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Cellcom Israel Ltd. (NYSE:CEL)

Q1 2011 Earnings Call

May 16, 2011 10:30 am ET

Executives

Ehud Helft - IR, CCG

Amos Shapira - CEO

Yaacov Heen - CFO

Analysts

David Kaplan - Barclays Capital

Daniel Meron - RBC Capital

Darren Shaw - UBS

Operator

Welcome to the Cellcom Israel Limited first quarter 2011 results conference call. (Operator Instructions) I would now like to hand the call over to Mr. Ehud Helft of CCG Investor Relations.

Ehud Helft

I would like to welcome all of you to the conference call, and thank Cellcom Israel’s management for hosting this call today. With us here are today Mr. Amos Shapira, the CEO; and Mr. Yaacov Heen, the CFO.

Mr. Shapira will open by providing a summary of the main highlights of the first quarter 2011 results, followed by Mr. Heen, who will review the Cellcom Israel’s financial performance in further detail.

Before I turn the call over to Mr. Shapira, I would like to remind our listeners that in this call, management’s prepared remarks contain forward-looking statements which are subject to risks and uncertainties, and management may make additional forward-looking statements in response to your questions. Therefore, the company claims the protection of the Safe Harbor for forward-looking statements that is contained in the Private Securities Litigation Reform Act of 1995 and in the Israeli Securities Law of 1968.

Actual results may differ from those discussed today, and therefore we refer you to a more detailed discussion of the risks and uncertainties in the company’s filings with the Securities and Exchange Commission, including under risk factors in the company’s annual report for the year ended December 31, 2010 20-F filed with the SEC.

In addition, any projections as for the company’s future performance represent management’s estimates as of today, May 16, 2011. Cellcom Israel assumes no obligation to update these projections in the future as market conditions may change. You should have, by now, received a copy of the company’s press release. If you have not yet received so, please call CCG Investor Relations at 1-646-233-2161.

Now, I would like to hand over the call to Mr. Shapira.

Amos Shapira

Thank you, Ehud. Good day everyone, and welcome to our first quarter 2011 earnings conference call. This quarter Cellcom Israel witnessed the initial impact of the regulatory changes. Some of which came into effect at the beginning of the quarter and some during the quarter, overall we presented a slight increase in total revenues and EBITDA. Service revenues decreased by approximately 15% due to the reduction of interconnect fees, our ARPU also decreased for the same reason.

In light of the regulatory changes, which resulted in accelerated competition, leading to a significant increase in company’s gross recruitment of subscribers, we presented a 130% increase in revenues from handsets and accessories. We also presented a 13.5% increase in revenues from content and value added services, and 3.1% increase in operating income.

The regulatory changes not only affected our revenues, but it also increased our operating expenses, mainly in customer service and retention expenses. These effects were offset by our efforts to increase revenues on the one hand and our efficiency measures on the other hand. But also this increase in operating income, our net income decreased by 2.5% due to an increase in financing expenses, which resulting from the increased inflation in the first quarter of this year compared with the first quarter of last year.

Following the regulatory changes, we noted a number of developments. We show a significant increase in the number of customers’ queries to our sales and service centers. We observed a material increase in our gross recruitment of subscribers. And at the same time, we saw a material increase in our churn rate.

As we previously noted, the reduction of early termination fees in calling plans with a time-period commitment led to a decrease of double counted and inactive subscribers in the market. This offset a considerable part of our gross recruitment of new subscribers and caused our net additions to be lower than in previous quarters.

However, we increased our 3G subscriber base by approximately 48,000 net new 3G subscribers reaching 1.188 million subscribers and representing 35% of our total subscriber’s base. Overall, I am pleased with our quarterly results, in light of the changes in the market. However, I also believe that the stabilization process to the new market conditions has not ended yet.

Finally, I would like to touch upon Netvision. Following our previous announcement with regard to a potential merger with Netvision and after Netvision notified us of its decision to enter into negotiations with us in this matter, both companies have begun the negotiations. As previously noted, the transaction is subject to various conditions and there is no assurance that it will be eventually completed.

In closing, we will continue to focus on our core business, while also looking for opportunities that create preparation and synergies. We remain as always committed to providing the best services to our customers. And stock financial result for the benefit of our shareholders. I look forward to talking with you again next quarter.

With that, I would like to turn the call over to our CFO, Mr. Yaacov Heen for a review of our financials.

Yaacov Heen

Thank you, Amos, and good day to all of you. I will now provide more detailed review of our financial. Revenues increased by 0.4%, revenues from handsets increased by 130% and operating income increased by 3.1%. We also raised additional debt, which brought us high demand and attractive interest rate, demonstrating the great trust the capital markets have in us.

This debt was issued under a shelf offering report, after Standard & Poor’s Maalot reaffirmed the ilAA/stable rating of our debentures. I would like to highlight that this debt issuance resulted in the lowest interest rate of the company’s debentures to date.

The regulatory changes, a portion of which came into effect only during the quarter, which led to accelerated competition, affected only part of the first quarter this year. And therefore, during this quarter we saw only part of the impact of these changes. We estimate that the full effects of the reduction of early termination fees and the price erosion on our service revenues and profitability will be seen mainly in the coming quarters.

Furthermore, increased sale of handsets is expected to cause a decrease in our operating cash flow, because we not only pay for the handset suppliers immediately, while we typically get the payments from our customers over 36 months period.

Revenues for the first quarter of 2011 totaled NIS1.6 billion, increasing by 0.4%. This slight increase can be attributed to revenue from handsets, which increased by 130%. While service revenue decreased by 14.8%, totaling NIS1.2 billion. Revenues from content and value added services increased by 13.5% rising up about 24% of our service revenues.

Operating income increased by 3.1%, totaling NIS471 million. While EBITDA increased by 0.2%, totaling NIS639 million. Financing expenses for the first quarter increased from NIS36 million in 2010 to NIS67 million in 2011. This increase resulted mainly from the increased penetration and the increase in the Israel (inaudible) expenses associated with the company’s debentures. This increase was partially offset by a gain from CPI hedging transactions in the first quarter of 2011.

As such, net income decreased by 2.5%, totaling NIS306 million. Turning to our KPI’s, MOU for the first quarter of 2011 totaled 334 minutes compared with 328 minutes in 2010, an increase of 1.8%. ARPU totaled NIS115.2 decreasing by 17.2% year-on-year. As Amos mentioned, this decrease is due to the decrease in interconnect fees.

Free cash flow for the first quarter of 2011 increased by 3.6%, totaling NIS401 million. We have distributed a dividend of approximately NIS291 million, representing approximately 95% of net income for the first quarter to our shareholders. Please be advised that the dividend distribution is not a guarantee and is subject to company’s Board of Directors sole discretion.

With that, I would like to open the call for questions.

Questions-and-Answer Session

Operator

(Operator Instructions) The first question is from David Kaplan of Barclays Capital.

David Kaplan - Barclays Capital

First of all, you talked a little bit about interest rate having an impact on financial results. And with the current CPI continuing to increase over the next couple of quarters, has Cellcom taken any steps in term with derivatives to mitigate that?

Yaacov Heen

In the past we could mitigate this easily because of the hedging structure that we had. But now when we have to buy a (inaudible) the pricing is more or less the same as expectation. So we have a limit hedging possibility. That’s why we expect that the financial expenses will be almost directed to our (divestiture), which most of it is CPI linked, and about total 30% is nominal which is not exposed to the CPI.

David Kaplan - Barclays Capital

And then, just lastly on dividend payout ratio. Given the new competition seen in the market and the resulting NPRs, and the reduction in free cash flow, and net income from that, do you think that there is a possibility that dividend policy will be changed?

Yaacov Heen

Our former dividend policy is 70% of the net income. We distribute usually 95% in every quarter. This quarter we decided to analyze the next quarter. And we believe for the moment that we can continue. But as I mentioned before, every quarter we analyze it again, especially when we have to take care of the new debt that we have. And this is the Board of Director’s decision.

Operator

The next question is from Daniel Meron of RBC Capital.

Daniel Meron - RBC Capital

Amos, given the cuts in the interconnect fees, can you characterize any changes in the dynamics in the marketplace or the customer behavior apart from the increase in the churn. Anything else that we should note here as far as your competitive positioning, do you see more impact on the one set of market players or others? And how should we think about these developments in next several quarters? Are we going to see any ongoing impact on your revenue as the year progresses?

Amos Shapira

Due to what change, due to the termination fee or due to other regulation?

Daniel Meron - RBC Capital

Both, the termination fees and also the easing of the exit contract.

Amos Shapira

As to the termination fee, which took place in the beginning of the year, we anticipated the impact of the termination fee reduction. As to other changes that took place along the quarter, we have told that we haven’t seen the full impact in the first quarter. And we expect to have more impact without being able to say what will be the end result, because this is a dynamic market. So I can’t give you more indication than I gave you in the press release. So sorry to say, but this is the best that we can say. Cellcom is one company in the market without any indication about the same. What I say is that we have all the tools. Yes, we believe that we have all the tools to be competitive in the new environment of the market.

This doesn’t say that we’re not going to be affected by the changes, but we’re updating any measures in order to hold our leading position in the market.

Daniel Meron - RBC Capital

As we go into 2012, you did the reference the potential of the new entrant into the market. Can you provides with some views as you have it right now on the potential impact on the marketplace or is it something that we just have to wait until these guys launch and then you’ll be able to have a sense of what’s the impact on the market?

Amos Shapira

You will have to have the patience and to wait, because I don’t have a crystal ball to say what will be the impact, because it also depends on when and what will be the regulatory entity vis-à-vis the new players. I am talking about the fourth and fifth player.

On one end, I can’t say that these entries will not impact the market. Of course, the market is highly penetrated. I wouldn’t say saturated, but I will say highly penetrated. And then there are these new players. It seems that there will be an impact.

Now, I don’t know that with the entry of the new players that these players will have any advantage over our activities. On the long run, I believe in the power of Cellcom to overcome this period, even though it might be a more competitive period. But this is the nature of things.

I believe that finally it’s up to the management of the company because I want to remind you that five years ago Cellcom was the company number two in the market and now we are number one in the market vis-à-vis the profitability and cash flow and revenue.

And in this period, I also want to indicate that we didn’t create any magic. We don’t have anything that we didn’t have five years ago. The only thing is how the company is managed, how the professional are, processors in the market, in the company, and how we deal with the topline and with our cost.

This is the whole issue. And I believe that this will take place also in the future or no, it makes sense to assume that the environment will be more competitive. But all these things happen.

Daniel Meron - RBC Capital

Yaacov, is there a way to quantify the amount of upgrades we are seeing in the equipment side as far as your subscriber base, basically looking at how sustainable are the levels that you had this quarter on the equipment side and also I guess the rest of the market are, how similar they are throughout 2011?

Yaacov Heen

We didn’t expect this high volume in the handset sales and as the result the revenues. We certainly saw the market become very nervous and more competitive, because the customer can switch form one operator to the other operator. And by the way, they try to change the phone model, not to mention the iPhone 4 and the other smart phones that are now very popular in the market.

And you’re familiar with the Israel market relative to other markets, the early adopter. Mainly the change in the pricing model that happens in this market and you know that now we cannot sell anymore with subsidy, because the customers can switch the day after to another operator. So we have to sell it at least with a fair value.

And that’s why we saw this increase. And we have to keep our customer base. So if see that the level of the services is coming much higher, then we put it to our customer base, and that’s why we (inaudible 8, 0.06). I can not predict about the future. Generally, we prefer to keep it in economic rate that we can see return on this investment of especially the smart phone, they are very expensive.

And even though the revenue we recognize, it’s immediate, but there is an indirect subsidy. So finally, the impact is on the ARPU in the next quarter.

Operator

(Operator Instructions) The next question is from Darren Shaw of UBS.

Darren Shaw - UBS

I just wondered if you can give us a guide on the intense competition you’ve seen in the market since the February change of regulation, whether it’s got tougher or softer in April and May. Have we seen the worst part of it over now or is it getting worse?

Amos Shapira

When it comes to regulation, I never give prediction. But to my best knowledge, I am not aware of any change. In the coming two months, yes, in regulation, but as I said before, we should see the remaining steps of the regulatory changes that took place in the first quarter in the quarters to come. So I can’t say more than this.

Darren Shaw – UBS

There are very attractive deals in the marketplace, iPhones and another smartphones. Has it got better or worse? Have the best deals disappeared off the market or are other deals getting more favorable for the customer or has the intense pressure subsided?

Amos Shapiro

I can’t give you a specific answer on this. I can’t give you more than what I said.

Darren Shaw – UBS

In terms of SMS, we saw in Europe and KPN that customers were moving away from SMS, people moving from SMS into data. Are you always seeing similar trends happening in Israel?

Amos Shapira

Yes, we can say that we can see the decrease in the growth rate of SMS. We see this phenomenon also in Israel.

Operator

There are no further questions at this time. Mr. Shapira, would you like to make your concluding statement?

Amos Shapira

Thank you, everybody, for joining Cellcom Israel’s first quarter 2011 earnings conference call. I look forward to hosting you again at our next call. Good day.

Operator

Thank you, sir. This concludes the Cellcom Israel Limited’s first quarter 2011 results conference call. Thank you all for your participation. You may go ahead and disconnect.

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