Is Orange Cheap?

By Cameron Fen Age 22 Brandeis University

Summary

Highlights
Orange is Cheap
P/FCF of 5

Bad news is priced in

Competition from Iliad (low cost carrier in France) Relatively High Leverage

Even if the worst case scenario plays out, Orange is still cheaper than AT&T and Verizon Significant emerging market customers when compared to AT&T and Verizon

Not a Story Stock, but Negative News Already Priced In

The market usually overreacts to negative news
P/E of stocks with negative sentiment is too low Backtesting, picking the 10 lowest P/E stocks quarterly from 1986-2012 returns 17% (compared to a market return of 10%)

The stock has a low P/FCF because it has somewhat high debt
However even on a EV basis

Enterprise Value
14

EV/Adjusted FCF

12

10 E V / F C F

0 Orange Telefonica KPN Duetsche Telecom Company AT&T Verizon

Adjusted FCF
FCF is better than earnings because Maintenance Capex < Depreciation & Amortization
Payout ratios have been higher than 100% at times because the available excess cash is so much higher than earnings

As such when using an EV ratio, have to add back interest and taxes to FCF All FCF numbers are Trailing Twelve Months

Background

Company Information
Orange (originally France Telecom) provides mobile phone and fixed line phone service (as well as internet, TV etc.) to France, Spain, Great Britain, Poland, Portugal, Belgium, Eastern Europe, Africa,

Competitive Advantage
Incumbent mobile operator in France Highest brand loyalty, largest telecom network in France Significant barriers to entry
Market shares relatively stable over the past 10-20 years

Oranges large size, stable market share, and significant barriers to entry and lower interest rate costs give it a competitive advantage

Earnings in France
France accounts for 47% of Oranges revenue as well as almost 75% of FCF Emerging Markets account for about 0-500m Euros in FCF
Rest is in Britain, Spain, Belgium, Luxembourg and Switzerland

FCF = 5.7 Billion Euros

What the Bears See

FCF Trend
2005 2006 2007 2008 2009 2010 2011 2012 7,232.00 7,131.00 8,185.00 9,710.00 9,833.00 8,421.00 8,600.00 5,725.00

Net income for the past 12 months = 150mm Euro due to goodwill write down Massive P/E ratio and FCF decline in 2012

Real reason for the decline in Earnings

Frances fixed line division took a 1.5 billion Euro hit last year because of a new value added tax (VAT) for triple play plans
Untapped pricing power to recover VAT, as all competitors faced the same tax
Iliad has already raised its Triple Play Prices

VAT tax was responsible for around half of the 2.9 billion FCF decline in 2011-2012

Earnings Decline (cont.)

Price war with Iliad, affecting the mobile division in France, responsible for about half of the remaining decline
European macro responsible for the remainder We will talk about Iliad later

Political conditions in Egypt responsible for much of the 2 billion+ goodwill write-down

French Mobile Division

Oranges French Mobile Division

French Mobile division earns extremely high ROE Mobile EBITDA = 3.3 billion euros, Mobile Capex = .7 billion euros The high (EBITDA CAPEX)/CAPEX ratio suggests that the company has a serious competitive advantage in France
It is the incumbent telecom in France with a reputation for the best network Significant barriers to entry in the mobile space

Competition
Orange historically has had and still has pricing power over its competitors
Prices are 5 Euros higher than competitors given same/similar service offering

New entrant Iliad is selling phone service below cost to take market share
The history of a stable market share in the telecom space suggests Iliads entry into this space will be difficult

Comparing prices on same service (Unlimited calls and txt + 3Gb data)
Iliad Orange

Orange

19.99 29.99 Euros 39.99 Euros

unlimited/ 3GB SFR Unlimited calls/2GB Bouygues of data

Unlimited calls/ unlimited text/ 29.99 3 GB of data Unlimited txt/unlimited calls/ 29.99 3gb data/

Unlimited calls/ 4 GB of data

Sooner or later, Iliad is going to have to charge a price which allows it to earn a profit Orange can charge an even higher price and earn higher profits Note: Iliad has the resources to continue their price war for a few years so one needs a longer time horizon Average price of Oranges 2GB plan and its 4Gb plan is 5 Euros more than SFR and Bouygues 3GB plan with historically stable market share

Valuation of Orange
Main takeaway: Even if Oranges lucrative French Mobile Division loses the price war to Iliad and stops earning a profit, Orange is still trading at P/FCF of around 7
This situation is extremely unlikely as, over the long term, Iliad also needs to earn a profit Keep in mind Iliad is at a competitive disadvantage to Orange, so if Iliad is making a profit, Orange will be making a larger one

Debt

Debt compared to European Peers

Debt/Adjusted FCF
6

D 4 e b t 3 / F C 2 F

0 Orange Telefonica Company KPN Duetsche Telecom

Debt Compared to American Peers

The Myth of the High Debt European Telco

Oranges debt is rated Aa3 by Moodys Verizon after the Vodafone deal has debt rating of Baa1
Lower than Orange

Verizon has an EV/adjusted FCF of 12.7

P/adjusted FCF approx. 7

Orange has an EV/adjusted FCF of 6.3

P/adjusted FCF approx. 3

Lowering Leverage
Orange is aware of its debt load and like many other European Telecoms is actively trying to sell assets and reduce the dividend to pay down debt
Management is targeting a net debt/EBITDA ratio of 2 by the end of 2014

Furthermore, macroeconomic conditions will improve in Europe at some point

Broadband prices could still increase over the long term and regain the 1.5 billion euro in lost profit due to the VAT

Debt
Among its European peers, Orange has a relatively strong Debt to FCF ratio Even among American Peers, Orange has a lower EV/FCF compared to Verizon Even if a worst case scenario where Oranges French Mobile Division loses the price war with Iliad and doesnt earn a profit, Oranges Debt/FCF and EV/FCF still in line with peers
EV/bear case FCF of 8.2 slightly below Ts EV/FCF of 10.7 Significantly below VZs EV/FCF of 12.7

Markets outside of France

Poland, Spain, Great Britain

Polands EBITDA CAPEX has been relatively stable to slightly declining at around 600m euros a year (300m belong to Orange)
Some of the CAPEX in Poland is probably for growth

Great Britain earnings have been around 250300m euros for Orange a year (50% ownership)
Stable 33% leading market share

Spain earned 500m euros last year

Taking share and increasing earnings in a difficult macro condition

Macroeconomic Conditions in Europe

Macroeconomic conditions in Europe have been hurting Orange significantly However these forces are cyclical and earnings will likely rebound in places like Poland, Spain and even France

Emerging Markets
Leading market share in countries like Cote DIvoire, Slovakia, Romania, Jordan, Egypt, Madagascar, Botswana, Senegal, Morocco, Tunisia, Iraq, Dominican Republic Most of these countries have robust growth in the telecom sector as people have more purchasing power. Orange does not break down earnings for these countries
Earnings probably very low or negative

Analysis
Orange has over 90 million effective mobile customers (ownership stake * number of customers) in emerging markets
In comparison, Orange has only 30 million mobile customers in France and earns upwards of 2 billion euros in this segment Orange has #1 or #2 market share in 16 different markets, many of which mobile penetration is significantly below 100%

For a company trading at a multiple significantly below T and VZ, the number of customers Orange has in developing countries is an asset that the market has yet to assign a value
Neither T nor VZ have any developing market customers
Keep in mind even in the bear case, Orange has a lower multiple that T and VZ

Valuation and Conclusion

Discounted Cash Flow

2014 53307.4423 -3.0% 6182.1 1041.4 7683.6 -5899.7 31.3 6893.4 6379 105906 71895 97917 2015 51708.2191 -3.0% 5935.0 983.6 7458.5 -5710.8 -273.2 6972.2 5971 2016 50156.972 -3.0% 5640.2 913.8 7278.5 -5666.6 233.0 6105.3 4839 Cash Debt MV Equity S/O Price Per Share 2017 49655.4028 -1.0% 5585.3 926.3 7231.5 -5679.7 -11.7 6222.5 4564 7533.31167 40181 65270 2631 25 2018 49158.8487 -1.0% 5560.3 902.6 7133.7 -5699.8 -195.3 6286.8 4268 Rd Re Risk Free Equity Risk Beta E/V D/V LTD Equity 3.7% 12.9% 3.00% 9.00% 1.1 48% 52% 40181 36365

Revenue Revenue Growth EBIT Less: Taxes Plus: D&A Less: CAPEX Less: Changes in NWC Free Cash Flow Discounted Terminal Value - Terminal Growth PV of Terminal Value (Growth) Enterprise Value - Terminal Growth

Weighted Debt Weighted Equity WACC Terminal Growth

Closing Price (as of 10/10) S/O

1.9% 6.1% 8.1% 2%

13.82 2631.341917

Price Target
Excluding Orange, among peers, Deutsche Telecom has the lowest EV/Adjusted FCF multiple of 9 At a 9 EV multiple, the stock has a price of $24.37
Upside of 78%

Still a considerably lower multiple than T and VZ as well as any of its other European peers