Millicom Is Not Attractive At Current Prices

| About: Millicom International (MIICF)

Summary

While mobile data revenues are growing strongly, they are still not sufficient enough to outweigh the voice and SMS revenue declines.

The cable business, while growing, is still a much smaller part of the business than the mobile business.

Most importantly, even if the operational targets can be reached, the stock is currently not offering any material price upside.

Millicom International Cellular (OTCPK:MIICF) is a well-managed company with a market leading position in many of its markets. Operationally, however, it still faces a number of challenges. Most importantly, its current share price is not offering any significant upside from here. I will discuss the operational performance with reference to Millicom's results for the quarter ended March 31, 2016 (Q1 2016).

Operational Overview

Millicom splits its operations into three geographical segments: Central America, South America and Africa. Millicom refers to Central America and South America collectively as Latin America, and the current focus in their quarterly presentations is on the Latam segment. 91% of Q1 2016 revenues came from Latam and 9% from Africa. Product-wise, the company has four segments: mobile, cable, mobile financial services (MFS) and others (primarily equipment).

Turning first to mobile, Millicom -- like most emerging market mobile companies -- is enjoying a growth spurt with respect to smartphone users and data consumption. Millicom's smartphone users increased 48% between Q1 2015 and Q1 2016, while data ARPU (average revenue per user) increased by 11.2% y/y in constant currency terms. The growth in smartphone users and data ARPU led to a 19.5% y/y constant currency increase in Latam mobile data for Q1 2016.

Data growth, however, comes at the expense of Voice and SMS revenues (which still represent 66% of mobile revenues). Voice and SMS revenues declined by 12.8% y/y for Q1 2016. Putting it all together, Latam mobile service revenues declined by 2% y/y in constant currency terms for Q1 2016 (or 9% y/y in reported terms).

Millicom -- like many emerging market mobile companies -- is seeing impressive data growth, but it is coming at the expense of Voice and SMS revenues. Consumer preferences and operators strategic decisions are dictating the pace at which this cannibalization is occurring. The tipping point in terms of data's contribution to revenue growth outweighing Voice and SMS revenue declines is still in the future. As such, we should expect ARPU to continue to decline in the near term. With fully penetrated mobile markets in Latam (as illustrated in the International Telecommunication Union's annual country statistics), the opportunities for mobile subscriber growth are largely limited to taking share from others. I do not expect Millicom to be overly aggressively in seeking subscriber growth in these fully penetrated markets, as this would require increasing subscriber acquisition costs and/or operational costs. With limited subscriber growth and declining ARPU, I expect declining mobile revenues in the near term.

Millicom is expanding its residential Cable footprint in Latam, with the number of homes passed increasing by 547 thousand to 7.7 million at the end of Q1 2016. The number of cable customers increased by 5% y/y for Q1 2016. Unlike in the mobile market, there are opportunities to increase cable customers in Latam due to low broadband and TV penetration, as highlighted in Millicom's Q4 2015 investor presentation. Furthermore, as stated during the Q1 2016 conference call by the CEO, Millicom is, by and large, building new HFC networks to compete with the existing copper based networks in their markets. Residential cable ARPU increased by 10% y/y in constant currency terms for Q1 2016 (a 9% y/y decline in reported terms) as the number of double/triple play bundles increased per household. Residential cable revenue increased by 14% y/y in constant currency terms for Q1 2016 (an 8% decline in reported terms).

With subscriber growth opportunities, pricing power for a new service, and bundling opportunities, I expect continued low double-digit growth in residential cable revenues in constant currency terms before levelling off to mid-single digit growth. The other component of the cable business is the B2B offering where revenues increased by 7% in both constant currency and reported terms in Q1 2016. Again, this is a segment where I expect to see continued growth in the future given it is an under-provisioned segment in many of Millicom's markets.

For Q1 2016, MFS only contributed $8 million to Millicom's Latam service revenues of $1,219 million. This is not a revenue stream I expect the company to add materially to the bottom line in the coming years. Equipment revenues of $90 million are included in the total revenue figure of $1,308 million and fluctuate with the pace of customer acquisitions, but are low margin -- hence the company's focus on service revenues in their investor presentations.

As discussed above, in constant currency terms we had declining mobile revenues (66% of service revenues), increasing cable revenues (30% of service revenues) and negligible Other revenues. This lead to a constant currency revenues increasing by 2.9% for Q1 2016 (an 8% decline in reported terms). These are the trends I expect to continue for FY 2016 and FY 2017, before we see slightly higher constant currency growth rates as the data tipping point is reached.

Millicom does have a significant presence in Africa, with 25 million mobile subscribers across five markets. As highlighted by the ITU statistics, the mobile penetration in Africa is also quite high. With numerous competitors in most markets, it has been a difficult environment for many operators, including Millicom. In FY 2014 and FY 2015, Millicom's African operations saw capex exceed EBITDA by $141 million and $69 million, respectively. Per the Q1 2016 conference call, the company's goal for FY 2016 -- which it achieved in Q1 2016 -- is to get capex below EBITDA.

More generally, Plan A is to maximize cash flow from the Africa segment. The Africa segments financials are included in the overall Group analysis below, but I have not spent too much time on Africa here as it only represents 9% of revenues; it appears that Plan B is an exit from Africa. In April 2016, Millicom completed the sale of its Democratic Republic of Congo operation to Orange. Furthermore, in May, according to a Bloomberg article, "Orange SA started informal talks with Millicom to buy some of the emerging-market focused company's operations in Africa, according to two people familiar with the matter."

Cash Converter

The company increased EBITDA for FY 2015 by 4% to $2,178 million at a margin of 32.4%. Operating cash flow increased by 21% y/y and operating free cash flow increased by 62% y/y to $812 million for FY 2015. It is important to remember that Millicom does not control all of its operations (notably Guatemala, Honduras and Colombia), and that leakage needs to be taken into account in valuation.

Cash Flow, $ millions

FY14

FY15

y/y

Group EBITDA

2,093

2,178

4%

Movements in working capital and others

79

81

3%

Capex (net of disposals, including spectrum and licences)

(1,292)

(1,195)

-7%

Operating Cash Flow

880

1,064

21%

Taxes paid

(380)

(252)

-34%

Operating Free Cash Flow

500

812

62%

Interest paid, net

(331)

(354)

7%

Free Cash Flow

169

458

171%

Dividends to minorities

(300)

(269)

-10%

Equity Free Cash Flow

(131)

189

-244%

Net debt

3,997

4,295

7%

Net debt / LTM reported EBITDA

1.91x

1.97x

Click to enlarge

As highlighted in the Q1 2016 investor presentation, the company's longer-term targets are for high single-digit revenue growth in constant currency terms, a 35% EBITDA margin and capex to sales decreasing toward 15% (from 19%).

For my five-year forecast, I have assumed reported revenue growth of 3.2% CAGR from FY 2015 to FY 2020. I do believe Millicom should be able to raise their EBITDA margin to 35% by 2020, but I do not have capex (including spectrum payments) dipping below 17% by 2020 (in my view, telecom companies continually promise lower capex but rarely deliver). So in all, there's not a huge difference from the company's own aspirations.

Past the five-year forecast horizon, I have assumed that Millicom can earn a return on capital 3% in excess of their cost of capital and that they can grow at a nominal rate of 3%. The assumption of continued excess returns reflects the regulated nature of Millicom's business, the minimum efficient scale require to enter these markets and the network effects that they have built up. Based on these assumptions, I get a present value for the operating assets of $9,869 million. Netting out the $4,419 million in net debt from the Q1 2016 financial report and adding the net deferred tax asset of $138 million on their balance sheet and the value of their associates leads me to a fair value share price of $59.20, or 3.6% upside from Friday's close.

$ millions

PV of Operating Assets

9,869

Less Net Debt

-4,419

Plus Net DTA

138

Plus Associates

350

Equity Value

5,938

Per Share Value

59.2

Share Price 6/24/16

56.00

Upside/(Downside)

5.7%

Click to enlarge

Conclusion

I do not place too much emphasis on point price targets, but rather use them to see whether there is sufficient upside potential (at least 20%) to warrant taking a position. In this instance, there is no margin of safety even from what I would classify as relatively upbeat assessment. On the downside, there is potential for further FX depreciation, the data tipping point is still at an unknown point in the future, investment is continually required in mobile technologies (e.g., LTE networks), and furthermore there is an investigation into potential improper payments at Millicom's Guatemala operation (the company did not provide any update on this situation during the Q1 2016 conference call). In conclusion, Millicom at $56 is not an attractive entry point. I would consider taking another look at this company if the share price were to retreat to $45.

Disclosure: I/we 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.

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