Palm Harbour Capital - Telekom Austria: Value Play, Plus Upside Potential, Minus Significant Risk

The following segment was excerpted from this fund letter.

Telekom Austria (OTCPK:TKAGY)

The combination of a defensive business model, growing free cashflow and low leverage creates a particularly attractive investment thesis around Austria’s largest telecommunications provider. Additionally, the spin-off of its tower assets is expected to unlock value and potentially allow them to re-lever with a special dividend or M&A.

Telekom Austria (TKA) is a leading Austrian telecommunication provider with growing business in Central and Eastern Europe. The company splits operations geographically with Austria representing 55% of sales, followed by Bulgaria (13%), Croatia (9%), Belarus (9%), Serbia (7%), Slovenia (4%) and North Macedonia (3%). TKA operates in oligopolistic markets being the incumbent in Austria and number two or three in all other jurisdictions. While telcos are perceived as mature businesses, TKA has managed to grow top line at 2.7% pa over the last five years mainly due to the growth of its international activities, which benefit from price increases, a post-covid recovery, convergence, and rising penetration rates. Moreover, the group is not suffering from changes in consumer behavior or increased churn, and it continues to benefit from strong demand for highbandwidth products and successful upselling.

TKA has more pricing power than most European peers, with inflation-linked tariffs in the two key jurisdictions, Austria and Bulgaria, and price increases in most other markets, protecting profitability in a particularly challenging macro environment. Simultaneously, the ongoing restructuring program combined with the main shareholder’s focus on financial performance has already borne fruit with the EBITDA margin increasing from 32.5% in 2016 to 36.7% in 2022 to grow EBITDA at 5.0% per annum over the last five years. Finally, the lowly-levered balance sheet (<1.0x excluding leases) offers ample space for management to execute a 5G and fiber investment program without adding debt risk. It is worth noting that the United Group, the main competitor in Bulgaria, Croatia, Slovenia and Serbia has a similar investment program but it is 5.0x levered.

The most interesting part of the story is the announced spin-off of the tower business and its listing on the Vienna stock exchange. While public markets are unlikely to pay recent private market multiples for this business, publicly traded peers are still highly appreciated by the market. Apart from the value recognition of the tower company asset, currently ignored by the market, the spin-off is expected to benefit the thesis in multiple ways. As an independent entity, the tower company could expand its strategy by signing agreements with other telecom operators and tower companies, hence increasing the tenancy ratio, which is the main driver of profitability. Moreover, TKA will transfer approximately 50% of their leases and we estimate 200-250 million of financial debt to the tower company, reducing lease (IFRS 16) and financial debt and their linked lease and interest expense cash outflows.

Exposure to Belarus, roughly 10% of the business, weighs negatively on investor sentiment. Thus far they have been able to extract dividends and the currency has been remarkably stable, however this could change at any time. Even in the most pessimistic scenario, the thesis remains attractive. Low liquidity of the share and the required investment in 5G and fiber are probably two other reasons for the discount. We don’t see them as a concern since the first has nothing to do with the value of the company and the second is a market-wide trend which probably affects the levered peers more. The major shareholders have already agreed to a capital expenditure plan so the risk that the government forces uneconomic 5G/fiber rollout is limited.

Excluding any value realization from the tower business divestment, we estimate that Telekom Austria trades at a 12% free cash flow yield, which for a stable and growing business with improving margins should be considered a bargain. Although the details of the spin-off haven’t been released yet, the tower company should add an extra €2.53.0 per share value to our thesis. The spin-off is also expected to further reduce leverage, which could give room for a special dividend. Overall, we see this as a classic value play with an interesting upside potential without taking significant risk.

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