Description

We recommend Freenet AG (FNTN GR) as a compelling long opportunity. Our price target is conservatively €15, roughly 60% upside from today’s price.  In addition we recommend Drillisch AG (DRI AG), a major Freenet shareholder with even more upside. Our price target is €8.5, roughly 85% upside. 

We believe this opportunity has a number of hard catalysts including the resumption of a conservatively estimated >10% divi yield on a sustainable basis, M&A and synergy prospects through acquiring its much smaller No. 2 in the market (which we recommend owning as well), an implicit stock-buyback linked with the latter, and all at a valuation level that is in the mid-to upper teens on both levered and unlevered free-cash flow yields and is simply too cheap to ignore, even if there were no catalysts.

Executive Summary

1.      1.  The stock is very cheap, trading with an 18% FCFE yield, 15% FCFF yield, 5.2x PE and 4.3x EV/EBITDA for consensus 2010e (with a very solid capital structure, only 1.9x net debt/EBITDA YE09, highly cash generative and management LT debt target of 1.5x EBITDA).

2.     2. The business model is extremely easy to understand as the company resells mobile phone contracts through its own stores and online.

3.     3. Freenet offers substantial upside from the hidden value of both NOLs and PPA amortisation making reported EPS very different from cash EPS.

4.      4.   Freenet has restructured over the last couple of years turning from a conglomerate of telecom businesses to a focused “Mobile Service Provider” (MSP) by selling two main divisions (DSL and web hosting) while doubling its MSP business by buying Debitel.

5.     5.   The near term catalyst is starting dividend payments likely in mid-2010 potentially with >10% yield (based on company's own guidance).  This is a level it has hinted to paying on a recurring basis.  We would note that FNTN continue continues to de-lever despite this level of dividend payout.

6.     6.  In the MSP business, topline pressure from ARPU declines is abating while merger synergies have allowed EBITDA margin to improve from 7.5% in 2007 to c.10.5% in 2009 - the fundamentals of the business are solid.

7.    7.   High-return asset-light business with c.40% lease-adjusted ROIC (post capitalizing leases on its stores).

Business Model

1.     1.  Freenet is a Mobile Service Provider in Germany; it resells mobile telephone contracts under its own brands through the internet, its own stores and through concessions.

2.     2.   As a consumer, you can enter one of the newly launched “mobilcom-debitel” stores and choose any voice/data mobile tariff from any operator. Although note that Freenet is not merely a reseller. Freenet “owns” the customer and is responsible for billing, customer service as well as branding, marketing and any handset subsidies, making them an extremely attractive partner for the network operators.

3.     3.  Freenet does not own its own network, but the mobile network operators (MNOs) (T-Mobile, Vodafone, E-Plus and O2) partner with Freenet as a low cost way to access substantial distribution. Freenet operates over 6,000 points of sale (c.5,000 concessions and 1,000 own stores) vs. roughly 4,500 own stores operated by the MNOs combined, as well as a strong online presence.

4.    4.   Freenet is responsible for c.25% of the MNOs EBITDA, yet the cost to service the subscriber for the MNO is minimal as Freenet takes all that responsibility and expense. The network operator just has to maintain the network.

5.    5.   The continued success of Freenet is vital for the operators as the Freenet store presence gives the operator a retail presence in regions that are not economical to maintain a store for just one brand. Also, the maintenance of current subscriber numbers would be impossible without the Freenet contribution and to manage the network most efficiently, operators need to maximise subscribers.  Therefore, the MNO's are supportive of FNTN's business model.

6.     6.  The business model is similar to a Mobile Virtual Network Operator (MVNO) but with some important differences. Unlike a typical MVNO, Freenet offers all networks in Germany rather than just one; similar to the Carphone Warehouse stores in the UK which resell all four networks. That is very important for the consumer who wants a one-stop-shop with unbiased advice and one point of contact.

7.    7.   Regulations require MNOs to offer their tariffs to MSPs at the same retail price they offer in their own stores, less a discount to allow the MSP to generate reasonable profit margins.

8.    8,   MSPs also re-package MNO tariffs to create their own new unique tariffs. For example, Freenet is one of the lead innovators in the “no-frills” segment (very simple flat rate tariffs without a handset subsidy or minimum contract length) which are growing extremely fast today (Freenet no-frills subs up 34% y/y TTM).

Company Overview

1.     1.  Freenet is the number 1 MSP in Germany with 90% share of the duopoly MSP market (Drillisch has the other 10%). Relative to the total market Freenet is the third largest mobile player with 16% share behind T-Mobile (30%), Vodafone (26%), although similar in size to E-Plus (14%) and O2 (11%).

2.     2.   The business model is extremely asset-light as the company does not own a network and the majority of its retail presence is concessions. Furthermore, subscriber acquisition costs (in particular handset subsidies) are run through the P&L rather than capitalised. As a result the bulk of invested capital is simply working capital, which is not onerous around €200m on sales of €3.5bn.

3.     3.  If we adjust for leases, the ROIC is around 40%.

4.    4.   Freenet also operates an internet portal (1% of sales) and two non-core businesses B2B and narrowband (2% of sales).

Recent Performance

1.    1.  The mobile market in Germany is fully saturated (130% penetration) and has been undergoing almost continual ARPU pressure owing to competition between the four MNOs.

2.     2.   Freenet’s shift away from pre-paid customers to contract (post-paid) and no-frills has allowed the ARPU to reach an inflection point in Q209 with q/q ARPU up  4% and up a further 2% in Q309. As a result the ARPU decline has slowed from -15% in 2008 to c.-5% in 2009.

3.     3.  Increasing data usage will also help offset ARPU pressure; data ARPU was up 56% y/y in Q109 and reached 5-6% of total ARPU.

4.     4.  Following the Debitel acquisition at the end of 2008, the restructuring has created substantial synergies which have allowed the company to improve EBITDA every quarter last year, a trend that is likely to continue through 2010. 9M09 EBITDA was up 9% y/y owing to cost savings and synergies.

5.     5.  Analysts are well aware of the pressure on the topline and expect sales to decline a further -5% in 2010, while absolute EBITDA will remain roughly stable.

Merger Synergies

1.     1.  Following the Debitel acquisition, Freenet gave synergy targets of €210m run rate from YE2011 onwards and the company has met or beaten all of the milestones since then.

2.     2.  For the YE09 run rate we expect the company to realise over €120m with a further c.€50m over each of the next couple of years.

3.     3.  That synergy target will easily offset any pressure on the topline.

4.     4.  Synergy targets are very likely to be beaten as the company has taken steps to realise cost savings not included in the original plan such as shutting additional call centres.

Hidden Value

1.     1.  The Bloomberg stated consensus EPS for 2010 is €1.00 which is far below the actual underlying cash EPS, which we estimate around €1.80.

2.     2.  The company has €2.5bn of NOLs which mean that the company pays only 12% cash tax rate for the foreseeable future rather than the typical German corporate tax rate around 30% (we estimate the NPV of the NOLs around €400m).

3.     3.  The company has €128m per annum of PPA amortisation which is non-cash.

4.     4.  Taking into account these two major factors accounts for the difference between reported and cash EPS, putting the stock on a 5.2x 2010e PE rather than Bloomberg’s consensus 9.4x

Valuation and Catalyst

1.     1.  The stock is cheap on every metric for 2010e: 18% FCFE yield, 15% FCFF yield, 4.3x EV/EBITDA, 5.2x PE on consensus numbers.

2.     2.  On a DCF basis with an 8% WACC (beta 1.1) and -1% growth rate the intrinsic value of the stock is €15, which would put the company on 8x PE, 6x EV/EBITDA and 11% FCFE yield.

3.     3.  The board has clearly stated that the stock should become a dividend paying stock. However, owing to the Debitel acquisition the company was highly levered (3.9x net debt/EBITDA YE08). The company has used their disposals and cashflow to pay down debt to c.1.9x EBITDA at the end of 2009. The company is aiming to further delever to c.1.5x over the next couple of years.

4.     4.  The remaining cash could be used for dividends and would imply an 11-12% yield, although some cash may be held back for working capital purposes such as bulk buying from the MNOs.

5.     5. The company is likely to announce the full dividend policy at the full year results in March, with the dividend paid after the AGM in May/June.

Our expectations versus consensus

1.     1.  Consensus numbers take into account the target cost saving and a -5% decline in sales for 2010, which leads to an EBITDA of €389m. Our analysis suggests that the company might deliver €405m+.

2.     2.   The MSP business delivered €101m EBITDA in Q309 and will improve on that in Q4. The top line is relatively seasonal with a lower Q1 q/q but we think the cost saving timing may allow Q1 EBITDA to be UP q/q. Overall that implies conservatively maintaining the Q309 EBITDA run rate and delivering c.€405m. The non-MSP businesses should be EBITDA breakeven.

3.     3.   At the same time, we think there is a good chance of over-delivery on merger synergies leading to a further EBITDA beat.

4.     4.  The main question in the medium term is what might happen to ARPU going forward. We think we have reached an ARPU inflection point in 2009 but historically ARPU has declined for mobile service owing to penetration growth and regulation (mobile termination rate cuts). Unfortunately, there are no precedents for mature ARPU growth/decline as the mobile market is so new. As a margin of safety however, it should be noted that Germany has by far the lowest ARPU of any western market at c.€17 vs. >€30 for most markets, the nearest being Italy >€21. The reason for the difference is mostly owing to the level of competition with 5 main players.

5.     5.   It seems unreasonable to argue that ARPU will decline forever. Most wireless operators are already running on the lowest possible capex and the low-hanging cost saving is done (and more). Wireless equipment costs inflate, wages inflate and new investments in LTE (the next generation of mobile network) will have to be paid for. At maturity a rational market won’t destroy its own profit pool forever.

6.     6.  Longer term the potential for consolidation in German mobile is high as the licence auctions really only allow for 3 players and for that and other reasons we expect E-Plus and O2 to merge (similar to the UK consolidation). Also, the “land grab” for subscribers is over (the market is fully penetrated) and hence the extreme price competition between players should lessen.

7.     7.  As competition eases and as data increases in the mix we think there is a chance that ARPU declines will slow substantially leading to far less pressure on the topline.

8.     8.  However, those expectations are only included in our blue sky scenario.

Drillisch

1.     1. We strongly suspect that Freenet will attempt to acquire Drillisch as Freenet has been the active consolidator in the market, taking its original 25% share up to 90%.

2.     2.  Drillisch owns 12% of Freenet which accounts for roughly half of the Drillisch market cap and is hence another way to play a re-rating in Freenet stock.

3.     3.  If anything Drillisch is even cheaper than Freenet, currently trading on 4.2x PE and 3.3x EV/EBITDA with no net debt (treating the Freenet stake as cash).

4.     4.  After detailed discussion with the CEO the synergy potential of acquiring Drillisch is substantial, potentially up to half of the cost bar, which would add nearly 50% to Drillisch’s EBITDA.

5.     5.   Note that Drillisch is the only other player in the duopoly MSP market with 10% share and is primarily focused on the pre-paid value niche, as opposed to Freenet focusing on no-frills and post-paid.

6.      6.  In a buy-out situation, if Freenet pays 6x EV/EBITDA (typical transaction multiple for this industry) and shares the synergy value 50:50 we see a value of €8 or c.75% upside at the current Freenet stock price.

7.     7.   However, even if Freenet doesn’t buy Drillisch, the core business should be worth 6x EV/EBITDA and putting the Freenet stake at our price target (€15) the Drillisch stock should be worth €8.2 (80% upside) and on a DCF basis (9% WACC, 0% growth) €9.8 (>100% upside) again with the Freenet stake at price target rather than current price.

Risks

1.     1.  Clearly a major risk is that a MNO could end its relationship with Freenet and improve margins by eliminating the profit paid to Freenet. However, the scale of the Freenet operation is such that the market share impact for a MNO would be dramatic. At the same time it is very cheap for the MNO to service MSP subs since they aren’t responsible for service, billing or SAC. In general, the MNOs view the MSPs as partners rather than competitors and we believe the regulations in the mobile licenses protect Freenet in any case.

2.     2.  Synergies and cost saving: if management fail to execute on their cost saving targets a currently stable/improving EBITDA will be in decline.

3.     3.  Share overhang: Permira still own 10.1% of Freenet having sold down from 25%. Also the MSP partnership between United Internet and Drillisch recently dissolved which may cause United to sell their 4.1% stake. Drillisch own 11.5% of Freenet but are very unlikely to sell as Drillisch recognises the value in Freenet and in any case is keen to be acquired by Freenet.

4.     4.  Macro: is always a risk.

Disclosure

We are shareholders of both FNTN and DRI.  We may buy additional shares, or sell some or all of our shares, at any time.  We have no obligation to inform anyone of any changes in our viw of FNTN or DRI.  VIC members should do their own work before deciding whether to buy or sell shares.

Catalyst

We believe this opportunity has a number of hard catalysts including the resumption of a conservatively estimated >10% divi yield on a sustainable basis, M&A and synergy prospects through acquiring its much smaller No. 2 in the market (which we recommend owning as well), an implicit stock-buyback linked with the latter, and all at a valuation level that is in the mid-to upper teens on both levered and unlevered free-cash flow yields and is simply too cheap to ignore, even if there were no catalysts.