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Deutsche Telekom - Sprint merger completed

Sophie Lund-Yates, Equity Analyst | 14 May 2020 | A A A
Deutsche Telekom - Sprint merger completed

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Deutsche Telekom AG NPV

Sell: 15.13 | Buy: 15.14 | Change 0.07 (0.50%)
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Deutsche Telekom's first quarter revenue reached €19.9bn, up 1.1% on the same period last year excluding the impact of exchange rates. Adjusted cash profits (EBITDA) rose 9.0% to €6.5bn, reflecting strong growth in the US. Net profits rose 1.8% to €916m.

The group does not expect COVID-19 to have a significant effect on its financial results, and maintains previous guidance.

The shares rose 0.9% in early trading.

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Our view

Deutsche Telekom (DTE) was already a massive telecoms provider, and the recently completed merger between T-Mobile and close rival Sprint in the US makes it bigger still. Despite being a German company, DTE makes the bulk of its revenue and profits in the US through its subsidiary T-Mobile.

The deal has much to recommend it. While Sprint's been struggling, it owns a large chunk of valuable mid-band spectrum and DTE estimates that cost savings will outweigh integration costs after three years.

However, the tie up has led Standard & Poor's, a credit ratings agency, to downgrade the group from a "BBB+" rating to "BBB". Integrating Sprint will be costly and complicated, and Standard & Poor's expects it'll reduce free cash flow in the near term - increasing the burden of the group's substantial debt pile.

The combined group could have both the bandwidth and scale needed to take on Verizon and AT&T in the US 5G market but mergers always come with risks, especially one of this size. Either way any material benefits are unlikely to be realised before 2023.

In any case, telecoms is a difficult industry to do well in.

Firstly, building and maintaining modern communications infrastructure, like towers, cables and data centres, costs a fortune. Add the ever increasing payments to governments for spectrum rights, and the capital requirements of the business become truly eye watering. In 2019 alone Deutsche Telekom spent EUR14.4bn in cash on investments and spectrum.

Secondly, the industry lacks pricing power. Telcos compete primarily on price, which leads to pretty feeble margins and meagre returns on the massive amounts of capital employed. This is why telcos are bundling broadband and mobile data with entertainment services and other perks, and in DTE's case Magenta TV is a big part of the offering. The idea is to offer something meaningfully different that justifies higher pricing, but it's led to something akin to an arms race.

Debt has mounted as a result and efforts to keep it in hand recently led management to trim the dividend. The stock now offers a prospective yield of around 4.7%. The group intends to pay a minimum dividend of 60 eurocents per share until 2022, although nothing is guaranteed.

We doubt investors will see much if any dividend growth until around 2023 when Sprint has been sufficiently integrated, and that's conditional on the integration going smoothly.

DTE's fortunes are largely dependent on the Sprint merger. We think the strategic rational makes sense, but executing is another matter. If all goes well the combined group could be formidable and the payout could rise, but if not the group may struggle beneath its capital requirements and debt load.

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First quarter results (constant currency)

The merger between T-Mobile and Sprint was completed on April 1, and the combined group now has a market capitalisation of $110bn using share prices on 31 March. Deutsche Telekom holds 43.6% of the shares in T-Mobile, but thanks to an agreement with Softbank, holds the majority of the voting power - around 68.3% of voting rights.

US revenue increased 0.7% to €10.2bn as growth in customer numbers was partially offset by lower revenue per customer, due mainly to lower equipment sales thanks to social distancing and store closures. Adjusted cash profits rose 14.5% to €3.2bn, thanks mainly to increased service revenues.

In Germany revenue rose 0.9% to €5.4bn, primarily thanks to a strong performance from the mobile business. Adjusted cash profits rose 2.7% to €2.2bn thanks to increased revenue and lower costs.

Europe generated €2.9bn in revenue, an increase of 2.0% when the sale of Telekom Albania is excluded. The fixed network business continues to drive growth, with strong growth from both broadband and TV. Adjusted cash profits increased 3.4% to €963m, thanks to higher revenue and lower costs, particularly staff costs.

Systems Solutions generated adjusted cash profits of €100m, up from €92m, and Group Development generated €269m, up from €255m.

Net debt at the end of the quarter stood at €77.4bn, an increase of €1.4bn from the end of 2019. This is largely the result of spectrum payments, exchange rate changes and financial derivative contracts at T-Mobile. Free cash flow before spectrum payments fell by €0.3bn to €1.3bn, reflecting contractual changes affecting the timing of cash flows, lower cash capital spending and an increase in lease payments.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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