In May of 2012, I wrote an article in these pages describing the changes Israeli telecom companies were experiencing. At the time, I suggested that Cellcom Israel (NYSE:CEL) would not continue to trade at a P/E multiple of 5.6X estimated earnings. Since that time, shares of CEL have traded up by 55% to a recent price of $11.71 per share and a trailing P/E of 11.2X. The company ended FY12 with basic earnings of $1.50 per share and analysts expect FY13 earnings to drop to $0.93 per share. Third quarter 2013 results will be released on November 18th.
Despite the run-up in share price and the gloomy analyst forecasts, I think this rally has legs and as we move into 2014, share price appreciation will continue. This assessment is based on several catalysts. Catalysts include expansion into the landline market and the provision of television.
Cellcom Israel is a telecommunications company providing a range of services including cellular and landline telephony. In addition, since its 2011 acquisition of Netvision Ltd, the company has been providing internet service, international landline telephone service and local landline services.
The upheavals in Israel's communications market in the past few years and the changing rules of competition have greatly affected the ability to forecast developments in it for the coming years.
Analysts see a market that has undergone upheaval whose peak has passed. Cellcom distributes a lot of dividends, it has strong cash flow, and is still strong. Competition in infrastructures is complicated and takes time.
Among the veteran mobile carriers, new sales campaigns by Cellcom enabled it to slash its churn rate, and it lost a net 1,443 subscribers in September. However, it had the largest subscriber loss in the third quarter, at 21,215 subscribers.
I really think that the market has reached a status-quo, and that mobile prices have bottomed out. Competition, including the mobile virtual network operators (MVNO) are no longer responding to lower prices. I think that their arsenals have emptied. Most of the drop is behind us, or almost certainly behind us.
Cellcom has targeted the next arena for competition in the communications market, and is trying to establish a foothold in the landline sector. The carrier today announced that all its mobile subscribers who switch their landline number to it, will receive the service free for one year. The offer is also valid for mobile subscribers who switch to Cellcom.
2014 may be the turning point in the landline market. The company is preparing for it now on the basis of its presence in this market. Since the completion of Cellcom's merger with Netvision, they have created a strong, efficient, and leading telecommunications group that offers customers high-quality comprehensive communications solutions.
If in 2013, there was competition in the mobile market, 2014 will mainly be characterized by competition in all aspects of the landline market. Cellcom is establishing a foundation to participate more broadly in the consolidation in the landline market. It is intended to allow their customers to benefit from comprehensive communications services under one roof and one service. This step, like its predecessors, strengthens Cellcom's presence in the customer's home, a presence that will allow the customer to enjoy the range of communications services offered by the company.
The next catalyst is the introduction of television service to customer's homes. Cellcom's board approved a pilot program with a view to entering the television market. The pilot is intended to test the Idan Plus digital terrestrial television system and its reliability as part of the television service. At present the Idan Plus system has six stations - Israel Broadcasting Authority's Channel 1 and 33, education station Channel 23, commercial stations Channel 10 and 22, and the Knesset Channel. The plan is to augment the DTT system with television services over the internet. In the past two years, Cellcom has looked intensively at the possibility of entering television over the Internet, and even signed an agreement with Ericsson to supply a broadcasting platform. Basic channels will be transmitted via digital terrestrial television service Idan Plus, while additional content, such as a sports channel, will be via Internet.
Now for the numbers.
When I evaluate a company for possible investment, I always compare income statement metrics with statement of cash flow-derived metrics. The income statement is largely based on management assumptions and projections whereas cash flow is tangible.
I measure profitability by looking at EBITDA less CapEx to Invested Capital. The EBITDA less CapEx to Invested Capital ratio for Cellcom is 21.74%. This can be compared with ROIC of 13.36%. My minimum required return for this metric is 20%. I use free cash flow to invested capital to confirm profitability. For Cellcom, CFROI is 21.38%, well above my minimum requirement of 12%.
I also want to see the relationship between free cash flow and operating income. The better the company is able to convert operating income into free cash, the more efficient the company operates. Cellcom converts about 159% of its operating income into free cash. I am also interested in how capable a company is of covering its long term debt with free cash. In this case, free cash is about 24% of long term debt.
Valuation is always important. I use EBITDA to Enterprise Value as my primary indicator of value and confirm that assessment with free cash flow to price. EBITDA/EV is 5.43X and free cash to price is 28.81X. If we use the industry median EBITDA/EV ratio as a benchmark, Cellcom appears to be undervalued by about 30%.
As previously stated, it is very difficult to forecast developments in the Israeli telecom market. However, if Cellcom successfully executes its expansion in the landline market and enters the television market, the company's prospects are greatly enhanced. The coming calendar year will provide some clarity on this.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.