The Capital Cycle Podcast - Telecom-Moditization

Episode Date: September 6, 2024

Examining the chequered history of the European telecoms industry and what it teaches us about the capital cycle. Presented by Edward ChancellorWith Charles Carter, Portfolio Manager EuropeFor more information, or to access select articles from Marathon’s Global Investment Review publications which accompany this podcast series, please visit www.thecapitalcycle.co.uk Hosted on Acast. See acast.com/privacy for more information.

Welcome to the Capital Cycle podcast from Marathon Asset Management. My name is Edward Chancellor. I'm a financial historian, journalist and former investment strategist. In these podcasts, I would talk to the authors of Marathon's Global Investment Review about their current investment thoughts. Welcome to another episode of the Capital Cycle podcast from Marathon Asset Management. My name is Edward Chancellor, and I have with me Charles Carter, who is the European portfolio manager of Marathon. Nice to see you again, Charles. Very nice to see you too, Eddie. So Charles and I have a long history.

20 years ago, we put together the first marathon book explaining, of the capital cycle, if you remember that. A large part of that book was really about the capital that was flowing into the telecom sector in the late 1990s as part of the dot-com technology and telecoms bubble that we were seeing. And there, what we were describing in the various global investment reviews that we selected for the book was how the inflow of capital. driven by very high valuations, was bound, soon or later, to lead to disappointing returns for shareholders. And it was Marathon's valiant stand at the time to go underweight, or not her own Deutsche Telecom, as far as I remember, for instance, or Vodafone.

And there is another aspect of the capital cycle that is detrimental to investors, which is when businesses in an industry are not earning their cost of capital. and yet the capital doesn't leave the industry for one reason or another, that also dooms investors to low returns. What I want to talk about now, based on a recent piece you've written for the GIR, is the state of the Europeans telecom sector today. But let's start by reminiscing a tiny bit about how the telecom sector looked in the late 1990s in early 2000s. That was a time of great excitement about the prospects for future profitability, which created these enormous valuations of companies, both in the mobile telecom sector and in

the fixed line sector. And we can come on to talk about the way in which those two areas converge. But the high valuations obviously led to a lot of capital flowing into the industry and a lot of competition, which wasn't foreseen. And I think that was the great mistake of that boom was to underestimate really the impact of competition, which ties in a little bit as well with the way in which the industry became commoditized. So there wasn't enough differentiation. And where there was differentiation, the benefits tended to accrue to what are now large-cap US tech companies, which benefited from the internet revolution in a way that the telecom operators never did. And yes, as you say, the story of how the industry has struggled

to reform itself and get back to a situation where it can earn decent returns has been an interesting one because you've got really two sort of test cases here in Europe where the regulators have been quite strict and have prevented consolidation at the national level within Europe. So, Charles, before we talk about the contemporary position of the European telecoms players, there are, I think, two stories that you're telling here. one is a US story and the other is a European story and how the telecoms industry, in particular mobile telephony, the industry dynamics or structure have changed. I think let's start by discussing

the US telecoms industry and what's happened there. It used to be the Europeans used to rue the American market for being overcompetitive. So let's start from the position in the early 2000s, when US telecoms was highly competitive and relatively low return. I was recalling this conversation I'd had with the CEO of Vodafone back in 2003 when Vodafone had an investment in Verizon Wireless. He was lamenting how it wasn't covering its cost of capital. There were too many players in the industry, and players number three to number six weren't even covering their cost of capital on their incremental investment.

And then, you know, you contrast that with today after this huge consolidation in the US. So tell me about consolidation. So you've really gone down from quite a fragmented market to one in which the top three players have got 90% of mobile connections. And the level of ARPU, which is the average revenue per user in the market, is considerably higher than it is in Europe. So Europe, in the average, is around 15 euros. In the US, it's over 40 euros per month in terms of what is earned. So this big consolidation that has occurred has enabled the companies to gain some pricing power, which you can see on the mobile side.

And also you can see on the fixed side because broadband pricing is quite a lot higher in the US compared to Europe. And sometimes when we're talking about the capital cycle, we note that when an industry has consolidated the players, they're not contravening the rules, but they engage in what we call tacit collusion to keep their prices relatively high. Is that, do you think, what we see in the United States today? Well, I think that if you've got a consolidated market, it's easier to maintain a so-called pricing discipline. It's obviously not going to be overt collusion because that's clearly illegal, and it gave you into trouble.

So it's the way in which I think they've used their scale to gain spectrum, to build their infrastructure in a way that makes it very hard for smaller players to enter and compete in. In some ways, Europe is different because at each national level, markets are quite different and have different regulation. So actually even a company like Vodafone, which had at one point more or less a pan-European network, they've been retreating because they've been unable to get the,

kind of scale benefits that the US players have been able to get because the markets, I think, are different. Vodafone has left. It's exited Italy. It's exited Spain quite recently. So there's been this kind of end of empire issue going on there. And you point out in your piece that Vodafone's market cap has shrunk to what, something like a tenth of the valuation? Yeah, I think at the peak. So back in May 2000, Vodafone was valued at $380 billion, nearly five and a half percent. of the European stock market index. And now it's valued at 25 billion. So over that time, assets have been divested,

shares have been bought back. But the overall market cap has declined very significantly. So let's talk about the competitive dynamics of the European market, how many players there are, and what type of returns European telecoms players are earning relative to their US counterparts? So I think overall, there are probably over 50 mobile operators in Europe and over 100 fixed line operators. And of these, I think the data that I've seen says that around 35 have less than 500,000 customers. So they're really subscale. And the overall impact of that fragmentation

and excess competition is that the industry is not earning its cost of capital. So the return on capital, the industry generates back in 2022 was 5.8%. I don't think it's improved a lot since then. In a capitalist system, when businesses don't earn their cost of capital, that capital, in theory, is withdrawn and put to higher return uses elsewhere. And that is really part of the thinking behind the capital cycle analysis. So the question is, why are European telecoms operators not earning their cost of capital? and why things not improving over time?

Well, I think it's because they haven't really been allowed to consolidate. So you've seen various attempts to shrink the number of players per national market. So where you've had five players, attempts to merge and get down to a smaller number. And the regulators at the European level, I think, have really wanted to maintain access for a kind of maverick player to be in the mix to ensure that prices. is low. So it's partly about consumer protection. And, you know, as I said earlier, the result of all this is that European consumers have benefited hugely because they have much lower telecom bills compared to consumers in the US. Yes. And this actually points to an interesting issue with the capital cycle is that what tends to be good for investors isn't always good for consumers and vice versa. I think what you're

saying about the European situation is that politicians have a keen interest in keeping mobile telephone bills down, particularly in an age when people worried about the cost of living crisis, and therefore the politicians have an interest in preventing the industry consolidating. Yeah, and I think if you look at it from the shareholder perspective, that the entire value of the European telecom sector at the moment, if you exclude Deutsche Telecom's investment in T-Mobile USA, is around $170 billion, and that compares with over 500 billion attributable to the top three mobile carriers in the US.

In what is, after all, a smaller market. In a smaller in terms of population market. Yeah. Now, you write here that the Europeans, telecoms, lobbyists, the industry association, are trying to improve things. It's something called et no. Are they getting anywhere or not really? They're arguing that investment per capita has been lower in Europe because the firms

aren't really able to earn a decent return, to which I think the commission can turn around and say, well, actually, if you look at statistics like the coverage of 5G across Europe and the coverage of fibre to the home connections. So that's having fibroptic cables to your home beaming in all your internet and your TV and so forth. Those coverage levels are actually higher in Europe. So the outcome in terms of infrastructure is not that much worse compared to the situation in the US. And you get, I mean, I was at a conference recently where I was listening to the chief executive of Iliad, which is a French company which has been very successful as a disruptor entering markets with low pricing

and building up businesses across Europe. And they were saying, well, actually, I mean, partly they like the commission because the commission has allowed them to break in and to do what they've done. And they were arguing that actually, you know, this has been quite a good outcome in terms of regulation for both consumers and society. And obviously there are some European telcos who have done better than others in this whole process. And Iliad has been very successful and has created a lot of wealth for its founder. You want to tell me a bit about Marathons' experience in investing the sector through the Dutch operator KPN, because that sort of is how you've been tracking things over the years.

Yeah, I mean, we've had an investment in Deutsche Telecom, thankfully, which has benefited from its ownership of this asset in the UST-Mobile USA, which in itself is now valued at more than the entire European sector. But KPA, and I think it's an interesting case study because I think it's a company that's been very well managed, but it has suffered from this inability of the industry to consolidate. So shortly after the TMT bubble burst in Holland, there were, I think, five mobile operators. And over the years, that has changed. That came down to three at one point. And then the regulator encouraged a new entrant to come in. And then more recently, we've had the emergence of private equity coming into the industry. And as I say in the piece, the whole experience has

felt a bit like game of snakes and ladders. You know, you go up a stubby little ladder and then you encounter a large snake as the industry and the regulator in particular has sought to bring more competition back in, either through allowing new entrance or by opening up infrastructure. to third parties through a wholesale market. That sense that one has of the industry just not really being able to sort itself out in the light of all these constraints has meant that it's been a disappointing area

to invest in over the years. Yes. So the upshot, really, from a capital cycle perspective, one wants to look at when high valuations are attracting too much capital into an industry, which brings down future expected returns. And conversely, and this is the situation with European telecoms today, when relatively low valuations, and I take it their valuations are relatively low,

don't bring about a reallocation of capital away from the sector and that poor competitive dynamics lead to ongoing poor returns for investors. And your conclusion is that until we have, have greater consolidation in the European market. Of the type of consolidation we saw in the US with the T-Mobile sprint merger, for instance, you're not going to get very excited about this sector. It speaks to the conundrum of value investing where you look at companies which are on low multiples, apparently, of current profitability or asset base. And these can be value traps if you don't have that catalyst of a change on the supply side, which can bring about a reform in the way that an industry works.

And one of the themes that we've talked about a lot is the way in which a lot of capital during the era of low interest rates was brought in and never really taken out of industries. So you had persistent excess capacity. And clearly that can be a problem if you're expecting change to come about on the supply side. it's been a problem for value investors, I think, over the last 10 or 15 years. Yes. And the last point, which you actually make in your piece, is that these European telecoms businesses are highly levered, aren't they? I mean, Altis has been what on the verge of the French telecoms operators.

So that's a, yeah, that's a private company and operating on a kind of private equity style at debt levels, which doesn't see quite so much in the public market. documents extend to 1,000 pages of which towards the end of the document it says that the holding company has a right to remove assets beyond the reach of the creditors. Anyhow, that's an aside. I'm glad you got to page a thousand, I'm afraid the lenders didn't. We'll wait for a change in the European telecoms market before we get excited. Thanks a lot for that, Charles, and I look forward to going through another GRR with you soon.

Great. Thank you. I hope you will listen to the next edition. of the capital cycle. This communication is provided for information purposes only. Please refer to Marathon's website and the Global Investment Reviews for further information, including important disclosures.