From inorganic to organic growth - Europe's long haul

Looking at the recent financial results reported by the large European operator groups, it is interesting to note that ‘inorganic’ financial items are often largely contributing to free cash flow (FCF) and net debt improvements. This situation is not sustainable and could be a sign of difficult times ahead. European operations are becoming too costly – due to a high level of maturity - and are often backed by faster growth from operations in emerging markets. This trend highlights the urgency to return to organic growth in the region.

Organic growth refers to an increase in a company’s own business activity, excluding profits generated from takeovers, mergers and acquisitions. It indicates how well management has used its internal resources to expand profits. By contrast, inorganic growth represents the increase in profits that a company generates from M&A activity.

FCF is used to a) finance organic or inorganic growth; b) pay dividend to shareholders; and c) repay debt. However, in such difficult market conditions, operators are struggling to balance those priorities and long-term growth prospects do not look good. Take Vodafone as an example. What helped the operator’s FCF in its 09/10 fiscal year was the dividends received from associates and investments, the amounts received from non-controllable shareholders in Qatar, and favourable foreign exchange activity. Those ‘inorganic’ items helped Vodafone to improve FCF and to reduce debt; further inorganic growth is expected when Verizon Wireless will finally pay out Vodafone's dividends. However, Vodafone cannot continue to preserve cash flows by betting on how well its associate operations are performing, nor by letting its operation in India and its stake in South Africa’s Vodacom drive organic profit growth. There is a clear urgency to return to organic growth in Europe.

The situation is not dissimilar at Deutsche Telekom (DT). Through 2008-09, DT’s T-Mobile has seen its FCF and net debt impacted by the acquisition of OTE in Greece, and more recently by the deconsolidation of its UK operation to form a JV with France Telecom’s Orange (known as 'Everything Everywhere'). As a result, EBITDA took a plunge, cash from operating activities decreased and net debt increased. The operator’s profit growth mainly relies on the performance of its US business. There is an urgent need for T-Mobile to return to organic growth in its European operations, which represent 90 percent of profits generated over the first half of the year (including fixed-line businesses).

France Telecom is also reporting similar patterns as EBITDA declined year-on-year, FCF decreased and net debt increased. The group reported negative organic growth at 4.6 percent in 1H10 with Spain the only country to report a positive organic growth (4.3 percent). Even at its domestic operations in France - which represents 60 percent of total EBITDA generated over the period – the group has recorded negative organic growth at 5.7 percent. Unfortunately, France Telecom has less ‘inorganic’ financial items than Vodafone that are able to shore up cash flow.

But there is light at the end of the tunnel. In Germany, T-Mobile recently reported a return to profit as EBIT increased by 22 percent between 2Q09 and 2Q10 and subscriber acquisition and retention costs (SAC/SRC) decreased by 5 percent and 40 percent, respectively, over the same period. Vodafone Germany also reported a return to organic revenue growth at 0.2 percent in its fiscal 1Q10/11. However, looking at the 10 percent annual fall in voice revenues and 2 percent decline in messaging revenues - and considering the 9 percent increase in customer costs from 2008/09 - the return to organic profit growth at Vodafone Germany may take longer.

It seems clear that in order to return to organic profit growth, operators must focus on reducing SAC and SRC, and speed up the migration of prepaid users to contract (as well as continue the ongoing push behind data services). These factors are no doubt a central focus of the multibillion-euro savings programmes currently being implemented by operators such as Vodafone and T-Mobile.