion euros and plans to sell a 40% stake, which would raise 960 billion euros. EBITDA and EBITDA Margin

Price and P/E Ratio

14000

46

12000

44

10000

42

8000

40

6000

38

4000

36

2000

34

0

32

EBITDA

EBITDA Margin

2 1,8 1,6 1,4 1,2 1 0,8 0,6 0,4 0,2 0

25 20 15 10

5

24 0 PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

Orange Price and Performance P rice

14,94

52 Week M ax

16,45

52 Week M in

10,20

YTD (%)

5,58

A verage Daily Vo lume (millio ns)

9.678.258

M arket Capitilizatio n (millo ns)

39.574

B eta

1,063

Dividend

n.a.

EP S

0,31

Financial Information Sales (millio ns)

39.445

EB ITDA (millio ns)

Description: Orange, formerly known as France Telecom, is the one of the major players in the European telecommunication carrier industry. The company offers public fixed-line telephone, leased lines and data transmission, mobile telecommunications, cable television, Internet and wireless applications, broadcasting services, and telecommunications equipment sales and rentals. These services are currently available in 29 countries with 244 million customers. The company has a market capitalization of €40B.

10.824

Results: Orange reported sales and earnings exceeding analysts’ estimates as the French phone market ROE (%) 4,30 recovered and revenue in Africa increased. Adjusted D/E 0,87 earnings before interest, taxes, depreciation and DY 1,41 Source: Bloomberg: Research BiG amortization were little changed at €3.29 billion on sales of €9.89 billion. Analysts had predicted Ebitda of €3.14 billion on sales of €9.76 billion on average, according to data compiled by Bloomberg. In August Orange looks to complete the full acquisition of Jazztel (Spain) for €3.4B. Emplo yees

155.000

ROA (%)

1,45

Analysis: Orange has a P/E 2015E of 16.32x, P/E 2016E of 15.13x, and a P/BV of 1.32x, which is a discount when compared to its competitors averages of 24.77x, 21.86x, and 2.03x respectively. Orange SA’s EBITDA margin of 27% is the lowest among the telecom carries being analyzed. Comparative Performance: Since the beginning of the year, Orange SA’s stock price has increased 5.90%. However, the average YTD for telecom carriers is 21.55%. This indicates that Orange SA has been underperforming significantly among its peers. Nonetheless, with recent growth in earnings and expansion into Spain, Africa, and India, Orange shows signs of future growth.

EBITDA and EBITDA Margin 25000

Price and P/E Ratio 45 40 35 30 25 20 15 10 5 0

20000 15000 10000 5000 0

EBITDA

EBITDA Margin

16

40

14

35

12

30

10

25

8

20

6

15

4

10

2

5

0

0

PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

25

Vodafone Price and Performance P rice

241,05

52 Week M ax

258,00

52 Week M in

179,10

YTD (%)

8,26

A verage Daily Vo lume (millio ns)

58.694.310

M arket Capitilizatio n (millo ns)

63.916

B eta

1,057

Dividend

0,1107

EP S

0,22

Financial Information Sales (millio ns)

42.227

EB ITDA (millio ns)

12.753

Description: Vodafone Group Plc, based in Newbury, United Kingdom, was founded in 1984 and is the second largest telecom carrier in the world behind China Mobile. The company operates as a telecommunications company worldwide offering voice, messaging, and data services across mobile and fixed networks; fixed broadband and TV services. Vodafone currently serves 446 million mobile, 12 million fixed broadband, and 9 million TV customers with a market capitalization of 62 billion pounds.

Results: Vodafone Group Plc reported service revenue that topped estimates as its European businesses began Emplo yees 105.300 ROA (%) 4,71 to recover after years of declines and as sales in Asia ROE (%) 8,41 increased. Service revenue, the cash Vodafone gets from customers’ plans and traffic on its network, rose 0.8 D/E 0,55 percent to 9.2 billion pounds (€13 billion) in the first DY n.a. Source: Bloomberg quarter through June, compared with an average 0.5 percent increase predicted by analysts. Total sales rose 3.3 percent in the quarter to 10.1 billion pounds. Vodafone is reviewing its business in India, where service revenue grew 6.9 percent as more customers started adopting mobile data plans. The company may hold an initial public offering for the business as a result. Analysis: According to the fundamental metrics of analysis, Vodafone is operating at a premium with P/E 2015E of 46.38x, and P/E 2016 of 39.54x. However, the P/BV indicates a discount at 0.97x. The corresponding P/E 2015, P/E 2016, and P/BV for the sector average are 24.77x, 21.86x, and 2.03x, respectively. Vodafone is relatively unleveraged with a D/E of 53%; competitor's D/E is 181.42%. In addition, Vodafone is more efficient at generating profits with a ROE and ROA of 8.41x, and 4.71x, respectively. The sector average for ROE and ROA is 6.07x and 2.35x, respectively, if Telefonica is not included in the calculation. Comparative Performance: Since the start of the year, Vodafone stock price has increased 8.24%. This metric show that the company has underperformed when compared to YTD sector average of 21.55%. Although investors may be losing confidence in the company, the stock continues to sell at a premium. This outcome is due to the lack of growth in the past years and loss of clients to rival carries offering better pricing and promotions. Price and P/E Ratio

EBITDA and EBITDA Margin 20000 18000 16000 14000 12000 10000 8000 6000 4000 2000 0

50 45 40 35 30 25 20 15 10 5 0

EBITDA

EBITDA Margin

250

12

200

10

8

150

6 100

4

50

2

0

0

PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

26

KPN Price and Performance P rice

3,59

52 Week M ax

3,65

52 Week M in

2,13

YTD (%)

36,72

A verage Daily Vo lume (millio ns) M arket Capitilizatio n (millo ns) B eta

16.091.620 15.343 0,904

Dividend

0,07

EP S

-0,15

Financial Information Sales (millio ns)

7.999

EB ITDA (millio ns)

Description: Koninklijke (Royal) KPN NV provides telecommunications services throughout the Netherlands. The Company provides local, long distance, international, and mobile telecommunications services for businesses and individuals. In the Netherlands, KPN has 6.3 million fixed-line telephone customers. Its mobile division, KPN Mobile, has more than 33 million subscribers in the Netherlands, Germany, Belgium, France, and Spain under different brand names. The Company's current market capitalization is €15.18B

3.015

Results: KPN reported second-quarter earnings that topped analysts’ estimates as rising consumer revenue ROA (%) 0,90 offset the decline of its corporate business. Ebitda rose ROE (%) 3,65 1.5 percent to €602 million. The average estimate in a D/E 0,63 DY 1,21 Bloomberg survey of analysts was for €596 million. KPN Source: Bloomberg agreed in April to sell its Belgian unit to Liberty Global Plc’s local arm for €1.33 billion. KPN is facing intensified domestic competition and can’t offset Dutch performance because it’s already sold most of its foreign assets over the past few years. Emplo yees

14.280

Analysis: From a number of fundamental metrics, we see that KPN is trading at a very high premium with a P/E 2015E of 76.87x, a P/E 2016E of 48.17x, and a P/BV of 3.05x. The sector averages for P/E 2015E, P/E 2016E, and P/BV are 24.77, 21.86, and 2.03, respectively. KPN has a ROE of 3.65 and ROA of .90, which shows that the company has been inefficient at generating profits. Sector averages for ROE and ROA are 6.06 and 3.35. Comparative Performance: KPN has a YTD of 37.14% making the company the highest gainer among its competitors. This substantial increase in price is due to recent talks of KPN being acquired by fellow telecoms such as Deutsche Telekom and Altice. KPN has been facing a negative bottom-line for two years. Without any signs of future growth, investors hope that the possibility of an acquisition of the company will generate a significant upside for their investment. As of right now, talks of an acquisition are in their beginning stages and there have not been any bids. Net Income 3000 2500 2000 1500

1000

Price and P/E Ratio 6

70

5

60 50

4

40

3

30

500

2

0

1

10

-500

0

0

20

-1000 PX_LAST

PE_RATIO (dta)

Source: Bloomberg: Research BiG

27

Conclusion European Telecom is a highly competitive industry marked by price wars, high capital expenditures, rapidly changing technology, and frequent M&A activity with capacity for further consolidation. Over the next several years we expect to see increased M&A activity as the European regulatory environment undergoes dramatic changes. As a result of rulings by the European Commission, roaming charges have drastically decreased, and are set to be eliminated altogether. The Commission is also drafting proposals for a single European telecommunication market with consistent policies regarding spectrum auctions and other infrastructure investments. As decreased and eliminated roaming charges cut into earnings, companies will continue to seek efficiency and scale through consolidation. A single telecom market will also spur consolidation by making it easier to enter into foreign markets. Carriers that operate within a single market are the most likely targets for acquisition. Average revenue per user has decreased over the last several years, but expansion of 4G should promote increased subscriber data usage, the most expensive component of wireless plans. Data Wireless ARPU is the only part of ARPU that has consistently increased since 2008.

Opportunities: Regulation: A single European telecom market should spur consolidation and increase value for the sector as a whole. Diversification: Carriers could benefit from distribution of video content, a strategy currently being pursued by AT&T. Data Usage: The amount of time spent on connected devices continues to increase, spurring demand for larger data plans.

Risks: Ongoing Price Wars: The sector is still highly competitive, and carriers that can’t match competitors’ costs could lose out. Alternative Communication: Various Internet-driven modes of communication, such as Facebook, Viber, WhatsApp, Skype, and iMessage could allow customers to bypass carrier fees. Regulation: Policies at the Euro and national levels (as they have historically promoted competition) also have the potential to inhibit consolidation that would provide scale and efficiency. Buy Telefonica Orange

Hold Deutsche Telekom Telecom Italia

Sell Vodafone KPN

28