Commentary: Europe's Telcos: Sliding toward Junk?

Give France Telecom credit: Its executives certainly know how to get the markets' attention. Trouble is, they've been getting the worst kind. Just weeks after the spin-off of its wireless operator Orange PLC raised a disappointing $6 billion, the company was back trawling the markets for cash. On Mar. 7, it sold $16.4 billion in debt, the biggest corporate bond issue ever. That signaled to investors that France Telecom was desperate to raise as much money as possible while the credit markets would let it. The result: At yields of 8.5%, the telecom's investment-grade debt is now trading near the lower end of some European junk bonds.

So we are treated to the spectacle of France Telecom, Europe's biggest telecom operator and a certified blue chip, hawking junk like a 1980s leveraged buyout victim. It's an ill omen for an industry that six months ago was freely spending tens of billions of dollars on licenses for the next generation of wireless networks. Now, pessimists fear that the resulting debt is sucking operators toward disaster.

There's reason for concern. Since the start of last year, the seven largest European phone companies have accrued more than $170 billion in debt. Individual companies' interest burdens doubled on average last year. Investors already know that the third-generation mobile networks are going to be late, and no one knows when--or if--they'll make money. Small wonder that the Dow Jones European telecom index was down 15.7% for this year as of Mar. 12.

There's no reason to panic. But investors need to stop thinking of telecom operators as widow-and-orphan stocks in high-tech clothing--safe bets with growth stock potential. Instead, they have become high-risk bond plays like those costly mergers and LBOs of 15 years ago.

How far have Europe's top telcos fallen? The credit-rating agencies will downgrade some telco debt in the coming months, analysts say. But none of the big franchises--France Telecom, Deutsche Telekom, Spain's Telefonica, British Telecom, Telecom Italia, and the Netherlands' KPN--will fall to junk status, which is a rating of BB or below. Moreover, the firms have enough cash to cover interest and principal payments over the next year. The free cash flow of Europe's top operators--earnings before interest, taxes, and depreciation--ranges from 3 to 13.1 times their debt payments, according to Lehman Brothers (table).

So what's the problem? The alarm bells start to sound only when you look at the companies' bigger predicament. The burden of huge interest payments eats into cash flow. There's less money for dividends, acquisitions, and much needed investment in technology and infrastructure. "In the telecom industry, capital expenditure remains key to staying ahead of the competition," says Felix Kaiser, executive director of credit research at Goldman Sachs International in London.

Some telcos are better off than others and may be able to profit from their rivals' distress. Best-positioned are Telefonica and Telecom Italia, which didn't bet big on 3G licenses. Telefonica looks especially strong compared with its rivals in Europe. It paid for acquisitions with stock, and it suspended dividends two years ago. For the rest, things don't look so good. Companies need cash reserves for emergencies and to reassure shareholders. That's why KPN is the worst off--it has less than $300 million in cash.

WARNING SIGN? Even British Telecom, Deutsche Telekom, and France Telecom are squeezed. Much of their debt is short-term, meaning they'll have to come back to skittish markets soon and will probably pay more. One-third of France Telecom's debt matures next year and $8.5 billion more in 2003. The six big telcos are hoping to raise a total of $27 billion from asset sales and stock offerings this year. KPN, for example, wants to take in $1.7 billion from an IPO of its mobile unit. But these scenarios might founder or only half-succeed in this year's rocky markets. The Orange IPO could be a warning of things to come.

Were this another industry, the squeeze would force takeovers, with stronger telcos buying weaker rivals' cheap shares, forcing management changes and mergers. But Europe's government-dominated telecom operators are only partly in the free market. More's the pity. Under current conditions, telecom shares and earnings will languish while they dig themselves out. The telcos don't qualify as true junk yet. But they sure look battered. By Kerry Capell

Capell covers European telecoms from London.

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