Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. I'm here today with Associate Director, Mike Hodel to take a closer look at international telecoms to see how their bonds are trading and why our view might be a little bit different than some of the major rating agencies.
Mike, thanks for talking with me today.
Michael Hodel: Thanks for having me Jeremy.
Glaser: So when you take a look at the big picture of the European telecoms, how do they differ from the ones that we might be familiar with in the United States like AT&T and Verizon?
Hodel: Sure, the big incumbent carriers in Europe are going to be fairly similar to the big incumbents here in the U.S., AT&T and Verizon. They are subject to the same technological trends, technological changes. They both operate in very mature markets where there is not a lot of growth potential left. Competition has kind of settled in most markets to a fairly steady-state. You are going to have some differences in regulation, and one area that we pay particular attention to in Europe is cost flexibility.
So, one of the risks that you have as a telecom company is that as technology migrates and changes and customer habits change. There is potential that revenues could start to drop fairly rapidly again, sort of what we saw maybe 10 years ago, starting with the shift away from fixed line to wireless. Some of these carriers had pretty big revenue declines for much of the last decade.
If you get into a situation where revenues start to slide again, you really want to have cost flexibility. Some of the carriers in Europe don't have as much as cost flexibility, the ability to pair down their workforce as we might have in the U.S. An example that we frequently give is Germany, Deutsche Telekom has a much less flexible labor pool than you typically find in most telecom carriers, and as a result, it is one of the only companies, major telecom companies that we don't give a moat rating too. We actually have it as no moat. The company has been unable to earn its cost of capital for much of the last decade and a lot of that is due to their inability to bring costs in line with revenues.
Glaser: So if they have trouble cutting these costs and profitability isn't as good, what's the impact of that on the balance sheet? The balance sheets of a company like Deutsche Telekom and France Telecom are fundamentally different from those in the United States?
Hodel: The balance sheets aren't fundamentally different. European carriers tend to carry a bit more leverage than the typical major U.S. carrier. The bigger impact on our credit rating is in our business risk or business risk is one of our four ratings pillars that we look at Morningstar. Because we rate Deutsche Telekom no moat, it has a lower business risk or than a typical carrier.
Glaser: So this lead to a divergent view, where you see the credit for Deutsche Telekom versus some of the major rating agencies?
Hodel: Our rating in Deutsche Telekom is BBB minus, which is a couple notches lower than the major rating agencies. One of the biggest pressure points on our ratings versus the major agencies across all of telecom is that we really pay a lot of attention to dividend payouts in our ratings. We have what's known as a cash look cushion. It's the second of our four pillars.
We look at a company's ability to meet its cash obligations over the next five years whether its cash on hand or cash that we expect the firm to generate, and we adjust that cash flow cushion calculation for dividend payouts. Typical telecom carriers pay out a lot of their cash flow as dividends. That weighs really, really heavily on our cash flow cushion score.
So both Deutsche Telekom, France Telecom, if you look across Europe Telecom Italia, British Telecom and even in the U.S. companies like AT&T and Verizon, they pay out a lot of cash, and as a result, our cash flow cushion scores are generally poor.
Glaser: Even with that poor cash cushion, a lot of investors still seem to be pretty excited about these bonds. Why do you think that is?
Hodel: Well, I think these companies are viwed as very, very stable businesses that generate great recurring cash flow. I think a lot of investors still view them as utilities more or less. We don't think that view is quite right. There are a number of risks with telecom that you wouldn't have with like an electric utility or water or gas utility.
Glaser: So when thinking about investing in credit abroad, the telecoms will not be the place to go?
Hodel: Right now, credit spreads are very, very tight across telecom, especially for the major incumbent carriers in Europe and in the U.S. So we don't think they are generally favorable places to look. If we were looking for exposure in telecom, we generally prefer the stocks to the bonds. A lot of these stocks have very, very nice yields and you have upside potential as well. So we think a stock bought at a great price is a better bargain right now or a better place to invest than the typical telecom bond.
Glaser: Great, Mike, thanks so much.
Hodel: Thank you.
Glaser: For Morningstar.com, I'm Jeremy Glaser.