P&L CHECK

Deutsche Telekom's Costly US Success

  • Why it matters

    Why it matters

    Deciding on the future of its US subsidiary T-Mobile could dramatically impact Deutsche Telekom’s stock and earnings potential.

  • Facts

    Facts

    • Deutsche Telekom is the largest European-headquartered telecoms group, with revenues of €73 billion ($81.5 billion) in 2016.
    • After several loss-making years, its mobile phone subsidiary T-Mobile US has rapidly increased its customer base in recent years, but marketing costs have eaten into profit margins.
    • Telekom was close to selling T-Mobile US to AT&T in 2011 for $39 billion and again in 2014 to Sprint for around $32 billion, but antitrust regulators blocked those deals.
  • Audio

    Audio

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main 30414294 source Gary He DPA – John Legere CEO T-Mobile US March 2013
Breaking up is hard to do. Source: Gary He / DPA

Angela Merkel is not the only German leader with tough decisions to make on trans-Atlantic relations. Timotheus Höttges, chief executive of the telecoms giant Deutsche Telekom, also faces a dilemma over the future of his increasingly important subsidiary, the wireless network operator T-Mobile US.

Deutsche Telekom, the largest Europe-based telecommunications provider, has already tried twice to sell its US subsidiary, once in 2011 to AT&T and again in 2014 to Sprint. On each occasion, regulators blocked the deal, fearing it might hurt competition and limit consumer choice as one of the four big mobile phone operators in the United States would disappear.

Will Mr. Höttges revive his efforts to find a buyer this year? That was the big question on everyone’s mind as Deutsche Telekom prepared for its annual meeting with shareholders this week. The answer depends on whether he chooses to see T-Mobile as a blessing or a curse on his overall business. A look at the numbers from last year shows the record is decidedly mized.

The revived merger talk has partly been prompted by expectations of laxer antitrust laws under President Trump, and partly by T-Mobile’s rapid growth in customer numbers.

In Europe, Telekom is already the undisputed industry leader, having achieved its key strategic goal of becoming the largest telecoms company on the continent. It earned €73 billion in overall revenue in 2016, putting it €20 billion ahead of the continent’s next largest group, Spain’s Telefónica, with Vodafone, Orange and BT trailing behind.

A fair amount of that success is down to the surprising strength of its US business. T-Mobile US earned €33.7 billion in revenue last year, more than any other division (see graphic below) and helped to offset weaknesses in its Romanian, Polish and Dutch operations as well as at its loss-making IT provider, T-Systems. Without T-Mobile, Telekom would be relegated to a fifth place among European telecom firms.

The success of T-Mobile’s share price of late has also reflected well on that of Telekom, which has far outstripped the performance of its rivals. The German company’s stock has surged more than 50 percent in the last three years, while Vodafone lost 2.3 percent, Telefónica nearly 9 percent and BT fell more than 35 percent. T-Mobile’s shares have quadrupled in value over that timeframe.

And yet, selling T-Mobile has never been completely off the table, though Deutsche Telekom now seems to be mulling a merger rather than a sale. Earlier this month, the company confirmed it was exploring merger possibilities, with T-Mobile’s Chief Financial Officer Braxton Carter suggesting that a deal with rival Sprint could yield $30 billion in synergy effects. In fact, Mr. Carter went further, speculating on an alliance between a merged company and cable providers Comcast and Charter Communications, in a consolidated American telecoms market.

The revived merger talk has partly been prompted by expectations of laxer competition regulation under President Donald Trump, and partly by T-Mobile’s rapid growth in customer numbers in the past year.

30 p23 Deutsche Telekom-01

It wasn’t always this way. Deutsche Telekom bought the US business for almost $40 billion in 2001, when it was still called Voicestream. But its foray into the US market didn’t initially bring the successes it had hoped for. T-Mobile struggled to gain traction in the United States, where larger rivals Verizon Wireless and AT&T dominated the market. After T-Mobile ran a $4.7-billion loss in 2011 and a $7.3-billion loss the following year, Deutsche Telekom listed a third of the stock on Nasdaq in 2013 through a reversed takeover of smaller rival MetroPCS.

Since its listing and under the leadership of the energetic CEO John Legere, put at the helm of T-Mobile US in September 2012, the company has started to flourish, gaining customers and taking over Sprint’s position as the third-largest mobile carrier in the US. T-Mobile’s share price has also quadrupled since its 2013 flotation. Last year alone saw an increase of 47 percent in T-Mobile’s market value, adding €10.3 billion to the value of Telekom’s own 65-percent stake. Given those gains, Mr. Höttges of Deutsche Telekom is probably happy that regulators blocked the sales in 2011 and 2014: Telekom’s stake was worth €32.2 billion at the end of last year.

Deutsche Telekom’s American business now provides more than 46 percent of the German group’s worldwide sales, compared to just 30 percent from its German operations. Without its American turnover, which jumped 16.6 percent in 2016, the group’s overall revenues would have declined last year.

But while T-Mobile now contributes the lion share of revenue, its profitability is a trickier subject. Though T-Mobile US substantially raised its overall operating profit last year (excluding one-off items), its operating profit margin remained well below that earned by the German business (see graphic below). An added problem: T-Mobile US’ profits have so far been only realized on paper, since Deutsche Telekom has no control or profit agreement with its US subsidiary. That means the German owner will only receive money when T-Mobile pays out a dividend. However, the US business has traditionally not paid out a dime.

Therein lies the dilemma for Mr. Höttges: T-Mobile has helped grow Deutsche Telekom’s revenue and market value, but its profitability issues could still be a reason to spin off the US subsidiary.

Deutsche Telekom vs t-Mobile US-01

There are other negatives. The German operations’ better profit performance is not least thanks to the high marketing costs of its American sales drive. T-Mobile’s rapid gains in customer numbers have in part been the result of its popular (and comparatively cheap) unlimited data plans, which have eaten into margins. Other marketing gimmicks — including free pizza, milkshakes and films — also add to costs. T-Mobile has even given away its own shares as a reward for new mobile contracts.

T-Mobile’s push for market share will also require substantial investment to upgrade its networks in the United States, estimated at $40 billion over the next five years, to be financed from its existing cash flow and bond issues. These costs are dragging down T-Mobile’s cash reserves, which currently stand at just 1.3 percent of its total revenues. By comparison, Telekom’s German operations are at a healthy 6.2 percent.

The company’s cash reserves (or free cash flow) figure is of key interest to investors – also in the parent company – since this is the cash from which dividends are paid. At this week’s annual meeting, shareholders are expected to approve a payout of €0.60 per share, up five cents on last year. As in recent years, Deutsche Telekom is also offering shareholders the chance to accept dividends in the form of new shares.

A final aspect causing concern at Telekom’s head offices in Bonn: T-Mobile doesn’t invest its money particularly well. The company has long tended to post comparatively weak returns on capital employed, or ROCE, a metric indicating how efficiently a company generates profits. Worldwide, Deutsche Telekom had a ROCE margin of 5.7 percent, while the American figure is even lower at 4.5 percent. Both numbers are bad: According to auditors KPMG, telecoms and media companies need to earn around 7.2 percent to cover their capital costs. Mr. Höttges has promised shareholders that ROCE will exceed capital costs in 2018. A sale or merger of T-Mobile could help in this.

“T-Mobile US has the size and financial power to successfully continue its growth trajectory. It is a success story we want to continue with.”

Timotheus Höttges, CEO, Deutsche Telekom

Despite those concerns, for the moment the hard-won strength of the T-Mobile brand has made a merger more likely than a straight sale. Speaking in late March, Mr. Höttges sounded distinctly unwilling to give up on his US subsidiary. “T-Mobile US by now has the size and financial power to successfully continue its growth trajectory. It is a success story we want to continue with,” he said.

Mr. Höttges, 54, will have to weigh all the options before deciding T-Mobile US’ future. While Chancellor Merkel has no choice but deal with the US and its unpredictable president, Telekom’s CEO still has the liberty to cut ties if he chooses.

 

Ina Karabasz is an editor at Handelsblatt’s companies and markets team, covering telecommunications, IT and security issues. Christoph Schlautmann covers the logistics and waste management sectors for Handelsblatt. To contact the authors: karabasz@handelsblatt.com,  schlautmann@handelsblatt.com

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