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We are maintaining our long-term Neutral recommendation on France Telecom S.A. (FTE) following first half 2012 earnings results. Despite healthy performances in Spain and the emerging markets, revenue and profits in the first half slipped year over year hurt by weak domestic market operations.

The company is gradually overcoming last year’s challenges on the back of its benefits from a diversified portfolio and the national roaming contract signed with Iliad SA, the fourth largest mobile operator in France.

France Telecom is progressing well on its Conquests 2015 plan that will reinvigorate growth and restore profitability in the business. The company, in the midst of the first or adoption phase (2011–2013) of its five-year plan, is working on various initiatives to enhance growth in the domestic and international markets. Further, the company is shedding underperforming European assets due to weak economic conditions in that region and unfavorable regulatory measures that continue to restrict its top line.

Despite the economic uncertainty and competitive pressures, France Telecom continues to strengthen its balance sheet with net debt-to-EBITDA ratio target of 2 times over the medium term. The company also expects to maintain an operating cash flow of €8 billion for the year. In addition, it will provide healthy dividends to its shareholders by distributing 40–45% of operating cash flow in the form of dividends in fiscal 2012 and 2013.

However, higher VAT rates, persistently weak domestic economic conditions, labor concerns, lower mobile termination rates, unfavorable regulatory measures across its key European markets and intensifying competition from Bouygues, Telecom Italia spA (TI - Snapshot Report) and Vodafone Group Plc (VOD - Analyst Report) might restrict the upside potential of the stock.

Further, increased investments related to expansion and network improvements might accelerate the company’s cost of operation, resulting in lower profits going forward.

As a result, France Telecom retains a Zacks #4 (Sell) Rank for the short term (1–3 months).

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