Commentary: Europe's Telcos: What to Do with All That Cash?

It's hard to believe that just a year ago, Europe's telecom giants were the dogs of the business world. Bludgeoned by the tech crash, they suffered humiliating credit downgrades, watched their once high-flying stocks plummet to earth, and sacked CEOs right and left. Today it's a different story. Thanks to steadily improving financials, telcos are enjoying newfound investor appeal. In the last year, the S&P Europe 350 Telecommunications Services Index, which comprises 18 companies, has risen 4.8%, vs. an 8.6% decline for the broader S&P Europe 350 index.

Why are investors so upbeat? They've rediscovered that Europe's telcos are veritable money machines. Deutsche Telekom, Europe's largest, will spin off a cool $6.8 billion in free cash flow this year, while former basket case France Télécom is on track to mint $3.6 billion. It helps that the telcos have dug their way out of the crushing debt they piled on during the boom. London financial researcher JCF Group figures net debt for the S&P telco index companies will decline by $52 billion this year, to $190 billion. That's just 1.6 times their expected aggregate operating earnings, a reasonably healthy ratio.

Now a debate has opened up over what, exactly, Europe's cash-rich telecom outfits ought to do with all that money. One camp wants fatter dividends, while another is rooting for continued debt reduction. A few telecom CEOs say they want to hold on to the money for potential expansion and acquisitions. But the most compelling view is that European telcos should pump some of the lucre into upgrading their networks and hawking new revenue-generating services, such as broadband access, wireless data, and videoconferencing. Here's a run-down of the different choices telcos face:

-- Option 1: Boosting payout. It's true that European telcos aren't very generous when it comes to dividends. As a group, they now yield just 2% -- that's dividends divided by capitalization. Some investors say telcos ought to behave more like the slow-growing, regulated utilities they resemble and hike yields as high as 5%. There's no question that some giants now paying no dividend, including France Télécom and Orange, could afford to share a bit with shareholders -- just as Deutsche Telekom revealed on Aug. 14 that it will do starting next year.

But investors should be careful what they wish for. Cash spent on dividends is money companies can't use for more productive purposes. And higher yields are typically associated with slower growth -- and thus, lower price-earnings ratios. Europe's telcos now have a forward p-e ratio of 16, while utilities boast just 11.5. If telco dividend payouts tripled this year to utility levels, shareholders would pocket an extra $30 billion. But if p-e ratios declined to match, the market capitalization of Europe's telcos could shrink by $250 billion.

-- Option 2: Housecleaning and war chests. Saving money for potential acquisitions is also a bad idea. Europe's sickest telcos got that way by making pricey cash acquisitions. Besides, the value of mergers among fixed-line telcos is unproven. Evidence from the U.S. is not promising: Telecom mergers there have created revenue giants often with lower financial returns than their forebears. As for debt reduction, the worst is over. Deutsche Telekom and France Télécom still have work to do. But others can easily make their payments and have plenty left over to fund growth.

-- Option 3: Building a future. All carriers face the prospect of long-term revenue decline because of saturated markets and falling tariffs. The only way to stem the tide is to roll out profitable, innovative new services and promote them like crazy. Yet capital spending among European telcos fell to less than 10% of revenues in this year's first quarter, well below historic norms in the mid-teens. Fitch Ratings recently warned that companies may be taking cost-cutting too far, potentially compromising their future growth and credit quality.

When the same people who rang alarm bells about telco debt change their tune and start urging reinvestment, it's time to take notice. Telcos that need to should continue paring back debt, and those that can afford to should pay dividends. But all of them must fire up top-line growth or they can kiss stock growth good-bye.

By Andy Reinhardt

    Before it's here, it's on the Bloomberg Terminal.