Orange Is The New Green

Orange may be the new black in the world of TV series, but Orange is the new green in the stock market.

Shares of French telecommunications provider Orange (ORAN) ("Orange" or "the company") have rallied to the tune of 51% since hitting fresh multi-year lows in July 2013. While it's hard to recommend shares that have run so far, so quick, it is my opinion that Orange is still presenting investors a compelling asymmetric risk/reward situation. One way to limit risk is to set limit orders to pick up shares on any pullback caused by the shenanigans going on inside the Beltway.

The four most dangerous words in investing are "this time it's different." But this time, I think it really is different for Orange and the broader equity markets in Europe. After a couple of years of deteriorating business performance at Orange in the wake of fierce competition, government austerity and a tightened regulatory environment, the feral stock market punished the price of Orange shares so much that Orange entered bargain territory.

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I normally don't look at charts much, but comparing Orange to its competitors in the French telecommunications market is quite fascinating. As one can see, incumbents Bouygues (BOUYF.PK) and Vivendi (VIVHY.PK) (owner of SFR) saw similar price declines. The market, on the other hand, rapidly bid up the price of new entrant Iliad SA (ILIAF.PK), as a result of forecasts for Iliad to capture significant mobile market share (which it did, around 10%). The wide divergence in price relative to changes in underlying value favor going long the incumbents, including Orange. Because this time it's different.

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This Time It's Different: M&A Ac! tivity Indicating Value

For those who keep tabs on the media and telecommunications industries, 2013 has proved to be a historic year in terms of the number and size of deals consummated, with the cornerstone deal being the Verizon (VZ) buyout of Vodafone's (VOD) 45% stake of Verizon Wireless for $130 billion in a cash and stock deal. After maximizing the value of its crown jewel asset, Vodafone may be on the lookout to buy up beaten down telecommunications businesses in Europe and/or invest in growth in emerging markets. Vodafone will retain about a $30 billion cash balance after returning significant value to shareholders realized from the Verizon Wireless deal.

I see considerable strategic value and potential synergies in a Vodafone/Orange tie up provided, of course, it be approved by regulatory agencies in the European Union. It would bring the Orange brand back to Vodafone who was required to sell it as part of its $180 billion takeover of German conglomerate Mannesmann in 2000. Both Vodafone and Orange frequently collaborate to develop telecom infrastructure in target markets, most recently in Spain and Romania. While Orange is levered most to France, it also has exposure to Spain, the UK, Africa, the Middle East and India.

Buying Orange at depressed prices would allow Vodafone access to these markets at bargain prices. Of course, taking full control of Orange is unlikely, given the French government owns a substantial stake in Orange. We all know about the many frustrating French government policies and regulations on business, in particular in the telco space. In my mind, this is the largest deterrent from a takeover of Orange.

In addition, with SFR, France's second largest telecom operator likely being demerged from its parent, Vivendi, by the end of 2014, there are a number of interesting outcomes in the French telecom market after the disruption caused by Iliad. Maybe the government would be more apt to allow another French telco to merge with Orange rather than a fore! ign enter! prise.

Other potential suitors for beaten up telecom assets in Europe include John Malone's Liberty Media Corporation (LMCA), who recently lost a bidding war for Kabel Deutschland to none other than Vodafone, who picked up the business for a shade over $10 billion.

To say that there are watchful and opportunistic eyes on Europe's telecom industry would be an understatement. In my view, this time it is different as telcos attempt to realize economies of scale in their operating models and move to a more converged product offering: wireless, wireline and pay-television services.

Valuation

Orange is currently valued at $36 billion and carries net debt of about $38 billion (using $1.30 : €1 exchange rate), for a total enterprise value of about $74 billion. With 231 million paid subscribers at the end of June 2013, prospective investors are paying about $320 EV/per subscriber and $155/per subscriber for the equity. That strikes me as a particular bargain, given the relatively stable cash flows provided in this defensive industry. Recent declines in average revenue per user ("ARPU") are a cause for concern among prospective investors, but I expect those to abate as market share among competitors becomes more defined after Iliad has reached 'critical size.'

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With mobile plans that are priced well below incumbents, Iliad has forced Orange to compete on price. It is evident in the numbers, as Orange reported ARPU down 12% year/year. However, as telcos move more towards converged service offerings and compete in 4G, LTE and FTTH, I expect that pricing will become less cutthroat as customers place a premium on the best service.

In terms of valuation, Orange is currently priced at 4.8x TTM EV/EBITDA, 1.4x TTM EV/Revenue and 1.1x book value. Relative to European competitors such as Bouygues and Iliad which trade a! t 5.6x an! d 10.3x EV/EBITDA, Orange trades at discounted multiples. However, these 'comparables' aren't perfect, as Bouygues has significant construction-related businesses and Iliad is being valued as a growth business.

Relative to US comparables such as AT&T (T) and Sprint (S) (now majority-owned by Japan's Softbank) which trade at EV/EBITDA multiples of 8.9x and 7.9x, respectively, the valuation gap is more pronounced. Because of all the moving parts in the recent Verizon Wireless deal, I've chosen to exclude it from the comparable set. US telcos also operate in a completely different regulatory environment from European telcos, which could explain the valuation gap.

Even with the significant pressure experienced by Orange, it is still on target to deliver over 7 billion euros in operating cash flow (which the company defines as adjusted EBITDA less capex) on the back of substantial cost reductions (422 million euros through the half-year).

Orange is practicing the "never let a good crisis go to waste" mantra to restructure its business. Most poignantly, the company is wringing out excess costs from its operating structure, and achieved a lion's share of its full-year 2013 cost reduction goals (600 million euros) in the first half (422 million euros), particularly with respect to direct costs. Reducing its variable cost structure is setting Orange up for significant operating leverage, which will allow Orange to harvest more cash from incremental revenue as growth stabilizes.

Meanwhile, the equity also stands to benefit from prudent financial management and refinancing its debt at historic low rates, thereby allowing interest savings to flow to shareholders. By the end of 2014, management is targeting a 2x net debt/EBITDA multiple, down considerable from levels seen just a couple of years ago. In my view, Orange has passed the high-risk zone in terms of financial leverage as it gets its operational house in order and reduces costs.

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Any way you slice it though, Orange looks cheap relative to its peers and on an absolute basis. When you combine the fact that sentiment on the European economy is turning bullish, and the worst was priced into Orange's share price relative to Iliad's known entrance into the market, Orange is set up to deliver solid risk-adjusted returns.

While the stock isn't as cheap as it was this past summer, I think shares still have another 25% to run based on EV/EBITDA multiple expansion to 6x, which were levels investors were willing to pay before many of the difficult regulatory and competition scenarios played out over the past couple of years.

When operating cash flows stabilize, it may be feasible that investors bid up prices allowing for additional multiple expansion on par with US comparables, around 8x EV/EBITDA. As such, Orange's stock quote has tarmac ahead of it both in terms of investors returning to Europe in search of fertile ground for bargain hunting and from improved operational performance.

Both should provide tailwinds to Orange at current price levels, coincident with lower risk than at the initial onset of recession in Europe, a materially lower debt profile and from Orange's competitive response to Iliad's entrance into the French mobile market.

Conclusion

There are a lot of forces at work in the telecommunications industry, many of which are conducive for recovery in underlying values and, ultimately, stock prices. Regulatory risk remains, but as the European market becomes less fragmented, a more unified European telecommunications market should allow incumbents to realize economies of scale and synergies from increased M&A activity.

Orange is cheap, and ready to show patient, long-term investors some serious green. Because this time it is different.

Europe is on its way back. A rising tide lifts all boats, and strategic players are a! wash with! cash and/or new found independence to maximize value. One way for that to happen is through buying up bargain assets such as Orange.

Even after a significant rise in share price, Orange is still in the bargain bin. Its shares have meaningful upside if it stays independent or if it gets a go private offer.

Either way, orange is the new green.

Source: Orange Is The New Green

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ORAN over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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