I decided to have a look at the company and found it interesting. The company had a yield of above 8% and the dividend was well covered at a payout ratio of 45%.
Furthermore, the dividend had grown quite nicely and unlike the French market, the Dutch seemed more stable.
I quickly looked at the annual reports of the company and its business and decided against investing. For a company in an industry with relatively large capital expenditure, a higher debt load is the norm. But KPN was one of the worst in terms of its balance sheet.
Let us quickly look at its debt versus equity graph.
This was quite a steep climb. What was the reasons for such gross leveraging? One possible explanation is a combination of share buybacks and dividends which eats away the equity part of the balance sheet (see Large Debt-Equity Ratio Can Be a Byproduct Of Share Repurchases).
This seemed to be the case. So, I got excited again! The company seemed like the definition of “Cannibal” (see Charlie Munger): a company that uses its prodigious cash flow to buy back shares. KPN bought back more than 1.1 billion shares and looking at the price graph below and assuming a reasonable average price of €14 apiece, it spent at least €15.4 billion on buybacks!
Nevertheless, during this time the stock did not appreciate in value by much. It was range bound between €14 and €18. Meanwhile, it seems that KPN was taking on debt to finance the share buybacks. We see that KPN generated €20 billion in FCF and paid nearly €9 billion in dividends. The net debt on the other hand did not change by much.
This seemed like a dream company. It paid good dividends and used the excess free cash flow to buy back shares.
The company was then (in 2012) selling for near €8 a share for €11.2 billion (1.4 billion shares outstanding). The net debt was almost the same, i.e. around €12 billion. This was a significant amount of debt and it made sense to look at two important figures: interest cover and debt maturity profile.
The interest cover of the company has been historically around 3.5. This is not great. A jump in interest rates will have severe consequences on the profitability. Given that the company operates in an asset intensive business with high capital expenditure, this is something which made me uncomfortable.
Following is the debt profile of KPN. As we see, the debt profile is also quite heavy with greater than €1 billion due every year until long in future. Given that the company generates around €2.6 billion in FCF and pays €1 billion in dividends, this puts a significant pressure on the uses of cash. The management needs to be careful and any acquisition needs to be carefully planned in terms of funding. A high debt load restricts such possibility. It will first need to roll over the current debt and then find financiers who are willing to loan money to a company with such a high debt-to-equity ratio. This makes the situation quite dangerous.
In the end, I decided not to buy this company. I did not agree with the management's decision to keep the debt near the same levels and buyback stocks. In my opinion, the shareholders would have been better served if the debt was repaid instead of the share buybacks.
One obvious reason for share buybacks is clear if we look at the revenue of the company over the years. There has been no growth on the revenue front. It has stayed in the region of €12 billion since 2003. This has been mainly due to lack of expansion into different countries and lack of significant acquisitions. As such, this is not a bad thing, and having a good and stable business which throws cash at you is great.
Sadly, telephony has a lot of competition and it seems that the company has not even been able to increase revenue in terms of inflation. One would assume that the business will increase revenue even if there is no growth in absolute terms.
To obviate the lack of growth in revenue, the management may decide to buy back shares. This will increase the EPS and the dividend per share, even if the company was making the same amount of money and paying the same amount of dividend on an absolute basis. Probably this was one of the significant reasons for the management to do such a thing.
From the stock price above, it seems that this did not work out well. The huge debt load finally caught up with KPN and the stock plunged during 2012.
The reason was summed up quite nicely at [Bloomberg]. It seems that in a bid to rebuff American Movil, the company tried to sell its Belgian unit to Belgacom and merge the German unit with Telefonica. Both these attempts failed and the stock price suffered the consequences.
KPN is among European phone companies looking at asset sales and raising capital to cope with the rising costs of maintaining high-speed networks for devices like Apple Inc.’s iPhone. Under Blok, who took over in 2011, KPN’s shares have plunged amid stagnant revenue and abortive attempts to sell its Belgian unit and merge its German operations with those of Telefonica SA.For raising cash, KPN then turned to equity markets. The stock price dropped 16% on Feb. 5, when the following news was released by KPN.
On 5 February 2013, KPN announced a € 4bn capital raise. The capital raise to be supported by AMX will consist of an underwritten € 3bn rights issue and, in addition, issuance of hybrid capital instruments which are expected to receive partial equity recognition. Through this combination KPN intends to achieve the targeted € 4bn equity equivalent capital.Meanwhile, Carlos Slim has €1.7 billion in paper losses and the stock trades at its 11-year low.
Competitive Pressures, More Risks
KPN also has lost some footing in its home market. The company is facing eroding margins on its existing business. The SMS market has been nearly cannibalized by apps like Viber and Whatsapp. KPN also purchased 1.5 billion worth of spectrum in 2012 in the Dutch auction. Predictably, it needs to raise capital to meet the payment which was due in first quarter 2013.
In the same auction Tele2, a fourth entrant, bought spectrum, and it plans to invest heavily in the 4G network development. Furthermore, given that KPN has a BBB- rating from S&P and Baa2 from Moody’s, it is effectively shut out from the financial markets. This is because very few institutions are allowed to buy such low grade bonds. Interestingly, as opposed to France where the entrance of Illiad has played out, it seems that in Netherlands it is only beginning. As opposed to France Telecom, KPN has not done a good job of diversifying its business and will face the short end of the stick. The debt is going to haunt them, even after the equity offering.
It is hard to calculate the value of KPN shares before the equity offering is finalized. At current prices the company will need to issue nearly 1.2 billion new shares to raise €3 billion in cash by rights issue. This will push the shares outstanding to 2.6 billion and the EV to €20 billion. Given that the company has averaged a FCF of €2 billion and has been quite shareholder friendly up until the recent past, this will be an okay price to pay.
At current prices though the situation looks “distressed” and “special." I will need to do significantly more research before jumping in. The chances are that this is a “pass” for me.