European telecommunications companies that have successfully managed inflation so far are bracing for higher energy prices and employee salary demands.
To date, most of the sector insulated itself from rising electricity costs via hedges and power purchase agreements, or PPAs. Some of those agreements will expire by the year's end. Still, energy costs make up a relatively small part of a telecom company's cost base, typically more than 5% of sales. A much larger risk is looming in the form of growing employee demands for higher wages.
"The European labor market is generally not as overheated as in the U.S., but the longer we see inflationary pressures, the more we see the probability of wage hikes," said Mark Habib, an S&P Global Ratings credit analyst who specializes in telecom and tech.
The costs of goods and services, particularly energy, have skyrocketed in the past year, exacerbated by the war in Ukraine and reduced gas supplies from Russia. The consumer price index was up 8.1% for European Union countries in April, according to Eurostat. In the U.K., the Office of National Statistics reported 7.8% inflation in April.
That is leading to more pressure on companies to raise wages to keep pace. The U.K.'s average total pay increased 5.4% in February 2022, compared to the same period last year, according to the Office for National Statistics. Labor costs were up by 1.9% in the euro area in the fourth quarter of 2021, according to Eurostat.
"I am surprised that wages are not accelerating yet, but there could just be a lag," said Justin Funnell, a telco analyst at Nextgen Research.
High inflation adds to the list of headwinds that have plagued the telecom sector in recent years, including high indebtedness, weak returns, 5G expenditures and regulatory challenges. The S&P Europe 350 was up nearly 10% over the past five years, while most telecoms posted negative returns during the same period. Telefónica SA and Vodafone Group PLC, for instance, lost about 50% and 42% of their value, respectively.
British Telecom in April agreed to raise wages for half of its employees by £1,500 ($1875), resulting in an increase of between 3% and 8%. The Communication Workers' Union, which represents the interests of BT employees, rejected the pay proposal, increasing the odds for tough labor negotiations that could lead to even higher salary costs. BT has passed some of its higher expenses to U.K. customers via inflation-linked contracts.
Other continental European companies like Deutsche Telekom AG and Orange SA have agreed to more modest salary bumps.
In terms of energy costs, Telefonica and Telenor ASA are among the few companies that do not have a hedging strategy or PPAs, which impacted the companies' profitability in recent quarters. Telefonica’s operating income before depreciation and amortization, or OIBDA, (its preferred profitability measure), declined more than 6% in the March quarter, partly due to higher energy bills, the company said. Telenor said its organic EBITDA declined 2.5% in the most recent quarter, with energy costs contributing the most to the decline.
Conversely, some companies are benefiting from higher inflation. Vodafone had energy hedges in place and has not raised employee wages to date. Combined with its ability to automatically pass higher inflation costs to customers in the U.K. via inflation-linked contracts, its profitability has improved in recent quarters.
While the inflation effects are negligible so far, the future might be more challenging. S&P Ratings' Habib does not expect energy prices to come down to pre-pandemic levels until well after 2025. Most telecoms have one-year PPAs or hedges, meaning they would have to be renegotiated soon at higher prices.
Withstanding inflationary pressures will hinge on companies' ability to find efficiencies and pass on higher costs to consumers. In some markets, this will prove more challenging than in others.
"The U.K. market is one where telecom companies have been successful in passing inflation to customers," Habib said. All telecom operators in the country have contracts with customers that allow them to increase prices every year by the same amount as the rate of inflation plus 3.9%.
Funnell expects German and French companies will also be able to cope well with higher prices. But Spain and Italy, where tough competition is impacting prices, might be more challenging, according to Funnell.
Many companies are already putting in place strategies to cope with inflation. Orange and Telefónica are offering clients enhanced data plans for more money, a strategy commonly dubbed "more for more." Deutsche Telekom will drop promotional pricing in Germany. "Our preference is higher prices through growth in ARPU and pullback in promotional pricing," said Srini Gopalan, managing director at Deutsche Telekom's Germany business Telekom Deutschland said on a recent earnings call.
Orange's Deputy CEO Ramon Fernandez suggested more price increases could be coming.
"It would be surprising if the telecom sector would be the only sector that would not be able to pass some of the cost increases to consumers," Fernandez said on an earnings call last month.