Rising Regulatory Hurdles And 5G Costs Will Shrink Profitability

Key Takeaways

• Increasing regulatory demands, competitive pressure from global tech entrants, and evolving customer trends threaten 1&1's margins, revenue growth, and ability to scale earnings.
  
• Heavy network investment and technological disruptions risk stranding current assets, squeezing cash flow, and undermining long-term profitability and market position.
  
• Transition to owning and operating its own 5G network boosts profitability, enables differentiation, and strengthens 1&1's position amid rising demand for secure, high-speed connectivity.

Catalysts

Operates as a telecommunications provider in Germany.

• Intensifying regulatory scrutiny on data privacy and network neutrality is likely to substantially increase compliance costs and restrict lucrative monetization opportunities from customer data, resulting in sustained downward pressure on net margins and limiting the company's ability to grow earnings over the long term.
  
• Escalating competition from hyperscalers and technology giants, who are rapidly entering European connectivity markets, is expected to erode 1&1's potential profit pools through disruptive service innovation and aggressive price competition, leading to weaker revenue growth and possible market share losses.
  
• The company's heavy dependence on large upfront investments to build out and maintain its 5G network, coupled with rising operating expenses and increased interest burden from new long-term loans, is set to constrain free cash flow and curtail near-term and medium-term profitability prospects.
  
• Lower-than-anticipated customer acquisition and persistently high churn rates during and after the large-scale migration to their own infrastructure, combined with ongoing price wars and commoditization in German wireless, threaten both average revenue per user and top-line growth well beyond the transition period.
  
• Accelerated technological changes, such as a shift toward cloud-native infrastructure, Open RAN, or the emergence of 6G standards, could render portions of 1&1's current network investments obsolete, thereby requiring further capital expenditures and impairments and posing a structural risk to long-term earnings and asset values.

1&1 Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on 1&1 compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming 1&1's revenue will decrease by 1.2% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 3.7% today to 3.6% in 3 years time.
• The bearish analysts expect earnings to reach €141.7 million (and earnings per share of €1.12) by about August 2028, down from €151.0 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 16.5x on those 2028 earnings, down from 21.6x today. This future PE is lower than the current PE for the DE Wireless Telecom industry at 16.8x.
• Analysts expect the number of shares outstanding to grow by 3.61% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 4.76%, as per the Simply Wall St company report.

1&1 Future Earnings Per Share Growth

Risks

• Once the migration to the company's own 5G network is complete, costs related to wholesale usage of other networks will meaningfully drop, which should structurally improve both gross margins and net margins over time.
  
• 1&1's move from a network reseller to a full infrastructure operator is likely to provide meaningful opportunities for service differentiation, enabling higher ARPU and stickier customers, supporting revenue and earnings.
  
• The company expects to meet regulatory 25% national coverage by end of the year and continues to ramp network build-out, positioning it well to capture growth from the secular shift toward 5G, IoT, and high-speed mobile data, which can drive top-line growth.
  
• Strong demand from digitalization across Europe and the increasing importance of data privacy may favor regional telecom providers like 1&1, enhancing customer retention and reducing churn, which supports a resilient revenue base.
  
• Strategic access to long-term funding via the development loan, as well as ongoing partnerships and infrastructure-sharing, may lower capital intensity and enable the company to self-fund expansion, which improves free cash flow and reduces financial risk over the long run.

Valuation

• The assumed bearish price target for 1&1 is €10.4, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of 1&1's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of €30.0, and the most bearish reporting a price target of just €10.4.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be €3.9 billion, earnings will come to €141.7 million, and it would be trading on a PE ratio of 16.5x, assuming you use a discount rate of 4.8%.
  
• Given the current share price of €18.48, the bearish analyst price target of €10.4 is 77.7% lower.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.