Formerly represented by only a handful of fixed line operators, today's Russian telecommunication sector consists of a diverse mix of publicly-traded and privately-owned mobile network operators, broadband internet providers and fixed line telephone companies. Unfortunately, only two of them are publicly traded in the U.S.: Vimpel-Communications (NASDAQ:VIP) and Mobile Telesystems OJSC, also known as MTS (NYSE:MBT). Nevertheless, with the two companies being industry leaders, they appear to be fairly efficient means of getting exposure to Russian telecoms. Below I will try to answer whether the sector is actually worth getting exposure to, and, if so, whether the two companies demonstrate attractive risk-return profiles.
As both VIP and MBT operate primarily in the industry of wireless services, instead of focusing on trends of the whole Russian telecom sector, I will study those directly pertaining to this particular segment.
Some of the key metrics are presented below to demonstrate the development of wireless telecommunication industry in Russia and compare it to its international peers (telecoms in the U.S. and Poland).
On chart 1 we can see a global trend of declining rate of subscribers’ base growth developing globally and affecting wireless providers in developed as well as emerging markets. Most of the acceleration that some companies demonstrate (Verizon (NYSE:VZ) in particular) is caused by external growth (acquisition of competitors). In terms of number of subscribers, major Russian providers appear to grow on par with the U.S. telecoms and somewhat faster than their Polish peers. With those trends in mind is seems reasonable to assume that the rate of growth will continue to decline in the long term as the mobile penetration rate (which is nearing 150% in Russia) faces stronger resistance in its growth.
Although the rate of customer base growth is essentially the same for the three markets under consideration, the turnover of customers differs significantly. An indicator used to measure the turnover of customer base is churn rate, defined as the proportion of customers that discontinue their subscription to a service. Traditionally high churn rates in Russia and Poland are explained, at least in part, by a high percentage of pre-paid subscribers, but the recent increase is probably caused by escalating competition, which is common for industries transitioning to mature stage.
Chart 3: Wireless business OIBDA margins
OIBDA margins of Russian providers are on par or slightly higher than those of their American counterparts and significantly higher than those of major Polish wireless providers. This suggests the presence of conditions favoring further escalation of competition, since relatively high margins are likely to attract new entrants into the industry or stimulate mutually detrimental price competition among existing players.
Chart 4: Average wireless revenue per user, USD/Month
Difference in the average disposable income is, perhaps, one of the major factors leading to Russian operators being outperformed by their Polish peers in terms of ARPU. Information from American operators confirms the strong tie between ARPU and levels of disposable income.
Chart 5: GDP per capita and ARPU growth rate (as reported by MTS), Russia
Chart 6: GDP per capita (right axis) and ARPU (as reported by MTS, left axis), absolute values, Russia
Although, other things being equal (which is perhaps the case for the short term), increased incomes (measured here as increased GDP per capita) do translate into increased ARPU, in the long term other hardly predictable factors play essential roles (those factors being technological progress, change in consumer behavior patterns, etc.). Also, Chart 5 demonstrates the seasonality in ARPU trends (3rd quarter is typically negative and 1st quarter is typically positive).
Chart 7: ARPU / Average disposable income, 2008
Chart 8. Stock prices, VIP (ADR) and MTS (ADR)
Data for the columns above is calculated as current market cap divided by a respective year’s net income, and demonstrates that, should MTS and VIP return to the levels of profitability seen before the recession (later on we will touch on whether this is likely), prices of their common stocks are most probably going to appreciate (although future income growth might be already partially factored in MTS prices). That being said, further analysis of the companies’ financial results is warranted.
Chart 10: Monthly coefficients of stock price variance
In valuing companies operating in emerging markets, it’s necessary to understand that the room for stock price appreciation comes at a price, which is to some extent embodied in increased volatility of stock prices. As shown in Chart 7, volatility of VIP and MTS stock prices is most of the time only slightly elevated compared to that of American telecoms. But in times of severe economic distress (to which Russian economy is presumably more prone), massive capital outflows bring about dramatic spikes of volatility.
With both companies being undisputable leaders of the Russian wireless industry, what is needed is a summary of some basic differences between the two.
Table 1: VIP vs. MTS (Q3 2010)
Chart 11: Weight of Russian geographic segment in companies’ wireless business, relative values
Chart 12: Weight of Russian geographic segment in companies’ wireless business, thousands
As seen in the table above, both companies are remarkably similar in structure of their revenues and subscribers’ base size, with MTS being somewhat more diversified in terms of business segments and VIP being more geographically diversified. That being said, the Russian market, which is core for both companies, is dominated by MTS (32% of subscribers vs. 24%). It needs to be noted, that recent growth in VIP’s total number of subscribers is explained by exogenous factors, particularly by acquisition of Kyivstar, one of the major Ukrainian mobile operators.
Chart 13: Components of revenue, MTS, $mln (*)
Chart 14: Components of revenue, VIP, $mln (*)
Over the last years, the companies have demonstrated identical revenue trends, which suggest that neither had substantial competitive advantage.
Chart 15: Components of revenue, MTS (*)
Trends in revenue structure are somewhat differentiated. MTS has recently seen a meaningful increase in general and administrative costs with a corresponding decrease in operating income margin, while VIP faced increased costs of goods (services) sold, which were largely offset by decreased SG&A. Overall, VIP appears slightly more operationally efficient, particularly because of its ability to keep SG&A stable as percentage of revenues in spite of decreasing revenues.
Chart 17 shows, that, being no less operationally stable than its competitor, VIP is definitely more financially stable, as it operates on only roughly $2 of assets with $1 of equity, compared to MTS with more than $4 of assets per $1 of equity.
Chart 18: Interest expense / Operating income (*)
Nevertheless, Chart 18 demonstrates that, unless the Russian economy is to undergo another severe recession, neither of the two companies is likely to face difficulties servicing its debt. Therefore, we can conclude that, despite MTS’s overreliance on external financing, difference in levels of financial leverage does not constitute a threat to investment attractiveness of either of the companies in the short term.
Cash flows, quality of earnings
Chart 19: Relationship between cash flows and income, MTS, $mln (*)
Chart 20: Relationship between cash flows and income, VIP, $mln (*)
In both cases operating cash flows confirm the quality of operating income and net income. In some cases (2008-2009) divergence between operating cash flows and net income suggests that reported net income underestimates the true economic results of the companies’ activities. In years 2008 and 2009 net incomes of both companies were suppressed by unprecedentedly high net foreign-exchange losses (caused by ruble depreciation), and also were affected by recognition of investments impairment. Projection based on net income, that captures foreign-exchange losses or investments impairment recognized, are likely to result in underestimated intrinsic value of a business, since recent currency depreciation and management’s decisions regarding the value of investments cannot be extrapolated into the future. Therefore, net income based evaluation of businesses intrinsic value will require us to factor in the non-recurring status of these items.
Intrinsic value of business
In order to estimate the intrinsic values of the companies under consideration we form 3 scenarios of future trends, which ultimately define the intrinsic value.
Table 2: Qualitative characteristics of the scenarios
Market opinion today seems to fluctuate between the first two scenarios, suggesting that some combination of the two constitutes the likeliest course of events. Specific inputs used in our model are listed below.
Table 3: Scenarios for intrinsic value estimation, MTS
Table 4: Scenarios for intrinsic value estimation, VIP
Several additional assumptions need to be made:
New projects that companies are to undertake in the future will, on average, produce the same amounts of operating income per dollar invested in PPE and intangibles as the companies are expected to produce in case of unchanged business structure
Table 5: Results of scenario testing, $mln
1 - Company will increase its dividend payout ratio, repay its debt or intensify its investing strategy
2 - Company will be forced to either raise additional equity or increase its leverage
Results of market cap modeling lead us to conclude, that:
- In both cases estimates of intrinsic value differ significantly between scenarios
- Under the optimistic scenario MTS seems to have higher growth potential than VIP, while under conservative and adverse scenarios MTS appears more vulnerable
- In the course of modeling final results were found to be highly sensitive to changes in non-current assets turnover and discount rates
- Assuming that the likeliest scenario is a combination of optimistic and conservative scenarios described above, both companies appear to be more or less properly valued with huge growth potential in case of accelerated macroeconomic recovery
1) The investment attractiveness of the analyzed businesses is highly dependent on the development of macroeconomic trends
2) Under favorable conditions, which resemble those present in pre-recessionary years, intrinsic values of both companies are likely to increase significantly
3) Under a conservative macroeconomic scenario, the two companies appear to be properly valued or slightly overvalued
4) Variables, that will need to be watched closely in future include:
- Non-current assets turnover trends
- Factors affecting applicable discount rates
- Rate of GDP growth in Russia and other key CIS markets,
- Relationship between GDP growth and ARPU
- Intensity of competition
- Development of non-wireless business segments
5) More precise projections of non-current assets turnover and discount rates are required, since final results turned out to be unexpectedly sensitive to these to variables
6) Overall, both MTS and VIP seem to be fairly attractive investments, as long as you don’t expect a second dip of recession or decades-long recovery, with VIP providing better downside protection and MTS having somewhat higher growth potential. Target prices for the two companies depend upon one’s macroeconomic expectations. The baseline scenario, which lies between optimistic and conservative scenarios and implies slow recovery to pre-recessionary revenue growth rates as well as minor escalation of competition, points to a gradual increase in stock prices at least to the levels of summer 2008, which means approximately +50% upside potential for MTS and +100% for VIP. How soon the potential is going to be realized eventually depends on international investors’ confidence, which, as attested by emerging stock markets’ recoveries, is improving at a steady pace, but is still far from exhausting its potential
* - data for 2010 is calculated for first 3 quarters
** - FCFE = NI – (CapEx - D&A + Increase in non-cash current assets) / ( Equity / Assets )
***- FCFE = CFO + Net borrowing – FCinv.
Disclosure: I am long MBT