By Leila Abboud and Harro Ten Wolde
PARIS/FRANKFURT (Reuters) - A rally in European telecom stocks has closed the big valuation gap with U.S. peers seen nine months ago, boosted by hopes that regulators will allow more mergers in the industry as it starts to recover from the bruising recession.
A series of telecoms and cable industry deals this year has helped fuel speculation that competition regulators will loosen the leash on mobile firms wanting to merge to encourage the investment needed for Europe to catch up on building faster broadband networks.
At the same time Europe's sovereign debt crisis which pushed up corporate borrowing costs has abated, leaving many of its telecom companies in better financial shape after they cut debt and raised new equity instead.
In February the transatlantic gap in telecoms valuations was at its widest since 2008 and the European sector traded at roughly 9.9 times forecast earnings against 17.6 times for U.S. peers. The ratios are now at 13.9 times forecast earnings for Europe and 14.5 for the U.S, according to Thomson Reuters data.
The Stoxx Europe 600 telecoms sector index has risen 30 percent this year, second only in gains to the autos sector, as many investors rotated out of U.S. leaders AT&T and Verizon Communications and into a basket of long-unfashionable European operators, such as Telefonica, Orange and Deutsche Telekom.
The trend picked up pace in August after Vodafone agreed to sell its 45 percent stake in U.S. joint venture Verizon Wireless to Verizon Communications for $130 billion, giving Vodafone plenty of cash for investments in Europe.
And while some groups, such as Orange, Telecom Italia and Telefonica are still struggling in their domestic markets, analysts predict that others will at least be able to stabilize operating profits in the next year or so.
Conversely growth in the U.S. mobile market has slowed and a rejuvenated T-Mobile US, backed by majority owner Deutsche Telekom, is winning customers from AT&T and Verizon with more flexible terms and lower prices. They also face stronger competition from their nearest rival Sprint Corp, following its $21.6 billion takeover in July by Japanese entrepreneur Masayoshi Son's Softbank.
As margins flatten, AT&T and Verizon shares have underperformed the wider U.S. market by roughly 10 percent in the past six months.
Olivier Lefevre, a portfolio manager at French bank Natixis, believes the European rally has further to go, at least until the sector index gets back to a price multiple of six times core operating profits, the level which it used to trade at before the economic crisis. Early this year it stood at historical lows of roughly five times EBITDA, and is now around 5.6 to 5.7 times EBITDA, he said.
"The growth that operators in the United States have enjoyed in recent years due to a very concentrated market will certainly be challenged by second-tier operators," he said.
"So investors are looking to Europe to play the same trade here, a bet on the improvement of the telecoms sector."
Yet some investors said there are clear risks in betting on the sector rather than particular stocks, given that European telecom revenues are expected to shrink again next year.
Orange, for example, is fighting a painful price war in France which sliced 8 percent off operating profits in 2012 and is expected to have suffered a further 8 percent cut this year. Although it has predicted profits will stabilize next year, some investors remain skeptical.
Nevertheless, Orange shares have risen nearly 25 percent in three months, outperforming an 11 percent increase for Norway-based European and Asian operator Telenor, putting the stocks on forward P/E multiples of 9.9 and 13.2 times respectively.
"The rally has been driven by generalist investors who looked for the cheapest big-cap telcos and threw money at them," said Bruno Grandsard of Axa Investment Managers.
Adding to the rally have been hopes that more foreign buyers might follow America Movil into Europe after the Mexican group acquired key stakes in KPN and Telekom Austria.
The prices they would have to pay are now higher, but industry bankers say prospective buyers still see potential in a recovering Europe.
AT&T has been scouting for targets, with Vodafone seen as the most attractive once its deal to sell out of Verizon is completed in the new year, according to the bankers, since it would give the U.S. group instant scale across Europe.
There are also still hopes that EE, the UK mobile operator co-owned by Orange and Deutsche Telekom will be floated on the London Stock Exchange next year.
And AT&T's chief executive Randall Stephenson has already said he thinks there is a "huge opportunity" for somebody in Europe to profit with demand for mobile broadband growing as people increasingly surf the web on the go.
Meanwhile the outlook for further consolidation within national markets in Europe has reached a critical juncture with Competition Commissioner Joaquim Almunia due to decide whether to allow two mobile mergers to go ahead. The review of Hutchison Whampoa unit 3 Ireland's $1 billion bid for Telefonica's O2 Ireland is due by March 24, while Telefonica Deutschland's $10.7 billion bid for KPN's German subsidiary E-Plus is expected in the summer.
If they are allowed bankers and industry executives predict further deals will follow to reduce the number of mobile players across Europe and allow the remaining ones to boost profits by reaping cost savings.
"The biggest risks to the rally would be a reversing of some of the factors which led to it, namely higher sovereign debt risk premiums, regulators not allowing consolidation, or AT&T losing interest in Europe," said Erling Thune, a portfolio manager at DNB Technology.
(Editing by Greg Mahlich)