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Morningstar | Tele2 Reported Solid 2Q Results; We Expect to Raise Our FVE to SEK 83, but Stock Overvalued

Tele2 reported solid second-quarter results and we expect to increase our fair value estimate to SEK 83 per share from SEK 78. We maintain our no-moat rating and believe the shares are significantly overvalued. The firm reported revenue growth of 5% year over year, which is one of the highest in our European communications coverage. However, Tele2 counts its Netherlands business as discontinued as it has agreed to merge it with Deutsch Telekom's Dutch operation. We are highly sceptical of this deal receiving regulatory clearance from the European Union, so we count the Netherlands in our revenue and margin results. Tele2's Dutch business generated revenue growth of 5.5% in line with the whole firm, but its EBITDA margin was just 4.7% versus the rest of the company at 27.6%. Hence our revenue projection is much higher than the firm's and our EBITDA margin projection of 22.2% is much lower than management's guidance.

Sweden, which accounts for about 60% of reported revenue generated a small revenue decline, while the Baltic countries and Kazakhstan produced average revenue growth of about 10%. Kazakhstan's EBITDA margin jumped to 33.7%, which is about one year ahead of our expectations. Increasing our EBITDA margin for this year to 23.2% and the time value of money account for our higher fair value estimate. We were already projecting significant revenue growth from the Baltic countries and Kazakhstan.

Where we think we disagree with the market in valuing Tele2 is its free cash flow. Tele2's capital expenditures are extremely low for a telephone company. In Sweden, its capital expenditure was only 5% of revenue and its objective for the whole company for 2018 is SEK 2.1-2.4 billion, which is 8.2-9.3 times consensus revenue as the firm calculates revenue. These levels are totally unsustainable in our opinion. The capital expenditure/sales ratio for telecom stocks in our coverage generally is between 12% and 18%.

With 5G coming soon and Sweden likely to be one of the first countries in Europe to launch 5G service, we believe Tele2 must significantly increase its capital expenditure or have the quality of its networks left in the dust. Increasing its capital expenditure will dramatically dent its free cash flow going forward. We don't believe the market believes this will happen. As an example of the potential risk, Sprint only spent 5% of its revenue on capital expenditure in fiscal 2009 and 5.9% in fiscal 2010. It increased capital expenditure to 9.3% in fiscal 2011 and has been trailing in quality ever since, despite spending over 20% of revenue for the past three years. The only European communications company that is remotely close to Tele2's level is Sky, whose primary business is satellite TV, so it doesn’t own a significant network that it needs to maintain and upgrade and even Sky's capital expenditure hasn't dropped below 6% in the past 10 years.