INDEPENDENT RESEARCH Telecoms in Italy 31th January 2017 Definitely not la dolce vita Telecom services TELECOM ITALIA (SELL, EUR0.71€), ILIAD (BUY, EUR220)

ALTICE BUY FV EUR20.7 In this report, we analyse the Italian telecoms market and initiate coverage of Bloomberg ATC NA Reuters ATCA.AS Telecom Italia (TI). We also take a first look at what Iliad’s business plan could Price EUR20.295 High/Low 20.345/11.235 Market cap. EUR25,154m Enterprise Val EUR73,734m be in Italy. We believe that Iliad’s move into Italy will create value for the PE (2016e) NS EV/EBIT (2016e) 23.9x group, but that it poses a serious threat to Telecom Italia which could already

BOUYGUES BUY FV EUR35.5 experience difficulties in the fixed-line market. We initiate coverage of Bloomberg EN FP Reuters BOUY.PA Price EUR34.69 High/Low 37.205/24.99 Telecom Italia with a Sell rating and fair value of €0.71. We stress that our Buy Market Cap. EUR12,312m Enterprise Val EUR14,339m rating on Iliad is a high-conviction call, but for now we do not include the PE (2016e) 20.4x EV/EBIT (2016e) 17.0x value of Iliad’s Italian operations in our fair value, which remains unchanged at ILIAD BUY FV EUR220 Bloomberg ILD FP Reuters ILD.PA €220. Price EUR197.6 High/Low 236.25/168.35 Market Cap. EUR11,605m Enterprise Val EUR13,164m PE (2016e) 33.2x EV/EBIT (2016e) 18.6x  In spite of the real challenges facing Iliad in terms of distribution and marketing, we think that entry conditions are sufficiently advantageous to ORANGE BUY FV EUR17.8 Bloomberg ORA FP Reuters ORAN.PA allow it to create value in excess of €600m in Italy. At this stage, however, Price EUR14.45 High/Low 16.445/13.1 Market Cap. EUR38,438m Enterprise Val EUR61,620m we do not include the Italian project in our fair value or our models for PE (2016e) 15.1x EV/EBIT (2016e) 12.6x Iliad. We maintain our fair value of €220 excluding Italy and we stand by

SFR Group NEUTRAL FV EUR30 our Buy rating, for which prospects in Italy have reinforced our conviction. Bloomberg NUM FP Reuters SFRGR.PA Price EUR27.7 High/Low 38.1/19.975 Market Cap. EUR12,207m Enterprise Val EUR26,575m  Structural changes in Italy’s fixed market and especially the arrival of Iliad PE (2016e) 68.3x EV/EBIT (2016e) 18.5x on the mobile market pose a real threat to the historical operator, Telecom TELECOM ITALIA Rating FV Bloomberg TIT IM Reuters TIIT.MI Italia, in spite of improved prospects in Brazil and ambitious cost-cutting Price EUR0.8 High/Low 1.046/0.6335 e Market Cap. EUR21,878m Enterprise Val EUR47,589m and investment plans. Moreover, Telecom Italia’s 2017 EV/EBITDA- PE (2016e) 8.6x EV/EBIT (2016e) 12.7x CAPEX multiple of 14.1x suggests that the stock is not particularly

attractive.

30/01/17 109  Of the historical operators, we continue to prefer Orange to Telecom 104 Italia. Orange enjoys better protection against a decrease in its « legacy » 99 revenues thanks to retail and wholesale fiber, near-complete absorption of 94 the Free Mobile shock, strong growth at its Spanish activity, less exposure 89 to emerging markets, lower debt, current multiples (EV/EBITDA-Capex) 84 and a more generous dividend policy. We have one reservation: the 79 Telecom Italia stock could attract speculative interest at the expense of

Source Thomson Reuters STOXX EUROPE 600 TELECOM E STOXX EUROPE 600 Orange.

Analyst: Sector Analyst Team: Thomas Coudry Richard-Maxime Beaudoux 33(0) 1 70 36 57 04 Gregory Ramirez [email protected] Dorian Terral

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Table of contents 1. Investment case ...... 3 2. Mobile: the Iliad challenge ...... 4

2.1. A dynamic, competitive environment in mobile ...... 4

2.2. Free Mobile’s experience in France revisited ...... 9

2.2.1. The day before ...... 9 2.2.2. Impact of Free Mobile and transformation of the market ...... 10 2.2.3. The main reasons for Free Mobile’s success in France ...... 16 2.3. Opportunities for Iliad in Italy ...... 17 2.3.1. Differences to the French experience...... 17 2.3.2. Image and communication ...... 18 2.3.3. Offer and pricing ...... 18 2.3.4. Distribution ...... 20 2.3.5. Innovation ...... 21 2.3.6. Network deployment and quality of service ...... 21 2.3.7. Cost structure and business model ...... 21 2.3.8. Regulatory environment ...... 22 2.3.9. Market structure...... 23 2.4. Iliad should create value in Italy ...... 24

2.5. TI’s strategy ...... 28

2.6. Telecom Italia’s prospects with Iliad as a rival ...... 28 3. The fixed market is changing rapidly too ...... 33

3.1. A market notable for broadband growth ...... 33

3.2. TI’s oulook troubled by its competitors’ own investments ...... 35 Telecom italia (Fair Value EUR0.71, SELL Coverage initiated) ...... 41

The calm before the storm ...... 41 We initiate coverage of Telecom Italia with a Sell rating and fair value of €0.71. Structural changes in the Italian fixed-line market, and especially the forthcoming arrival of Iliad in Italy, pose a real threat to the historical operator, despite improving prospects in Brazil and ambitious cost-cutting and investment plans...... 41 Iliad (Fair Value EUR220, BUY-Top Picks) ...... 67

The Italian campaign ...... 67 In this report, we present our initial view on what the business plan for Iliad in Italy could be. In spite of real challenges in terms of distribution and marketing, we believe that entry conditions are sufficiently advantageous to allow Iliad to create value exceeding €600m in Italy. We stress that our Buy rating on Iliad is a high-conviction call, but for now we do not include the value of Iliad’s Italian operations in our fair value, which remains unchanged at €220...... 67 Bryan Garnier stock rating system ...... 75

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1. Investment case Telecom Italia enjoyed a return to positive growth in 2016, but Italy’s historical operator faces multiple challenges this year in its domestic market (80% of group EBITDA) including: 1/ the forthcoming arrival of Iliad in consumer mobile services and 2/ Enel’s expansion into wholesale fixed fiber.

In mobiles (25% of TI’s domestic revenues), we believe that the arrival of Iliad in late 2017 (or in very early 2018) poses a very serious threat. Despite real challenges in terms of distribution and marketing, we think that Iliad enjoys sufficiently advantageous entry conditions to capture an 11% share of the overall mobile market. In our view, in order to cause real disruption in the market, Iliad might decide not to launch a very low-cost offer, but instead offer an all-in service for about €10 per month. Thanks to a highly-optimised cost structure, a gradual move from a variable-cost opex model to a fixed-cost capex model that allows the group to spread investments and risks, we believe that Iliad’s Italian venture is bound to create value for the group. In this report, we present an initial view of what the business plan for Iliad in Italy could be. Given limited visibility at this stage, we estimate at €635m the NPV of the Italian project, ie +€10 on our fair value of €220. Besides, we believe that a subsequent move into fixed is likely to be high on Iliad’s list of strategic priorities and would help to raise potential value creation significantly. For now, we do not include the value of Iliad’s Italian operations in our fair value, but we stress that our Buy rating is a high-conviction call.

Faced with this threat, we believe that Telecom Italia is the best-placed player in the Italian market to face the challenge (like Orange in France), thanks to a value strategy based on ambitious investments and generous content. Nevertheless, we think that Telecom Italia could lose 2.6 million clients in the long run, and suffer a decrease in ARPU exceeding 15% within 3 years. In fixed, while facing substitution of its traditional fixed business with high-speed services, we think that Telecom Italia will struggle to prevent the slide in wholesale activities at a time of rising deployment of its own network by competitors and of limited growth in very high speed due to new competition from Enel. However, a plan to reduce opex by €800m in 2016-2018 should help to cushion the impact of the changes described above. On the other hand, prospects in Brazil should pick up, thanks to ambitious cost-cutting and investment plans coupled with an improving macro-economic context.

In this report, we initiate coverage of Telecom Italia with a Sell rating and fair value of €0.71. We do not include the strong catalyst of possible asset sales (notably Brazilian operations or an interest in subsidiary Inwit). We cannot rule out speculation around such potential deals, but we believe that the focus is currently on cost-cutting rather than asset sales, although the latter may become a priority again in case of increased difficulty in Brazil or the domestic market.

In this report, we prefer not to include in our Fair Value and rating the persistent speculation concerning the stock (Vivendi, Orange…) which is denied regularly. The economic rationale of such deals, as well as the political context and market conditions, suggest that this would be inappropriate for now.

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2. Mobile: the Iliad challenge 2.1. A dynamic, competitive environment in mobile With penetration in the region of 150%, the Italian mobile market had 97.5 million SIM cards at end June 2016. As illustrated below, the total volume of clients has been fairly stable for a year. However, the residential market has lost 1.7 million clients in a year. This 2% shrinkage has been offset by growth of the business market. Moreover, the market is still 76% prepaid SIM cards, although the number of subscribers has increased by 1.5 million (+6.7%) in a year.

Fig. 1: Number of SIM cards in the Italian market (millions)

120,0

100,0

80,0

60,0

40,0

20,0

0,0 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16

Residential Business

Source: AGCOM.

Fig. 2: Changes in share of prepaid cards in Italy

90%

85% 81% 79% 80% 78% 77% 76% 75%

70%

65%

60%

55%

50% Jun-12 Jun-13 Jun-14 Jun-15 Jun-16

Source: AGCOM.

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Before the Wind/Tre merger, Telecom Italia was the market leader with 30 million lines and 31% market share, including 43% in the business segment and 27% in residential. But the merger of Wind and Tre, which respectively had 23% and 11% market share for a total of over 32 million lines, relegates Telecom Italia to second place. Vodafone is in third spot, with 29% market share and roughly 28 million lines. Since the Wind / Tree merger, therefore, the market is shared fairly equally by three large players. The dynamics of each player are quite different, however, especially in residential, as illustrated in the chart below, with declining market share for Telecom Italia and especially Vodafone, which has benefited Tre and Poste Mobile, notably. The other MVNOs are globally stable, with a combined 4.2% share of the residential market.

Fig. 3: Market share (%) trends in residential mobiles

100% 4,0 3,8 3,7 3,9 4,0 4,1 4,2 3,8 3,9 4,1 4,2 4,3 4,4 4,4 90% 11,6 11,9 11,9 11,7 11,9 12,0 12,4 80% 70% 25,9 25,9 26,0 26,1 25,9 25,8 25,7 60% 50% 40% 27,2 27,1 26,8 26,7 26,5 26,4 26,1 30% 20% 27,6 27,5 27,4 27,4 27,4 27,3 27,2 10% 0% Dec-14 Mar-15 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16

Telecom Italia Vodafone Wind Tre Poste Mobile Other MVNOs

Source: AGCOM.

Churn in the Italian market is between 25% and 30% with Telecom Italia’s churn the lowest, as shown in the chart below. For several quarters, churn has been trending lower in this market, mainly due to a gradual migration to subscriptions.

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Fig. 4: Churn trends in Italian mobile

40% 38% 36% 34% 32% 30% 32% 32% 31% 30% 28% 30% 26% 27% 28% 27% 27% 24% 27% 22% 20% mars-14 14 june sept-14 14 dec mars-15 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16

Market Telecom Italia Vodafone Wind Tre

Source: Company Data; Bryan, Garnier & Co ests.

In 2013, a vicious price war broke out in the market, causing rates to fall by over 20%. Since late 2014, prices have been generally stable. And since 2015, mobile ARPUs have been rising again, thanks to two simultaneous trends: 1/ increased subscriptions, as mentioned above, for which the average bill is higher (we estimate subscriber ARPU is between 1.5x and 2x prepaid ARPU in this market), and 2/ monetisation of rising data traffic.

Fig. 5: Price trends in mobile (base 100 in 2010)

ARPU

Source: AGCOM.

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Fig. 6: Annual changes in mobile ARPUs

15,0 14,5 14,0 13,5 12,8 12,9 12,8 12,6 12,7 13,0 12,3 12,1 12,2 12,5 11,8 11,9 12,0 11,5 11,0 10,5 10,0 mars-14 14 june sept-14 14 dec mars-15 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16

Market Telecom Italia Vodafone Wind Tre (12 months trailing)

Source: Company Data; Bryan, Garnier & Co ests.

According to AGCOM, the number of mobile data users exceeded 50% in 2016, and the volume of data exchanged on the network is rising exponentially, as illustrated below. Note that Telecom Italia is experiencing very strong growth of mobile data usage on its network.

Fig. 7: Trend of mobile data usage in Italy

600

500

400

300

200

100

0 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16

Data trafic (petabyte)

Source: AGCOM. Fig. 8: Trend of mobile data usage at Telecom Italia

7,0 2,5

6,0 2,0 5,0

4,0 1,5

3,0 Millions 1,0

2,0 Gbyte/month 0,5 1,0

– – mars-14 june 14 sept-14 dec 14 mars-15 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16 Sept-16

Total LTE users Data traffic / user (Gb/month)

Source: Company Data.

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Telecom Italia and Vodafone have very extensive 4G networks, with respectively 95% and 96% coverage at end Q3 2016. In our opinion, they are thus best placed to capture the value creation arising from rising data usage (improvement of the mix of offers, top ups revenues..). The other two players, Wind and Tre, have limited investment capacity and are far behind with coverage of 68% and over 70% respectively.

Fig. 9: Available frequencies per operator

TIM VF Wind Tre Total Iliad before Iliad Band: Expires in: (MHz)

800 LTE 2029 10 10 10 30

900 GSM/UMTS 2018 10 10 10 5 35 5

1500 2029 20 20 40

1800 GSM/LTE 2018 15 15 15 10 55 10

1800 LTE 2029 5 5 5 15

2100 2021 15 15 15 15 60 10

2600 LTE 2029 15 15 20 10 60 10

2600 TDD LTE 2029 30 30

Total 90 90 70 75 325 35

Source: Company Data..

Under these circumstances, we believe that Telecom Italia is well placed to continue along the path that it is currently tracing. But the arrival of Iliad will alter the landscape.

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2.2. Free Mobile’s experience in France revisited

2.2.1. The day before Iliad launched its mobiles activity on 10 January 2012. Having invented the « Triple Play » offering, Iliad operated in the fixed internet market with 4.849 million clients at end 2011. It was the third player ahead of Bouygues Telecom, with an estimated 21% share of the fixed market. The mobile market was transformed by the arrival of Free Mobile, and was very different at end 2011 from what it is today. In order to assess the impact of Free Mobile, it is important to understand the point of departure.

At the time, the mobile market was dominated by three main players: Orange, the leader with 42% market share, followed by SFR with 32% and Bouygues Telecom with 17%. The rest of the market was shared between a small number of MVNOs, including Virgin Mobile, NRJ Mobile, CIC Mobile and La Poste Mobile, as well as Lyca and Lebara in the market for “ethnic” prepaid cards. The penetration rate for mobile phones in France was 100% at the time.

The mobile market was dominated by fixed-term subscription offers that included a subsidised mobile. The low-cost market (no free mobile, no contract and mainly online distribution and client management) was still marginal. In anticipation of the arrival of Free Mobile, Orange, SFR and Bouygues Telecom launched their own low-cost services (Sosh, Red and B&You), but they represented less than 3% of their mobile subscriber base at end 2011. As a result, over 70% of residential subscribers were still bound by a contract when Free Mobile arrived. In 2011, churn for the average subscriber was 19%, but overall market churn including prepaid clients was 29%.

Prices for access to an unlimited mobile phone service were high and data capacity was low. Figure 10 shows the rates offered by the main operators before the arrival of Free. As illustrated, users had to pay at least €80 including taxes per month for a subscription with unlimited voice and a generous data allowance (at least 1Go). For around €20, low-cost subscriptions offered only a few hours of voice (apart from B&You) and little data. The average mobile bill (subscriber or prepaid) in 2011 was €25 (source: ARCEP). Unlimited SMSs were usually included in new offers, but 4G was still not operational. Moreover, fixed/mobile convergence was developing rapidly, thanks to attractive combined rates that offered discounts to limit churn: roughly 20% of fixed clients had a mobile with the same operator.

To conclude, in France at end 2011, the mobile market was still expensive and oligopolistic with voice and data allowances still relatively low. The new trends of falling prices, development of low-cost offers and generous voice/data allowances accelerated sharply with the arrival of Free Mobile.

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2.2.2. Impact of Free Mobile and transformation of the market Preface: To analyse the impact of Free Mobile on the French market, we confine ourselves at this stage to the first three years of Free Mobile operations: 2012 to 2014. In 2015, the commercial dynamics were severely disrupted when SFR and Numericable came under the governance of Altice, which complicated analysis. On the other hand, the impact of Free clearly did not end on 31 December 2014. It continues today. In particulier, Bouygues Telecom implemented a major overhaul of its offering in late 2014, introducing the low-cost B&You service via physical distribution. This led to an acceleration in falling mobile ARPUs alongside a significant commercial rebound. Moreover, this note does not look at the impact of Free Mobile on the fixed market, but it was clearly significant in view of converging offers – especially given Free’s greater capacity to attract and retain fixed clients at the expense of rivals.

Free Mobile began with an offering that was extremely aggressive in terms of rates and content, in addition to having innovative terms. Free introduced: 1/ A subscription that cost €19.99 including tax (€15.99€ for Free’s fixed clients) that gave unlimited calls and a generous data allowance. As shown in the table below, this offer was four times cheaper than the equivalent offering of competitors and half the price of an offer that included a subsidized mobile. Only the most competitive low-cost offers could compete with these rates, but their content was inferior to Free’s. 2/ A subscription that cost €2 including taxes (€0 for Free’s fixed clients). There was no comparable offering on the market. For a similar content, the market rate was €10 including tax. But more importantly, these offers marked the advent of the “low cost” model: online distribution (almost exclusively), no subsidized mobile phone (but alternative financing available) and no term contract.

Fig. 10: Free’s €19.99 offer and a comparison with competitors on introduction

Offer as of end 2011 Content EUR/Month vs Free Price of Total price vs Free (excl. Iphone 4S incl. (incl. Handset) 16G (EUR) Handset Handset) over 24 months

SFR - Red 3h voice, no data, unlimited sms 19 x1 615 1 071 x0.9

Orange - Sosh 2h voice, 500Mb data, unlimited sms 19 x1 599 1 055 x0.9

Bouygues Telecom - B&You Unlimited voice, 100Mb data, unlimited sms 25 x1.2 603 1 201 x1

Free Mobile Unlimited voice, 1Gb data, unlimited sms, roaming 20 721 1 200

Bouygues Tel. Eden iPhone Unlimited voice, 1Gb data, unlimited sms 80 x4 230 2 148 x1.8

Orange Origami Jet Unlimited voice, 2Gb data, unlimited sms, roaming 109 x5.5 179 2 795 x2.3

SFR Carré Absolu Unlimited voice, 3Gb data, unlimited sms 85 x4.3 150 2 190 x1.8

Source: Company Data; Bryan, Garnier & Co.

At this stage, it is important to note that the differences in rates illustrated above concerned list prices being marketed. The book of clients was heterogeneous and notably included old generations offers that were often more expensive than list prices.

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These cut-price offers in a market that was unprepared to such a radical pricing allowed Free Mobile to enjoy ultra-rapid growth (we discuss this lack of preparation in section 2.6). In three years, Free gained 10pts of market share and had 10 million clients by end 2014, in a market where penetration rose from 100% at end 2011 to roughly 110% at end 2014 i.e. an additional six million clients (at end 2016, penetration was still around 110%, but Free Mobile now has an 18% market share and 12.4 million clients). Free Mobile’s growth has therefore been fueled by winning market share from other operators AND by market growth, in roughly equal (50/50) proportions.

However, it is not certain that Free was responsible for this growth in the mobile market. Although the advent of Free Mobile spurred growth of the market in 2012, a catch-up phase began in 2013, as illustrated in figure 11.

Fig. 11: Growth of the French mobiles market (SIM volumes)

6,5%

5,5%

4,5% yoy growth

3,5%

2,5%

1,5% Q1 2008 Q1 2012 Q1 2009 Q1 2010 Q1 2011 Q1 2013 Q1 2014

Source: ARCEP; Bryan, Garnier & Co ests.

In three years, Free mobile transformed the structure of the market. As illustrated below, between 2011 and 2014, the share of prepaid clients fell from 30% of total clients to 20%. The number of prepaid clients fell by 28%, while subscriptions rose by 26%. The overall market grew 10% (this trend continues: today, with prepaid clients only accounting for 16% of the overall client portfolio). In response to very inexpensive subscription offers, the number of prepaid clients has gradually shrunk to a hard core (i.e. people who do not want to reveal their identity or banking information, or who are determined to control their phone budget rigorously), to occasional users (tourists, foreign students etc) and to so-called « ethnic » offers which are basically prepaid.

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Fig. 12: Changes to the structure of the mobile market

80 67,9 70 62,0 60 20%

50 31%

40

30 80% 20 69% Number of SIMs (millions) 10

- End 2011 End 2014

Subs. Prepaid

Source: ARCEP; Bryan, Garnier & Co ests.

As a result, before the arrival of Free Mobile, the proportion of subscribers (residential) who had no contractual agreement was 20%. At end 2014, it had risen to 51% (and 68.6% today, according to ARCEP). Moreover, the low-cost model spread rapidly thanks to Free Mobile: at end 2014, over 12% of the Orange and SFR subscriber base had switched to their low-cost Sosh or Red offers, and 25% of Bouygues Telecom clients had moved to B&You. These numbers do not include clients who had preferred the « SIM only » (no mobile) options of classic premium offers.

Apart from first-quarter 2012 when Free Mobile added 2.6 million clients, Free Mobile’s growth has been fairly linear, at the expense notably of the long-standing network operators, as shown in the following chart:

Fig. 13: Cumulative net sales of mobile operators since Free Mobile arrived

12 000

10 000

8 000

6 000

4 000

2 000

Cumulated Net adds (k) adds Net Cumulated -

-2 000

-4 000

-6 000 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2012 2012 2012 2012 2013 2013 2013 2013 2014 2014 2014 2014

Orange+SFR+Bouygues Tel Free

Source: ARCEP; Bryan, Garnier & Co ests.

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This exceptional commercial performance of first-quarter 2012 stemmed from the large number of people who were waiting for Free Mobile to launch and from the large number of prepaid clients, amplified by a powerful media buzz (we will return to this later). In the following quarters, recruitment continued as competitors’ clients contracts expired, as prepaid clients signed up and as the market grew (note that Free Mobile’s net growth should decrease mechanically as the client base grows, because the number of churners (at constant churn rates) is rising proportionally.

Not all operators were impacted to the same extent. The chart below shows changes in the market shares between end 2011 and end 2014.

Fig. 14: Changes in market share of French operators (volumes)

End 2011 End 2014

9% 10%

17% Orange 15% 36% 42% SFR Bytel Free 14% Others

32%

25%

Source: ARCEP, Company Data; Bryan, Garnier & Co ests.

Orange lost 600bps of market share, SFR (the hardest hit) -700bps, and Bouygues Telecom -300bps. Between end 2011 and end 2014, Orange lost 1.5 million clients or 6% of its base, SFR lost 2.4 million clients, (-13%) and Bouygues Telecom 1.3 million (-12%).

The operators responded in various ways to Free Mobile’s invasion (we will go into more detail in the section on Telecom Italia’s riposte). With varying intensity and timing, they all took proactive and reactive action: new low-cost offerings, updated listings of classic offers, higher below-the-line loyalty/retention incentives, guided migration of existing clients to new, less expensive subscriptions.

Volumes alone do not tell us the full story about the impact of Free on the other players. The following chart shows the trend in operators’ mobile revenues (we have restated Orange’s mobile revenues for a €750 million national roaming contract with Free).

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Fig. 15: Changes in mobile revenues of French operators

30 000

25 000 -34%

20 000

15 000 -31%

10 000

Mobile revenues (EURm) 5 000 -27%

- 2011 2014

Orange (excl. Free national roaming) SFR Bouygues Telecom Free

Source: Company Data; Bryan, Garnier & Co ests.

Orange lost 27% of its mobile revenues, while SFR lost 31% and Bouygues Telecom (the hardest hit in value terms) 34%. The operators were able to amortise part of the impact thanks to growth in the wholesale mobile market for MVNOs. Moreover, the BtoB proportion helped players such as Orange to cushion the blow. We estimate that 12-15% of SFR’s mobile clients are BtoB, while the proportion is probably over 20% at Orange. Although the very small companies or professionals were impacted by Free’s new offering, most of the BtoB segment was spared in terms of volumes. In terms of price, the segment suffered knock-on price cuts in the BtoC and the BtoB offerings.

Even without these factors, it would appear that Orange was still the least affected, as we estimate that its ARPU fell « only » 23% from end 2011 to end 2014, versus a decrease of about 32% for Bouygues Telecom. On average, ARPUs in the mobiles market fell 31% from end 2011 to end 2014 (- 34% to end Q2 2016).

We attribute Orange’s greater resilience to four main factors which are all related:

 A premium positioning, thanks largely to high investment in network coverage and quality of service.

 A reassuring, high-quality brand image, inherited from the traditional operator.

 A base/client profile that was probably a little less price sensitive than the average.

 Better handling of its response to Free, as we believe that Orange was better at managing segmentation of its offering between classic premium and low cost.

On the other hand, Bouygues Telecom was hardest hit. In our opinion, the main reason was its positioning as the traditional challenger, with prices that were lower than those of rivals and thus in direct competition with Free whose target was very price-sensitive clients.

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It is important to note that Free Mobile won less market share in value terms than in volume. Comparing only to the traditional network operators, Free Mobile captured 16% of market volumes in three years, versus « only » a 9% in value terms (restated for national roaming revenues with Orange). Free Mobile’s growth has (until recently) mainly been fueled by low-value subscriptions which have diluted ARPU, as illustrated in the following chart:

Fig. 16: Change in Free Mobile’s ARPU (Bryan Garnier estimates)

25,0

20,0

15,0

10,0

5,0

0,0 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

BG estimates for Free mobile services ARPU

Source: Company Data; Bryan, Garnier & Co ests.

We currently estimate Free Mobile’s ARPU at around €12.5, or roughly 50% below that of competitors.

Note that despite the gap between Free Mobile’s prices and those of its competitors on launch, ARPU of the traditional players did not fall by 50% or more. There were several reasons for this: 1/ the operators did not bring their rates completely into line with those of Free Mobile, but kept a small premium which was justified by a supposedly better service (physical stores, a quality network and better service…) and they retained their more expensive, more complete offerings (roaming, for example), 2/ catalogues of offers contain classic premium offers, with rates that include a subsidised mobile, 3/ some clients moved upmarket to unlimited voice/data for a small extra charge, and 4/ mechanically, clients who reposition do not necessarily reduce their bill by 50%: for example, a client who pays €30 for five hours of voice may reduce his bill by “only” 30% when he switches to unlimited voice for €20.

Within just a few years the mobile market became ultra competitive and largely contract-based, as low-cost offers that did not include a subsidized mobile became standard. Orange was the least affected; Bouygues Telecom the most.

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2.2.3. The main reasons for Free Mobile’s success in France We group the reasons for Free Mobile’s success in the French market into two distinct categories: endogenous factors and exogenous factors.

Among the endogenous factors, we note three key points:

 Aggressive and differentiated communication that attacked the traditional operators’ practices head-on with the client as witness. This generated a ‘buzz’ in the media and enhanced an already strong brandname. A well-orchestrated launch allowed Free Mobile to present itself as the clever choice, and competitors’ clients were openly referred to as « suckers » by Xavier Niel.

 The strong portfolio of fixed-line clients was a powerful lever for recruitment of mobile clients. With 4.85 million fixed clients when Free Mobile launched, Iliad had a large reservoir of clients for its mobile service which it was able to recruit at a very low acquisition cost, thanks notably to a discount on the mobile service for fixed clients.

 An adaptable business model coupled with strong cost leadership. Iliad used cash flow from the fixed business to finance the introduction of its mobile service, with a cost structure that was largely variable at first, and a focus on winning market share in volume terms. Subsequently, rising client value thanks to data usage, coupled with a decrease in Orange roaming, allowed mobile profits to self-finance the business. Meanwhile, Free Mobile continued to apply the principles that underscored its success in fixed: maximum internalisation of personnel and development and extreme simplicity of the marketing package. Combined with an absence of legacy in mobile, Free Mobile was able to function with ultra-competitive costs. All of these factors combined to enable the group to offer highly aggressive rates.

As regards the exogeneous factors, we also note three key points:

 A favorable regulatory environment. The French authorities created a set of conditions that allowed a new entrant to find a place in the market, notably by favoring national roaming agreements on launch, issuing a fourth mobile license at a reduced price and putting in place an asymmetric call termination in favour of the new entrant. Other legal measures such as the Châtel law created opportunities for the newcomer, notably by making contractual requirements more flexible. For example, a client who had signed for 24 months only has to pay 25% of the remaining months if he cancels his contract after the 12th month. In a market where contracts were commonplace, this law helped the new entrant to gain a foothold.

 A stable environment that was not very competitive. Despite regular adjustments that mainly involved offering more content for the same price, the three operators shared the market without engaging in a real competitive war. The main competitive activity took place in fixed and growth of converging offers. Unlimited mobile voice offers appeared, but the rates were very high. Market shares in mobile changed little, as players wanted to avoid upsetting the balance. No serious efforts were made to reduce Opex in order to fund significant rate reductions, and rising volumes continued to push up earnings.

 An inept response by competitors. Firstly, we believe that the arrival of Free Mobile was not anticipated adequately by the traditional operators. Clearly, the aggressive nature of Free Mobile’s offering was under-estimated and, perhaps more fundamentally, the existing players

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took no pre-emptive steps to counter Free’s marketing and communication. In our opinion, there were several reasons for this, some of them rational, others psychological/behavioral. We will return to this question in the chapter devoted to Telecom Italia’s response, but where anticipations are inadequate there is every chance the counter attack will be ineffective. Even when the Free Mobile offering was known, the operators struggled to strike back quickly and strongly, preferring below the line measures that did little to limit churn. SFR waited until early 2013 to reprice its catalogue. Bouygues Telecom did not launch B&You and overhaul its marketing machine until late 2014.

As a result, Free Mobile’s success was the result of several factors. But Iliad’s highly talented management team deserved full marks for knowing how to exploit the endogenous factors and how to take advantage of the exogenous ones.

2.3. Opportunities for Iliad in Italy

2.3.1. Differences to the French experience Market conditions and the context in which Iliad arrives in Italy are very different from the situation in France when Free mobile was launched in early 2012. Iliad seized opportunities in France that are not available in Italy. On the other hand, there are opportunities in Italy that did not exist in France, and which Iliad can tap to foster its development in the Italian market. The table below presents a multi-dimensional analysis and comparison of opportunities in France and Italy. A 5 rating corresponds to a major opportunity that could help to make the launch a success (proven for France; assumed for Italy). A 1 rating, on the other hand, corresponds to a major weakness in a project (again, proven for France, but assumed for Italy). All points are considered in detail afterwards.

Fig. 17: French context vs Italian context: a comparative analysis of opportunities for the Free Mobile launch

Image and communication 5 Regulatory 4 Offer and pricing environment 3 2 Market structure 1 Distribution 0

Competitive Innovation environment opportunities Cost structure and Network deployment business model and quality of service

France Italy

Source: Bryan, Garnier & Co.

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2.3.2. Image and communication As we saw in section 2.2.3, we believe that Free Mobile’s brand image and aggressive communication were decisive to its commercial success. In Italy, Iliad is unknown so the brand image has to be created. Iliad could use its French story to incite media coverage of its arrival and find a different angle for its institutional communication and advertising. But creating a consumer-friendly profile will take longer and it will be necessary to win the confidence of clients.

Notably, we think it is likely that Iliad will try to show that the rates currently being charged are not competitive, but the “sucker” argument will not be as strong as in France in a market where prices have fallen significantly over the past 3-4 years and where some players are unprofitable.

2.3.3. Offer and pricing We have seen that in France Iliad began with a proposition that we have labelled « much more for much less ». Although we think the context in Italy is less favourable than in France, we still see scope for the « much more for less » strategy.

The following table summarizes the main mobile offerings in Italy today:

Fig. 18: Prices of main mobile phone offerings in Italy

Price range ~EUR5 ~EUR10 ~EUR15 ~EUR20 ~EUR30 ~EUR40 ~EUR50

Vodafone na VF Start VF Digital VF Super na Red Start Red Maxi

Price (€/month) na 10 15 18 na 39 49

Voice (mins) na 400 400 400 na ill ill

SMS (#) na 100 100 100 na ill ill

Data (Gb) na 0.1 2 3 na 4 8

Handset offer na No No No na yes yes

Telecom Italia na Special Voice Special Special Start Special large Special na Voice+Data Unlimited Price (€/month) na 10 15 20 30 40 na

Voice (mins) na 500 1000 2000 6000 ill na

SMS (#) na 0 0 0 0 ill na

Data (Gb) na 0 4 4 6 6 na

Handset offer na yes yes yes yes yes na

Wind Noi Tutti Noi Tutti 1000 Celebration All digital Magnum Magnum Magnum na

Price (€/month) 7 9 10 14 20 30 40 na

Voice (mins) 400 1000 400 500 ill ill ill na

SMS (#) 0 0 0 ill ill ill ill na

Data (Gb) 0 0 2 2 5 10 20 na

Handset offer No No No No yes yes yes na

Tre all-in 400 all-in unl. all-in VIP Full unlimited Full unlimited na na plus Price (€/month) 5 10 15 20 25 na na

Voice (mins) 400 ill ill ill ill na na

SMS (#) 400 400 300 ill ill na na

Data (Gb) 4 8 30 4 8 na na

Handset offer no no no no no na na

Source: Company Data; Bryan Garnier & Co.

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This table is not exhaustive. It does not show offers combined with options, as the objective is to illustrate the main subscription plans in the market and the corresponding rates.

We would make several observations:

 Offers in the region of €5 are scarce

 Unlimited SMSs are rare too

 With the exception of Tre, high data capacity (>5Go) is not available for less than €25

 Offers with unlimited SMS and voice and >5Go of data are uncommon, and only available from Wind and Tre for €25 or more.

 For €20, the best deal one can find is unlimited voice and SMS with a maximum of 5Go of data, available from Wind.

 Tre is the most aggressive player in this market. It notably has an « all-in unlimited » offer at €10, which includes unlimited voice and up to 8Go of data. But as we mentioned previously, the quality of Tre’s network is clearly lower than that of its competitors.

It is clear that prices in Italy are lower than they were in France in early 2012, but (contrary to the situation in France) there exists in Italy a real opportunity in unlimited offers.

Will Free surprise the market by offering unlimited voice and SMS + large data capacity for €20, as it did in France? In view of the above analysis, we think not. Will it surprise the market with a €2 offer that includes generous voice and SMS? Maybe, provided it offers more than in France i.e. a minimum of 400 minutes of voice plus unlimited SMS. But it would be risky for Iliad to launch a very low-cost offer without a significantly more expensive one to raise ARPU.

We assume, therefore, that Free Mobile will attempt to gain a foothold in the Italian market with the following offer:

UNLIMITED VOICE + UNLIMITED SMS + 10Go DATA FOR €9.99 (FOR 4 WEEKS)

Unlimited SMSs may prove costly given the cost per SMS (0.0328€), but the Italian market already seems to have rejected the old SMS operators in favour of OTT message providers (Apple Whatsapp, Facebook messenger…).

We can imagine the tone of advertising that will accompany the launch:

« You thought we could not do in Italy what we did in France? Well, we can do much better: a package that costs half our introductory offer in France! ».

« In Italy too, we will cut your phone bill in half: our offer is 50% cheaper than the best unlimited voice/SMS offer currently on the market (ie Magnum 5Go), with twice as much data capacity! »

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« Are you tired of limits, whether it be for voice, SMS or data – to say nothing of topping up? With us, no surprises or constraints – it’s all unlimited! »

We will go into the detail of the P&L of such an offer by Iliad in Italy in section 2.4. Briefly, we think that an offer of this sort could be economically viable for two key reasons:

 It would generate service ARPU similar to our estimates for France (around €12 before tax) and a gross margin that is at least equivalent, as greater generosity on average would be offset by a much more favourable roaming contract than in France (we will discuss later) and less generosity in roaming.

 Such a simple offer implies an extremely optimal cost structure, to say nothing of synergies with France which will help to optimize the business model.

Moreover, as we saw previously, mobile ARPU is currently ~€12.7. With penetration at 155%, that is equivalent €19.7/client. In France, when Free Mobile was launched ARPU was €24.1 for 100% penetration implying €24.1 / client. So in Italian mobile, ARPU/client is ~20% lower than ARPU / French mobile client in early 2012, and not ~-50%. There is therefore an opportunity for Free, by offering an unlimited service, to discourage consumers from holding multiple SIM cards. That would be the opposite of what Iliad did in France where, as we have seen, Free Mobile enjoyed market volume growth and particularly multi-line development.

In conclusion, although Italy has a different economic and price landscape to France, we still see a real opportunity for Iliad to lunch disruptive offers in Italy.

2.3.4. Distribution Italy’s Pisanu law, which requires clients to show identification when they take a new mobile line, is a serious constraint for development of direct distribution (web, incoming/outgoing calls etc). This legislation should make Iliad’s distribution more complicated than it was in France. Clearly, Iliad will have to use its know-how in digital marketing and user experience to deploy its direct distribution method, but they may prove insufficient in our view.

We do not think that an extensive network of boutiques (owned or franchised) is critical in this market, where the purchase of a SIM card does not necessarily lead to the purchase of a mobile terminal. However, we think that Iliad should seek partnerships with third-party distributors (tobacconists, multi-operator sales outlets…) in order to develop its marketing capacity.

The corresponding remuneration agreements will have a negative impact on the operator’s cost structure relative to online distribution. However, we think they will not necessarily be more costly than the telemarketing model that Iliad used extensively in France.

Moreover, Iliad does not have a portfolio of fixed-line clients that it can leverage to market its mobile offering, as it did in France with the added advantage of 4P tariffs. Iliad will thus be obliged, at least initially, to purchase contact lists from third parties in order to proceed with its telemarketing (contacts cost from a few dozen centimes to several euros each, depending on the level of qualification).

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2.3.5. Innovation In mobile in France, Iliad’s innovation was largely in terms of pricing (we leave aside possible technical innovation in the development of IT systems and network service platforms). As we have seen, we believe that the scope for pricing innovation is more limited in Italy, but it remains sufficient for Iliad – notably in the development of unlimited services.

In fixed, on the other hand, Iliad’s technological innovation was particularly disruptive, with the introduction of the first boxes and 3P offers, followed by the launch of successive generations of boxes. This explains why we believe, as we mentioned in section 3, that Iliad has a real role to play in the Italian fixed market, by accompanying the development of 3P notably.

2.3.6. Network deployment and quality of service The network-sharing agreement signed by Iliad and Wind/Tre includes the following terms:

 2G, 3G and 4G roaming on the merged network for a period of five years, renewable once for a similar period at the request of Iliad.

 The transfer of 3G/4G frequencies of 2x35MHz (2x5MHz in 900MHz, 2x10MHz in 1800MHz, 2x10MHz in 2100MHz and 2x10MHz in 2600MHz). Note that Iliad does not have its own 4G golden frequencies 800MHz, but will have them thanks to the roaming agreement.

 A commitment to acquire several thousand sites in dense zones offered by Wind/Tre or rented to third parties.

 The obligation to activate either a RAN-sharing agreement in rural areas with Wind/H3G, or to acquire in these areas several thousand sites from Wind/H3G or third parties.

In France, the deployment challenge was (and still is) considerable for Iliad, which had « only » a roaming agreement with Orange. Iliad had to find all the points necessary for deployment of its network and to manage the operational complexity of such a deployment. In Italy, deployment conditions seem much more favourable, given the terms of the agreement with Wind/Tre detailed above.

Note that Iliad has an extensive portfolio of frequencies in Italy (about 15% of the spectrum available in Italy, as illustrated in figure 9), which was not the case in France where Iliad recently had to buy 4G 700MHz frequencies for €930m.

Apart from the impact on the economic model discussed in the following section, we believe that the two main consequences of these technical factors are: 1/ easier deployment (thus secure and less costly) and 2/ a quality of service that will certainly be high from the beginning, which should allow Iliad to reassure its clientele in Italy where it is unknown.

2.3.7. Cost structure and business model Apart from the question of distribution costs discussed previously, we think that Iliad enjoys very favourable economic conditions in Italy.

First, the roaming contract with Tre / Wind appears to be significantly better than the one with Orange in France, which allows Iliad more economic space for its launch. In this respect, it is

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reassuring that the investigation by the European Commission prior to the merger of Wind and Tre gave its approval after looking at the terms of the agreement between Iliad and Wind/Tre. We believe that the Commission would not have approved the merger if Iliad’s conditions of entry into the market had not been sufficiently attractive. Moreover, it would appear that the French contract with Orange (still worth €700 million in 2015) was particularly expensive relative to similar contracts in Europe.

What’s more, Iliad can optimise its fixed cost structure by means of synergies with France. There is scope at the head office notably, but also in IT systems and platforms and network services. On the other hand, we believe that synergies in the offers/billing information system will be limited due to a different structure of offers in Italy compared to France (prepaid vs subscribers).

Lastly, in the same way that Iliad financed its development in French mobile with cash flow generated by the fixed business, we think that Iliad will be able to use future cash flow from France to fund its launch in Italy (we would expect Iliad to generate positive cash flow after licenses in France from 2017) that would allow Iliad to limit borrowing and the rise in its group EBITDA/net debt ratio. Moreover, the risk profile should be limited by the structure of the agreement between Iliad and Wind/Tre which allows gradual deployment of Iliad’s own network as the client base expands and generates EBITDA, thus avoiding the need for Iliad to make extensive investments in Italy. As we have already mentioned, the roaming contract signed by Iliad and Wind/Tre is for five years and can be renewed for five years, which leave Iliad time to deploy its Italian network gradually.

2.3.8. Regulatory environment For Iliad, the position of the public authorities will be crucial to its success, not only prior to the launch but all though the development phase.

In France, the authorities (government, ARCEP, competition authorities) were particularly conciliatory towards Free Mobile (reduced price for the fourth licence, asymmetric call termination the first years, roaming contract…). Positions have hardened subsequently, with pressure from ARCEP to renew the national roaming contract between Free and Orange. Similarly in fiber, Iliad is having difficulty getting its way.

In Italy, the public authorities seem fairly conciliatory with the new entrant on the one hand, and unprotective vis-à-vis Telecom Italia on the other. They have accepted Iliad’s project in Italy and facilitated the emergence of Enel in fiber with the acquisition of Metroweb. Moreover, note that the Italian authorities seem much less inclined to defend Telecom Italia from different « threats » (Vivendi’s increased stake, competition in fiber, Iliad’s arrival…) than they are to defend Mediaset in the face of Vivendi’s rising shareholding.

What will the situation be in a few years under a new government, if Telecom Italia is permanently weakened? It is difficult to say, but the contract signed by Iliad and Wind/Tre seems to shelter the development of Iliad from political U-turns. Note, on the other hand, that the government still controls the process whereby new licenses are granted.

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2.3.9. Market structure As we have already said, prices in the Italian market give Iliad less economic leeway than it had in France at end 2011. On the other hand, the Italian market has features that are favourable to Iliad’s entry.

As detailed in section 2.1, the Italian market is overwhelmingly prepaid (80%), so there are few contracts and churn is roughly 30%. This implies a very large reservoir of uncommitted clients that Iliad can attract.

On the other hand, since the Wind/Tre merger the market has been shared between three players of roughly equal size, each of which has a large client base and is thus not very vulnerable. In France, Bouygues Telecom was significantly smaller than its two competitors and did not have sufficient critical mass to absorb a major shock. A war inside the war broke out between Free Mobile and Bouygues Telecom. The latter, which badly lacked volumes, refused to match Free’s rates, but had to be more aggressive in terms of price to survive: in fixed by lowering rates by 30% and in mobile by introducing its low-cost B&You offer that was distributed physically. For Iliad in Italy, paradoxically, having solid competitors looks an advantage to us: they can absorb the shock of Iliad’s entry more easily than Bouygues Telecom in France. Hopefully the Italian players will not try to squeeze out the new entrant. We think that would be risky, difficult to implement and not necessarily in their interests as a market that is only viable with three players would face competition problems. In France, SFR and Orange responded to the price challenge and cut their costs, but they did not seek to evict Free Mobile by means of a damaging deflationary spiral.

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2.4. Iliad should create value in Italy As we have already seen, we expect Iliad to launch in Italy in late 2017 or early 2018 at the latest, with a very aggressive offer based on the ‘much more for less’ principle: possibly an all-in offer at €10 for four weeks. For all the reasons listed previously (especially the lack of a distribution network and well- known brand), we expect results to be below those achieved in France:

 Slower progress than in France, with a market share of 8% after four years versus 17% in France after a similar period, due to: 1/ the brand /awareness / confidence; 2/ the need to build up distribution; 3/ probably less media coverage in Italy than in France.

 An 11% target for market share (i.e. 14% of the residential market) and 11 million clients within 10 years,, compared to Free Mobile’s stated objective of 25% in France (we consider this French number overly ambitious, but this is not a problem if mobile ARPU takes over from volumes). In line with the scenario modelled here, we think that the absence of a very low-cost offer by Iliad and limited scope to undercut prices in Italy justify a lower penetration target.

The following table summarises our projections for Iliad’s volumes in Italy.

Fig. 19: Flows and client base for Iliad Mobile in Italy

Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10

Market churn 22,8 23,4 23,9 23,9 23,9 23,9 23,9 23,9 23,9 23,9

MS Iliad on Market churn 7% 12% 15% 14,2% 13,8% 13,7% 13,6% 13,5% 13,4% 13,4%

Gross adds Iliad 1,6 2,8 3,6 3,4 3,3 3,3 3,2 3,2 3,2 3,2

Churn Iliad 14% 22% 24% 26% 27% 28% 28% 28% 28% 28%

Net adds Iliad 1,5 2,3 2,4 1,6 1,1 0,7 0,5 0,4 0,2 0,2

Iliad's number of customers EoP 1,5 3,8 6,1 7,7 8,8 9,5 10,0 10,4 10,6 10,8

Iliad's market share (Residential, EoP) 2% 5% 8% 10% 12% 13% 13% 14% 14% 14%

Iliad's market share (Total market, EoP) 2% 4% 6% 8% 9% 10% 10% 11% 11% 11%

Source: Bryan, Garnier & Co ests.

Regarding the business plan, we have assumed aggressive deployment/investment by Iliad in mobile, alongside steady increases in the client base. In seven years, therefore, we move from an ‘asset light’ opex model with thin operating margins to a ‘capital intensive’ capex model with high margins, similar to the French experience.

We could imagine another scenario where Iliad would decide (for economic and/or strategic reasons, or in response to slow progress in marketing) to live with thin margins or to postpone/cancel investment in its own network. This ability to choose between two models reduces the risks attached to the project, in our view. Aside from the €450m for licence purchases and the €230m for renewal of the 900MHz and 1800MHz licences, Iliad does not have to make massive investments in the initial years of operations. Note that we are talking about an ability to spread or postpone mobile investments but not about a definite choice. After 10 years of roaming contract, it would be better for Iliad to have deployed a significant share of its own network, so that its future did not depend on contract renegotiations.

Our projections for Iliad’s business plan in Italy is detailed in the following table.

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Fig. 20: Iliad’s Business Plan in Italy

EURm (unless otherwise stated) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10

Revenues (EURm) 95 332 660 923 1113 1251 1353 1432 1496 1549

Iliad's ARPU (EUR) 11,0 11,0 11,0 11,0 11,2 11,3 11,5 11,7 11,9 12,0

COGS -73 -245 -462 -572 -612 -626 -609 -630 -643 -671

Gross margin 21 87 198 351 501 626 744 802 853 877

Iliad's gross margin per user (EUR) 2,5 2,9 3,3 4,2 5,0 5,7 6,3 6,5 6,8 6,8

Gross margin 23% 26% 30% 38% 45% 50% 55% 56% 57% 57%

Fixed and indirect costs -16 -57 -112 -157 -189 -213 -230 -243 -254 -263

% total fixed costs -17% -17% -17% -17% -17% -17% -17% -17% -17% -17%

Extra start off acquisition costs -40 -20 -10 0 0 0 0 0 0 0

EBITDA -35 11 76 194 312 413 514 558 598 614

% -36,8% 3,2% 11,5% 21,0% 28,0% 33,0% 38,0% 39,0% 40,0% 39,6%

Total CAPEX (excl. Licenses) 50 200 250 300 350 375 406 401 389 387

% of revenues 53% 60% 38% 32% 31% 30% 30% 28% 26% 25%

Licenses 380 150 150 0 0 0 0 0 0 0

Source: Company Data; Bryan, Garnier & Co ests.

We forecast initial ARPU of €11 before tax (‘all-in’ for four weeks at €10 including tax), rising to €12 after 10 years thanks to increased data usage. In Year 1, thanks largely to roaming traffic, we forecast a gross margin of 23%, which is similar to the estimated margin at launch in France (see figure 21). Implicitly, we assume that the additional generosity of the Italian offer relative to the French one will be offset by significantly lower unit roaming costs. Similarly, our estimates assume that Iliad’s unit gross margin in Italy four years after the launch will be 15% lower (absolute value) than Free Mobile’s in France after a similar period, for equivalent ARPU and despite a more favourable roaming contract. Eventually, we expect a gross margin of 57%, far below that of competitors in Italy the generosity of Iliad’s offers. In other words, as illustrated in figure 22, we assume that direct costs (gross margin) are nearly triple those of Tre’s prepaid offers, notably. What’s more, this simulation is equivalent to an Iliad offer with the same content as Tre’s subscription offers for ARPU that is 40% lower.

Moreover, we estimate that indirect opex will tend towards 17% of sales. This is slightly above our estimates for France (see table 21), mainly due to higher distribution costs. Opex for the first three years will include a total of €70m of exceptional spending on communication and marketing to impose the brand in the Italian market.

Concerning capex, we assume a cumulative investment of €1.5bn over the first seven years, plus €450m to buy licences from Wind/Tre (spread over three years) and a €230m payment to the Italian government (2017) for extension of the 900MHz and 1800MHz licences. We thus find a normalised capex budget in the region of €400m per annum, or 25% of revenues.

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Fig. 21: Reminder of the breakdown of Iliad’s EBITDA in France

EURm 2011 2012 2013 2014 2015 Revenues 2 122 3 153 3 748 4 168 4 414 of which mobile (est.) 0 844 1 261 1 614 1 829 Gross margin 1 170 1 485 1 725 1 845 2 176 % 55,2% 47,1% 46,0% 44,3% 49,3% % mobile gross margin (est.) 20,5% 23,9% 24,5% 39,5% Total expenses (337) (564) (532) (561) (686) of which mobile (213) (171) (194) (300) % of mobile revenues (est.) #DIV/0! -25,3% -13,6% -12,0% -16,4% EBITDA 833 921 1 204 1 284 1 490 % 39,3% 29,2% 32,1% 30,8% 33,8% % mobile EBITDA (est.) -5,5% 9,0% 12,5% 23,1%

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 22: Comparison of gross margins in Italian mobiles (10 year target)

Tre (mix pre & post) Tre (pre) Tre (post) VF (mix pre & post) Iliad est.

ARPU 13,9 8,6 17,6 13,8 12,0

Direct costs 3,0 1,7 3,8 3,4 5,2

% Gross margin 79% 80% 79% 75% 57%

Gross margin 11,0 6,9 13,8 10,4 6,8

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 23: Impact of Iliad Italy on group debt

EURm 2016e 2017e 2018e 2019e

EBITDA France 1677 1855 2059 2217

EBITDA Italy 0 -35 11 76

Net debt France 1524 1550 1410 880

Net debt Italy 0 465 804 1128

Total EBITDA 1677 1821 2070 2293

Total Net debt 1524 2 015 2 214 2 008

Leverage ratio 0,9 1,1 1,1 0,9

Source: Company Data; Bryan, Garnier & Co ests.

To calculate the project’s NPV, we take the 6.8% discount rate of our initial Iliad model. We assume growth to infinity is 1%. We thus estimate the project’s NAV at €635m, or €10.6 per existing Iliad share.

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Fig. 24: Value of the Italian project

EURm (unless otherwise stated) Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10

Revenues 95 332 660 923 1113 1251 1353 1432 1496 1549

EBITDA -35 11 76 194 312 413 514 558 598 614

EBIT -40 -40 -22 50 122 177 231 230 223 193

Tax rate 0% 0% 0% 16% 31% 31% 31% 31% 31% 31%

NOPAT -40 -40 -22 42 84 122 160 159 154 133

CAPEX + licenses -430 -350 -400 -300 -350 -375 -406 -401 -389 -387

- Change in WC 29 52 71 46 28 18 8 12 9 11

Free Cash Flow -435 -287 -253 -68 -48 0 45 99 150 178

DCF -408 -252 -208 -52 -35 0 28 59 83 92

Sum of DCF -692

Terminal Value 1327

Entreprise value 635

Source: Company Data; Bryan, Garnier & Co ests.

The following table shows three different sensitivity scenarios.

Fig. 25: NPV of Iliad Italy - sensitivity analysis

FV Italian Project (EUR/share) Target EBITDA %:

Target MKT share: 37% 40% 43%

8% -3,5 2,2 7,8

11% 3,2 10,6 17,9

14% 10,0 19,0 28,0

Source: Garnier & Co ests.

To conclude, of all the discussions contained in this report, we think it is highly likely that Iliad will create value in the Italian market. For that not to happen, its performance would have to be half the French performance and EBITDA after 10 years still below the level achieved in France after seven years.

The above economic projections only concern Iliad’s mobile business in Italy, but we think it very probable that Iliad will move into the Italian fixed market later.

We will discuss this later, but we think that such a move would be 1/ relatively easy, given the environment in Italian fixed, 2/ justified by a market imperative, and 3/ likely to sustain value creation in Italy, as it did in France. We even believe that, depending on opportunities and market conditions, Iliad might divert investments from mobile to fixed. As we mentioned above, there is less pressure to deploy its own mobile network due to the roaming contract with Wind/Tre, which allows Iliad some leeway in this domain.

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2.5. TI’s strategy In order to face challenges in its domestic market notably, Telecom Italia launched a vast cost-cutting and investment plan in 2016. We will look at the numbers and the financial repercussions in our report “Telecom Italia: the calm before the storm”. Telecom Italia hopes to pull further ahead of its rivals by strengthening its leadership in infrastructures and value-added services, thanks to a « premium » positioning.

As a result, Telecom Italia is aiming for 84% VHS coverage in fixed and 98% 4G coverage in Italy by end 2018. Moreover, the operator hopes to step up development of content services: video (TIM Vision, TIM Sky et TIM online), but also music and video games thanks to support from main shareholder Vivendi. TI also hopes to accelerate penetration of its converging offer « TIM Smart », which should build client loyalty. Offers of 3P and 4P, VHS fixed and mobile, value-added content all require high investment capacity, but may allow real differentiation and maximum value creation for Telecom Italia.

Faced with a new competitor such as Iliad, it looks impossible to us for a historical operator such as Telecom Italia to compete on cost alone. However, it has the advantage in terms of investment capacity and brand image and thus in quality of service and innovation. These advantages should allow TI to position itself as the preferred operator of high-value clients. This strategy enabled Orange to absorb the shock of Free Mobile’s arrival in France better than rivals. Since the price factor remains crucial, this strategy will not prevent very cost-conscious clients from leaving, or make rate adjustments unnecessary. On the other hand, it should retain many clients who appreciate the content and service, and even attract new clients, thus limiting the damage to the subscriber base and to ARPU. 2.6. Telecom Italia’s prospects with Iliad as a rival It is sometimes said that, contrary to France, the surprise tactic will not work in Italy, and that operators will be better prepared to respond to Iliad. We find this view excessively optimistic for three main reasons:

 It is true that no operator anticipated Free Mobile’s very aggressive pricing (especially unlimited data for €20 and the offer at €2), but it is a mistake to think that the French operators did not prepare for the arrival of Free Mobile. All of them introduced low-cost offers (Sosh, Red, B&You) a few months before the arrival of Free Mobile, even if the offers did not get maximum exposure. In the weeks and months that followed, the operators lowered their rates significantly to compete with Free Mobile, but that did not prevent the tsunami that we have described.

 Although anticipation of the potential shock should be better in Italy, it is not certain that the operators would act very differently beforehand, for reasons arising both from psychology and governance. First, it is difficult and risky to reduce rates to early, when one is uncertain about the offering of the newcomer (one could even argue that this obliges the new entrant to lower his prices even more, and that the best strategy is to raise prices before the arrival of a new player). Moreover, even if we are faced with a fait accompli, it is always tempting to wait and see the real impact of the new entrant over time and to test the various possible « below the line » responses before launching a massive counter attack. Decisions concerning the volume / value trade-off (i.e. net sales versus ARPU) are never easy to take. The right response often only

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becomes clear (and is only approved) in the medium term. But by that time the new player already has a solid foothold in the competitive landscape.

 Lastly, we think it is wise not to under-estimate Iliad’s capacity to surprise the Italian market, in spite of the French experience. In our opinion, the failure of the French players to foresee Free Mobile’s pricing policy reflected their inability to decipher Free’s long-term strategy and economic model: a strategy that focused initially on volumes and promoted with very aggressive communication and with very low mobile margins. However, this had a positive collateral impact on fixed and led to value creation via migration of €2 clients and gradual exit from the roaming contract. In Italy too, rather than generate near-term cash, Free Mobile will need to win clients - many clients. At the expense of its margins, but also those of competitors… Value creation can only take place in later, and it could well stem from a move into fixed line…

However, no price response can be effective without changes to the cost structure. This has been anticipated much better than in France, by Telecom Italia. In France, the operators waited to see how aggressive Free’s rates were before starting to slash their costs. Telecom Italia has already planned to cut its costs by €1.6bn (€800m of opex + €800m of capex) which should allow it to absorb a significant fall in its revenues and will facilitate a possible decision to lower rates.

We think that Telecom Italia’s strengths in the face of Iliad’s invasion of its market are similar to those of Orange in France: 1/ leadership in fixed coupled with development of 4P offers help to build client loyalty; 2/ a capacity for investment that has no equivalent in the market should allow the group to reinforce its position in very high-debit fixed and mobile infrastructures; 3/ the image of long-standing operator providing a quality service.

As for all players in the market, the response of Telecom Italia is likely to include: 1/ a rate review, 2/ increased segmentation of its offers, 3/ below the line measures to retain clients (discreet reductions, telemarketing, reinforced retention departments…) and 4/ acquisition promotions. But for all the reasons discussed above, we think Telecom Italia should suffer less (proportionally) than its rivals from the arrival of Iliad. So, as illustrated in the chart below, we estimate that Telecom Italia could lose 160bps of market share by 2019, and 330bps in 10 years. Over the same 10-year period, we estimate that Wind+Tre will lose 520bps and Vodafone 400bps.

Concerning Wind+Tre, we think the two brands will continue to exist post the merger. In response to Iliad, we expect the two operators to increase segmentation of their offers. We think it is unlikely that the Tre / Wind merger leads to a merging of the two brands, even if that necessarily means slightly less synergies (notably spending on the brands and on communication, as well as IT costs). Moreover, Wind/Tre’s knowledge of network-sharing contracts with Iliad should allow them to anticipate Iliad’s arrival better than other players. Nevertheless, we think the positioning is an advantage. Moreover, the Tre/Wind integration phase which is beginning and the generation of major synergies do not favour maximum commercial efficiency.

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Fig. 26: Projected residential market share in mobile

100% 8,9% 5,8% 14,1% 90% 8,1% 80% 7,0% 38,6% 70% 36,7% 60% 33,6% 50% 40% 25,6% 23,9% 21,7% 30% 20% 26,9% 10% 25,5% 23,6% 0% 2016 2019 2026

Telecom Italia Vodafone Wind+Tre Others Iliad

Source: AGCOM; Bryan, Garnier & Co ests.

The following chart shows the breakdown of Iliad’s net sales in terms of the original operator, and the corresponding deformations relative to market shares shown above, notably in the initial years. Note that unlike the French situation, we do not foresee any market growth and thus no Iliad sales arising from new entrants.

Fig. 27: Breakdown of Iliad’s net sales in terms of the original operator

45,0%

40,0%

35,0%

30,0%

25,0%

20,0%

15,0%

10,0%

5,0% 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026

Telecom Italia Vodafone Wind + 3 Others

Source: Bryan, Garnier & Co ests.

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The chart below presents our assumptions for changes to the Iliad and Telecom Italia client portfolios in the mobile market.

Fig. 28: Changes in residential client portfolios of Telecom Italia and Iliad in Italy

25 22,1 21,4 20,5 20,2 19,9 19,4 18,9 20 18,6 18,3 18,2 18,1 18,0 18,0

15 10,1 10,5 10,7 9,0 9,7 10 8,0 6,6 4,4

Cusomer base (millions) 5 1,9 0,3 0 2022 2023 2024 2025 2014 2015 2016 2017 2018 2019 2020 2021 2026

Iliad Telecom Italia

Source: AGCOM, Company Data; Bryan, Garnier & Co ests.

Concerning the ARPU impact, firstly we think that Telecom Italia special situation (discussed above) will allow it to continue to charge a premium rate and to limit the impact of Iliad. Secondly, in spite of Telecom Italia rates which are mostly above €10, the operator’s ARPU was around €12 for the first nine months of 2016 (including an incoming ARPU that we consider very low – below €1) due mainly to numerous promotional above-the-line or below-the-line offers that impact revenue. The gap between Iliad’s rates and Telecom Italia’s is not as large as it seems, and Telecom Italia could finance part of its commercial response by being less aggressive below the line.

So, as the following chart shows, we estimate that Iliad’s arrival could lower Telecom Italia’s ARPU by -17% in 2019 (excluding the possible impact of incoming revenues due to generalization of unlimited voice, which in any case would be offset in the gross margin by interconnection costs). We also expect more rapid repricing than in France, as fewer contracts make it easier for consumers to change offer.

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Fig. 29: Projected mobile ARPU at Telecom Italia

14,0

13,0

12,0

11,0

10,0

9,0

8,0

1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18 4Q18 1Q19 2Q19 3Q19 4Q19

Source: Company Data; Bryan, Garnier & Co ests.

The following tables provide an overview of our assumptions for changes to the main mobile KPIs at Telecom Italia and the corresponding revenues. We estimate loss earnings at €800m from 2016 to 2019 on revenues from Telecom Italia’s mobile service following the arrival of Iliad.

Fig. 30: KPI of Telecom Italia domestic mobile

2014 2015 2016e 2017e 2018e 2019e

Total Market (m) 96,9 97,7 97,3 97,3 97,3

of which residential (m) 80,0 78,0 76,4 76,0 76,0 76,0

Total customer Base (m) 30,4 30,0 29,4 29,1 28,7 28,3

net adds (k) -870 -343 -651 -246 -382 -415

of which residential (k) -849 -346 -482 -515

Mobile arpu (EUR/month) 12,1 12,1 12,4 12,4 10,8 10,5

yoy growth -0,1% 2,1% 0,4% -13,1% -3,2%

Source: AGCOM; Company Data; Bryan, Garnier & Co ests.

Fig. 31: Telecom Italia’s domestic mobile revenue

EURm 2014 2015 2016e 2017e 2018e 2019e

Equipment 483 551 591 621 652 685

Services (retail) 4325 4231 4257 4205 3622 3454

Wholesale 283 286 294 294 294 294

Total 5091 5068 5142 5120 4567 4432

yoy growth (excl. Equipment) -2,0% 1,5% -0,4% -10,8% -3,0%

services excl equipment 4608 4517 4550 4499 3915 3747

Source: Company Data; Bryan, Garnier & Co ests. Note that Telecom Italia will not enjoy the wholesale national roaming revenues that allowed Orange to absorb the financial impact of Free Mobile’s arrival. These are booked by Wind/Tre.

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3. The fixed market is changing rapidly too 3.1. A market notable for broadband growth The Italian fixed market currently has a little over 20 million lines, of which 75% are high or very high debit. As shown below, the market has been contracting continuously for several years. The decrease in low-debit subscribers has been only partially offset by the increase in high-debit clients, although have been signs of a stabilization in recent quarters. Note too the very significant growth in very high- debt access (+81% over 12 months), even if this only represents 13% of high-debit access to date.

Fig. 32: Long-term trend in the Italian fixed market (number of lines)

25

20

8,2 7,5 6,9 5,8 5,5 5,3 5,1 5,0

15

10 LInes (million) 13,3 13,5 13,5 13,5 13,4 13,4 13,7 13,7 5

1,4 1,7 1,9 0 0,3 0,3 0,5 1,1 1,2 Jun-12 Jun-13 Jun-14 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16

NGA accesses BB accesses, other than NGA Narrowband accesses

Source: AGCOM.

Four main operators share the fixed high-debit market: Telecom Italia, clear leader with 46.6% market share at end June 2016, ahead of Wind, Fastweb and Vodafone whose shares were very comparable at 15.4%, 14.9% and 13.3% respectively in mid 2016. Tiscali is the fifth player, with 3.5% market share. Recent quarters have seen slippage in Telecom Italia’s market share, which has mostly benefited Vodafone. In one year, Telecom Italia has lost 100bps of market share while the British operator gained 60bps.

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Fig. 33: Market shares in high-debit fixed

100% 6,3 5,5 5,7 6,8 6,9 6,2 6,4 90% 3,4 4,1 3,9 3,1 3,1 3,6 3,5 12,3 12,6 12,7 12,8 12,9 13,3 13,3 80% 70% 14,4 14,6 14,8 14,7 14,8 14,8 14,9 60% 15,4 15,5 15,3 15,4 15,4 15,4 15,4 50% 40% 30% 48,1 47,7 47,6 47,2 46,9 46,6 46,6 20% 10% 0% Dec-14 mars-15 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16

Telecom Italia Wind Fastweb Vodafone Tiscali Altri (Others)

Source: AGCOM.

Buoyed by market growth, Telecom Italia’s portfolio of high-debit clients grew 2% from September 2015 to September 2016 (+140k clients). Over the same period, Telecom Italia’s very high-debit access doubled. In mid-2016, they represented 41% of total very high-debt access, or market share that is lower than in the overall high-debt market. On the other hand, traditional low-debit access of fixed telephones is falling by about 10% per annum.

Fig. 34: Telecom Italia’s domestic fixed client base

14000

12000

10000 5559 5339 5109 4923 4719 4535 4380 4245

8000

Lines (k) 6000

4000 6395 6298 6252 6690 6655 6597 6549 6485

2000

672 790 872 0 231 290 374 435 538 Dec-14 mars-14 Jun-15 Sept-15 Dec-15 Mar-16 Jun-16 sept-16

NGA BB accesses, other than NGA Narrowband

Source: Company Data.

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3.2. TI’s oulook troubled by its competitors’ own investments Market trends in Italian fixed will, in our opinion, be structured by the following fundamental factors:

 Ongoing decreases in demand for traditional fixed and rising demand for high debit

 Development of fixed/mobile convergence offers

 Development of 3P content offers alongside growth in infrastructures and very high debit

 Development of Enel’s wholesale offer in fiber (Enel Open Fiber « EOF »)

 Acceleration of Fastweb in very high-debit infrastructures (FTTC and FTTH)

 The likely arrival of Iliad in the fixed market.

All these trends will impact Telecom Italia’s retail and wholesale markets.

As shown in the chart below, we expect the retail market to stabilise at around 20m lines, but average growth of high debit could be 3% per annum for the first three years, including +45% a year in very high debit, which we see rising to about 50% by end 2019 – almost 50% of total high debit access.

Fig. 35: Estimated growth of the Italian fixed market (number of lines)

25

0,78 20 1,44 2,57 3,76 5,50 8,06 15 13,59 13,46 12,92 10 12,17

Lines (million) 10,88 8,93

5 6,22 5,31 4,63 4,19 3,74 3,13 0 2014 2015 2016 2017 2018 2019

Narrowband Broadband, other than NGA NGA Broadband

Source: AGCOM; Bryan, Garnier & Co ests.

Growth of very high debit should mainly be fueled by the aggressive deployment plans of operators, as shown in the following table:

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Fig. 36: Current / planned very high-debit deployment in Italy (« NGA » networks)

Nbr of sockets TI EOF Fastweb VOD Wind

FTTH FTTC FTTH FTTC FTTH FTTC FTTH FTTC FTTH FTTC

Current 0.9 13.6 1.5 na 2 5.5 1 2.9 0.9 13.6

% of households 3% 52% 6% na 8% 21% 4% 11% 3% 52%

Planned 3.9 21.8 9.5 na 5 8 9.5 4.5 9.5 21,8

Time horizon 2018 2018 2021 2021 2020 2020 2021 2021 2021 2018

Source: Company Data; Bryan, Garnier & Co ests.

So in the retail high-debit market, we expect Telecom Italia to experience stiffer competition due to: 1/ EOF deployment in fiber, allowing competitors attractive wholesale offers as an alternative to Telecom Italia in very high debit and 2/ the arrival of Tre in the fixed market, as an indirect result of the merger with Wind.

Regarding the first point, Vodafone and Wind already have plans to link up with EOF to gain access to the 9.5m FTTH sockets available by 2021. Meanwhile, Vodafone will pursue deployment of its FTTC infrastructures, while Wind continues to benefit from a FTTC wholesale agreement with Telecom Italia. Fastweb too is pursuing its own FTTH and FTTC deployments. Regarding the second point, the new unit created by the Wind/Tre merger will address its Tre base to strengthen its hand in fixed, via the development of 4P offers, for example.

Telecom Italia’s long-standing leadership in very high debit offers, with the most extensive NGA network, as well as its aggressive 3P and 4P offers, should help it to limit the impacts described above. Over the next three years, we expect loss of market share in high debit to be “only” 90bps, as illustrated below:

Fig. 37: Projected changes in market share in fixed high-debit market

100% 6,3% 6,9% 6,4% 6,3% 6,2% 6,1% 90% 3,4% 3,1% 3,5% 3,4% 3,3% 3,2% 12,3% 12,9% 13,3% 13,5% 13,7% 13,8% 80% 70% 14,4% 14,8% 14,9% 15,1% 15,2% 15,3% 60% 15,4% 15,4% 15,4% 15,7% 15,9% 16,1% 50% 40% 30% 48,1% 46,9% 46,4% 20% 46,1% 45,8% 45,5% 10% 0% 2014 2015 2016 2017 2018 2019

Telecom Italia Wind Fastweb Vodafone Tiscali Altri (Others)

Source: AGCOM, Company Data; Bryan, Garnier & Co ests.

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On the back of growth in the high-debit market, we expect the volume of Telecom Italia’s high-debit clients to grow at an average of 2.4% per annum for the next three years. ARPU growth should remain robust thanks increased 3P offer and content. However, the old low-debit lines should continue to fall around 10% per annum. Forecasts for the key indicators of Telecom Italia’s fixed retail activity are illustrated below:

Fig. 38: KPI Telecom Italia – Fixed domestic market

2014 2015 2016e 2017e 2018e 2019e

Total customer Base (k) 12480 11742 11314 11065 10864 10761 of which Broadband users (k) 6921 7023 7175 7325 7484 7707 net adds (k) 103 152 150 159 223

BB arpu (EUR/month) 19.8 20.8 22.0 23.1 23.9 24.5 yoy growth 5.3% 5.8% 5.0% 3.5% 2.5%

Source: Company Data; Bryan, Garnier & Co ests.

In the wholesale market however, the situation should prove complex for Telecom Italia for two reasons: 1/ competitors will continue to develop their own infrastructures, notably very high debit, reducing their dependence on those of the traditional operator, and 2/ Telecom Italia cannot offset this loss of revenue with NGA wholesale, due to new competition from EOF in this niche. As regards point 1, Fastweb has announced a doubling of its FTTC target, with an objective to cover over 50% of Italian households by 2020. And concerning point 2, as already mentioned, the traditional operator’s competitors will be able to migrate their high-debit clients currently in Telecom Italia unbundling to EOF very high debit. A regulatory issue arises with these competition questions: regulated rates for access to the fixed network should fall again in 2017, as they did in 2016.

The following chart and table show our assumptions for changes in the wholesale market and access resales by Telecom Italia. Thanks to growth of the high-debit market, the volume of lines sold by Telecom Italia to its competitors should rise slightly again in 2017, before a stabilisation in 2018 and an initial decrease in 2019 due to an acceleration in the infrastructure of third parties. Simultaneously, the mix of wholesale access resales by Telecom Italia to its rivals should change in favour of SLU (sub loop unbundling, which is sufficient where the alternative operator has deployed its own infrastructures at access points, which is notably the case for the alternative FTTC infrastructures). This mix effect is negative for value, because SLU access costs ~40% less than the total LLU unbundling. And once again, growth of Vula access (very high-debit wholesale, which costs more than €15 per month) will be slowed by stiffer competition from EOF, which will not offset the negative mix effect mentioned above.

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Fig. 39: Projected trends in the Italian wholesale fixed market

25,0

20,0 0,9 1,0 1,2 1,4 1,6 1,9

7,2 7,5 15,0 7,6 7,7 7,7 7,5

10,0

12,5 11,7 5,0 11,3 11,0 10,8 10,7

0,0 2014 2015 2016 2017 2018 2019

OLO lines using own infra. or third party provider OLO lines using TI's wholesale Telecom Italia lines

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 40: Detailed forecasts for trends in the Italian wholesale fixed market

2014 2015 2016 2017 2018 2019

Total access lines on the market 20.6 20.2 20.1 20.1 20.1 20.1

of which Telecom Italia lines 12.5 11.7 11.3 11.0 10.8 10.7

of which other operators lines 8.1 8.5 8.8 9.1 9.3 9.4

of which using TI's wholesale offers 7.2 7.5 7.6 7.7 7.7 7.5

of which SLU 0.2 0.4 0.7 1.1 1.7 2.0

of which Vula-Bitsream NGA 0.0 0.1 0.3 0.5 0.7 0.9

of which LLU 5.2 5.2 5.0 4.7 4.2 3.4

of which wholesale line rental 0.6 0.5 0.5 0.4 0.4 0.4

of which Naked DSL 1.2 1.2 1.2 0.9 0.6 0.7

of which using own or third party provider 0.9 1.0 1.2 1.4 1.6 1.9

Source: AGCOM; Company Data; Bryan, Garnier & Co ests.

Combining retail and wholesale revenues and excluding the potential impact of Iliad on fixed, we estimate that total revenue from Telecom Italia’s domestic fixed business should fall between 2 and 3% per annum over the next three years, as growth of high-debit should not completely offset the pressure on wholesale revenues and structural shrinkage of traditional activities.

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Fig. 41: Projected revenues from Telecom Italia’s domestic fixed

12000

1136 1215 10000 1299 1378 1450 2316 1525 8000 2205 2065 1962 1913 1817 2199 6000 2314 2459

EURm 2607 2751 2853 4000

5021 4638 4147 3733 2000 3359 3023

0 327 282 384 325 334 339 2014 2015 2016e 2017e 2018e 2019e

Equipment Traditional services Innovative services (BB) Domestic Wholesale TIS Group, adjustments and others

Source: Company Data; Bryan, Garnier & Co ests.

Concerning Iliad, although the company has stated that it does not plan to enter the fixed market in the near term, we think that Iliad will find good reasons to do so:

 Iliad has proven expertise in box and 3P offers and Italy provides an opportunity to generate major synergies with France;

 As stated previously, fixed/mobile convergence offers should become widespread thanks to Telecom Italia, but also to the Wind/Tre merger. Not having such an offer could rapidly become a handicap for Iliad (which would be the only one of the four MNOs without such an offer);

 The Italian market has, via Telecom Italia, Fastweb and EOF, a large range of operators who can form a partnership with Iliad, thus facilitating the latter’s entry into the fixed market.

At this stage, we do not include this potential in our estimates. Nevertheless, we estimate that the possibility is an additional risk for Telecom Italia’s performance.

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INDEPENDENT RESEARCH Telecom Italia 31st January 2017 The calm before the storm TMT Fair Value EUR0.71 (price EUR0.80) SELL Coverage initiated

Bloomberg TIT IM We initiate coverage of Telecom Italia with a Sell rating and fair value Reuters TIIT.MI of €0.71. Structural changes in the Italian fixed-line market, and 12-month High / Low (EUR) 1.0 / 0.6 especially the forthcoming arrival of Iliad in Italy, pose a real threat to Market capitalisation (EURm) 21,878 Enterprise Value (BG estimates EURm) 47,589 the historical operator, despite improving prospects in Brazil and Avg. 6m daily volume ('000 shares) 92,469 ambitious cost-cutting and investment plans. Free Float 75.3%  In our opinion, Telecom Italia is best-prepared to meet Iliad’s challenge. 3y EPS CAGR ns Gearing (12/15) 172% However, in view of the newcomer’s c.11% target for market share, we Dividend yield (12/16e) 1.40% estimate that Telecom Italia could lose 2.6 million clients and that ARPU could fall more than 15% over three years, implying a €1bn YE December 12/15 12/16e 12/17e 12/18e Revenue (EURm) 19,718 18,804 18,540 17,814 decrease in full-year revenues. In fixed, Telecom Italia will also have to EBITA EURm) 2,961 3,759 3,539 3,373 deal with Enel in wholesale fiber and to offset a decline in its Op.Margin (%) 15.0 20.0 19.1 18.9 traditional activities. We forecast a 2.6% decrease in average yearly Diluted EPS (EUR) 0.00 0.09 0.06 0.06 EV/Sales 2.49x 2.53x 2.55x 2.65x sales from Telecom Italia’s traditional activities in 2016-2019. In Brazil, EV/EBITDA 6.1x 5.8x 5.8x 5.9x where the macroeconomic environment is improving, we expect TI’s EV/EBITA 16.6x 12.7x 13.4x 14.0x P/E NS 8.6x 12.7x 13.8x businesses to pick up, with sales growth averaging 0.2% in 2016-2019. ROCE 0.6 4.6 4.2 3.9  A plan to reduce Opex by c.€800m should allow organic EBITDA to fall only 1.2% per annum from 2016 to 2019. In line with the group’s 1.4 strategic plan for 2016-2018, capex should remain a healthy €5.3bn per 1.3

1.2 annum over the next two years, on FCF of just €100-200m. 1.1  Although the stock’s valuation looks reasonable on organic 2017e 1.0 EV/EBITDA 5.7x, the EV/EBITDA-Capex multiple of 14.1x is above 0.9 the market norm at 12.5x. Besides, we forecast an average yearly decrease 0.8 for organic EBITDA of 0.8% over 2016-2018, whereas the consensus 0.7 forecasts a growth of 0.6 1.7%. 27/07/15 27/10/15 27/01/16 27/04/16 27/07/16 27/10/16 27/01/17 TELECOM ITALIA EURO SXX TELECOM E  We exclude from our calculations the impact of potential speculation in the stock (a bid by Vivendi, entry by Orange, interest from Mediaset etc.), about which rumours are regularly denied. The economic rationale, the political context and the market environment do not inspire us to include the speculative element at present.

Analyst: Sector Analyst Team: Thomas Coudry Richard-Maxime Beaudoux 33(0) 1 70 36 57 04 Gregory Ramirez [email protected] Dorian Terral

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Telecom italia

Simplified Profit & Loss Account (EURm) 2014 2015 2016e 2017e 2018e 2019e Revenues 21,573 19,718 18,804 18,540 17,814 17,470 Change (%) -% -8.6% -4.6% -1.4% -3.9% -1.9% Adjusted EBITDA 8,786 8,080 8,156 8,161 8,031 7,863 EBIT 4,530 2,961 3,759 3,539 3,373 3,425 Change (%) -% -34.6% 26.9% -5.9% -4.7% 1.5% Financial results (2,194) (2,525) (873) (1,380) (1,370) (1,352) Pre-Tax profits 2,347 447 2,889 2,158 2,003 2,072 Tax (928) (401) (895) (675) (627) (648) Minority interests 610 729 153 153 153 153 Net profit 1,960 657 2,041 1,483 1,376 1,424 Restated net profit 1,960 657 2,041 1,483 1,376 1,424 Change (%) -% -66.5% 211% -27.3% -7.2% 3.5% Cash Flow Statement (EURm) Operating cash flows 8,158 7,171 7,331 7,816 7,618 7,642 Change in working capital (464) (334) (588) (141) (209) (17.2) Capex, net, and licenses paid (4,984) (5,197) (5,139) (5,282) (5,282) (4,806) Dividends (252) (204) (227) (227) (227) (227) Net debt 26,651 27,278 25,711 25,460 25,347 24,739 Free Cash flow 188 (606) (53.9) 478 340 834 Balance Sheet (EURm) Tangible fixed assets 13,387 14,867 16,540 17,403 18,231 18,803 Intangibles assets 36,770 35,863 36,281 36,281 36,281 36,281 Cash & equivalents 4,812 3,559 3,999 4,250 4,363 4,971 current assets 11,369 11,271 7,854 7,738 7,550 7,499 Other assets 5,213 5,672 5,716 5,716 5,716 5,716 Total assets 71,551 71,232 70,390 71,389 72,141 73,270 L & ST Debt 37,011 36,742 36,629 36,629 36,629 36,629 Others liabilities 12,841 13,157 11,693 11,436 11,039 10,970 Company description Shareholders' funds 21,699 21,333 22,068 23,324 24,473 25,670 Telecom Italia S.p.A. (Telecom Italia) Total Liabilities 71,551 71,232 70,390 71,389 72,141 73,270 Capital employed 52,922 53,886 56,877 57,882 58,918 59,508 operates fixed voice and data infrastructure as well as mobile Ratios Operating margin 21.00 15.02 19.99 19.09 18.93 19.60 network platforms in Italy and Brazil. Tax rate (39.54) (89.71) (30.99) (31.29) (31.29) (31.29) Its segments include Consumer, Net margin 9.09 3.33 10.85 8.00 7.73 8.15 Business, National and international ROE (after tax) 7.44 (0.41) 9.53 6.36 5.58 5.54 Wholesale. ROCE (after tax) 0.0 0.57 4.56 4.20 3.93 3.95 Gearing 171 172 166 157 150 143 Pay out ratio 12.86 31.05 11.12 15.31 16.49 15.94 Number of shares, diluted 19,367 19,367 20,179 21,067 21,067 21,067 Data per Share (EUR) EPS 0.07 (0.00) 0.09 0.06 0.06 0.06 Restated EPS 0.07 (0.00) 0.09 0.06 0.06 0.06 % change -% -105% -% -32.5% -8.0% 3.9% BVPS 0.94 0.91 0.98 0.99 1.04 1.09 Operating cash flows 0.42 0.37 0.36 0.37 0.36 0.36 FCF 0.01 (0.03) (0.00) 0.02 0.02 0.04 Net dividend 0.01 0.01 0.01 0.01 0.01 0.01

Source: Company Data; Bryan, Garnier & Co ests.

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Telecom italia

Table of contents

1. Telecom Italia: An introduction ...... 44 1.1. Scope of business ...... 44 1.2. Shareholders, governance and dividend policy ...... 47 2. Domestic: the Iliad challenge - and more ...... 49 3. Activity in Brazil: a macroeconomic challenge ...... 50 3.1. The macroeconomic context ...... 50 3.2. Encouraging prospects ...... 52 4. Cost cuts: necessary to restore leeway ...... 57 4.1. Context ...... 57 4.2. Cost-cutting plan and outlook ...... 58 5. Valuation ...... 60 5.1. Performance of the stock ...... 60 5.2. Summary ...... 61 5.3. DCF ...... 61 5.4. Peer groups ...... 63 6. Appendices ...... 64

6.1. Group P&L ...... 64 6.2. Revenues breakdown ...... 64 6.3. Organic EBITDA breakdown ...... 65 6.4. Group Cash Flow and net debt ...... 65 Bryan Garnier stock rating system ...... 67

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1. Telecom Italia: An introduction 1.1. Scope of business Telecom Italia’s activities can be divided into three categories: Domestic activities, Brazil, Medias and others. In 2015, the breakdown of Telecom Italia’s revenues and EBITDA between these three segments was as follows:

Fig. 1: Breakdown of Telecom Italia’s 2015 revenues

EURm 2015 %

Domestic 15001 76.1%

Core domestic (incl. Inwit) 13858 70.3%

International wholesale (Sparkle) 1314 6.7%

Olivetti 172 0.9%

Elim. -343 -1.7%

Brazil 4636 23.5%

Media (Persidera) and others 131 0.7%

Adj. & Elim. -50 -0.3%

Total revenues 19718 100.0%

Source: Company Data.

Fig. 2: Breakdown of Telecom Italia’s 2015 EBITDA

EURm 2015 %

Domestic 5567 79.5%

margin 37.1%

Brazil 1449 20.7%

margin 31.3%

Media (Persidera) and others -14 -0.2%

Adj. & Elim. 2 0.0%

Total EBITDA 7004 100.0%

Margin 35.5%

Source: Company Data.

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Domestic activities generate 76% of group revenues and 80% of group EBITDA. They also account for over 95% of the group’s net debt, as illustrated below:

Fig. 3: Breakdown of Telecom Italia’s net debt

EURbn Q3 2016 % Gross debt 34.3 Domestic 32.1 Brazil 2.2 Cash & equiv. 7.6 Domestic 6.3 Brazil 1.3 Net debt 26.7 100.0% Net debt / EBITDA 3.3 Domestic 25.8 96.6% Net debt / EBITDA 3.8 Brazil 0.9 3.4% Net debt / EBITDA 0.6

Source: Company Data; Bryan, Garnier & Co ests.

The group is still heavily indebted, with Net Debt / Organic EBITDA of 3.3x at end 2016e (3.8x for the Domestic segment). Domestic activities mainly comprise:

 BtoC and BtoB activities, Telecom Italia’s core business / TIM, mobile and fixed lines;

 Sparkle’s international wholesale activities;

 Inwit’s management of network infrastructures (hosting of radio transmission equipment, site maintenance etc). Inwit is a 60%-owned subsidiary of Telecom Italia; the remaining 40% is listed on the Milan stock exchange. Inwit is consolidated by Telecom Italia.

 Olivetti’s IT service activities (Europe, Asia, South America) The table below shows the breakdown of revenues from Domestic activities and the trends of recent years. While the mobiles segment has returned to growth thanks to more favorable conditions, fixed remains under pressure mainly due to a structural decline in traditional fixed voice activities. The domestic mobile segment, which is particularly exposed to the arrival of Iliad, currently accounts for a little less than 25% of total group revenues.

Fig. 4: Breakdown of Domestic revenues

EURm 2014 2015 2016e % Equipment 969 943 974 6.6% yoy growth -2.7% 3.3% Mobile services 4608 4517 4550 30.7% yoy growth -2.0% 0.7% Fixed services 9428 9058 8607 58.0% yoy growth -3.9% -5.0% Sparkle 1244 1314 1363 9,2% yoy growth 5.6% 3.7% Elimination & Other -946 -831 -650 -4.4% Total 15303 15001 14844 100.0% yoy growth -2.0% -1.0%

Source: Company Data; Bryan, Garnier & Co ests.

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Telecom Italia owns 67% of its Brazilian subsidiary. The remaining 33% is listed on the Sao Paulo stock market, as illustrated by the following chart:

Fig. 5: Shareholder structure of Telecom Italia Brazil.

Source: Telecom Italia.

Telecom Italia Brazil is mainly focused on mobiles, as fixed activities are still very marginal although they are growing, as illustrated below:

Fig. 6: Breakdown of Telecom Italia Brazil revenues

BRLm 2014 2015 2016e %

Handsets 3173 1755 881 5.6%

yoy growth -44.7% -49.8%

Mobile services 15750 14727 14044 89.6%

yoy growth -6.5% -4.6%

Fixed services 579 660 742 4.7%

yoy growth 14.1% 12.3%

Total 19498 17139 15665 100.0%

yoy growth -12.1% -8.6%

Source: Company Data; Bryan, Garnier & Co ests.

To conclude, the Media de Persidera activities include service and digital signal processing platforms, mainly for clients who require broadcasting services. There are no production/content editing services.

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1.2. Shareholders, governance and dividend policy Telecom Italia’s capital comprises 15.5bn ordinary shares (including 164m of treasury stock) and 6bn savings shares. For our calculation of fair value and EPS, therefore, we use 21bn shares (ex treasury stock and dilutive elements currently out of the money).

The following pie chart illustrates Telecom Italia’s shareholder structure. Vivendi increased its TI stake in rapidly in 2015 and 2016; it is now the leading shareholder and close to the 25% takeover bid threshold.

Fig. 7: Telecom Italia’s shareholder structure (ordinary shares, 31 Sept. 2016)

4,2%

12,2% 24,7%

4,4%

54,6%

Vivendi Italian institutional investors Foreign institutional investors Other italian shareholders Other foreign shareholders

Source: Company Data.

Of the 16 board members, four were appointed by Vivendi. They include Arnaud Roy de Puyfontaine, deputy chairman of the Telecom Italia board and chairman of the management board at Vivendi. The CEO, Flavio Cattenao, was appointed in late March 2016, three months after Vivendi’s arrival on the board, in place of Marco Patuano.

The Italian government has no direct shareholding in Telecom Italia. However, the law allows it special powers to intervene in several of the group’s key businesses, as Telecom Italia operates assets that are of strategic importance to the country. Specifically, the Italian government can impose certain conditions, or even veto a change of control of the company.

If Telecom Italia shows a profit in a given year, it must pay a minimum of €0.0275 per savings share, if necessary from its reserve. It may also opt to spread the payment over two years. If earnings are below zero, the €0.0275 payment is optional. However, whenever this was the case, Telecom Italia chose to make the minimum payment per savings share. If Telecom Italia decides to pay a dividend per ordinary share, the dividend per savings share must be €0.011 higher than the dividend per ordinary share (and never less than €0.0275€ per share).

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Having decided to prioritize debt repayment and investment (in very high debit fixed, notably), Telecom Italia does not plan to pay a dividend to ordinary shareholders until 2019. Beyond that year, the question will be reconsidered. We assume there will be no significant change to Telecom Italia’s dividend policy before 2020.

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2. Domestic: the Iliad challenge - and more Telecom Italia enjoyed a return to positive growth in 2016, but Italy’s historical operator faces multiple challenges this year in its domestic market (80% of group EBITDA) including: 1/ the forthcoming arrival of Iliad in consumer mobile services and 2/ Enel’s expansion into wholesale fixed fiber.

In mobiles (25% of TI’s domestic revenues), we believe that the arrival of Iliad in late 2017 (or in very early 2018) poses a very serious threat. Despite real challenges in terms of distribution and marketing, we think that Iliad enjoys sufficiently advantageous entry conditions to capture an 11% share of the overall mobile market. Faced with this threat, we believe that Telecom Italia is the best-placed player in the Italian market to face the challenge (like Orange in France), thanks to a value strategy based on ambitious investments and generous content. Nevertheless, we think that Telecom Italia could lose 2.6 million clients in the long run, and suffer a decrease in ARPU exceeding 15% within 3 years.

In fixed, while facing substitution of its traditional fixed business with high-speed services, we think that Telecom Italia will struggle to prevent the slide in wholesale activities at a time of rising deployment of its own network by competitors and of limited growth in very high speed due to new competition from Enel. However, a plan to reduce opex by €800m in 2016-2018 should help to cushion the impact of the changes described above.

All these considerations are described in detail in our sector report on Italian Telecoms published today.

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3. Activity in Brazil: a macroeconomic challenge 3.1. The macroeconomic context In recent years, Brazil has been badly shaken by a deep economic crisis, which has entailed severe devaluation of the currency and high inflation. In 2015-2016, the country went into a recession from which it is currently emerging and prospects are now looking brighter.

The chart below shows the main macroeconomic indicators for Brazil and the corresponding forecasts of various international organisations.

Fig. 8: Brazil’s GDP growth

10 7,54 8

6 3,92 4 3,02 1,93 1,97 1,99 2 1,23 -0,13 0,1 -0,02 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 -2 -3,37 -3,82 Real growthGDP change)(% -4

-6

Source World Bank Source IMF Source OECD

Source: World Bank, IMF, OECD.

Fig. 9: Brazil’s real inflation rate

10 9,03 9,02 9 8

7 6,2 6,33 6 5,4 5,39 4,8 4,6 5 4,47 4 3 2 1 Consumer price inflation change)(% 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Source IMF Source OECD

Source: IMF, OECD.

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Telecom italia

Fig. 10: EUR/BRL exchange rate

5,0 4,5 4,0 3,5 3,0 2,5 2,0 1,5 EUR/BRL change rate 1,0 0,5 0,0 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016

Source: Thomson Reuters.

After two years of negative growth, Brazil’s GDP should stabilise in 2017 and begin to rise in 2018. Inflation peaked at 9% in 2015 and 2016, but should return to a more reasonable c.5% in 2017.

In an emerging market where budgets are very constrained, subscription offers are uncommon and “pay per use” is still popular. Telecom spending is restrained when households experience financial strain and trends are highly correlated to the country’s macroeconomic health.

The economic context has thus affected the whole sector, and especially Telecom Italia. To illustrate this, the following chart shows the correlation between Telecom Italia’s mobile ARPU and growth of the Brazilian economy.

Fig. 11: Telecom Italia Brazil’s mobile ARPU and Brazil’s GDP growth

19,5 4% 19 3% 18,5 2% 1% 18 0% 17,5 -1% 17 -2% 16,5 -3% 16 -4% 15,5 -5%

TIM Mobile arpu Brazilian GDP growth Poly. (TIM Mobile arpu) Poly. (Brazilian GDP growth)

Source: Company Data; World Bank, IMF, OECD, Bryan, Garnier & Co ests.

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Telecom italia

3.2. Encouraging prospects In Brazil, Telecom Italia operates in both fixed and mobile. The latter accounts for 95% of revenues, but the dynamics are currently reversed with revenues from mobile down 6.5% in 2016, when we estimate that fixed grew 12.3%.

The mobile market is shared by four main operators: Telefonica, the leader with a near-30% share, followed by Telecom Italia and Claro with about 25% each, and OI with 18%. These players are present throughout Brazil, with market shares that vary from one region to the next.

Fig. 12: Market share in Brazilian mobile

1,3% 1,7% 1,7% 1,8% 100% 90% 17,8% 18,6% 18,8% 18,3% 80%

70% 26,4% 25,7% 25,3% 25,2% 60% 50% 40% 25,2% 25,6% 25,4% 25,0% 30% 20% 29,3% 28,4% 28,9% 29,7% 10% 0% Q2 2015 Q4 2015 Q2 2016 Q4 2016

TELEFÔNICA BRASIL S.A. (Vivo) CLARO S.A. (America Movil) TIM CELULAR S.A. OI MÓVEL S.A. Others

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 13: Brazil’s mobile phone market

300 160%

140% 250 120% 200 100%

150 80%

60% 100 40% 50 20%

0 0% 2010 2011 2012 2013 2014 2015 2016

Number of mobile customers (millions) Mobile penetration

Source: ANATEL.

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Telecom italia

In recent years, Brazil’s mobile phones market has seen a decrease in the number of lines due to the recession and rationalisation of multi-lines by operators.

Telecom Italia’s trajectory has also been shaped by a decline in the number of lines. However, mobile ARPU has risen following a change in the subscriber mix and increased usage, probably a mechanical effect related to rationalisation of the number of SIM cards.

Fig. 14: TI Brazil’s mobile revenues and subscriber mix

2 000 22,5% 25,0% 1 035 21,5% 1 000 20,5% 20,1% 19,0% 0 20,0% -1 000 -741 15,0% -2 000

-3 000 -2 027 10,0% -4 000 -3 281

-5 000 5,0% -6 000 -7 000 -6 339 0,0% 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16

Mobile net adds % postpaid (cust. Base)

Source: Company Data.

Fig. 15: TI Brazil’s ARPU and mobile revenues

15% 12,2%

10% 7,0%

5% 3,0%

0% 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 -5,9% -5% -3,0% -5,6% -6,7% -6,8% -10% -9,0% -9,2%

-15%

Mobile services revenues yoy growth Mobile arpu yoy growth

Source: Company Data.

In line with the improving macroeconomic outlook, we expect ongoing increases in the number of subscribers at TIM Brazil, as well as moderate ARPU growth. Our main forecasts are summarized in the following table:

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Fig. 16: KPI of mobiles at TIM Brazil

2014 2015 2016e 2017e 2018e 2019e

Market penetration (m) 138% 126% 120% 116% 115% 115%

TIM market share 27,0% 25,7% 25,2% 25,2% 25,2% 25,2%

Total customer Base (m) 75,7 66,2 62,3 59,8 59,5 59,5

of which postpaid 17% 21% 23% 26% 28% 29%

net adds (k) 2,3 -9,5 -3,9 -2,5 -0,3 0,0

Mobile arpu (EUR/month) 17,7 16,7 18,1 19,4 19,7 19,7

yoy growth -4,8% -5,6% 8,4% 7,0% 1,5% 0,0%

Source: Company Data; Bryan, Garnier & Co ests.

The market for fixed internet access is shared by three main operators: Claro, Telefonica, and OI, which have market share of 32%, 28% and 24% respectively. With 300K clients at end Q3 2016, Telecom Italia is fifth on 1% market share. The rest of the market is shared between a multitude of local operators.

Note, however, that Telecom Italia does not serve the whole territory. Of the 26 million clients who currently have fixed internet access, Telecom Italia only has the potential to reach five million. Moreover, in the very high-debit segment (> 34Mbps, fiber and cable), Telecom Italia is No.2 with 35% market share.

As shown in the following chart, the market for fixed internet access has been growing steadily for several years, but penetration is still low with only 40% (of households) expected in 2016.

Fig. 17: Market for fixed internet in Brazil

30,0 45% 40% 25,0 35% 20,0 30% 25% 15,0 20% 10,0 15% 10% 5,0 5% 0,0 0% 2010 2011 2012 2013 2014 2015 2016

Number of broadband customers Penetration rate

Source: ANATEL.

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Telecom italia

In addition to market growth, we are seeing a significant increase in available debit. Very high debit now represents 10% of the market, versus less than 4% two years ago.

Fig. 18: Available debit in fixed internet in Brazil (Jan.2015-Oct.2016)

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2015-01 2015-02 2015-03 2015-04 2015-05 2015-06 2015-07 2015-08 2015-09 2015-10 2015-11 2015-12 2016-01 2016-02 2016-03 2016-04 2016-05 2016-06 2016-07 2016-08 2016-09 2016-10

Narrowband (<512kbps) 512kbps to 2Mbps 2Mbps to 34Mbps Ultra broadband (> 34Mbps)

Source: ANATEL.

Telecom Italia is benefiting from favorable market conditions with a value strategy that is focused on very high debit and convergence with mobile. So, as we saw above, Telecom Italia is enjoying double- digit growth in fixed which we think can continue thanks to a positive economic context. From Q3 2015 to Q3 2016, Telecom Italia Brazil attracted 100K new fixed clients and growth in Q3 2016 was similar to the preceding quarters at 10.2%, as illustrated below:

Fig. 19: Annual revenue growth for fixed at Telecom Italia Brazil

20%

18% 17,7% 16% 15,1% 15,1% 14% 14,3% 12% 12,4% 11,3% 10% 10,2% 8% 6% 4% 2% 0% 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16

yoy growth

Source: Company Data.

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Telecom italia

Below, we provide a summary of our estimates for revenue trends in fixed and mobile for TI Brazil.

Fig. 20: Revenue forecasts for TIM Brazil

BRLm 2014 2015 2016e 2017e 2018e 2019e

Services 16325 15384 14785 14969 14967 15048

yoy growth -5,8% -3,9% 1,2% 0,0% 0,5%

of which Mobile 15750 14727 14044 14153 14069 14061

of which Fixed 579 660 742 816 897 987

Equipment 3173 1755 881 734 697 697

Total 19498 17139 15665 15703 15664 15745

Source: Company Data; Bryan, Garnier & Co ests.

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4. Cost cuts: necessary to restore leeway 4.1. Context Today, Telecom Italia faces three constraints:

 Debt repayment: the organic Net debt / EBITDA ratio was estimated by the group to be 3.3x at end 2016 (3.8x for domestic operations). This level of debt is among the highest in the sector.

Fig. 21: Comparison of telecom operators’ debt ratios

2016e Net Debt/EBITDA

SFR 3,6

Telecom Italia 3,3

Telefonica 3,1

Deutsche Telekom 2,5

Orange 1,8

Bouygues Tel. 1,2

Iliad 0,9

Source: Bryan, Garnier & Co ests; Thomson Reuters.

 Investment: In both Italy and Brazil, the group’s positioning requires heavy investment in very high-debit fixed notably (deployment of fiber / cable). The group has unveiled a plan to invest €12bn in Italy and R14 billion (~€3.6bn) in Brazil in 2016-18, or 28% of total group revenues in 2016E.

Fig. 22: Comparison of telecom investment ratios

2016e CAPEX/SALES

Telecom Italia 28,0%

Iliad 27,3%

SFR 20,6%

Orange 18,9%

Bouygues Tel. 18,1%

Deutsche Telekom 17,3%

Telefonica 17,1%

Source: Bryan, Garnier & Co ests; Thomson Reuters.

 Uncertainty arising from the arrival of Iliad: As we have already seen in detail, Iliad’s arrival implies significant risk for Telecom Italia’s domestic mobile business (~25% of the group’s total revenues).

Under these circumstances, Telecom Italia must restore its financial leeway. To do that, the group has two main options: 1/ Divest assets, 2/ Cut costs drastically.

As regards asset divestments, the group has already taken a number of measures. Notably it IPOed 40% of its infrastructure management subsidiary, Inwit, in mid 2015, divested its mobile antennas in

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Brazil for R3bn (~€780m) in late 2014 and sold its minority stake in Telecom Argentina for $215m in late 2014.

Of the asset divestments that remain possible, we note: 1/ 45% of Inwit (Telecom Italia would like to retain some influence over the company, with 15% of the capital mentioned). This deal could raise €1.2bn for Telecom Italia based on the subsidiary’s current share price; 2/ The sale of Brazilian activities has been mentioned frequently, but no longer looks likely given the uptick in Brazil’s economy. At least initially, the priority seems to be cost-cutting. However, we cannot rule out a divestment later. Today, we value Telecom Italia’s stake in its Brazilian subsidiary at €3.5 billion based on the current share price.

The cost-cutting plan is detailed below.

4.2. Cost-cutting plan and outlook In 2006, Telecom Italia presented a new plan to reduce opex and capex in Italy and Brazil in 2016- 2018. In Italy, the plan calls for an €800m (-9%) reduction in opex and an €800m (-20.5%) reduction in capex. In Brazil, the plan calls for a R600m (-5% after inflation and excluding volumes, implying an effort that is at least equivalent to Italy’s) reduction in opex and a R900m (-19%) cut in capex. Note that the numbers put forward by Flavio Cattenao were significantly higher than those of the previous CEO, Marco Patuano.

We welcome this plan as it should address the issues mentioned above, notably Iliad’s potential impact on the market. Let’s not forget that there is a significant difference relative to the anticipations of French players. Moreover, we think these objectives are realistic for two reasons. Firstly, the plan comprises a very generous incentive programme for management. It sets aside €55m for the top managers, of which €40m for Flavio Cattenao (80% in shares and 20% in cash) linked to objectives in the 2016-18 plan (cost cuts, EBITDA and debt ratio). Secondly, as illustrated in the table below, the objectives of the plan look reasonable to us: -9.5% overall for costs (excluding non-recurring items) of which 7.2% for the workforce and 17.7% in processes, the other savings being generated by market factors or volumes. Consequently, we believe that the risk associated with these efforts is limited. We are far from the type of cost-cutting implemented by Altice, where opex was reduced by about 30%.

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Fig. 23: TI’s plan to cut domestic opex in 2016-2018

Excl. Non rec. 2015 cost base 2018 cost base TI Plan Effort vs 2015 2018 cost base BG Effort vs 2015

Total domestic (EURm) 8406 7606 -9,5% 7185 -14,5%

Labour 2777 2577 -7,2% 2577 -7,2%

Process driven 1811 1491 -17,7% 1389 -23,3%

Market driven 1092 862 -21,1% 760 -30,4%

Volume driven 3261 3211 -1,5% 2994 -8,2%

Other prov/income -535 -535 0,0% -535 0,0%

Source: Company Data; Bryan, Garnier & Co ests.

However, in view of our assumptions regarding the impact of Iliad, we think the savings could be higher - especially for volume and market effects, as illustrated in the above table and included in our assumptions. Moreover, we think that the estimate for payroll cuts should be raised to roughly 15% in total, which would save an additional €150m, but we currently use the group’s estimate for that line.

Lastly, regarding capex, we assume that the savings will be fully reinvested in order to speed up deployment in very high debit, in line with the investment plan put forward by management, and illustrated in the following table:

Fig. 24: Telecom Italia capex forecasts

EURm 2014 2015 2016e 2017e 2018e 2019e

Total CAPEX 4984 5197 5139 5282 5282 4806

Domestic 2783 3900 4001 4001 4001 3641

Brazil 2195 1289 1138 1281 1281 1165

(Brazil in BRL) 6855 4766 4431 4931 4931 4487

Source: Company Data; Bryan, Garnier & Co ests.

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Valuation Performance of the stock The following chart shows the share price of the Telecom Italia stock (ordinary shares) since the beginning of 2016. To date, the stock is down 32% versus the Euro Stoxx 600 Telecom down 18%.

Fig. 25: Performance of Telecom Italia stock (ordinary shares)

110,0

100,0

90,0

80,0

70,0

60,0

50,0

40,0

TELECOM ITALIA STOXX EUROPE TELECOM

Source: Thomson Reuters.

The Telecom Italia stock was highly volatile in 2016, when upward revisions to the group’s ambitious cost-cutting and investment plans failed to offset the negative news – notably linked to the arrival of Iliad in the market and Enel’s expansion in fiber. Fears arising from the Italian referendum also weighed on the stock, but the doubts were soon dispelled and the stock did some catching up towards the year-end. Since early Q4 2016, the share price has risen 8.3% versus -3.4% for the Euro STOXX 600 Telecom.

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Summary We initiate coverage of Telecom Italia with a Sell rating, and a DCF-based fair value of 0.71€ for ordinary shares (11% below the current price). Our analysis of EBITDA-capex multiples tends to confirm our view that Telecom Italia is over-valued at present.

The Telecom Italia stock has performed well in recent weeks. The coming weeks do not carry specific risk factors for the group, but we think that the situation is likely to change and that investors may become more cautious in H2 2017 as the Iliad launch approaches. In particular, we feel that the consensus is over-estimating sales and thus EBITDA in 2017e (BG 2017e organic EBITDA is €8,161m vs consensus at €8,274m) and especially the following year (BG 2018e organic EBITDA is €8,031m vs consensus at €8,284m).

Besides, we do not include potential speculative factor in our calculation of fair value or our rating. The economic rationale, the political context and the market environment do not inspire us to include the speculative element at present.

DCF Our DCF model values Telecom Italia at €0.71 per ordinary share, based on the following hypotheses:

 Revenues: we expect -2.4% a year on average in 2016-2019 (-1.4% in 2017), with stability in Brazil insufficient to offset pressure on domestic fixed and mobile operations.

 EBITDA: we estimate that organic EBITDA will fall 1.2% a year on average in 2016-2019 (as in 2017), mainly due to Italy.

 We continue to forecast capex of €5.3bn (€4bn in Italy and €1.3bn in Brazil) in 2017e and 2018e in order to fund ambitious investments; the budget will then tend towards 20% of sales (we include in capex a €50m annual payment for renewal of 900MHz and 1800MHz licences from mid 2018 until 2029).

 We assume the pre-tax cost of net debt to be 5.1%, and the tax rate to be 31%.

 We use a discount rate of 6.1% and a beta of 1.2 which corresponds to the historical two-year beta of Telecom Italia vs Euro STOXX 600 (for comparison, we took a beta of 0.8 for Iliad, 0.95 for Orange, 1.1 for SFR and 1.2 for Altice). Moreover, we assume a risk premium of 7.0% and a risk-free rate of 1.6%.

 We assume growth to infinity of 0.5%.

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Fig. 26: Calculation of the discount rate

Inputs

Risk Free rate 1.6%

Market risk premium 7.0%

Βeta 1,2

Cost of Equity 10.0%

Cost of Debt after taxes 3.5%

Gearing 161%

WACC 6.1%

Source: Thomson Reuters, Garnier & Co ests.

Fig. 27: DCF model

EURm 2016e 2017e 2018e 2019e 2020e 2021e 2022e 2023e 2024e 2025e 2026e Sale 18804 18540 17814 17470 17295 17209 17210 17296 17383 17470 17557 Change in sales -4,6% -1,4% -3,9% -1,9% -1,0% -0,5% 0,0% 0,5% 0,5% 0,5% 0,5% EBIT 3759 3539 3373 3425 3330 3368 3516 3668 3793 3898 4186 As % of sales 20,0% 19,1% 18,9% 19,6% 19,3% 19,6% 20,4% 21,2% 21,8% 22,3% 23,8% Tax rate 31,0% 31,3% 31,3% 31,3% 31,3% 31,3% 31,3% 31,3% 31,3% 31,3% 31,3% Net Op. Profit after Tax 2594 2431 2317 2353 2288 2314 2416 2520 2606 2678 2876 + D&A and prov. 4199 4419 4454 4234 4252 4176 4029 3915 3827 3761 3511 Cash flow from op. 6793 6850 6771 6587 6540 6490 6445 6435 6434 6439 6387 - Net investments (incl. Freq.) -5139 -5282 -5282 -4806 -4324 -3872 -3442 -3459 -3477 -3494 -3511 - change in WCR -588 -141 -209 -17 -9 -4 0 4 4 4 4 Free cash Flow 1066 1427 1281 1764 2208 2614 3003 2980 2962 2950 2880 Discounted FCF 0 1269 1074 1394 1646 1838 1991 1863 1745 1639 1509 Sum of disc. FCF 15968 + disc. terminal value 28633 - net debt -25711 - minorities -2957 - provisions -1537 Valuation 14396 Nbre of shares (fully dilluted) 21067 Value per share (ord.) 0,71 Source: Company Data; Bryan, Garnier & Co ests.

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Peer groups As illustrated in the table below, Telecom Italia currently trades at 5.7x 2017e EBITDA (organic), which is in line with our sample of historical operators in Europe. However, we think it is important to look beyond this indicator, and EV/EBITDA-capex multiple seems to us more appropriate in a market where the required investment is high. Here we find a multiple of 14.1x 2017e, some 12% above the sample average (12.5x).

Moreover, this valuation is based on consensus growth forecasts, which we believe are too high for 2017, 2018 and beyond. This analysis confirms our view that Telecom Italia is overvalued given its growth and investment profile, to say nothing of the doubts casting a shadow over the market.

Fig. 28: EBITDA and EBITDA-capex multiples

(consensus data) EV/EBITDA EV/EBITDA-CAPEX EBITDA-CAPEX Growth

2017e 2018e 2017e 2018e 2018e

Telecom Italia 5,7 5,7 14,1 12,7 11,2%

BT Group 6,1 5,8 10,4 9,7 5,8%

Deutsch Telekom 5,7 5,3 13,2 10,9 18,6%

Telefonica 5,6 5,3 11,6 10,4 7,8%

KPN 7,7 7,4 14,6 13,4 7,6%

PROXIMUS 6,2 6,0 13,4 12,5 6,8%

Orange 4,9 4,8 10,5 9,9 6,7%

Average 6,0 5,8 12,5 11,4 9,2%

Source: Thomson Reuters, Garnier & Co ests.

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6. Appendices 6.1. Group P&L P&L Global (EURm) FY15 FY16e FY17e FY18e FY19e REVENUES 19 718 18 804 18 540 17 814 17 470

Other Income 287 231 187 169 161

TOTAL OPERATING REVENUES AND OTHER INCOME 20 005 19 034 18 726 17 983 17 631

EBITDA 7 004 7 952 7 957 7 827 7 659

EBITDA Margin 36% 42% 43% 44% 44%

Organic EBITDA 8 080 8 156 8 161 8 031 7 863

Organic EBITDA Margin 41,0% 43,4% 44,0% 45,1% 45,0%

EBIT 2 961 3 759 3 539 3 373 3 425

EBIT Margin 15,0% 20,0% 19,1% 18,9% 19,6%

Income (loss) equity invest. valued equity method 11 4 0 0 0

Net Financial Income / (Expenses) (2 525) (873) (1 380) (1 370) (1 352)

Profit (loss) before tax from continuing operations 447 2 889 2 158 2 003 2 072

Income tax expense (401) (895) (675) (627) (648)

Profit (loss) from continuing operations 46 1 994 1 483 1 376 1 424

Profit (loss) from Discontinued operations/Non-current assets held for sale 611 47 0 0 0

Profit (loss) for the year 657 2 041 1 483 1 376 1 424

Source: Company Data; Bryan, Garnier & Co ests.

6.2. Revenues breakdown Revenues breakdown (EURm, unless mentioned otherwise) FY15 FY16e FY17e FY18e FY19e Domestic 15 001 14 844 14 486 13 771 13 406

o/w Wireline Domestic 10 654 10 354 10 004 9 806 9 557

o/w Mobile Domestic 5 068 5 142 5 120 4 567 4 432

o/w IG (831) (650) (638) (602) (583)

Brazil 4 636 3 985 4 079 4 068 4 090

Brazil in BRLm 17 139 15 665 15 703 15 664 15 745

TI Media 82 0 0 0 0

Other activities & Elim. (1) (25) (25) (25) (25)

TI Group 19 718 18 804 18 540 17 814 17 470

Source: Company Data; Bryan, Garnier & Co ests.

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6.3. Organic EBITDA breakdown Organic EBITDA Breakdown (EURm, unless mentioned otherwise) FY15 FY16e FY17e FY18e FY19e Domestic 6 595 6 734 6 713 6 586 6 410

% EBITDA 44,0% 45,4% 46,3% 47,8% 47,8%

Brazil 1 497 1 445 1 471 1 467 1 475

Brazil in BRLm 5 358 5 681 5 663 5 649 5 679

% EBITDA 32,3% 36,3% 36,1% 36,1% 36,1%

TI Media 17 0 0 0 0

Other activities & Elim. (29) (23) (23) (23) (23)

TI Group 8 080 8 156 8 161 8 031 7 863

% EBITDA 41,0% 43,4% 44,0% 45,1% 45,0%

Source: Company Data; Bryan, Garnier & Co ests.

6.4. Group Cash Flow and net debt Cash flow statement (EURm) FY15 FY16e FY17e FY18e FY19e

EBITDA 7 004 7 952 7 957 7 827 7 659

CAPEX (5 197) (5 139) (5 282) (5 282) (4 806)

Change in net operating working capital: (334) (588) (141) (209) (17)

Sale of investments and other disposals flow 1 571 737 0 0 0

Share capital increases/reimbursements, 186 0 0 0 0

including incidental costs 0 0 0 0 0

Financial investments flow (51) (11) 0 0 0

Dividends payment (204) (227) (227) (227) (227)

Change in finance lease contracts (1 523) (178) 0 0 0

Finance expenses, income taxes and other net (2 337) (2 208) (2 056) (1 997) (2 001) non-operating requirements flow 0 0 0 0 0

Red./(Incr.) in net financial debt from disc. ops/Non-current assets for sale (243) (38) 0 0 0

Net cash flow (627) 267 251 113 607

ENDING NET FINANCIAL DEBT (Adjusted) 27 278 25 711 25 460 25 347 24 739

Source: Company Data; Bryan, Garnier & Co ests.

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66

INDEPENDENT RESEARCH UPDATE Iliad 31st January 2017 The Italian campaign TMT Fair Value EUR220 (price EUR197.60) BUY-Top Picks

Bloomberg ILD FP In this report, we present our initial view on what the business plan Reuters ILD.PA for Iliad in Italy could be. In spite of real challenges in terms of 12-month High / Low (EUR) 236.3 / 168.4 distribution and marketing, we believe that entry conditions are Market capitalisation (EURm) 11,605 Enterprise Value (BG estimates EURm) 13,141 sufficiently advantageous to allow Iliad to create value exceeding Avg. 6m daily volume ('000 shares) 92.80 €600m in Italy. We stress that our Buy rating on Iliad is a high- Free Float 42.0% conviction call, but for now we do not include the value of Iliad’s 3y EPS CAGR 13.8% Gearing (12/15) 45% Italian operations in our fair value, which remains unchanged at €220. Dividend yield (12/16e) 0.19%

 We believe that Iliad’s entry into Italy in late 2017 or very early in 2018, YE December 12/15 12/16e 12/17e 12/18e will be more complex than Free Mobile’s entry into France in terms of Revenue (EURm) 4,414 4,690 4,936 5,156 EBITA EURm) 662.0 743.6 820.8 953.1 distribution and marketing. On the other hand, the technical and Op.Margin (%) 15.1 16.0 16.8 18.6 financial conditions of Iliad’s entry should be advantageous compared Diluted EPS (EUR) 5.58 6.27 6.74 8.21 EV/Sales 2.90x 2.80x 2.67x 2.52x to the French venture. Under these circumstances, we think that Iliad EV/EBITDA 8.6x 7.8x 7.1x 6.3x might launch an all-in subscription offer for around €10 per month EV/EBITA 19.3x 17.7x 16.0x 13.7x and eventually capture an 11% share of Italy’s overall mobile market P/E 35.4x 31.5x 29.3x 24.1x ROCE 9.8 10.0 10.1 11.0 (14% of the residential market).

247.1  Thanks to a highly-optimised cost structure, we expect Iliad to

227.1 progress in several phases, with a gradual move from a variable-cost opex model to a fixed-cost capex model that would spread investments 207.1 and risks. In our view, a subsequent entry into fixed could become a 187.1 strategic priority for Iliad and would add value to its operations.

167.1  We believe that Iliad is almost certain to enjoy value creation in 147.1 27/07/15 27/10/15 27/01/16 27/04/16 27/07/16 27/10/16 27/01/17 Italy. We currently estimate this at €635m, or €10 per share. We think ILIAD EURO SXX TELECOM E it is too early at this stage to include Italy in our fair value. We stick to our fair value of €220, but we are more than ever convinced that the stock merits a Buy rating.

Analyst: Sector Analyst Team: Thomas Coudry Richard-Maxime Beaudoux 33(0) 1 70 36 57 04 Gregory Ramirez [email protected] Dorian Terral

r r

Iliad

Simplified Profit & Loss Account (EURm) 2013 2014 2015 2016e 2017e 2018e Revenues 3,748 4,168 4,414 4,690 4,936 5,156 Change (%) 18.9% 11.2% 5.9% 6.2% 5.2% 4.5% Adjusted EBITDA 1,204 1,284 1,490 1,677 1,855 2,059 EBIT 537 566 662 744 821 953 Change (%) 32.5% 5.4% 17.0% 12.3% 10.4% 16.1% Financial results (83.7) (85.5) (82.5) (111) (127) (116) Pre-Tax profits 453 480 580 632 694 837 Tax (188) (202) (245) (252) (286) (341) Minority interests (3.8) (4.4) 0.14 2.4 2.4 2.4 Net profit 265 278 335 380 408 497 Restated net profit 265 278 335 380 408 497 Change (%) 42.3% 4.9% 20.3% 13.4% 7.4% 21.8% Cash Flow Statement (EURm) Operating cash flows 1,021 961 1,220 1,289 1,409 1,570 Change in working capital (23.2) (72.1) (23.4) 297 (30.3) (22.5) Capex, net (905) (968) (1,254) (1,263) (1,280) (1,280) Financial investments, net NM NM NM NM NM NM Dividends (21.5) (21.7) (23.0) (23.0) (23.0) (23.0) Net debt 1,023 1,084 1,191 1,536 1,557 1,406 Free Cash flow 64.1 (66.1) (89.7) (322) 1.4 174 Balance Sheet (EURm) Tangible fixed assets 2,501 2,788 3,229 2,622 2,812 2,925 Intangibles assets 1,396 1,450 2,468 3,583 3,536 3,490 Cash & equivalents 318 137 720 374 352 504 current assets 462 607 713 720 753 784 Other assets 99.1 66.1 83.9 78.0 78.0 78.0 Total assets 4,776 5,048 7,214 7,377 7,532 7,780 L & ST Debt 1,341 1,221 1,911 1,732 1,732 1,732 Company description Others liabilities 1,422 1,516 2,665 2,497 2,267 2,042 Iliad SA is a France-based holding Shareholders' funds 2,014 2,310 2,637 2,995 3,380 3,853 Total Liabilities 4,776 5,048 7,214 7,224 7,379 7,627 company active in the integrated Capital employed 3,149 3,443 3,904 4,578 4,985 5,307 telecommunications sector. The Ratios Company provides Internet access and Operating margin 14.43 13.66 15.09 15.98 16.75 18.60 telephony services and hosting Tax rate (41.45) (42.05) (42.20) (38.50) (38.50) (38.50) services. Net margin 7.08 6.68 7.59 8.10 8.26 9.63 ROE (after tax) 13.42 12.26 12.71 12.62 12.01 12.84 ROCE (after tax) 9.86 9.50 9.80 9.99 10.13 11.05 Gearing 50.80 46.92 45.16 51.28 46.08 36.49 Pay out ratio 8.10 7.79 6.86 6.06 5.64 4.63 Number of shares, diluted 59,443 59,808 60,037 60,168 60,168 60,168 Data per Share (EUR) EPS 4.53 4.73 5.58 6.27 6.74 8.21 Restated EPS 4.53 4.73 5.58 6.27 6.74 8.21 % change 40.0% 4.4% 18.0% 12.4% 7.4% 21.9% BVPS 33.76 38.58 43.88 49.72 56.11 63.98 Operating cash flows 17.18 16.07 20.31 21.42 23.41 26.09 FCF 1.08 (1.11) (1.49) (5.35) 0.02 2.90 Net dividend 0.36 0.36 0.38 0.38 0.38 0.38

Source: Company Data; Bryan, Garnier & Co ests.

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1. The Italian environment is more complicated than in France, but Iliad’s ambitions are legitimate Despite real challenges in terms of distribution and marketing, we think that Iliad enjoys sufficiently advantageous entry conditions to capture an 11% share of the overall mobile market. In our view, in order to cause real disruption in the market, Iliad might decide not to launch a very low-cost offer, but instead offer an all-in service for about €10 per month. Thanks to a highly- optimised cost structure, a gradual move from a variable-cost opex model to a fixed-cost capex model that allows the group to spread investments and risks, we believe that Iliad’s Italian venture is bound to create value for the group.

Given limited visibility at this stage, we estimate at €635m the NPV of the Italian project, ie +€10 on our fair value of €220. Besides, we believe that a subsequent move into fixed is likely to be high on Iliad’s list of strategic priorities and would help to raise potential value creation significantly.

All these considerations are described in detail in our sector report on Italian Telecoms published today.

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2. Valuation We think it is too early at this stage to include Italy in our fair value and estimates for Iliad. We take the opportunity of this note to update our main assumptions for France, with no impact on our fair value. We stick to our fair value of €220, but we are more than ever convinced that the stock merits a Buy rating.

As a reminder, our valuation for Iliad relies on a DCF. We use a WACC of 6.8%, with a beta of 0.8 and a growth rate to infinity of 1%. Our latest DCF is presented below.

Fig. 1: DCF Iliad

EURm 2015e 2016e 2017e 2018e 2019e 2020e 2021e 2022e 2023e 2024e 2025e 2026e Sale 4414 4690 4936 5156 5323 5452 5571 5662 5731 5787 5844 5901 Change in sales 5,9% 6,2% 5,2% 4,5% 3,2% 2,4% 2,2% 1,6% 1,2% 1,0% 1,0% 1,0% EBIT 662 744 821 953 1047 1121 1176 1237 1293 1337 1374 1408 As % of sales 15,0% 15,9% 16,6% 18,5% 19,7% 20,6% 21,1% 21,8% 22,6% 23,1% 23,5% 23,9% Net Op. Profit after Tax 383 457 505 586 644 690 723 761 795 822 845 866 + D&A and prov. 917 969 1135 1211 1276 1258 1256 1234 1208 1189 1176 1168 Cash flow from op. 1300 1426 1639 1797 1920 1948 1979 1995 2003 2011 2021 2034 - Net investments (incl. Fequ.) -1236 -1965 -1513 -1513 -1240 -1199 -1114 -1019 -974 -984 -993 -1003 - change in WCR 92 297 -30 -22 -35 -27 -25 -19 -15 -12 -12 -12 Free cash Flow 155 -243 96 262 645 721 840 957 1015 1016 1016 1018 Discounted FCF 0 91 231 535 560 612 653 650 610 572 537 Sum of disc. FCF 5050 + disc. terminal value 9575 - net debt, 2016 -1524 - minority interests -3 + financial fixed assets 32 Valuation 13131 Nbre of shares (fully dilluted) 60 Value per share 220

Our latest estimates for Iliad France’s main financial and operational KPIs are presented below.

Fig. 2: P&L France

EURm 2015 2016e 2017e 2018e 2019e

Revenues 4 414 4 690 4 936 5 156 5 323

% growth 6,2% 5,2% 4,5% 3,2%

EBITDA 1 490 1 677 1 855 2 059 2 217

% growth 12,5% 10,7% 11,0% 7,7%

EBIT 662 744 821 953 1 047

Net Profit 335 379 403 485 550

Source: Company Data; Bryan, Garnier & Co ests.

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Fig. 3: Cash flow and net debt France

EURm 2015 2016e 2017e 2018e 2019e

Operating FCF (incl. Taxes) 1 220 1 289 1 409 1 570 1 911 ow Change in WC - 23 - 19 - 30 - 22 - 35 ow EBITDA restat. & non rec. - 4 - 6 - 6 - 6 - 6 ow income tax - 245 - 252 - 283 - 334 - 374

Cost of debt - 58 - 68 - 90 - 89 - 78

CAPEX (incl. Licenses) -1 236 -1 965 -1 513 -1 513 -1 240

FCF -90 -322 1 174 563

Net Debt 1 191 1 536 1 557 1 406 866

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 4: Breakdown of revenues in France

EURm 2015 2016e 2017e 2018e 2019e fixed 2 597 2 682 2 775 2 851 2 899

% growth 3,3% 3,5% 2,7% 1,7% mobile 1 829 2 020 2 174 2 319 2 437

% growth 10,5% 7,6% 6,7% 5,1%

éliminations - 11 - 12 - 13 - 13 - 13

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 5: Mobile KPIs France

Mobile 2015 2016e 2017e 2018e 2019e

Mobile Postpaid cust. Base 11 685 12 700 13 594 14 354 14 925

Mobile Postpaid net adds 1 580 1 015 895 760 570

Mobile Postpaid ARPU 12,2 12,3 12,4 12,5 12,6

% growth 0,8% 0,8% 1,0% 1,0%

Source: Company Data; Bryan, Garnier & Co ests.

Fig. 6: Fixed KPIs France

Fixed 2015 2016e 2017e 2018e 2019e

Fixed cust. Base 6 138 6 379 6 575 6 732 6 799

Fixed net adds 270 241 196 157 68

Fixed ARPU 35,8 35,5 35,5 35,6 35,6

% growth -1,0% 0,1% 0,1% 0,2%

Source: Company Data; Bryan, Garnier & Co ests.

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Bryan Garnier stock rating system For the purposes of this Report, the Bryan Garnier stock rating system is defined as follows: Stock rating Positive opinion for a stock where we expect a favourable performance in absolute terms over a period of 6 months from the publication of a BUY recommendation. This opinion is based not only on the FV (the potential upside based on valuation), but also takes into account a number of elements that could include a SWOT analysis, momentum, technical aspects or the sector backdrop. Every subsequent published update on the stock will feature an introduction outlining the key reasons behind the opinion. Opinion recommending not to trade in a stock short-term, neither as a BUYER or a SELLER, due to a specific set of factors. This view is intended to NEUTRAL be temporary. It may reflect different situations, but in particular those where a fair value shows no significant potential or where an upcoming binary event constitutes a high-risk that is difficult to quantify. Every subsequent published update on the stock will feature an introduction outlining the key reasons behind the opinion. Negative opinion for a stock where we expect an unfavourable performance in absolute terms over a period of 6 months from the publication of a SELL recommendation. This opinion is based not only on the FV (the potential downside based on valuation), but also takes into account a number of elements that could include a SWOT analysis, momentum, technical aspects or the sector backdrop. Every subsequent published update on the stock will feature an introduction outlining the key reasons behind the opinion. Distribution of stock ratings

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