COLT

Negative signals lend a sombre tone to the telecoms firm

by Dan Coatsworth

COLT Telecom Group, (COLT) 133.5p, Stop loss 160.2p

Shares summary

Sales and free cashflow are not growing strongly enough to warrant the high rating

Business:

Provider of local telecommunications services for businesses and governments

Vital stats:

Market value: £908 million

Historic PE: 44.5

Prospective PE 2008: 24.9

Prospective PE 2009: 18.3

Sector PE (next 12 months): 16.5

1-month relative strength: -8.9%

1-year relative strength: 7.4%

Yield 2008: n/a

NMS: 6,250

Spread: 0.19%

Last week’s (24 July) interim results caused concern about COLT’s sales, profit and free cashflow growth prospects as the telecom services firm must spend much more money to secure extra business. Analysts are asking if the additional earnings are boosting cash returns at all. A prospective price earnings ratio (PE) of 24.9 for 2008 means the stock is expensive relative to the telecom sector’s 16.5 average. It is hard to justify the premium rating, particularly when weakening macro-economic prospects prompted management to adopt a cautious earnings outlook.

COLT provides telecommunications to businesses and government in Europe. Pre-tax profit for the first half of 2008 jumped from €8.9 million to €33.5 million, helped by a €17 million one-off credit related to a billing issue between 2004 and 2007. Yet progress in the top line was not spectacular.

The 1.5% rise in second quarter revenue to €416.3 million was the first positive growth period for two years, notes stockbroker Investec. Data revenue nudged up by €39.2 million, a 9.6% rise underpinned by rising demand for ethernet services and its data centres.

This did not offset an 11.1% decline (€47.6 million) in voice revenue. Negative factors included competition in Germany and increases in the number of people terminating mobile deals.

A bigger concern is COLT’s appetite for cash. A year-on-year rise in capital expenditure from €56.5 million to €85.7 million in the second quarter meant spending was 28% higher (nearly €20 million) than expected by stockbroker KBC Peel Hunt. For several years, COLT has been seen as a potential takeover target with healthy cash generation as a key attraction. A bid has yet to emerge and will be less likely if free cashflow lags and the telecoms market becomes even more cut-throat.

Worsening sentiment

There is a good chance telecom stocks will hold up well against the broader market, as earnings and cashflow should prove relatively resilient in the event of a big economic slowdown. But market sentiment on COLT has worsened and investors should take note.

Stockbroker Landsbanki is worried about COLT’s exposure to the financial services sector and push into management services. The latter has already shown signs of a slowdown in the US. Analyst Dan Gardiner says COLT’s ‘vague guidance does not inspire confidence’. He dislikes the way the company said it expected to improve results in the second half but added its outlook was ‘tempered with some caution’ in the light of economic uncertainties.

The shares have fallen 23% since June to 133.5p as investors questioned earnings visibility and cashflow. Landsbanki first flagged the risk posed by higher capital investment to free cashflow in April, when it argued rising capex could be an early sign of a slowdown in the data market. Analyst Dan Gardiner suggested the shares would fall from 166p to 140p over the subsequent year. This price drop was achieved in just over two months. With negative sentiment building, existing investors should sell; those not holding may consider shorting the stock.