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Morningstar | Italy’s Spectrum Auction Ended With High Bids; We’re Lowering Our FVE for Telecom Italia and Iliad. See Updated Analyst Note from 03 Oct 2018

The latest Italian spectrum auction ended on Oct. 2 with total bids of EUR 6.55 billion, much higher than we anticipated. After reviewing the impact on our models, we are reducing our fair value estimate for Telecom Italia to EUR 0.89 per share from EUR 0.98, and for Iliad to EUR 143 per share from EUR 163. We are maintaining our fair value estimates of GBX 250 per share for Vodafone, CHF 470 per share for Swisscom, and HKD 118 for CK Hutchison. We are maintaining our no-moat rating on Hutchison and our narrow moat ratings on the others.

There were three tranches of spectrum in the auction: 700 MHz, 3.6-3.8 GHz, and 26 GHz. The 700 MHz and 26 GHz generally went as we expected with Telecom Italia, Vodafone, and Iliad each acquiring 700 MHz spectrum, while all five operators acquired spectrum in the much larger 26 GHz band. The problem was in the middle band. In other European countries, auctions in the 3.4 GHz to 3.8 GHz bands have been dramatically cheaper. For example, in the U.K. Vodafone paid EUR 433 million for 50 MHz of spectrum and in Spain EUR 198 million for 90 MHz of spectrum. In Italy, Vodafone paid EUR 1.7 billion for 80 MHz of spectrum. Vodafone and Telecom Italia with total bids of EUR 2.4 billion are paying roughly one year’s worth of EBITDA for this auction. This makes generating a decent return on capital for that investment very difficult.

Other countries have learned from past mistakes that if spectrum auctions are too expensive the operators are limited in their ability to build out their networks to take advantage of the spectrum, which hurts consumers. Thus, many in Europe are choosing to price spectrum in the 3.5 GHz and higher bands relatively cheaply in order to enhance 5G network capabilities. However, Italy intentionally staged this auction to maximize revenue by issuing less spectrum and in big blocks rather than the number of bidders.

In 2016, when 3 Italia was allowed to merge with Wind it became the largest wireless operator by subscribers in Italy, but it had a poor network. We believe Telecom Italia and Vodafone felt it necessary to acquire the two large blocks of 80 MHz offered at 3.7 GHz in order to maintain their network advantage. This led to very high pricing, which we think will be detrimental to the market in the long run. This was pointed out by Nick Read, Vodafone’s CEO who said, “Auctions should be designed to balance fiscal requirements with the need for investment to enable economic development. Telecoms is the sector that enables all other sectors to participate in the Gigabit society. It is critical that European governments avoid artificial auction constructs which fail to strike a healthy balance for the industry.”

Telecom Italia has been trying to reduce its debt for years with minimal success, and this auction will make debt reduction all the more difficult. While for Iliad with its small size, this is a large investment that we doubt was anticipated when the company agreed to enter the Italian market. The positive for the market is that this additional expense will likely cause Iliad to raise prices, which will help stem the tide of its low-priced onslaught.

The amount being paid by CK Hutchison and Swisscom are too small relative to their size to have any meaningful effect on our fair value estimates. While Vodafone’s payment is significantly more than we anticipated, as bidding in other European countries for spectrum in the 3.4-3.8 GHz range has been quite low, we think the higher price is offset by the value of its joint ventures. As we’ve been reviewing our valuation of its JV’s, we believe we’ve been too conservative in our analysis. Thus, we believe the JV’s valuation offsets the higher spectrum price.

Even after reducing Telecom Italia’s and Iliad’s fair value estimates we believe the stocks remain undervalued. However, there are other stocks that we think are better positioned strategically that are also undervalued that we would prefer at this point, particularly best ideas Telefonica and BT Group.

Telecom Italia acquired 80 MHz in the 3.7 GHZ band for EUR 1.7 billion, 20 MHz in the 700 MHz band, and 200 MHz in the 26 GHZ band with total bids of EUR 2.4 billion. Vodafone also acquired similar amounts in the same bands, but with total bids fractionally less than Telecom Italia. Iliad acquired 10 MHz in the 700 MHz band, 20 MHz in the 3.6-3.8 MHz band, and 200 MHz in the 26.5-27.5 MHz band for EUR 1.19 billion. Wind Tre, owned by CK Hutchison, acquired 20 MHZ in the 3.6-3.8 MHz band plus spectrum in the 26 GHz band for EUR 516.5 million, and Fastweb, owned by Swisscom, gained spectrum in the 26 GHZ band for EUR 32.6 million.