Relaunching Coverage of Tele2 and Telia

We relaunch coverage of Tele2 TEL2 B and Telia TELIA, maintaining our narrow moat and stable moat trend ratings for both. Our new fair value estimates are SEK 100 and SEK 29 respectively, compared with SEK 115 and SEK 35 previously, after revisiting our medium- and long-term forecasts.

Despite both being narrow-moat firms in the stable Nordic markets, Tele2 is our preferred stock. In the past decade Tele2 has executed a brilliant strategy based on: 1) selling its noncore operations and strengthening its presence in its key markets of Sweden and the Baltics; 2) admirable cost controls, with selling and administrative expenses declining cumulatively by 700 basis points over sales in the past decade; and 3) very good capital allocation, with ordinary dividends growing at a 5% CAGR since 2013 and being topped up with extraordinary dividends when there were divestments or earnings surprises. We upgrade our Morningstar Capital Allocation Rating for Tele2 to Exemplary from Standard due to its outstanding dividend policy, correct M&A decisions, focus on cost controls, and fair balance sheet (net debt/EBITDA at 2.5 times). Tele2 and Deutsche Telekom are the only two firms with an Exemplary rating among our European telecommunication coverage.

Telia stretched its operations too much during the past decade, going into regions like Nepal, Turkey, Russia, and Kazakhstan. Telia has correctly divested these businesses, but still has exposure to seven countries and an underperforming TV business, which makes it a less lean firm. We downgrade Telia’s Morningstar Capital Allocation Rating to Poor from Standard. We believe a dividend cut is feasible in the medium term as Telia’s dividend isn’t covered by free cash flow generation and has been partially financed by debt in recent years. In our view, Telia will have to either: 1) increase its leverage above its guided range to maintain its dividend; or 2) cut its dividend to keep leverage in check. Any measure would be detrimental to shareholders.