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For many telecom companies, expanding into emerging countries can be very attractive. However, the telecom sector is highly exposed to country governance risk, such as changing regulations and bribery. For credits issued by telecom companies we assess this risk in a structured way to make better-informed investment decisions.
As competition and penetration rates in emerging markets are typically much lower than in developed countries, potential growth rates are compelling. However, emerging countries typically face high corruption and legal security is often not assured. The telecom sector is highly exposed to such ‘country governance risks’.
For credit investors, a primary concern is to select issuers that are able to repay their debt. Avoiding losers is more important than picking winners. Country governance risk is one of the risk factors that our credit analysts take into consideration while assessing an issuer’s business position. Especially for the telecom sector country governance risk plays an important role in this analysis.
Historically, telecommunication services were often provided by state-owned monopolies. Over the last two decades many of these companies were privatized and more competition was introduced. However, the sector has remained highly regulated, mainly because communication is a basic need that states are supposed to provide to their citizens at a reasonable price. Also a strong communication network is paramount to economic development.
Although telecom companies entering a country are usually well aware of current regulations, the long-term nature of their investments exposes them to the risk of changing regulations. Obtaining a license to set-up a telecom network is very valuable, which increases the incentive for bribing corrupt officials.
Recent examples show that country governance risks can have a material impact on the financial health of telecom companies. TeliaSonera, the Swedish-Finnish incumbent, announced to exit seven Eurasian countries including Uzbekistan, Kazakhstan and Azerbaijan following several corruption cases in these countries. The company has booked a EUR 539 million impairment for assets. MTN, a South African telecom company operating in Africa and the Middle East, received a huge fine of more than USD 5 billion from the Nigerian regulator relating to a minor incident of not timely disconnecting some unregistered users.
We gain insight in the extent to which various telecom operators are exposed to country governance risks by analyzing and combining country governance data with revenue data per operator.
The average governance risk for companies which have their main operations in developed countries is fairly low. However, there are companies with a decent average score but some exposure to more risky countries. TeliaSonera for example has a decent average score because of its relatively large exposure to Nordic countries with strong governance. But the lowest ranking country (Uzbekistan) indicates that the company has operations in countries with weak governance. The same holds true for Tele2, Orange, Telenor and Telefonica.
In our downside risk assessment of telecom companies not only their exposure to country governance risk is important, but also how they performed in the past in managing such risks. To this end we use ‘severity weighted’ news items data by RepRisk taking into account news items that can have a negative impact on companies’ reputation. RepRisk news items are a good proxy for identifying companies that were involved in cases related to country governance risks. We make a revenue adjustment to control for the size of the companies, since larger companies might by definition be more in the spotlight of global media.
To generate a complete picture on country governance risks in the telecom sector we bring together our findings in a Country Governance Risk Scorecard. This scorecard ranks telecom companies in quartiles on the dimension of exposure to country governance risk and on the dimension of how management has dealt with issues in the past.
An example of a company with high exposure but strong performance is Tele2. The company has operations in countries with weak governance, the lowest ranking country is Kazakhstan, but the company did not have any major issues in the past. Before considering to invest in Tele2 we would have to investigate more how the company assures that the risk is managed appropriately.
Most interesting are the companies that rank in the bottom half with regard to exposure to country governance risk. In the third quartile for ‘Country risk exposure’ we find, for example, Deutsche Telekom, TeliaSonera and KT Corp, all of which also rank weak on performance. Deutsche Telekom was involved in bribery issues in its subsidiaries in Macedonia and Greece. However, since both regions are only minor revenue contributors and because Deutsche Telekom has a decent corporate governance and compliance structure we believe the financial impact is limited. Both TeliaSonera and KT Corp had financially material issues in the recent past and therefore more research is needed to assess if the companies have, indeed, improved processes and corporate culture to mitigate risk in the future.
As for the companies that rank in the bottom quartile for country governance risk, we can divide them into a group of companies that generate the majority of revenues from developed markets, such as Orange, Vodafone, Telefónica and Telecom Italia, and the group of companies that have a dominant business in emerging markets such as Telenor, America Móvil, Bharti Airtel, Millicom and MTN. The former group had cases of arbitrary law enforcement and corruption but the companies claim that they have appropriate processes in place to limit the risk in the future. This means that we have to check if the companies really do what they say they are doing, as there seems to be a discrepancy between processes & policies and performance. In any case, the higher risk should be reflected in financial models.
Overall there is a relatively high correlation between companies’ exposure to riskier countries and the number of cases they experienced in the past. This means that it is fairly difficult, or even impossible, for companies to fully mitigate country governance risks.
Even if companies cannot fully avoid country governance issues, we see differences in how they manage the risk. This is particularly relevant because a proactive stance and collaboration with regulators can limit the financial impact of non-compliance. Since there are certainly benefits for telecommunication services companies to enter markets with lower market penetration and, consequently, higher growth rates, companies with high exposure should not be ruled out for investment per se, but the risk should be reflected in the investment case. We therefore believe that our research supports us with relevant information necessary to identify companies with a beneficial risk reward profile and helps us to avoid unpleasant surprises.