Description

EXECUTIVE SUMMARY

Euskaltel is a high-quality regional Spanish cable franchise that is trading at a 10% normalized levered free cash flow yield.  The Company is the leading fully invested fiber network in North Spain, operating specifically in Basque Country (legacy Euskaltel) and Galicia (R Cable acquisition; closed 11/30/15).  The legacy Euskaltel network covers 85% of Basque households and 873K homes (3.4% of Spain).  The Basque country is one of the richest regions in Spain with GDP per capita 30% above the Spanish average.  Thanks to its local roots and being the only cable player in the region, Euskaltel has >40% share in fixed broadband and is one of the two highest in Spain.  It also has 20% share in residential mobile market and 34% of the corporate segment.   61% of its revenue comes from Residential, 29% from business (42% large accounts, 38% SOHOs, and 20% SMEs), and 8% from wholesale.  Within the Large Accounts, the top 6 accounted for 58% of that segment’s revenue.  The largest single account is the recently lost Basque government (25% of Large Account), which has de-risk the customer concentration going forward. 

Euskaltel is a scarce asset and an attractive takeout candidate: it is one of two remaining independent regional cable operators in North Spain, the only Spanish region that has yet to consolidate.  With its fully invested network, Euskaltel covers 85% of Basque and >50% of Galicia households with theoretically unmatched broadband speeds, which will enable it to become a share gainer in 4P/convergence offerings as consumers prioritize broadband service quality and network.  The Spanish cable market is underpenetrated vs. European peers with respect to high speed internet (23%) and pay TV (28%).  After years of price competition and macro pressure, the Spanish cable/telecom sector has consolidated from 5 players to a rational 3 player market and, combined with macro recovery, should improve long term pricing in the market.  Lastly, the Company is past its investment phase and transitioning into its harvest mode.  While there’s modest brownfield buildout, incremental value will primarily be created by “sweating” its assets and earning a fair return: Euskaltel’s current after-tax returns on tangible capital are only low double digit when global comps earn high-teens or higher. 

I believe a LDD entry yield is not expensive for an “unregulated” utility business with a fully-invested/next generation broadband network that can grow at least with GDP in a cyclically depressed but improving Spanish economy.  Euskaltel should compound its AT FCFE by at least MSD (HSD in management’s case) especially as it deleverages.  Revenue growth should be LSD driven by increased ARPU from mobile convergence and pay TV penetration and subscriber/pricing growth led by its differentiated broadband network.  This leverages into 200 bps+ of EBITDA margin expansion from operating leverage and continued savings under its “Transformation Plan”, which then leverages into MSD/HSD FCFF growth from stabilizing/falling capex intensity over time (post-discretionary brownfield builds) and debt paydown.  I believe the end game is a likely takeout by Vodafone or Orange who both own the major Spanish cable operators Ono and Jazztel but are missing North Spain and cannot effectively compete against Telefonica in the region.  If anything, this should provide downside support or perhaps upside optionality.  Buying the incumbent Euskaltel with a next-generation pipe would be a lot cheaper than organically building.  In the meantime, Euskaltel aims to deleverage its balance sheet from 5x (largely as a result of R Cable acquisition) to its LT target of 2-3x, after which it aims to return a significant portion of its cash flow to shareholders in the absence of further consolidation opportunities (2017/18 timeframe).  The Company has stated that levering up to pay special dividends is within its capital return framework.            

The biggest risk would be competitive rationality as fiber becomes overbuilt.  While modest today, Telefonica and its telco peers plan for near 100% fiber build in Euskaltel’s region.  To date, Northern Spain (especially in Euskaltel’s Basque and R Cable’s Galicia regions) has been well insulated from Telefonica’s fiber build.  However, fiber rollout throughout Spain which would challenge Euskaltel’s monopoly in the premium fast speed segment.  I will note that execution and potential regulatory issues do present challenges for Telefonica.  Also, I find it hard for Telefonica to be very aggressive on pricing (assuming it is economically rational) given Euskaltel earns a modest low double digit return on a quasi-depreciated network (e.g. Euskaltel may benefit from pricing umbrella).

INVESTMENT MERITS

-          Fully invested best-in-class cable network in the Basque region à increased penetration in Spanish cable and market share gains as broadband becomes differentiator

Convergence is a big trend in Europe and almost a necessity in order to be truly competitive.  The prevailing view of cable/fiber network owners such as Altice and Euskaltel is that the mobile network is a commodity while the differentiator will be broadband.  Over time, customers will prioritize network quality, speed, and service over other services in the bundle.  In general, Spain’s high speed broadband penetration is much lower than its European peers (low 20% vs. 45-50% high speed data). 

Within its regions of operations, Euskaltel has >40% share of the fixed broadband market share and, more importantly, 85% share of the high speed market (>30 Mb) vs. Telefonica’s 15%.  This is especially interesting given the context that the overall Spanish market only has 23% of its subscribers within the >30 mbps segment.  In the Basque country, 50% of fixed broadband is on DSL and up for grabs between cable 41% and FTTH 9% leaving sufficient runway for share gains.  This dominant market share in high end speeds reflects its extensive 85% coverage of Basque households and the fact that its network is fully updated to DOCSIS 3.0.  I’ll add that its network can easily be upgraded to DOCSIS 3.1 with limited investment.  I would expect its overall share of fixed broadband to continue to creep up and converge towards its high speed data share as speeds become more important and consumers trade up with higher broadband capacity needs and recovering consumer incomes.  High speed connection net adds represented 30% of total market net adds in 2012, 91% in 2013, and 127% in 2014.  High speed data connections were only 9% of the total fixed broadband market in 2013 but increased 1 year later to 16%.  This growth is coming from cable and FTTH players, the only two technologies in the Spanish market able to provide more than 50 mbps.  The value proposition of fiber is well discussed by Telefonica: “fiber customers have 1.5x higher ARPU than ADSL customers and a high level of customer satisfaction, and therefore a lower churn rate (0.5x)”

I’ll also note that Euskaltel has a strong brand heritage in the Basque region.  As we’ve seen with CVC in New York, high customer service can be a significant churn deterrent which helps long term margins and economics.  The superior operations are reflected in penetration and market share metrics vs. Spain and other regions.  Fernando Ojeda addresses its “local” customer relationships that is better adapted to North Spain: “We don’t forget customers who want the personal touch. We also provide a very simple digital way. In the Basque country, we have two languages: Spanish and Basque. We have everything in Spanish and Basque. That’s also something that differentiates us from Orange, Vodafone and Telefonica. It enables us to be more local.”

Euskaltel’s share is more than double the average cable market share in Spain (18%), with Telefonica (34%) below its Spanish average share of 47% and alternative operators (24%) also below their national average of 35%.  Telefonica is the weaker competitor when it goes head to head with cable with only 30% share when cable coverage is >80% vs. >50% share when cable coverage is 20-30%.

-          Increased ARPU potential from mobile convergence and pay TV penetration

Euskaltel does not indiscriminately take up pricing every year on its customers because it has a “monopoly.”  Instead, the Company has a more value-added approach where it looks to provide the consumer with benefits such as increased speeds or capacity in order to justify the price increase.  This can obviously be done at very attractive economics (minimal incremental expenses) given the fixed cost structure/investment of the network.  There are two big drivers for increased ARPU: mobile convergence and pay TV penetration.  On mobile convergence, most of its peers are >75% whereas Euskaltel is still only at 59%.  R Cable’s 80% penetration shows that higher convergence potential is certainly achievable and will lead to higher ARPU.  For example, R Cable’s LFL offerings are priced at a discount to Euskaltel but it earns in-line/slightly higher ARPU given the higher mobile penetration.   Mobile and bundling helps reduce churn which should theoretically boost margins and customer lifetime values.  Data shows that 1P annual churn is 22% vs. 2P’s 18%, 3P’s 12%, and 4P’s 3%

Pay TV penetration is another source of ARPU upside.  In general, Spain is a strong FTA market where pay TV has only 28% penetration (~30% of Basque households).  While it’s nearly impossible for pay TV penetration would approach US levels, I do think that its current level is too low and that an improving Spanish economy and improved content should help boost penetration given TV is more of a discretionary purchase.  In other European countries where FTA is also stronger than in the US, pay TV penetration approaches 70-80%. 

-          EBITDA improvement from the completion of its “Transformation Plan”

Three big sources for EBITDA margin improvement over time: [1] operating leverage (especially with pricing power), [2] 20MM synergies, [3] completion of “Transformation Plan”.  As we’ve seen with cable operators around the world, there is inherent operating leverage in the business given the network’s cost and investment is largely fixed with little incremental costs associated with price increases or subscribers.  Therefore, we should see natural margin expansion as revenues grow.  With regards to synergies, Euskaltel has guided to EUR 25MM to be achieved by 2017.  These look very achievable and are the typical buckets we’ve seen in other acquisitions such as enhanced scale for better procurement, reduced overhead, and convergence of R Cable’s MVNO economics down to Euskaltel’s attractive levels. 

EBITDA growth would continue to benefit from the ongoing turnaround under its “Transformation Plan” that commenced with new shareholders in 2012.  The result to date has been 580 bp improvement in EBITDA margin and an average capex intensity of 14.6% in the last three years.  Over the next 5 years, the network will be expanded and 4G mobile will be rolled out.  Euskaltel plans to expand its network into 51K homes provisionable (brownfield) vs. the current 804K, 2200 new provisionable SOHOs, and additional 700 SMEs and large accounts.  For a total cost of 20-25MM (including deployment and installation costs of new clients), the network expansion should be margin accretive: incremental EUR 11MM of annual revenue and 5.5MM of EBITDA assuming similar penetration and ARPUs as the rest of its footprint. 

Lastly, there should be cost savings from Euskaltel rolling out its own mobile network.  The Company owns 2.6GHz spectrum which can be used to provide 4G services in the Basque country under a regional license.  Euskaltel has been vocal about building out its network in order to lower wholesale rental costs it pays to Orange.  This is hard to quantify (not reflected in #s or management’s forecast) but should be a meaningful LT driver.  The plan is to deploy its 4G network over 2015-2018.  Euskaltel aims to close the margin gap with Telenet (52.5% margin)

-          Recent industry consolidation + Spanish macro improvement = improved rationality and pricing power

The Spanish market has undergone tough price competition over the last few years with the deteriorating economy and the introduction of Telefonica’s convergent offering.  Telefonica aggressively discounted fixed-mobile bundles in 2012, consequently resulting in the rebasing of industry price points.  The rationale: control churn which seemed to work as its broadband/mobile churn of 25% reduced to 15% in 3 years.  The remaining telco operators were unable to compete and were pressured, which ultimately drove market consolidation as the telcos (Vodafone and Orange) bought the cable operators (Ono and Jazztel) to provide a true convergent offering with high quality fixed cable assets.  With next generation fixed/mobile networks (e.g. fiber and 4G) rolled out, I think pricing power should improve as competitors aim to upsell these services and earn fair returns on their capital.

We’ve already seen early signs of pricing power (or at very least stabilization) since the 2014 consolidation and I expect to see further rationality with industry focus on migrating customers to higher offers and passing through higher content costs (which Euskaltel has already lapped but its competitors are starting to face).  These upgrades may be part of the new commercial trend in the Spanish telecom market, with all the telecom providers enriching their product offering to support price increases, particularly in the product bundles, which could be the catalyst for migrations from ADSL to fiber/cable products, and from basic content TV to premium content package, driving ARPU increases, and putting an end to the deflationary trend seen in recent years.   

Euskaltel believes that there will be more consolidation in Europe driven by convergence.  Fernando Ojeda’s comments prior to R Cable acquisition: “I suppose that the telecom market will consolidate even further. In Europe, there are too many local operators, and there is potential for more consolidation there. In Spain, there will be more consolidation too. We have three major players—Vodafone, Orange and Telefonica—but in northern Spain, there are also three smaller cable operators. The biggest of these is Euskaltel, and the other two are smaller than us. Potentially, there will be consolidation between the big operators. Globally, I think convergence of mobile and fixed networks will push consolidation of global players, but we are already a much-converged company.”

-          Scarcity value as an attractive takeout candidate in the only independent cable region in Spain should limit downside protection while providing attractive upside optionality

All of Spain has already undergone consolidation with telcos buying out fixed cable assets such as Ono and Jazztel in order to compete with Telefonica’s convergent offering.  The only region that remains is the semi-autonomous Northern Spain, which one could argue is akin to a different country with its own cultural norms and language.  However, I think it is inevitable that consolidation happens in this region as Vodafone and/or Orange aim to fill out its footprint.  In the regions where Ono is not present (e.g. Basque, Galicia, and Asturias), Vodafone is at a strategic disadvantage given it has limited fixed next gen network assets to be competitive.  In these regions, the cable operators are in very solid competitive position to compete against Telefonica despite their limited geographical scope as they have fully convergent offers.  The case becomes more compelling when you compare the buy vs. build option as VOD/Orange plan to roll out fiber into the North Region. 

INVESTMENT RISKS

-          Aggressive fiber overbuild from Telefonica, Vodafone, and Orange into Northern Spain

This is the biggest investment risk given the explicitly stated intentions for FTTH overbuild by the telcos.  Currently, only 30% of Basque is covered by fiber, primarily by Telefonica and practically 0 investment by other players such as Orange/Jazztel or Vodafone/Ono.  This compares to >50% FTTx coverage by incumbents in Belgium, Netherlands, and UK.  However, this will likely change and Euskaltel has a 2-3 year window before the market becomes overbuilt with fiber (IF execution is according to management plans). 

In 2010, Telefonica started to deploy a new FTTH network, which has been significantly accelerated in the last two years (12.5MM homes/businesses at end of 1H15).  Telefonica recently announced it aimed to cover 97% of Spanish households with FTTH by 2020 (if regulations remain supportive), and Orange has a target of 10MM homes passed by 2017 (3MM shared with VOD + 7MM targeted by Jazztel).  While building and making fiber work at good economics is harder said than done, I’ll note that Spanish build costs per home are estimated to be EUR 150-200 and materially cheaper than the up to 900 we’ve heard in other regions of Europe.  The cheaper costs are a function of higher population density and Telefonica’s requirement to offer wholesale access to civil works infrastructure/ducts.  Absent forced wholesale access, I believe that the telcos will eventually build fiber in Euskaltel’s regions.  However, I would note that Euskaltel has a local brand heritage which would make stealing customers more challenging.  North Spain is semi-autonomous and therefore harder for Telefonica/VOD/Orange to blanket its services as it has in the other regions.  Believe it or not, Euskaltel actually earns high customer service marks which has got to be a first for cable operators!  The brand is recognized by 99% of the Basque population and 2/3 of its customers have never unsubscribed to the company.  Santander claims that its brand is associated with proximity to the client, good-quality service, value for money and commitment, and it is seen as a reference point in Basque society.

The other mitigant would be an unfavorable regulatory regime for Telefonica given it is the incumbent.  There have been rumblings that Telefonica would have to provide open access to its fiber network.  As expected, the company has threatened to scale back its build out.  This remains unresolved.  Lastly, the execution and subsequent returns generated from fiber are debatable especially with a fully invested cable network.  We can point to VZ and AT&T in the US as precedents.  Euskaltel’s regions (especially in R Cable’s footprint in Galicia) is a lot less densely populated, which makes it hard to earn attractive economics.

-          Large Basque government contract loss was precedent for looming competitive issues in large accounts business

Euskaltel recently disclosed that it lost the vast majority of the Basque government contract over 2016-2019 to Telefonica.  The quantifiable loss is EUR 10MM in annual revenue (3% of pre-R Cable revenue), EUR 4MM in EBITDA (2%), and EUR 2MM in PT FCFF (2%).  While the Company claims an unfair process to the CNMC (Spanish competition authority), Euskaltel believes it can offset the EBITDA impact through cost efficiency measures (requires a 2.5% reduction in group opex).  Over the medium term, management thinks it can offset the EUR 10MM revenue impact through Business segment contract wins.

The bigger risk is that the contract loss signifies intensifying competition from Telefonica in the large corporate and government contract space.  While I believe that competitive intensity is highest here of all the enterprise segments, I’ll note that the EBITDA margins are likely the lowest given the bargaining power of its customers (as opposed to highest margins with SOHOs or SMEs).  Also, Euskaltel does not have any other government contract exposure.  R Cable claims it has renewed regional government contracts as recently as 2014 and they’re secure for next 3 years (total EUR 9MM of revenue exposure at R Cable).  The Company has a strategy to be disciplined on pricing and to make up any shortfalls with cost reductions/efficiencies.

-          Bad regulation: Euskaltel’s network is required for open access to competitors

Spanish regulation around cable/fiber has been rather favorable.  Prices are really left to market dynamics and cable operators have not been forced to wholesale their networks.  Telefonica, as the incumbent, faces the biggest risk of asymmetric regulation especially as it looks to build out fiber.  The government is currently considering forcing Telefonica to wholesale its next generation fiber, which the company has pushed back and said such punitive regulation would be a deterrent for fiber investment.  As currently contemplated, Telefonica may be forced to open its FTTH network in these cities with less than 100K inhabitants (60% of Spanish market), while the remaining 40% of the market (cities >100K) will not be regulated.  These are the same mid-sized towns that are relatively dispersed and have lower incomes, making it a less attractive profit pool for Telefonica to invest.

Currently, only access to Telefonica’s network by third parties is regulated in two ways: [1] Telefonica has a wholesale regulated unbundling offer (access to its local copper loop by renting the infrastructure) and [2] Telefonica has indirect access wholesale offer for its fixed access network (copper and fiber).  This regulatory framework, which establishes prices and procedures, only obliges Telefonica to open its fixed access network to third parties; no other player is required to do.  Another significant regulatory nuance is that Telefonica is required by regulators to offer access to its ducts on a wholesale basis.  As mentioned earlier, this greatly reduces the FTTH entry investment given civil works costs are probably 70-80% of the fixed access network roll-out cost. 

Surprisingly, Euskaltel has not faced similar pressure given it effectively is the incumbent monopolist within its regions of operations.  Neither has Euskatel’s network nor its ducts been subject to open access requirements.  The risk is that Euskaltel is subjected to similar regulatory pressure in the future, especially if fiber is not built out or if it takes up ARPUs too aggressively.  Historically, there have been no discussions around more punitive regulations against cable.      

Important Disclosure

The provision of this report does not constitute a recommendation to buy or sell the security discussed herein.  The report is an example of the author’s company write-ups / research process; its breadth and coverage may differ materially from other such reports.  Certain statements reflect the opinions of the author as of the date written, are forward-looking and/or based on current expectations, projections, and/or information currently available.  The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term.  The views are those of the author acting in his individual capacity and not as a representative of the firm; in no way does this report constitute investment advice on behalf of the firm.

Catalyst

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