I decided to write an article about telecommunication companies since there are three spanish publicly traded companies whose market prices have behaved differently in recent years.
On the one hand, both Telefónica and Esukaltel prices have plummeted a 66% and 35% respectively. On the other hand, Másmóvil market price has risen 373% in the last thirty months. Seeing such movements in sotck prices an investor could think: Is the market overreacting? Are there investment opportunities?
In Spain, telecommunication industry suffers from an intense competition among market participants. To understand it better, I have used Porter’s five forces diagram:
From the above graph we can highlight the following facts:
- Threat of new entrants: new virtual mobile operartors can easily enter the market since they do not undertake significant investments in propietary resources. Such business usually rent mobile networks to bigger telcos and orient their efforts to produce low cost services. We have the example of Pepephone, Tuenti or LlamaYa. Regarding internet, it is unlikely that new low cost companies enter this market. And in case of doing so, they also need to rent the fiber to other companies. I said unlikely because there are at least five companies with propietary fiber network. This, the more companies doing the same, the less profitale it is this economic activity. To measure such profitability, I have calculate ROCE (return over capital employed) for Telefónica, Euskaltel and Másmóvil and the results are the following:
If we consider a long-term wacc of 6%, the resulting profitability may discourage new entrants.
- Bargain power of clients: regarding mobile and internet services, there is a very low differentiation among products. It is very common that customers, once their membership period has expired, collect several offers and choose the cheapest one. In fact, most telcos have a client retention department that usually offers high discounts . Therefore, there is a high customer churn specially for non-convergent services.
- Bargain power of clients: regarding mobile and internet services, there is a very low differentiation among products. It is very common that customers, once their membership period has expired, collect several offers and choose the cheapest one. In fact, most telcos have a client retention department that usually offer high discounts to those clients that try to leave the company. Therefore, there is a high customer churn specially for non-convergent services.
- Threat of new products: regarding substitute products we can distinguish between:
- Fixed, mobile and broadband network: new technologies are likely to appear in order to offer faster connections (remember copper-DSL-broadband and 2G-3G-4G-5G transition). It means that companies always need to invest in the latest and fastest technologies.
- Television (convergent services): many companies have offered TV services and video on demand for years. Nowadays, several substitute products have appeared on the market. I am referring to companies such as Netflix, HBO, Sky or Amazon, that can steal customers to telecommunication companies.
- Rivalry among competitors: for the reasons given above, I think that competition will continue to exist. I personally find two paths to profitability:
- Operating efficiency: reducing operating costs and assets disposals to face an eventual price war (specially in non-convergent services).
- Differentiation: offering value through convergent services (producing propietary content or negotiating with series and film producers).
Main movements of Spanish Telcos
Due to strong competition and the existence of a key asset, broadband network, we have witnessed an acquisition process. Among the main movements we find:
- Telefonica acquired Tuenti (virtual mobile operator, 2010)
- Telefónica acquired Canal+, TV serivce company (2015)
- Orange acquired Jazztel, a telco company with proprietary broadband network (2015)
- Vodafone acquired ONO, a telco ocmpany with proprietary broadband network (2014)
- Euskaltel acquired R (2015) and Telecable (2017), both with proprietary broadband network.
- Másmovil acquired Yoigo (2016), Pepephone (2016) and LlamaYa (2017).
As we can see, market participant number has been reduced to basically Telefónica, Orange, Vodafone, Másmovil and Euskaltel. This fact has allowed the big three firms to rise their prices in the recent past.
The following graph classifies the companies according to their broadband network size (homes connected):
Capacity totals 51,2 millions of connected houses, where the three more important companies are Telefónica, Orange and Vodafone. Taking into account that Spain has a population of 46,57 millions, we can see that the industry is almost reaching overcapacity. This fact may discourage competition and can give companies shares some stability.
I have measured market shares stability by their standard deviations.I retrieved data from “Comisión Nacional del mercado y la Competencia” website and have studied the evolution of market shares for broadband services between 2014 and 2016. The following graph shows the result:
Market shares have remained almost constant. As discussed earlier, I have calculated the standard deviation for them and the results are the following:
Here we can confirm the same fact that is seen on the previous graph: there are no significant movements in market shares. Nevertheless, a constant market share does not mean profitability. To better understand how companies are working, we need to analyse two common KPI in the telecommunication industry: average revenue per user and churn rate.
Two key metrics: ARPU and Churn Rate
Many business books state that a strong presence in the market can be measured by the arpu. It means that the stronger a Brand positioning , the higher the arpu. Regarding churn rate, it can assess how satisfied customers are. I have graphically represented both metrics for the following companies: Telefónica, Euskaltel, Orange and Vodafone. Másmovil has been excluded because no official churn rate has been published.
In the above chart it can be seen how Telefónica and Euskaltel have the best combination of arpu and churn rate. We could ask now the reasons behind that fact.
Regarding Telefónica, it is true that its strategy is oriented towards convergent services and high value added services. It does not only has one of the best mobile and broadband networks, but also one of the most competitive television services available in the country. Furthermore, is a company that has invested in creating proprietary TV series and channels. It also has signed an agreement with Netflix, through which Telefónica will offer Netflix content on its TV and video service. Telefónica already offers some of the best HBO series within its content catalogue, which is always a plus.
With regard to Euskaltel, is a deeply-rooted company in the north of the country, specially in País Vasco. It has a proprietary broadband and mobile network as well as TV and video services. Nevertheless, it is not as competitive as Telefónica on this field. Its strategy is focused on acquiring companies with strong presence, such as R in Galicia and Telecable in Asturias. This fact as allowed Euskaltel to gain presence and be the first operator in those regions. This fact can be appreciated in the following chart:
What is more, Euskaltel has signed an agreement that would allow Virgin to land in Spain using its infrastructure. This fact would allow the vasque company to compete in the virtual mobile operator segment. Said that, I should admit that I don’t see a clear path as I do with Telefónica: the firm is half-way between premium service and low cost, with no clear orientantion. The company is a cash-flow maker and has a strong position in some regions, but these characteristics will not make the company to grow in the future.
Regarding Másmovil, we do not have official publication about its churn rate. However, we do know that its arpu is 15,5 euro, just behind Vodafone and Orange. The group acquired companies focused on low-cost services, such as Pepephone, Yoigo (fourth mobile operator in Spain) and Llamaya. Currently, Másmovil does not offer TV on demand, so it focuses on mobile and broadband services at competitive prices.
Previously, we stated that one path to profitability was operating efficiency. The following table lists the EBITDA margin for the three selected firms, so we can have an idea of who could possess and advantage in an eventual price war:
At this point, the intrinsic value for the mentioned companies could be calculated. Valuation is always a very subjective exercise, so each investor can reach a very different result when calculating a reference price. In the following table, I have calculated companies intrinsic value along with its margin of safety:
As we can see, both Euskaltel and Telefónica have almost a 20% and 30% margin of safety, respectively.
Future is uncertain. As an Austrian Economics follower, I don’t rely on mathematical models that forecast the future financial performance of companies. I don’t think that tomorrow can be forecasted. Nevertheless, we still can assess which market participants are more likely to survive and create value for shareholders in the long run. We well see with 2018 financial reports if management if they really follow the stated strategies and how.