Description

We believe that Telecom Italia (“TI”) provides an opportunity to invest in a high quality asset with between 50% and 100% upside.  The Company has a well incentivized CEO, Marco Patuano, and a legendary new activist owner, Vincent Bolloré, both of whom are in the process of fixing a historically mismanaged, high quality business with a clear market dislocation. TI is the largest (and oldest) provider of wireline and wireless services in Italy. If management achieves its plan, the Company trades at 10x 2017 free cash flow.  The market views TI as a structurally declining business, but misunderstands the cause of recent revenue declines, which we think are temporary, and the near, medium and long-term benefits of rolling out fiber.  We forecast that by 2H 2016, revenue growth will be positive in constant currency, and the shares should re-rate to peer levels.  Further, we see upside from several levers that Bolloré can pull, including divesting two major non-core assets, monetizing real estate, and accelerating TI’s cost optimization plan. 

On two prior occasions, we have successfully invested behind TI’s new 21% owner (via Vivendi), Vincent Bolloré.  We first invested behind Bolloré at Havas and then later in Vivendi once he made a significant investment and gained board representation.  As detailed below, Bolloré’s track record shows tremendous value creation.  

Bolloré Groupe’s Investments Have Shown Strong

Returns Over an Average Five-Year Holding Period

Bolloré’s average investment price in TI shares is at or below the current share price, which implies the market does not assign much, if any, probability that Bolloré can add much value.

Vivendi’s Stake in Telecom Italia

TI, like many traditional telecom incumbents, experienced little competition throughout its history. Like other former quasi government-owned enterprises in Western Europe, TI failed to innovate for decades due to a lack of viable competition and despite significant cost largesse. As a result, the Company never transitioned to next generation technologies including ultra-high speed internet and advanced mobile data.  Italy has consequently lagged behind other developed countries with one of the lowest level of broadband and high speed mobile data penetration in the world.

Broadband Penetration (Connections / 100 People)

As a result of TI’s lack of innovation, several competitors entered the Italian wireline and wireless market over the last decade. These players include the giant Vodafone and low priced insurgents Wind and Three. As competitors started providing similar services to TI at competitive prices, TI lost significant share. The share loss translated into domestic revenues falling every year over the last decade.  As financial results continued to deteriorate, investors punished TI and the share price fell from nearly €2.00 in 2005 to a low of €0.50 in mid-2013.

Why do we think TI is a great investment NOW?

Reason 1: Bolloré will serve as an ongoing catalyst.  We believe he will accelerate a number of initiatives leading to increased value creation over the next 12-18 months.

As illustrated above, Vincent Bollore (through Vivendi) has recently taken his stake in Telecom Italia from 0% to 20% since the summer of 2015. In addition, news reports suggest that Bollore is interested in increasing his stake further beyond the 20% he currently owns to 25%+. At TI’s Extraordinary General Meeting a few weeks ago in Italy, Vivendi was able to elect four board members, including the CEO of Vivendi, Arnaud de Puyfontaine. We believe that Bollore now has significant corporate influence and is pushing for change at TI. We have seen this playbook before and believe he will be able to create significant value (see below).

Many news agencies have reported that Bolloré is pushing Telecom Italia to dispose of its 66% holding in Brazilian mobile telecom provider, Tim Brazil. While Tim Brazil represents less than 15% of TI’s value, a disposal would improve sentiment dramatically as Tim Brazil operates in a highly competitive Brazilian mobile market, is burning cash, and provides a drag on TI’s consolidated earnings.  We believe that Bolloré will also accelerate a number of other initiatives that will result in value accretion over the next 12-18 months. First, TI recently committed to a full exit of its tower portfolio.  After spinning off 40% during the summer, the Company now is looking to sell its remaining 60% stake and news reports suggest significant demand for the towers.  Given that the Tower business trades at 20x EBITDA, we do not believe that the market properly captures this value in TI’s 6.5x 2015 EBITDA multiple.  Second, we expect Bolloré to hasten the sale of TI’s vast real estate portfolio. While we can’t size the opportunity exactly, we think TI could potentially reap as much as ~€500 million.  Finally, on the operational side, TI’s CEO laid out a plan to cut ~€1 billion of costs by 2017 (we believe the number net of expenses to execute the plan is close to €650m). These costs look reasonable based on our research (~40% are industrial, G&A and excess real estate rental costs and 60% are customer-driven costs including customer care and other commercial costs) and we would be surprised if Bolloré did not aggressively accelerate and upsize the plan.

We also believe that Bolloré will likely serve as an ongoing catalyst for Pan European telecom consolidation. Bolloré’s strong ties to several governments (including Italy and France) could help pave the way for TI’s eventual merger with another European telecom behemoth. Given the recent trend of M&A in the industry, Bolloré likely wants to combine TI with another company, which could create significant value for shareholders.

Reason 2: TI still maintains a significant competitive advantage due to its national wireline network and its transition to fiber is a game-changer for revenue growth and margins.

The market remains focused on TI’s declining revenue and market share losses over the last decade, but TI still has a significant competitive advantage. TI is the largest provider of fixed line services in Italy with ~68% market share (note we estimate that fixed line services make up ~80%+ of TI’s domestic earnings) and TI covers roughly 85% of Italy with its fiber and copper network, 3x-4x more coverage than its closest competitor. The cost of replicating TI’s network is astronomical (billions and billions of euros) and would take decades.   Most important, TI’s management team has just decided to start innovating and using its competitive advantage to stifle the competition. TI recently began aggressively investing in fiber across its Italian footprint, bringing high-speed data to its entire customer base. Given its huge copper network across Italy, TI can deploy fiber much more quickly and efficiently than all its competitors.  The reason we view this as a game changer is because our value added research suggests that the lifetime value of a fiber customer is ~3x the value of a copper customer. Why? Fiber customers pay more every month than copper customers (because they get 10-20x the internet speed) and they also churn significantly less than non-fiber customers (because they can’t get this speed anywhere else). Currently, fiber penetration in TI’s base is ~5%. TI’s plan is to roll out fiber to over 75% of its footprint by 2017. Given the superior value generated by a fiber customer vs. a copper customer (see exhibit below), as TI’s base becomes increasingly penetrated by fiber customers we believe that there will be significant uplifts in domestic revenue and EBITDA. While consensus forecasts 2016 to be yet another year of negative growth in the domestic business, we believe that revenue and EBITDA will grow, both in 2016 and for years to come.

Unit Economics of Copper vs. Fiber Customer

Valuation

Core Telecom Italia ex. its 66% stake in Tim Brazil trades at ~6.5x normalized 2015 EBITDA. Consensus believes that domestic Italian EBITDA will stay flat for the next three years. We believe that EBITDA is on the cusp of growth and will turn the corner in 2H 2016 as the unit economics of the Company’s fiber strategy play out and Bollore’s cost cutting strategy boosts margins.

Normal U.S. and European telcos trade at b/w 7.5-10.0x normalized EBITDA. We believe that by mid 2017, TI’s multiple will re-rate to peers levels (as the company de-levers and EBITDA growth accelerates). We think the multiple could hit the higher end of the range if and when the Company disposes its stake in Inwit, sells real estate assets to de-lever, and sells its stake in Tim Brazil. We believe a base case upside of 50% is likely as the Company’s operations improve and that 100% upside will be achieved as the Company executes on these other operational initiatives.

How to Play This?

Telecom Italia has an outdated dual class share structure which consists of ordinary shares (TIT IM) and savers shares (TITR IM), both of which are publicly traded. The ordinary shares each carry one shareholder vote and no dividend. The savers shares carry no shareholder vote but pay an annual dividend (~2.5% yield). We believe both sets of securities provide significant upside.

Interestingly, the ordinary shares trade at a 21% premium to the savers shares despite the fact that both have the same economic interest in the underlying earnings of TI, indicating that investors in TI value a vote significantly more than they value a dividend.

Prior to TI’s December 2015 Extraordinary General Meeting, TI’s board announced it would put forward a proposal at its December meeting which would offer all savers shareholders the opportunity to convert their shares to ordinary shares at a ~10% discount. The spread between the savers and the ordinary shares immediately shrunk to reflect this difference. However, during the meeting Vivendi voted against the proposal since a conversion would result in a significant dilution of its voting power (since once the savers shares were converted to ordinary shares, each share would receive a vote). As a result, the proposal was defeated and the spread has ballooned to 21%.

The rationale for a conversion of the savers makes a lot of sense and we believe that Vivendi will vote in favor of this proposal in the future. By converting savers shares to ordinary shares, TI will save ~66m a year in cash that is being used to fund savers dividends (at a ~10% discount rate, the NPV to the ordinary shares is ~660m). In addition, savers shares will have to pay in ~10 cents/share to convert (if the conversion premium is 10% and the spread is 20% at the time of conversion ) resulting in an additional ~600m  of cash being raised which can be used to pay down high cost debt. Press reports indicate that Bollore and Vivendi are open to converting the savers shares to ordinary shares as they now have board representation. We believe that it is a question of if, not when, the conversion happens given its favorable economics. Once this happens, not only will the whole company benefit due to the savings and cash raise, the savers share premium will shrink from ~21% to ~10% providing incremental upside to savers shareholders.

Summary

In conclusion, Telecom Italia’s current share price offers us an opportunity to buy a cheap, misunderstood, high-quality business protected by strong moats at a material discount to intrinsic value.  We believe TI has reached an inflection point and will now transition from a decade of revenue decline to years of strong fundamental growth.  Further, the transition is being led by TI’s new, highly-incentivized CEO (>20mm shares and options) and its largest investor who boasts one of Europe’s strongest value creating track records. Once TI starts to grow and investors see a few quarters of margin expansion, we expect the stock will re-rate to a multiple in-line with peers.  Peer multiples, which don’t account for TI’s structural and secular superiority, imply a base case upside of ~50%.  This assumes no benefit from disposals of TIM Brazil, TI’s 60% ownership in Inwit (~€1.6bn), real estate, which alone could generate up to €500m, or a collapse of the dual class share structure.   All in, we think that between the fundamental improvements and potential value creation levers, TI offers 50-100% upside from the current share price.

Catalyst

Quarterly earnings reports, increasing intervention by Vivendi/Bollore, sale of real estate, Inwit and Tim Brazil, and collapse of dual share classes.