Orange SA 19 Mar 15

Competition set to bite

With investors having hung up on Orange (ORA.EPA) in the wake of the GFC, interest in the company’s shares has started to recover somewhat over the last 12 months. While we believe that Orange’s outperformance of the broader market over this latter period is warranted given the underlying improvements that have been made to the business since the GFC, our preference is to take exit at this juncture with intense competition our key concern.

What’s new?

Orange released its CY14 results in mid-February, reporting net income of €1.2 billion, down from €2.1 billion in CY13 despite a €112 million boost from lower debt financing costs. The key drivers of the €908 million decline in net income included the (i) €762 million decline in operating income, (ii) €168 million increase in corporate tax, and (iii) €90 million decline in net income from discontinued operations. A €0.40 final dividend has been declared, bringing CY14 dividends to €0.60.

The company’s CY14 result was predicated on revenues of €39.4 billion, representing a decrease of 2.5 percent on the previous corresponding period. While disappointing, it is worth noting that the year-on-year decline does compare favourably to the 4.5 percent decline in revenue reported in CY13. Excluding the impact of regulatory measures, the decline was limited to 1.6 percent CY14, which compares to a decrease of 2.6 percent in CY13.

In terms of Orange’s fourth quarter performance, underlying (i.e. excluding the impact of regulatory measures) revenues were stable, with this comparing favourably to the 2.2 percent decline reported for the first nine months of the year. The improvement was largely attributed to mobile services in France, Spain and Belgium, while Africa and the Middle East continued their steady growth. Added to this was the increase in mobile equipment sales, led by France and Spain.

Notwithstanding the year-on-year decline in revenue, from an operational perspective, the CY14 result was reasonably solid. In particular, we note that Orange’s mobile customer base increased by 11.3 million or 6.5 percent to 185.3 million, with the key contributors being Africa and the Middle East. Orange Money also had a strong year, with its customer base having increased by 51 percent to 12.6 million, while the fixed broadband customer base increased 3.5 percent.

At the operating line, Orange reported an adjusted EBITDA of €12.2 billion, which compares to guidance for restated EBITDA between €12.0 and €12.5 billion. Encouragingly for investors, the EBITDA margin remained stable at 30.9 percent, which is encouraging given the 100 basis point decline reported in CY13. The key driver of the EBITDA result for CY14 was the €707 million or 2.5 percent decline in operating costs, which offset 69 percent of the impact from lower revenues.

Notwithstanding the earnings decline, Orange reported a 21 percent increase in operating cash flow (excluding discontinued operations, which were nonetheless positive). Even after accounting for the 1.3 percent increase in capital expenditures (14.3 percent of CY14 sales), net debt fell €4.6 billion to €26 billion. This translated to a restated net debt to EBITDA of 2.09 times, which compares to the 2.37 times that was reported in CY13.

Commenting on the CY14 results, management stated that while competitive pressures remained elevated across all markets, “we succeeded in stabilising our restated EBITDA ratio thanks to our commercial performance coupled with our ongoing cost reduction efforts. Our strategy of differentiation through investment in very high-speed broadband has paid off” and “we have reduced our cost basis by more than 1.7 billion euros in three years”.

In terms of market guidance for CY15, management expects Orange to deliver a “restated EBITDA of between €11.9 and €12.1 billion euros”, with this seemingly premised to some extent on management’s “continuing work on the Group’s cost structure”. Management has supplemented the CY15 earnings guidance with (i) a medium-term net debt to EBITDA target of 2 times, and (ii) CY15 dividend target of €0.60. 

Summary

There is no doubt, in our view, that the underlying CY14 (and 4Q14) results represent an improvement on the previous corresponding period. While this is reflected in Orange’s outperformance of the broader market over the last 12 months, it is notable that the company has underperformed over the last three months. In our view, this is likely to reflect the market’s realisation that competition could limit the potential for a near-term recovery in earnings.

As evidenced by management’s ‘flat’ earnings guidance for CY15, Orange is currently having to invest in its business and drive further cost efficiencies just to keep earnings stable. While it could be worse (i.e. loss making), this is not an ideal situation for investors. In Orange’s favour is the fact that it has the requisite capital (i.e. deep pockets and cash flow) to differentiate its customer offering from its competitors by continuing to invest in its high-speed fibre and mobile networks.

While this is a strategic positive for Orange and its shareholders, it does not guarantee immunity from competition. At any rate, it seems reasonable to assume that over the near-term at least, Orange’s earnings will remain under pressure. Taking into account Orange’s recent share price performance, our average entry price of €0.00, and the current price to earnings ratio and yield of 0.0 times and 0.0 percent, respectively, we recommend Members sell their holdings.

Orange will be removed from the Fat Prophets Portfolio.

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