Calling on Paris for value

Benj Gallander and Ben Stadelmann
Friday, May 17, 2013

The Contra Guys are no strangers to world travel, and it is a pursuit that we relish. Between the two of us, every continent has been visited other than Antarctica, where we’d like to go just once and stand beneath the spectacular Milky Way and gaze at the Aurora Australis.

It’s likely the less extreme climate of Europe that makes it a favourite stop. There are lots of great choices, with France ranking near the top. Not only has French culture given us enjoyable experiences to remember, but as investors we also did well via the country’s main airline. We first bought KLM in 2003, and it received a merger offer from Air France a few months later. The Air France–KLM combination was a winner, and in 2006 the position was sold for a delightful 317 percent gain — not counting dividends.

And so it was in November that another big French company, France Telecom, was acquired for both of the Contra the Heard portfolios. The entry points for the ADR ranged from $10.25 to $10.38. It’s a classic Contra play, cherry-picking what we perceived to be the best of a beaten-down European field offering value and yield. Diversification was also a factor, as we wanted a play on the Euro.

In making an investment in any European company today, the key issue centres on the economic events unfolding, folding and then unfolding again. As recently as May 3, the European Commission revised its February forecast, indicating the euro zone would contract by an additional 0.1 percent to 0.4 percent this year. This would mark the first two-year drop in its history.

Unemployment levels remain at record highs and investment continues to flee. That prompted the European Central Bank to cut interest rates to a record low of 0.5 percent. Yet it is calling for stability in the last half of this year, and the growth prospect for next year was raised to 1.4 percent.

When we purchased FTE, we noted that the French economy was on shaky ground and, as the country’s main telecom provider, it was heavily exposed to its domestic market. To compound the pressure, competitors were being aggressive on pricing, undermining revenues and profitability. The dividend had been slashed twice in 2012, debt was high, and the balance sheet was bulging with goodwill and intangibles that could lead to possible writedowns.

Naturally, there are positives, or we would not have bought in. This is the leading company in the sector in France and Poland, with operations in numerous other countries, including Spain and the U.K. However, most of the current growth is coming from Africa.

To put France Telecom’s scale into perspective, annual revenues exceed those of BCE, Rogers and Telus combined. That kind of scratch can buy a lot of sports franchises. While the debt is high on an absolute basis, the debt/equity ratio is better than for other major European telecoms.

For income seekers, there is that juicy dividend, yielding nearly 10 percent. That level usually raises a tricolour of blue, white and red flags for yield seekers, but with two deep cuts already, manageable debt, and a reasonable payout ratio, the odds for sustainability seem good. Management has stated its plan is to hold the dividend to a minimum of .80 Euros in 2013 and 2014. That is good to hear, but if operations were to worsen and earnings dwindle, being whittled down further is not out of the question.

This telecom in La Belle Pays has a long history of trading at much higher prices. Whether it will return to former glory is, of course, the big question, and investors need to examine their personal comfort zone. Our sell targets are in the mid- to high-$20s, and that is something that will likely take years, if it comes to pass. Bon courage!