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Will Orange Survive Higher Interest Rates?

September 27, 2013 | About:
Chandan Dubey

Chandan Dubey

99 followers
I have been holding shares of Orange (ORAN)(XPAR:ORA), previously known as France Telecom, since December 2011. In this article, I want to discuss some of the things that worry me about the company.

A careful analysis of the debt is imperative. Orange has been investing nearly €5 billion a year in its infrastructure. To put that in perspective, the company has a market cap of €25 billion.

Unfortunately, Orange cannot cut down on its capital expenditure if it wants to stay relevant in the continually changing technological landscape. Buying new spectrum (e.g. 2G, 3G and 4G) is a necessity rather than foresight on the part of the management. This is one of the main reasons for staying away from investing in the telecom business. It eats a copious amount of cash, just to remain relevant, year after year.

The important questions to ask is: Where is this money coming from? One of the avenues is of course debt.

The company has a debt of €30 billion. With shrinking profitability due to competition in its home market by Illiad (XPAR:ILD), Orange lends itself to increasing risk in an environment with rising interest rates. Few will disagree that the situation with artificially low interest rates is not going to last. Is Orange ready for the change in scenery?

If we consider interest, debt is broadly of two kinds: fixed and variable. A fixed bond has a fixed interest rate associated with it and it does not change until the bond matures. A variable debt is one which is based on a benchmark, the most popular being LIBOR. The company pays the benchmark plus a small percentage on top of it. If the interest rates rise, the company with the higher percentage of variable debt will suffer more than the company with the smaller percentage. Following is the split of Orange’s bonds depending on the kind of interest, as of Dec. 31, 2012 (calculated from debt data on page 60 of consolidated financial statement 2012).

Outstanding debt (€ mn)% of total outstanding
Fixed rate29,51396.65
Variable1,3423.35


Orange looks fine at the moment.

This is only part of the story. If the rates increase, Orange will have to pay higher rates to interest new bond holders. Hence, we now divide debt according to maturity and see if Orange's interest rate will go up or down.

Maturityfixed rate debt (in €mn)Average interest (%)
2014-201812,0234.37
2019-20236,5554.24
2023+6,5357.13


This gives us an interesting set of data. The debt that has maturity greater than 10 years pays nearly twice as much interest.

A thought experiment is useful at this point. Suppose that Orange has to replace the debt maturing in the next five years by one at the higher interest rate. The company will have to pay €332 million more in interest expenses than what it is paying now.

What Does That Say About the Dividend?

Last year the company paid €3.6 billion in dividends. The company had a free cash flow of €3.25 billion in 2012 (according to GuruFocus). Fortunately, the company already cut the dividend from €1.4 to €0.80 this year. This will save the company €1.5 billion and assuming that the free cash flow does not deteriorate much further, the dividend will be well supported by the free cash flow.

It seems the home market has stabilised and in the near future the situation should be clearer. Hence, I do not expect nasty surprises in the free cash flow of the company.

An increase in €332 million of interest expense can be handled. At least until the last year, the situation of the bond market was favorable to Orange. It repaid €2.63 billion of bonds during 2012. It also issued €2.3 billion at an average fixed interest of 3.58%.

Bottom Line

The fear that increasing interest rates will reflect poorly on the financial performance of Orange is at the moment just that. Even if Orange has to replace the debt for the next five years by one at a substantially higher rate, i.e. 7% instead of 4.37%, it will not pose a substantial threat to free cash flow. The additional interest expense in such a case will be 10% of the current free cash flow.

The company also seems more able to handle the lowered dividend. I am happy to hold the shares at the moment, knowing that at least from a financial perspective the company seems secure.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.8/5 (6 votes)

Comments

vgm
Vgm - 1 year ago
"Unfortunately, Orange cannot cut down on its capital expenditure...This is one of the main reasons for staying away from investing in the telecom business. It eats a copious amount of cash, just to remain relevant, year after year."

CD -- Playing devil's advocate, I wonder if the question for a sound investment should be will it grow and thrive, rather than will it "survive". You list alot of negatives. The stock has been dropping for years. Do you see a catalyst to reverse investor perception? You talk about "shrinking profitability".

By way of contrast, a company like DTV has taken on low-cost debt to fund share buybacks and overall it is accretive - it's good capital allocation.

Just some thoughts.
cdubey
Cdubey - 1 year ago
@Vgm: DTV was an excellent opportunity. Maybe it still is. I should look into it.

I haven't bought or sold anything for a while. The stock market is not amenable to bargain hunting at the moment. With more than 8% dividend yield, something has to give. I don't see the dividend being cut again.

I also don't feel that the investing in infrastructure is necessarily a bad idea.

I think I suffer from the "boiling frog fallacy". A frog will jump out of hot water but will let itself slowly boiled if the temperature is raised gradually.

Thanks for playing an excellent devil's advocate.
vgm
Vgm - 1 year ago
Thanks CD. I wasn't actually recommending DTV, just comparing its use of debt and buybacks. But if you do want to read up on DTV, there have been two good articles on GF recently as well as a summary by Bill Nygren of his rationale in his GF Q&A:

http://www.gurufocus.com/news/229236/bill-nygrens-investing-answers-to-gurufocus-qa
cdubey
Cdubey - 1 year ago
I think Third Avenue also holds DTV. I should really look into it. Don't want to dilly-dally when the market crashes.

Thanks for reminding me of the company.
vgm
Vgm - 1 year ago
Berkshire (Weschler/Combs) and Southeastern are large holders. And a number of credible value Investors like Lou Simpson, Bill Nygren and Wally Weitz have significant positions. John Malone has a piece. I wasn't aware that Third Avenue had a position.

Good luck.

Long DTV

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