Description

Company Description & Investment Thesis

In late 2014, Numericable, the leading provider of fixed cable services in France, acquired SFR, the country’s second largest mobile carrier, from Vivendi. The new entity, called SFR, is 78% owned by Altice. Altice is a publicly traded multinational cable conglomerate with a management philosophy of lean OpEx, investment to increase broadband speeds, and a focus on cash flow. More than half of Altice is owned by management. Altice’s majority ownership of SFR does create trading liquidity issues worth flagging upfront, trading only €5-10mm per day.

Our SFR investment thesis centers on the transition to faster broadband speeds in France and margin improvement from cost cutting. Currently over 80% of French broadband subscribers have a DSL connection, which provides internet speeds inferior to those of cable/fiber. As we’ve seen in other countries, the bandwidth demands of streaming video have spurred a migration in France from DSL (subscribers shrinking 1-2%) to high speed (subscribers growing 30-40%). SFR owns the largest high-speed broadband network in France, enabling it to charge premium prices while delivering service at a lower cost than peers. We believe the transition to high-speed cable/fiber is inevitable and that SFR will be the biggest beneficiary. France is also in the midst of a transition to quad-play packages, which are bundled fixed+mobile offerings. This convergence trend was one of the reasons Numericable entered the mobile arena by acquiring SFR. These two transitions in the French market (faster broadband, quad play) should boost SFR’s mobile business versus peers Iliad and Bouygues, which lag behind on fiber investment and cannot match SFR’s fixed broadband speeds. Quad play plans carry lower customer churn at higher ARPUs.

Focusing on 2016 means the market hates SFR: “over-levered telco with shrinking EBITDA and an inferior mobile network in an irrationally promotional pricing environment”

As background, Iliad’s entry into the French mobile market in 2011 has made it a bad place to be, with ARPUs dropping from €25 to €16. This trend has largely stabilized, with mobile ARPUs between €16 and €17 for the last six quarters (through Q1’16). During this time, several consolidation attempts have been made to buy Bouygues Telecom and reduce the French market from 4 to 3 players. The most recent began in January 2016 with a months-long public negotiation as Orange, the incumbent, negotiated to acquire and dismantle Bouygues Telecom by selling off pieces to SFR and Iliad. The deal fell through after months of wrangling, but the process brought unsustainable promotional pricing. For example, Bouygues sold triple-play packages at €5 per month, despite a monthly local loop unbundling fee of €10 they must pay to Orange for each line.

In addition to promotional market issues, SFR has had problems with its mobile network from a lack of investment by the prior owner. These mobile network quality issues led to elevated customer churn and required a step-up in CapEx guidance for 2016-2017. The twin issues of promotional pricing and problematic network quality fed off of each other, resulting in a poor SFR Q1’16 result. EBITDA declined 9% in Q1’16, after growing 20% in 2015 on the first round of Numericable/SFR merger synergies.

To cap it off, SFR is levered at 3.9x compared to most peers closer to ~2x. Higher leverage paired with shrinking EBITDA in 1H’16 presents an ugly picture.

This framing of SFR has led to a valuation on 2016 of 6x EBITDA and a 10% FCF yield on our numbers.

When the market focuses on 2017, SFR will cease to be hated: “double-digit EBITDA grower with an advantaged fixed network and on-par mobile network with an improving price environment, upside on margins, a call option on French telco consolidation, and the potential for another large special dividend.”

The dramatic EBITDA turnaround in 2017 comes primarily from cutting employee costs. At the time of the Numericable/SFR merger, the company agreed to employment guarantees until April 2017. Just this week, SFR filed plans to reduce its workforce by 1/3 (5,000) as soon as the guarantees expire. In the meantime, in Q2’16, SFR launched new cost cuts related to IT and call centers along with price increases on its subscriber base that should lead to growing EBITDA in 2H’16. The company’s medium-term target of a 45% EBITDA margin, versus 35% in 2015, provides further upside into 2018.

SFR has made great strides to fix its mobile network after hiring wireless industry veteran Michel Combes as acting CEO of SFR (he is CEO of Altice now). Upgrades to the company’s 3G network (for voice) are now essentially done, while 4G radio placements have accelerated and put SFR on pace to catch Orange by year end 2016 or early 2017 (monthly data on French 4G radio placements are available at www.anfr.fr).

There are a number of reasons to believe the French telco market should see improved pricing. Of the four players in the market, two are aggressors: Iliad in mobile and Bouygues in fixed. Iliad’s strategy has prioritized subscriber growth without generating FCF, which has been matched by a flexible capital structure with less than 1x net debt. Over the last three years, Iliad has generated cumulative FCF of €170mm versus a market cap of €10bn, including slightly negative FCF in 2015. The company guided to increased CapEx in 2016 as they wean themselves off of the sweetheart mobile roaming deal from Orange. Recently, Iliad signed an agreement to buy wireless assets in Italy from the Wind/Hutch merger. Iliad said it will debt-finance these assets, which are likely to be negative FCF for some time. Shifting gears, Bouygues has put out a 25% EBITDA margin target for 2017 that likely requires higher prices, but at least limits the amount of loss-making revenue they can take absorb. It’s worth noting that Bouygues has signaled they would sell their telecom business if they cannot hit 2017 targets. Finally, while comparing ARPUs across geographies is imperfect, most analysts would agree that France is either the lowest in Western Europe or close to it.

When SFR’s leverage drops to ~3.5x, the company is likely to pay another special dividend. The last special dividend of €5.70, paid in December 2015, is nearly 30% of the current share price. We believe the company will have capacity to pay a larger dividend by year end 2017. SFR has no material debt maturities until 2022 and is highly cash generative even in 2016, a year with accelerated CapEx to fix the mobile network.

Finally, a word on future consolidation. Without a credible high-speed broadband plan and roughly zero EBITDA-CapEx before funding fiber builds, Bouygues Telecom has no future and needs to sell. The market values the consolidation call option at zero today given the unpredictability of the egos involved that managed to kill a win-win deal earlier this year. Martin Bouygues’ political connections mean French elections in the spring of 2017, which will likely to lead to a change in ruling party, could increase the probability of consolidation. But that would be gravy.

Potential Returns

We project 2018 free cash flow per share of ~€3. Applying a 10x multiple, value per share for the base business is €30. In addition, we expect the company to maintain leverage at 3.5x EBITDA. Coupled with annual free cash flow generation, re-leveraging the company’s growing EBITDA through 2018 provides cumulative dry powder of roughly €12 per share that we expect SFR to distribute as special dividends. In total, we estimate value per share of €42.

Disclaimer: We and our affiliates are long SFR. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

EBITDA returns to growth in 2H'16

Guidance for 2017

Consolidation talks restarted

Special dividends