Description

Description

Company overview (note: all figures in EUROs unless otherwise noted)

Royal KPN (“KPN” or “the company”) is the incumbent provider of telecommunications services throughout the Netherlands, providing both fixed line and mobile services. It also offers mobile telecommunications services through its E-Plus subsidiary in Germany and its BASE subsidiary in Belgium. KPN trades on both the Amsterdam stock exchange and as an ADR. It is currently trading at €6.00 per share, and should generate approximately €1.00-€1.10 of after-tax free cash flow per share this year, benefiting from a favorable tax position. KPN has also reduced its net debt from €15.8bn at the end of 2001 to an expected €8.7bn at the end of 2003/

KPN operates two main divisions: Fixed and Mobile Its Fixed division (approx. 60% of 2003e revenues, including intradivision and 62% of EBITDA) is a pure national play in the Netherlands, with its focus on exploiting existing business and maximizing value from broadband and data KPN has higher aspirations for its Mobile division, hoping to grow into a large European player and participate in an anticipated consolidation in the market The Company’s strategy is to grow mobile data, become a “better number 1” in the Netherlands, and strengthen its operations in Germany and Belgium

The Company has successfully transformed itself from an overleveraged poster-child of the telecom hype to a lean, free cash-flow generating entity.

Specifically, in 2001 the Company embarked on a “survival strategy”, developing a turnaround plan focused on cash flow, cost reduction and debt reduction. 2002 was characterized as “the year of execution”, as the Company implemented measures from large-scale personnel cutbacks to the sale of non-core assets. After successfully reducing its net debt by over $3bn from 2001 to 2002, in 2003 KPN was able to concentrate more on its customers while at the same time continuing to improve its balance sheet.

Going forward, KPN should continue to generate free cash flow for its shareholders as it seeks to offset the decline of its fixed wireline business with its growth strategy in ADSL and Mobile.

Thesis:

At its first-ever investor day on December 10th, the company gave guidance for 2004 and 2005 that was below analysts’ expectations. Specifically, the company initially gave pre-tax guidance for 2004 and 2005 of €1.4bn and €1.5bn. Subsequently, it restated its guidance, claiming that there could be an additional upside of €300mm for each year. The company will give an update of its guidance in March 2004, when it will publish its 2003 results.

The guidance led to an immediate drop in the stock of approximately 10% and at the time of this writing, it has not yet recovered.

Put simply, this an old-school valuation play: KPN generates significant free cash flow and is valued at a discount both to the domestic market and its peers. While it may continue to lose revenues in its fixed wireline business, it appears to be firmly entrenched nonetheless, and has potential upside in ADSL and its Mobile division. From a valuation/free cash flow perspective, the company benefits from a potential major tax credit from the Dutch tax authorities. Thus far, the company has guided no tax payments in 2003 and 2004, but there may be additional upside in future years.

Valuation

EV/EBITDA-Capex

Current enterprise value (@ €6.00/share):

Market Cap: €15bn
Debt + MI: €11.3bn
Pension deficit: € 350mm
Cash: $1.7bn
Total Enterprise Value: €25bn

2003e EBITDA-Capex: 3.5bn
2004e EBITDA-Capex: 3.1bn
2005e EBITDA-Capex: 3.2bn

EV/EBITDA-Capex (2003-2005): 7.1x, 8.1x, 7.8x

P/ATFCF

2003e: 5.7x-6.0x
2004e: 6.0x (including utilization of free cash to delever)

A DCF analysis yields a valuation of anywhere from €6.75 to €8.00 per share

The Company also pays a cash dividend of €0.12 per share

KPN could benefit significantly from even more tax write-offs, with a potential total upside of 8 billion. Currently, the company’s position appears to be that it will not pay cash taxes for 2003 and 2004 (which is what the above analysis assumes), which is included within the 8bn.

Risks:

Regulatory: The company has already been hit by a regulatory ruling reducing the tariffs on its fixed to mobile calls (€300mm fixed line revenues for 2004 and €480mm for 2005). As the dominant player in the industry, it is the natural target for further rulings that could potentially erode its market share and/or profitability

Competition/Pricing: The company competes against both alternative providers as well as new technology. Competitors include other ISPs, alternative operators in the Netherlands (Versatel, BabyXL, and Bbned), and other large mobile providers (Vodafone, T-Mobile, etc). Additionally, cable companies in the Netherlands continue to expand their offerings and cut pricing.

Catalyst

Favorable tax ruling
Recognition of valuation discount
Further accretive acquisitions in Mobile division
Deployment of cash/capital (e.g., increased dividend, share buyback, reduction of debt)