Top Stock Picks in European Telecoms

Key Telecom Stock Picks

• Deutsche Telekom (DTE)
• Tele2 (TEL2 B)

Telecom stocks are undervalued

Telecom conglomerates such as Vodafone and Deutsche Telekom are valued at around 0.85 price/fair value, while companies with more simplified structures such as Tele2 and BT.A are valued at 0.97. Historically, conglomerates have more complex corporate structures and less cash flow transparency due to different market dynamics in each country and currency fluctuations.

Investors in conglomerates can see higher returns on their investments, but they need to be aware of these pitfalls. At similar valuations, we tend to favor streamlined companies due to their clearer narratives and better cash flow visibility. Among conglomerates, Deutsche Telekom remains our favorite, given that 80% of revenue comes from the US and Germany, two rational markets.

Key issues in the telecommunications industry:

• Pricing power remains low (except in the UK)
• Falling inflation will reduce costs and increase margins
• Some dividend stocks seem to be at risk, such as Vodafone and Proximus

Only in select markets can price increases be effective, as competitive environments often neutralize or reverse the benefits by driving customers to cheaper suppliers. In contrast, British companies have been able to pass on the costs of inflation with minimal churn through industry-wide actions. However, in highly competitive markets such as Italy and Spain, price increases are less effective.

As inflation falls, we believe cost cutting is the most effective way to recover margins. With EU inflation falling to 2.5% in June 2024, telecoms companies can expect costs to fall.

Many telecom companies are maintaining absolute dividend policies despite deteriorating fundamentals and creating increased dividend risk. These companies are maintaining fixed dividend payments instead of a payout ratio policy, which often leads to unsustainable dividends. This trend highlights the danger of companies delaying necessary dividend cuts until the last minute.

Top Telecom Stock Picks

German Telecom

• Morningstar Rating: ★★★
• Estimated fair value: EUR 25
• Morningstar Economic Moat: Narrow
• Future dividend yield: 3.25%

Deutsche Telekom’s narrow moat offers investors exposure to two rational telecommunications markets, the US and Germany, and to a management team with an Exceptional Capital Allocation Rating. Deutsche Telekom demonstrates the financial discipline and operational expertise required to generate excess returns in a competitive telecommunications industry. In the US, Deutsche Telekom has executed an excellent M&A strategy over the years, acquiring MetroPCS and Sprint and realizing ambitious cost synergies.

Since the merger with Sprint in 2020, DT has consistently gained shares in Verizon and AT&T. In Germany, Deutsche Telekom is leveraging its superior networks and market knowledge and implementing gradual price increases that are driving steady revenue and EBITDA growth. Investors in DTE can expect strong organic execution, with increasing distributions to shareholders in the form of share buybacks and dividends. Since 2019, DTE’s dividend has increased from EUR 0.60 per share to EUR 0.77, and we see room for mid-single-digit dividend increases.

Tele2

• Morningstar Rating: ★★★
• Estimated fair value: SEK 100
• Morningstar Economic Moat: Narrow
• Future dividend yield: 6.47%

Tele2 investors can expect rising dividends in the future thanks to good management, a cost-conscious mentality and exposure to stable or growing markets. Dividends have grown at a CAGR of 4.5% over the past decade. We give Tele2 an exceptional capital allocation rating. We expect revenues to grow in the low single digits and EBITDA in the mid single digits thanks to cost control in the coming years.

In Sweden (80% of revenues), Tele2 is ahead of Telia, stealing market share in both mobile and fixed telephony with more moderate prices. Tele2 has a cost-conscious mentality, the most important in the telecoms industry, significantly reducing operating costs over the past decade. Around 20% of revenues come from the Baltic countries, where Tele2 could continue to grow in the mid- to high-single digits in the coming years. Tele2 understands well that telecoms companies tend to have a stronger position in the domestic market and a weaker position abroad, so it has narrowed its focus by selling most of its operations abroad.

This article is an edited version of the Telecoms Europe: Q2 2024 industry report, published on Morningstar Direct and written by Javier Correonero and Ben Slupecki.